August 2018

New Tax Law Favors Hedge Funds Over Managed Accounts

August 28, 2018 | By: Robert A. Green, CPA | Read it on

Hedge fund investors benefited from tax advantages over separately managed accounts (SMA) for many years. The 2017 Tax Cuts and Jobs Act (TCJA) widened the difference by suspending all miscellaneous itemized deductions, including investment fees. SMA investors are out of luck, but hedge fund investors can limit the negative impact using carried-interest tax breaks. TCJA provided a new 20% deduction on qualified business income, which certain hedge fund investors might be eligible for if they are under income caps for a service business.

TCJA penalizes investors with separately managed accounts
SMA investors cannot claim trader tax status (TTS) since an outside manager conducts the trading, not the investor. Therefore, investment expense treatment applies for advisory fees paid.

Beginning in 2018, TCJA suspended all miscellaneous itemized deductions for individuals, which includes investment fees and expenses. If a manager charges a 2% management fee and a 20% incentive fee, an individual may no longer deduct those investment fees for income tax purposes. Before 2018, the IRS allowed miscellaneous itemized deductions greater than 2% of AGI, but no deduction was allowed for alternative minimum tax (AMT); plus, there was a Pease itemized deduction limitation. (Taxpayers are still entitled to deduct investment fees and expenses for calculating net investment income for the Net Investment Tax.)

For example: Assume an SMA investor has net capital gains of $110,000 in 2018. Advisory fees are $30,000, comprised of $10,000 in management fees and $20,000 in incentive fees. Net cash flow on the SMA for the investor is $80,000 ($110,000 income minus $30,000 fees). The SMA investor owes income tax on $110,000 since TCJA suspended the miscellaneous itemized deduction for investment fees and expenses. If the individual’s federal and state marginal tax rates are 40%, the tax hike might be as high as $12,000 ($30,000 x 40%). (See Investment Fees Are Not Deductible But Borrow Fees Are.)

Investment managers do okay with SMAs
In the previous example, the investment manager reports service business revenues of $30,000. Net income after deducting business expenses is subject to ordinary tax rates.

An investment manager for an SMA is not eligible for a carried-interest share in long-term capital gains, or 60/40 rates on Section 1256 contracts, which have lower tax rates vs. ordinary income. Only hedge fund managers as owners of the investment fund may receive carried interest, a profit allocation of capital gains and portfolio income.

Additionally, if the manager is an LLC filing a partnership tax return, net income is considered self-employment income subject to SE taxes (FICA and Medicare). If the LLC has S-Corp treatment, it should have a reasonable compensation, which is subject to payroll tax (FICA and Medicare).

Hedge funds provide tax advantages to investors
Carried interest helps investors and investment managers. Rather than charge an incentive fee, the investment manager, acting as a partner in the hedge fund, is paid a special allocation (“profit allocation”) of capital gains, Section 475 ordinary income, and other income.

Let’s turn the earlier example into a hedge fund scenario. The hedge fund initially allocates net capital gains of $110,000, and $10,000 of management fees to the investor on a preliminary Schedule K-1. Next, a profit allocation clause carves out 20% of capital gains ($20,000) from the investor’s K-1 and credits it to the investment manager’s K-1. The final investor K-1 has $90,000 of capital gains and an investment expense of $10,000, which is suspended as an itemized deduction on the investor’s individual tax return. Carried interest helps the investor by turning a non-deductible incentive fee of $20,000 into a reduced capital gain of $20,000. Carried interest is imperative for investors in a hedge fund that is not eligible for TTS business expense treatment. With a 40% federal and state tax rate, the tax savings on using the profit allocation instead of an incentive fee is $8,000 ($20,000 x 40%). To improve tax savings for investors, hedge fund managers might reduce management fees and increase incentive allocations.

