7 tax issues investment companies should track in 2016
2016 brings a variety of tax changes for investment companies
Investment companies must track a number of tax changes in 2016. Following is a recap of seven key tax issues.
- New filing deadlines. Corporations, trusts and partnerships all used to have concurrent filing deadlines, which caused a significant compliance headache. For tax years after 2015, that had changed. Partnership tax forms will be due on the 15th day of the third month after year-end and C corporation forms will be due on the 15th day of the fourth month after year-end. S corporations and trusts filing dates are unchanged, but trusts will have two weeks added to their extension. These changes mean that partnership forms are due one month earlier than under the previous rules, but separating the due dates of partnerships and C corporations should ease filing headaches for many organizations.
- Re-characterization of profit allocations. The IRS is cracking down on profit allocations made as part of a management fee waiver and whether they should be treated as a true allocation, which is taxed as long-term capital gain, or re-characterized as a fee to the manager, which would be taxed as ordinary income. The IRS is looking for significant entrepreneurial risk (SER) to justify treatment as an allocation. If the manager is entitled to net profits instead of gross income and if the allocation lasts for the life of the partnership, a strong case can be made for SER. Capped allocations or allocations of gross income argue against SER.
- Basket contracts. The IRS is concerned that basket contracts and basket option contracts are used to lower or avoid taxes. Under these contracts, instead of owning the securities or investment in another fund outright, the contract owner has the ability to determine which securities or funds were bought and sold on an ongoing basis while they owned the option. Tax notices 2015-47 and 2015-48 now make such contracts reportable transactions. Failure to report these transactions to the IRS can lead to a penalty of $10,000 or more.
- Transfers to foreign partnerships with related parties. Notice 2015-54 indicates that the IRS will issue regulations under IRC section 771(c) that will require gain recognition when certain property is transferred to a foreign partnership that has foreign partners that are related to the U.S. transferor.
- The proposed Partnership Audit Simplification Act of 2015 (PASA). PASA would effectively revoke the Tax Equity Fiscal Responsibility Act (TEFRA), which required that the IRS push down any adjustments until they reached the final tax paying or exempt investor. In many situations, that required going through multiple layers of pass-through entities before reaching the taxable or tax-exempt investor. Many IRS agents found TEFRA cumbersome, which was holding down the audit rate for partnerships. PASA would bind partners to the elections made by the designated representative of the partnership and create joint and several liability among the partners. This could create a burden for “the last partner standing,” who would inherit the liability for tax due despite the fact that partners who had previously left the partnership would have received previous tax benefits.
- Carried interest. Tax treatment of carried interest has been a regular talking point among presidential candidates, including Donald Trump and Jeb Bush. While there is no pending or proposed legislation, a tax on carried interest has been a recurring issue and could result in tax revenues of as much as $17.7 billion over the next 10 years.
- State tax sourcing of hedge fund management fees. Hedge fund managers will need to carefully consider the state tax implications related to management fees. In the past, these were sourced according to physical presence for state tax purposes. Under market-based sourcing, a fairly new method, they are sourced to the state where the benefit of the service is received and intangibles are used instead of focusing on where costs are incurred.