Year-end tax issues and recent developments for hedge funds to consider
Year-to-date (YTD) trading activities
It's that time of year when prudent fund managers like you compare their tax picture to an economic picture. Many analyze or should analyze YTD trading activities to identify where you should:
- Evaluate any unrealized losses to see if there are any positions that could be disposed of in order to recognize those losses. Don't forget about the prior year tax adjustments that might increase your tax loss when disposing of a security.
- Identify wash sales. It's too late to double down on securities to avoid wash sales, but there are other strategies that can be utilized to recognize losses and avoid wash sales.
- Cover shorts with unrealized losses early enough so that they settle prior to year-end, or consider covering them with cash so that they settle prior to year-end. You cannot deduct losses on shorts that settle after year-end but you must recognize gains on shorts that settle after year-end.
- Consider the constructive sale rules that require you to recognize a gain if you own offsetting positions in the same security that have locked in appreciation. There are ways to undo the constructive sales (subject to some traps for the unwary) and avoid recognizing gains
- Evaluate the impact that the straddle rules may have on your fund since those could result in deferral of losses.
Given the aggregate methodology that is widely used in allocating gains and losses in hedge funds you might be surprised that the losses that the fund recognized will not be allocated to the partners you intended them to be allocated to (i.e., partners who are in the fund for many years or partners with large capital balances). Therefore, evaluate the aggregate account balances in order to ensure the fund allocates the benefit of the losses to the appropriate partners.
General concerns on trading swaps and recent developments on swaps
Investors in funds treated as "investor" funds (versus "trader" funds) have limitations on the amount of deductions they can deduct on their personal tax return. When a fund owns swaps that have decreased in value and those swaps are marked to market at the end of the year, the loss will be subject to the same limitations as other itemized deductions. They are subject to the 2 percent of AGI limitation. If you have swaps with unrealized loss that are marked to market, consider terminating the swap early thereby creating a capital loss rather than an itemized deduction.
The IRS issued proposed regulations on Sept. 16, 2011 that would include both credit default swaps and bullet swaps, those that have only one payment at the end of the contract, in the definition of notional principal contracts. If the regulations are enacted, these will be treated the same as swaps with periodic payments and not treated as capital assets eligible for any favorable capital gain treatment.
Income from offshore funds
If you have deferred income yet to be recognized or are looking to maximize income to be received in the future, there are several things which need to be evaluated - many of which are time sensitive. Here are some considerations to help you with your analysis:
- Last chance to defer income earned in the offshore fund prior to 2009
Taxpayers who earned incentives in an offshore fund prior to 2009 and elected to defer recognizing the income to Dec. 31, 2012 or Jan. 1, 2013, will now have one last chance to re-defer the recognition of income and to include it in the tax return for the year ending Dec. 31, 2017. Internal Revenue Code ("IRC") section 457A provides that after 2008 a taxpayer cannot defer income from an offshore corporation. However, if the income was earned prior to 2009 and the taxpayer elected to defer the income then the taxpayer must recognize the income by the end of 2017. IRC section 409A provides that if you make an election to defer income then the deferral cannot take effect until 12 months after the election. Additionally, code section 409A requires that the income be deferred for a period of not less than five years. An election before Dec. 31, 2011, is the last chance to elect to re-defer the income through the end of 2017.
- Offshore deferral arrangements to include income post 2018 should be amended
Pre-2009 deferral arrangements with offshore hedge funds should be amended by the end of 2011 (Dec. 31, 2011) to pay out all amounts by the last day of the last tax year of the fund starting before 2018. This will enable you to receive the deferral when the tax is actually due on the deferral, rather than be bound by the payment terms of an existing agreement.
- Spreading out the recognition of deferred income
While some investment managers may prefer to leave their money in the offshore fund, concern about future tax rate increases may encourage them to consider paying taxes on the income that was deferred previously. If you are cash basis, consider converting to the accrual method (we can assist you with this change in accounting method requiring approval) and electing IRC section 481, which would spread the income equally over a period of four years.
Future recognition of offshore income
- Consider restructuring so that current ordinary Income from incentive fees from offshore funds is converted to favorable allocations; retain their character
As noted previously, taxpayers were able to defer the recognition of income on the incentive that they earned from offshore funds only until Jan. 1, 2009. These fees are taxed as ordinary income subject to a highest rate of tax, currently 35 percent. Since the general partner cannot defer the recognition of income anymore it might make sense to consider restructuring into what is called a mini-master. In this structure the trades are done in an offshore entity that is treated as a partnership and the general partner (GP) and the offshore corporations are both partners in the foreign partnership, where the GP earns the incentive as a reallocation from the partnership. Long-term capital gain treatment is available and appreciation is not taxed until realized. Many funds hesitated to restructure because it seemed that the change in the rules for carried interest was imminent and that Congress was going to tax the incentive as ordinary income. Even though carried interest keeps regularly surfacing as a potential revenue raiser, it continues to look unlikely that Congress will change the way carried interest is taxed in the near future
Other important consideration
- Consider accelerating taxable income to 2012
In 2013 there will be a new 3.8 percent tax on unearned income for individual taxpayers with income (AGI) higher than $200,000 and for married taxpayers with income (AGI) higher than $250,000. Unearned income includes interest, dividends, capital gains, rents, royalties and income from partnerships and S corporations. With congress constantly seeking to raise revenue there might be other tax increases in the near future. Taxpayers should consider liquidating investments and recognize income in 2012 rather than incur this additional tax. The funds can then be reinvested, avoiding this incremental tax burden.
- You have until April 16, 2012 to review and modify partnership agreements for 2011
A prudent general partner should always review the partnership agreement. With a greater emphasis on redemptions, ascertain that it contains a stuffing (fill-up or fill-down) provision. This provision allows the general partner to specially allocate gains or losses to withdrawing partners in an amount up to their unrealized gains or losses respectively. Such a provision should be clear and unambiguous. Generally, it provides that the general partner has discretion to allocate "gross" gains or "gross" losses to the withdrawing partners. There are a lot of partnership agreements that have the stuffing provision that are vague or apply it to only gains (gross or net) but not losses. The agreement should provide for both. You may also want to consider a broader provision which would address the situation where there are not enough gains or losses to stuff the withdrawing partners. Under IRC section761(c) the partnership agreement can be amended until the original due date of the return.
- Form 8938, Statement of Specified Foreign Financial Assets
Congress enacted IRC section 6038D due to the highly publicized cases of tax evasion involving assets held in foreign banks. This will generally require certain individuals with assets above $50,000 in these accounts to file this form, currently issued as a draft, with certain information about those accounts. To ensure compliance the penalty for not filing this form is $10,000, rising to $50,000 for continued failure after 90 days of IRS notification. Currently, partnerships are not required to file Form 8938, but the IRS anticipates issuing guidance that will require partnerships to be required to file this form as well. So as to not overburden individuals and the Service, certain persons who file other forms with regards to foreign accounts will be exempted from this requirement. In its current form, however, it specifically overlaps the Form TD 90-22.1 (FBAR) and individuals in certain situations will have to file both forms unless the IRS comes out with additional guidance.
The experienced tax advisors at RSM remain available to assist you in implementing tax efficient year-end planning. Please consult with your RSM professional or call 800.274.3978.
Yaakov Tambor, CPA, MST, Tax Sr. Manager, RSM US LLP.