TCJA modified carried interest rules for managers
Hedge fund managers must now hold an underlying position in the fund for three tax years to benefit from long-term capital gains allocated through profit allocation (carried interest). The regular holding period for long-term capital gains is one year. I’m glad Congress did not outright repeal carried interest, as that would have unduly penalized investors. The rule change trims the benefits for managers and safeguards the benefits for investors. The three-year holding period does not relate to Section 1256 contracts with lower 60/40 capital gains rates, where 60% is a long-term capital gain, and 40% is short-term.

Trader tax status and Section 475 tax advantages
If a hedge fund qualifies for TTS, then it allocates deductible business expenses to investors, not suspended investment expenses. I expect many hedge funds will still use a profit allocation clause since it might bring tax advantages to the investment manager — a share of long-term capital gains, and a reduction of payroll taxes on earned income vs. not owing payroll taxes on short-term capital gains.

TCJA 20% QBI deduction on pass-through entities
The TCJA included a lucrative new tax cut for pass-through entities. An individual taxpayer may deduct whichever is lower: either 20% of qualified business income (QBI) from pass-through entities or 20% of their taxable income minus net capital gains, subject to other limitations, too. (Other QBI includes qualified real estate investment trust REIT dividends and qualified publicly traded partnership PTP income.)

The proposed QBI regulations confirm that traders eligible for TTS are considered a service business (SSTB). Upper-income SSTB owners won’t get a deduction on QBI if their taxable income (TI) exceeds the income cap of $415,000/$207,500 (married/other taxpayers). The phase-out range is $100,000/$50,000 (married/other taxpayers) below the income cap, in which the QBI deduction phases out for SSTBs. The W-2 wage and property basis limitations apply within the phase-out range, too.

Hedge funds with TTS are an SSTB if the fund is trading for its account through an investment manager partner. A hedge fund with TTS is entitled to elect Section 475 ordinary income or loss. Hedge fund QBI likely includes Section 475 ordinary income. QBI excludes all capital gains, commodities and forex transactions, dividends, and interest. The SSTB taxable income thresholds and cap apply to each investor in the hedge fund; some may get a QBI deduction, whereas, others may not, depending on their TI, QBI aggregation, and more. (See How Traders Can Get 20% QBI Deduction Under IRS Proposed Regulations.)

The proposed QBI regulations also describe investing and investment management as an SSTB. QBI includes advisory fee revenues for investment managers earned from U.S. clients, but not foreign clients. QBI must be from domestic sources. I presume QBI should exclude a carried-interest share (profit allocation) of capital gains but will include a carried-interest percentage of Section 475 ordinary income.

TCJA might impact the investment management industry
Many investors are upset about losing a tax deduction for investment fees and expenses. Some just realized it. I recently received an email from an investor complaining to me about TCJA’s suspension of investment fees and expenses. He was about to sign an agreement with an investment manager for an SMA but scrapped the deal after learning he could not deduct investment fees. Most hedge funds only work with larger accounts and adhere to rules for accredited investors and qualified clients who can pay performance fees or profit allocations.

Larger family offices may have a workaround for using business expense treatment without TTS, as I address on my blog post How To Avoid IRS Challenge On Your Family Office.

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.

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 complicated investor-level accounting, and the fund sends investors a Schedule K-1 that is easy to input to tax returns.

There are several other issues to consider with SMAs vs. hedge funds; tax treatment is just one critical element. “SMAs provide transparency, and this is important to many clients, particularly tax-exempts or fiduciary accounts,” says NYC tax attorney Roger D. Lorence.

Roger D. Lorence contributed to this blog post.

 


How Traders Can Get 20% QBI Deduction Under IRS Proposed Regulations

August 15, 2018 | By: Robert A. Green, CPA | Read it on

The IRS recently released proposed reliance regulations (Proposed §1.199A) for the 2017 Tax Cuts and Jobs Act’s new 20% deduction on qualified business income (QBI) in pass-through entities.

