Investment Management

Investment managers face different tax issues from retail traders.

Investment management is when you trade money belonging to investors. As you can imagine, handling other people’s money is serious business, therefore there is a huge body of investor-protection law and regulation on securities, commodities and forex. The investment manager may need various licenses and to register with the regulator in charge. 

Managed accounts vs. hedge fund

Investment managers handle two types of investors: separately managed accounts (SMAs) and hedge funds (or commodity or forex pools). In an SMA, the client maintains a retail customer account, granting trading power to the investment manager. In a hedge fund, the investor pools his money for an equity interest in the fund, receiving an annual Schedule K-1 for his allocation of income and expense. It’s different with offshore hedge funds.

There are important differences in tax treatment. SMAs cannot claim trader tax status (TTS) because the investment manager is responsible for the trading, not the investor. (The investment manager also doesn’t have TTS, but they have business treatment from providing investment management services.) Without TTS, the investor can’t elect and use Section 475 MTM. 

With a hedge fund structure, the investment manager is generally an owner/trader of the fund, and brings TTS to the entity level. That unlocks other tax breaks like Section 475, too. Additionally, as an owner of the hedge fund, the investment manager can be paid a profit allocation — otherwise known as carried interest — in lieu of an incentive advisory fee. The profit allocation has tax advantages like reporting a share of capital gains rather than ordinary income also subject to payroll taxes (FICA and Medicare). In an SMA, the investor deals with accounting (including complex trade accounting on securities), not the investment manager. In a hedge fund, the investment manager is responsible for complex investor-level accounting and the fund sends investors a Schedule K-1 that is easy to input to tax returns.

Carried interest tax break

The carried-interest tax break can be used in hedge funds, but it cannot be used in separately managed accounts (SMAs). If carried interest provisions are included in the fund’s operating agreement and PPM, the general partner investor is allocated a partnership K-1 share of each item of income — let’s say 20% — in lieu of the fund paying an outside advisor an incentive fee. Generally, the general partner and investors receive tax breaks in connection with carried interest. The advisor receives a share of lower tax rates on 60/40 or long-term capital gains, and the investor avoids investment expense treatment, which often is disallowed for AMT or doesn’t exceed the 2% of AGI limitation for miscellaneous itemized deductions.

Carried interest remains high on the list of “tax loopholes” facing repeal in discussions for tax reform. I have written many blog posts and articles defending it. Carried interest can be arranged in offshore funds with a mini-master fund structure. There are other nuances in connection with self-employment tax and the Obamacare 3.8% Medicare tax on unearned income (investment income).

Carried interest helps investors and investment managers and repealing this long-standing partnership tax law could hurt growth and investments. Corporate executives receive stock as part of compensation and they enjoy long-term capital gains rates on that stock, so why single out the investment management industry?

An S-Corp can reduce self-employment or payroll tax

Although investment managers can’t use profit-allocation clauses on SMAs, they can at least use the S-Corp SE tax reduction break. This could become even more important if carried-interest is repealed because incentive fees would be classified as earned income (rather than profit allocation of trading gains). Managed accounts pay advisory fees, which include management and incentive fees, whereas funds using profit allocation clauses only pay management fees.

In an LLC management company filing a partnership tax return, earned income passes through to the LLC owners as SEI subject to SE tax, unless an owner is passive.

Investment managers can only use profit allocation with investment funds because only partners can share special allocations of underlying income. Special allocations are permitted and useful on fund partnership tax filings, but not with S-Corp tax returns, since special allocations reverse (taint) S-Corp elections. The IRS only allows S-Corps to have one class of stock and they insist on equal ownership treatment.

That makes S-Corp elections a wise choice for management companies focused on reducing the SE tax on underlying advisory fee earned income. Conversely, partnership tax returns are a better choice for investment funds focused on carried-interest tax breaks using special allocations, plus there is generally no underlying income subject to the SE tax, anyway…. (See all the details in the below guide.)

For more in-depth information on investment management, read Green’s 2017 Trader Tax Guide.

Consider our investment management services.