Year-end has always been a time for tax planning and we send our clients our year-end tax planning newsletter on an annual basis. Tax planning for this year-end, however, is even more important (and more complex and more uncertain) because of the proposed tax changes. The proposed tax legislation is extremely complex and introduces new classes of income with different rates and changes many tax provisions. The proposed tax legislation is also being enacted very close to year-end which makes year-end tax planning difficult to determine and implement.
This newsletter briefly highlights certain tax issues and planning that hedge fund managers should consider (or reconsider) before year-end. Some planning may need to wait until 2018 and some planning may be able to be done retroactively. Lastly, there will be a number of glitches and mistakes in the new law which may provide tax opportunities as well as the potential for tax pitfalls.
HEDGE FUND PRINCIPALS AND EMPLOYEES
1. State and local income and property taxes. The tax changes propose to disallow deductions for non-business state and local taxes for taxes paid after 2017. Individuals should generally pay 2017 state and local income and property taxes prior to year-end. They need to remember to take into account the alternative minimum tax (AMT) in making this determination. One is issue which is being considered is the ability to prepay 2018 taxes and get a deduction in 2017 and, if so, how to make such payments. There seems to be a difference of opinion among tax professionals and this may not work.
2. Miscellaneous itemized deductions. Individuals might also prefer to prepay miscellaneous itemized deductions this year, since those expenses may not be deductible in 2018.
3. Realize gains and defer losses. Since the ability to deduct state and local taxes is going away in 2018, it might be preferable to realize gains this year and defer losses so that your income is higher in 2017 and thus your state and local taxes are higher in 2017. In determining this, AMT needs to be taken into account. Also, you need to weigh when the gains would otherwise have been recognized and that recognition in 2017 would start a new holding period for the shares if you buy the shares again. There are no wash sale rules for gains. There is the potential to constructively realize gains and undo them by January 30 of next year if it is decided not to realize the gains in 2017. For losses, you can potentially build in a collar in order to not change the economics substantially.
4. Receive bonuses in 2017. In line with accelerating gains into 2017 in order to increase 2017 income and pay state and local taxes while they are still deductible, one might prefer to have their bonuses received in 2017. Obviously, as with all the other potential tax planning ideas discussed herein, there are non-tax considerations that need to be taken into account.
5. Consider moving to another jurisdiction. One consideration is whether to move to another locality, state or even country. With an effective rate increasing from around 52% to around 57% and potentially on more income, some taxpayers might consider moving to a low- or no-tax jurisdiction. The proposed legislation does not adopt changes to taxing U.S. citizens on worldwide income, however. Puerto Rico could still work to reduce taxes substantially. What it means to move and the benefits of moving need to be evaluated.
6. Deferred fees — tax planning. At least this is no longer a concern… Paying state and local taxes and making any charitable contributions or implementing any other tax ideas need to be done if they have not already been done.
7. State and local tax-free trusts. Consider the use of state and local tax-free trusts. New York tax rules were changed in 2014 but there are still potential significant benefits and these have become even more beneficial due to the limitations on deducting state and local taxes.
8. Investing in PFICs. Investing in a PFIC may be a way to address miscellaneous itemized deduction concerns (if the fund you are investing in is an investor for tax purposes) and may be a way to minimize state and local taxes.
9. Invest in a reinsurance company. Investing in an offshore reinsurance company may be a way to defer taxes and change the character of taxes on sale. The proposed laws have many changes affecting insurance companies which might need to be taken into account.
HEDGE FUND MANAGEMENT COMPANIES
10. Consider moving to another jurisdiction. This could reduce state and local taxes either at the management company level or at the principal level. (See #5 above.)
11. Consider changing the type of management companies. How do the new pass-through rules affect your management companies? Is it better to be an S corporation or a C corporation? The introduction of changes to how pass-through income is taxed is one of the most significant changes in the new proposals. Some planning may be able to be done retroactively.
12. Planning for the changes to the carried interest. The 3 year rule would substantially affect hedge fund managers, since many do not have significant holdings that last for more than 3 years. What needs to or should be done now by the general partner? Should the general partner realize all of its unrealized? Withdraw most of its interest in the fund? How?
13. Consider changing the carried interest allocation to a fee. This might be beneficial to a fund’s investors and not be that detrimental to the manager. Is your fund an investor for tax purposes? Does your fund have significant qualified dividend income or other beneficial income that still might flow through in the carry? Does your fund have significant unrealized income generally?
14. Consider the use of stock-settled stock appreciation rights. If a substantial portion of the carried interest will now be taxable as short-term capital gains, should you consider the use of stock appreciation rights (SARs). SARS allow the deferral of income but there is a built-in clawback, they are very complex and no, or very few, funds have actually implemented SARs. There are a number of issues regarding the use of SARs and it might take a significant amount of time to implement a SARs plan.
15. Consider making a Section 475(f) election. Will a Section 475(f) election enable your investors to take advantage of the new pass-through rules? A Section 475 election may offer other tax benefits as well. Please click here to see our prior newsletter on making (or revoking) a Section 475 election.
16. Will the proposed FIFO rules require tax planning before year-end? The proposed rules would implement a first-in first-out regime for the sale of securities. How would this be done? Account by account basis? This change will supposedly not be enacted, fortunately.
17. Impact on investments. How will the new proposals affect the values of certain investments? There are changes to NOLs, the deductibility of interest expense, what is a CFC US shareholder, how and when foreign income is taxed, etc. Many of these could affect how certain investments are valued.
18. Re-evaluate going over the 25% benefit plan investor (“BPI”) threshold; Consider hard-wiring. With the influx of pension plan investments in hedge funds, the ability to exceed the 25% BPI test has become even more important. There are still some uncertainties in what happens when you exceed 25% BPI, but exceeding 25% may be worthwhile and offer substantial opportunities to grow your fund. One trend for funds in a master-feeder structure continues to be to hard-wire the feeder funds so that they must invest all investable assets in the master fund. This potentially causes the impact of ERISA to mostly be at the master fund level and increases the total that may be invested by BPIs without triggering many of the potentially negative implications of ERISA.
19. New DOL advice fiduciary rules. New advice fiduciary rules generally went into effect on June 9, 2017. Fund documents need to be updated for these rules and managers generally have required certain representations to allow ERISA and IRA investors to invest in their funds.
20. New partnership audit rules. New partnership audit rules were enacted in 2015 and are effective for audits of taxable years beginning after December 31, 2017. Your fund documents and your management company documents should be updated for the rules if they have not been updated already. These rules are significantly different than the current audit rules which were enacted in 1982. Partnerships can expect the new rules to result in more IRS audits and more taxes asserted and collected on audit. Fund documents need certain disclosures regarding the new rules and the ability to require partners, including former partners, take certain actions.