The proposed regulations confirm that traders eligible for trader tax status (TTS) are a service business (SSTB). Upper-income SSTB owners won’t get a deduction on QBI if their taxable income (TI) exceeds the income cap of $415,000 married, and $207,500 for other taxpayers. The phase-out range is $100,000/$50,000 (married/other taxpayers) below the income cap, in which the QBI deduction phases out for SSTBs. The W-2 wage and property basis limitations apply within the phase-out range, too. Hedge funds eligible for TTS and investment managers are also SSTBs.

The new law favors non-service business (non-SSTB), which don’t have an income cap, but do have the W-2 wage and property basis limitations above the TI threshold of $315,000/$157,500 (married/other taxpayers). The 2018 TI income cap, phase-out range, and threshold will be adjusted for inflation in each subsequent year.

A critical question for traders
The proposed regulations do not answer this essential question: What types of trading income are included in QBI? The proposed regulations define a trading business, so I presume tax writers contemplated some types of ordinary income might be included in QBI. They probably wanted to limit tax benefits for traders by classifying trading as an SSTB subject to the income cap.

In my Jan. 12, 2018 blog post, How Traders Can Get The 20% QBI Deduction Under New Law, I explained how the statute excluded certain “investment-related” items from QBI, including capital gains, dividends, interest, annuities and foreign currency transactions. That left the door open for including Section 475 ordinary income for trading businesses. After reading the proposed regulations, I feel that door is still open.

Trading is a service business
See the proposed regulations, REG-107892-18, page 67. The Act just listed the word “trading,” whereas, the proposed regulations describe trading in detail and cite TTS court cases.

“b. Trading: Proposed §1.199A-5(b)(2)(xii) provides that any trade or business involving the “performance of services that consist of trading” means a trade or business of trading in securities, commodities, or partnership interests. Whether a person is a trader is determined taking into account the relevant facts and circumstances. Factors that have been considered relevant to determining whether a person is a trader include the source and type of profit generally sought from engaging in the activity regardless of whether the activity is being provided on behalf of customers or for a taxpayer’s own account. See Endicott v. Commissioner, T.C. Memo 2013-199; Nelson v. Commissioner, T.C. Memo 2013-259, King v. Commissioner, 89 T.C. 445 (1987). A person that is a trader under these principles will be treated as performing the services of trading for purposes of section 199A(d)(2)(B).”

QBI excludes certain items
See REG-107892-18, page 30: “Section 199A(c)(3)(B) provides a list of items that are not taken into account as qualified items of income, gain, deduction, and loss, including capital gain or loss, dividends, interest income other than interest income properly allocable to a trade or business, amounts received from an annuity other than in connection with a trade or business, certain items described in section 954, and items of deduction or loss properly allocable to these items.”

See REG-107892-18, page 144: “Items not taken into account” in calculating QBI. Here’s an excerpt of the list.

 “(A) Any item of short-term capital gain, short-term capital loss, long-term capital gain, long-term capital loss, including any item treated as one of such items, such as gains or losses under section 1231 which are treated as capital gains or losses.

(B) Any dividend, income equivalent to a dividend, or payment in lieu of dividends.

(C) Any interest income other than interest income which is properly allocable to a trade or business. For purposes of section 199A and this section, interest income attributable to an investment of working capital, reserves, or similar accounts is not properly allocable to a trade or business.

(D) Any item of gain or loss described in section 954(c)(1)(C) (transactions in commodities) or section 954(c)(1)(D) (excess foreign currency gains) applied in each case by substituting “trade or business” for “controlled foreign corporation.”

(E) Any item of income, gain, deduction, or loss taken into account under section 954(c)(1)(F) (income from notional principal contracts) determined without regard to section 954(c)(1)(F)(ii) and other than items attributable to notional principal contracts entered into in transactions qualifying under section 1221(a)(7).

(F) Any amount received from an annuity which is not received in connection with the trade or business.”

Section 954 is for “foreign base company income,” and tax writers used it for convenience sake to define excluded items including transactions in commodities, foreign currencies (forex) and notional principal contracts (swaps). The latter two have ordinary income, but they are excluded from QBI.

Section 475 ordinary income
The new tax law excluded specific “investment-related” items from QBI. In earlier blog posts, I wondered if QBI might include “business-related” capital gains. The proposed regulations dropped the term “investment-related,” which seems to close that door of possibility.

I searched the QBI proposed regulations for “475,” and there were 20 results, and each instance defined securities or commodities using terminology in Section 475. None of the search results discussed 475 ordinary income and its impact on QBI. The proposed regulations seem to allow the inclusion of Section 475 ordinary income in QBI.

TTS traders are entitled to elect Section 475 on securities and/or commodities (including Section 1256 contracts). For existing taxpayers, a 2018 Section 475 election filing with the IRS was due by March 15, 2018, for partnerships and S-Corps, and by April 17, 2018, for individuals. New taxpayers (i.e., a new entity) may elect Section 475 internally within 75 days of inception. Section 475 is tax loss insurance: Exempting 475 trades from wash sale losses on securities and the $3,000 capital loss limitation. With the new tax law, there’s now likely a tax benefit on 475 income with the QBI deduction.

Section 1231 ordinary income
See REG-107892-18, page 37: “Exclusion from QBI for certain items.”

“a. Treatment of section 1231 gains and losses. (Excerpt)
Specifically, if gain or loss is treated as capital gain or loss under section 1231, it is not QBI. Conversely, if section 1231 provides that gains or losses are not treated as gains and losses from sales or exchanges of capital assets, section 199A(c)(3)(B)(i) does not apply and thus, the gains or losses must be included in QBI (provided all other requirements are met).”

If you overlay Section 475 on top of the above wording for Section 1231, there is a similar result: Section 475 ordinary income is not from the sale of a capital asset, and it should be included in QBI since it’s not expressly excluded.

Section 1231 is depreciable business or real property used for at least a year. A net Section 1231 loss is reported on Form 4797 Part II ordinary income or loss. Section 475 ordinary income or loss for TTS traders is reported on Form 4797 Part II, too. A net Section 1231 gain is a long-term capital gain.

Section 64 defines ordinary income
“The term ordinary income includes any gain from the sale or exchange of property which is neither a capital asset nor property described in section 1231(b). Any gain from the sale or exchange of property which is treated or considered, under other provisions of this subtitle, as ordinary income shall be treated as gain from the sale or exchange of property which is neither a capital asset nor property described in section 1231(b).”

The tax code does not define business income.

TTS traders with 475 ordinary income
A TTS trader, filing single, has QBI of $100,000 from Section 475 ordinary income, and his taxable income minus net capital gains is $80,000. He is under the TI threshold of $157,500 for single, so there is no phase-out of the deduction, and W-2 wage or property basis limitations do not apply. His deduction on QBI is $16,000 (20% x $80,000) since TI minus net capital gains is $80,000, which is lower than QBI of $100,000.

If his TI is greater than $157,500 but less than the income cap of $207,500 for a service business, then the deduction on QBI phases-out and the W-2 wage and property basis limitations apply inside the phase-out range.

If his TI is higher than the income cap of $207,500, there is no deduction on QBI in a trading service business.

Anti-abuse measures
The proposed regulations prevent “cracking and packing” schemes where an SSTB might contemplate spinning-off non-SSTBs to achieve a QBI deduction on them. “Proposed §1.199A-5(c)(2) provides that an SSTB includes any trade or business with 50 percent or more common ownership (directly or indirectly) that provides 80 percent or more of its property or services to an SSTB. Additionally, if a trade or business has 50 percent or more common ownership with an SSTB, to the extent that the trade or business provides property or services to the commonly-owned SSTB, the portion of the property or services provided to the SSTB will be treated as an SSTB (meaning the income will be treated as income from an SSTB).”

Other anti-abuse measures prevent employees from recasting themselves as independent contractors and then working for their ex-employer, which becomes their client.

Aggregation, allocation and QBI losses
There are QBI aggregation and allocation rules which come in handy for leveling out W-2 wage and property basis limitations among commonly owned non-SSTBs. If you own related businesses and one has too much payroll and property, and the other not enough, you don’t need to restructure to improve wage and property basis limitations. Aggregation rules allow you to combine QBI, wage and property basis limitations to maximize the deduction on aggregate QBI. Allocation rules are a different way to accomplish a similar result.

There are also rules for how to apply and allocate QBI losses to other businesses with QBI income and carrying over these losses to subsequent tax year(s).

Section 199A is a complicated code section requiring significant tax planning and compliance. The proposed regulations close loopholes, favor some types of businesses and prevent gaming of the system, which otherwise would invite excessive entity restructuring.

Hedge funds and investment managers
If a hedge fund qualifies for TTS, the fund is trading for its account through an investment manager partner. As a TTS trading business, the hedge fund is an SSTB.

A hedge fund with TTS is entitled to elect Section 475 ordinary income or loss. A hedge fund with TTS and Section 475 has ordinary income, which is likely includible in QBI. The SSTB taxable income thresholds and cap apply to each investor in the hedge fund; some may get a QBI deduction, whereas, others may not, depending on their TI, QBI aggregation and more.

The proposed regulations also describe investing and investment management as an SSTB (p. 66-67). I presume a carried-interest share (profit allocation) of capital gains should be excluded from QBI, but a carried-interest percentage of Section 475 ordinary income is likely included in QBI. Incentive fees and management fees are also included for management companies, which are SSTBs. QBI must be from domestic sources.

Service businesses
The proposed regulations state: “The definition of an SSTB for purposes of section 199A is (1) any trade or business involving the performance of services in the fields of health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, or any trade or business where the principal asset of such trade or business is the reputation or skill of one or more of its employees or owners, and (2) any trade or business that involves the performance of services that consist of investing and investment management, trading, or dealing in securities (as defined in section 475(c)(2)), partnership interests, or commodities (as defined in section 475(e)(2)).”

The proposed regulations exempted some types of service businesses from SSTBs, including real estate agents and brokers, insurance agents and brokers, property managers, and bankers taking deposits or making loans. It also narrowed SSTBs — for example, sales of medical equipment are not an SSTB, even though physician health care services are. Performing artists are service businesses, but not the maintenance and operation of equipment or facilities for use in the performing arts.

The proposed regulations significantly narrowed the catch-all category of SSTBs based on the “reputation and skill” of the owner. The updated definition is “(1) receiving income for endorsing products or services; (2) licensing or receiving income for the use of an individual’s image, likeness, name, signature, voice, trademark, or any other symbols associated with the individual’s identity; or (3) receiving appearance fees or income (including fees or income to reality performers performing as themselves on television, social media, or other forums, radio, television, and other media hosts, and video game players).”

Proposed vs. final regulations
The IRS stated that taxpayers are entitled to rely on these “proposed reliance regulations” pending finalization. The IRS is seeking comments, and they scheduled a public hearing for Oct. 16, 2018.

The 2017 Tax Cuts and Jobs Act was a significant piece of legislation for this Congress and President. I presume the IRS will attempt to issue final regulations in time for the 2018 tax-filing season, which starts in January 2019. The IRS needs to produce tax forms for the 2018 QBI deduction, and that is best accomplished after finalization of the regulations. Tax software makers need time to program these rules, too.

The new tax law reduced tax compliance for employees by suspending many itemized deductions. They may have a “postcard return.” However, the new law and proposed regulations significantly increase tax compliance for business owners, many of whom would like to get a 20% deduction on QBI in a pass-through entity.

See IRS FAQs and several examples on Basic questions and answers on new 20% deduction for pass-through businesses. 

Darren Neuschwander CPA contributed to my blog post.

 


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