Category: Investment Management

The Hedge Fund Medicare Tax Gap: Can Active Limited Partners Avoid SE Tax and NIIT?

November 17, 2025 | By: Robert A. Green, CPA | Read it on

Editor’s note: This article was first published on Nov. 17, 2025. Since then, the Fifth Circuit has issued two opinions addressing the limited-partner exception to self-employment tax under IRC § 1402(a)(13). The court’s January 2026 opinion was taxpayer-friendly and focused on state-law limited liability. The court later withdrew that opinion and issued a substitute opinion on Aug. 12, 2026, adopting a narrower, management-based standard. The Aug. 12, 2026 substitute opinion is now the operative Fifth Circuit decision.

Core point: A partner who significantly manages or runs the business should not assume that a state-law limited-partner designation protects their distributive share from self-employment tax and Medicare tax.

Update Aug. 17, 2026: Fifth Circuit Withdraws January Opinion And Narrows The Limited-Partner SE Tax Exception

On Aug. 12, 2026, the Fifth Circuit withdrew its January 2026 opinion in Sirius Solutions L.L.L.P. v. Commissioner and issued a substitute opinion under the caption K Alain LLLP v. Commissioner. Although the court denied the government’s petition for rehearing en banc, it abandoned the broad state-law test described in our Jan. 25 update below.

The January opinion held that limited liability under state law was sufficient for a partner to qualify for the self-employment tax exclusion under IRC §1402(a)(13). The substitute opinion instead defines a limited partner as “a partner who plays no significant role in managing or running a business.” Therefore, state-law limited-partner status alone is no longer sufficient in the Fifth Circuit; courts must examine the partner’s actual role in the business.

However, the Fifth Circuit did not fully adopt the Tax Court’s passive-investor test in Soroban. The court concluded that a limited partner may participate in some non-managerial business activities without losing the exclusion. Its new dividing line is managerial versus non-managerial activity—not simply active versus passive participation or material versus non-material participation under the passive-activity rules.

This flip-flop substantially narrows the taxpayer-friendly January decision and creates a new factual question: When does a partner’s involvement become a “significant” role in managing or running the business? Active partners who manage a hedge fund, private equity firm, registered investment adviser (RIA), or professional services management company should not assume that their state-law LP designation protects their distributive share from SE tax. Partners engaged only in non-managerial activities may have a stronger argument for the exclusion, although the extent of that protection remains uncertain.

Under the Tax Court’s Golsen rule, the substitute decision directly governs Tax Court cases appealable to the Fifth Circuit, which covers Texas, Louisiana, and Mississippi. Appeals involving Denham Capital Management and Soroban Capital Partners remain pending in the First and Second Circuits, respectively. Until the appellate courts, Congress, or Treasury provide greater clarity, relying on limited-partner status to avoid both SE tax and NIIT remains uncertain and potentially risky. An S-corporation management-company structure continues to offer a more established approach to managing payroll and Medicare taxes, subject to reasonable-compensation requirements.

The Jan. 25, 2026 update below is retained as a historical record of the Fifth Circuit’s original ruling. That opinion was withdrawn and replaced on Aug. 12, 2026, as explained in the update above. It is no longer controlling law.

Update Jan. 25, 2026: Fifth Circuit Rejects IRS Functional Test—Limited Impact Outside Three Southern States

In Sirius Solutions L.L.L.P. v. Commissioner, No. 24-60240 (5th Cir. Jan. 16, 2026), the Fifth Circuit Court of Appeals vacated a Tax Court decision involving the limited-partner exception to self-employment tax under IRC §1402(a)(13). The court held that qualification for the exception turned on limited liability under state law—not on whether the partner was a passive investor or materially participated in the business.

In doing so, the Fifth Circuit rejected the functional, passive-investor test applied by the IRS and the Tax Court in Soroban Capital Partners and Denham Capital Management. Instead, the court relied on the statutory text and the historical meaning of “limited partner.” In a footnote, the court expressly reserved the question of how—or whether—its reasoning would apply to interests in other entities, such as LLPs and LLCs.

The Fifth Circuit covers Texas, Louisiana, and Mississippi. Under the Tax Court’s Golsen rule, the Tax Court would have been required to follow Sirius in cases appealable to that circuit. Outside the Fifth Circuit, the Tax Court could continue applying the functional, substance-over-label analysis reflected in Soroban, Denham, and Castigliola.

This geographic limitation was important because many hedge-fund management companies operate outside the Fifth Circuit, particularly in the Second Circuit, which includes New York and Connecticut; the Ninth Circuit, which includes California; and the Third Circuit, which includes Delaware. Consequently, the original Sirius decision did not alter the enforcement environment for most hedge-fund managers, who remained exposed to IRS challenges and unfavorable Tax Court precedent when relying on limited-partner status to avoid SE tax.

Even under the original Sirius ruling, planning based solely on limited-partner classification remained uncertain outside the Fifth Circuit. For management companies seeking a more durable approach to Medicare tax exposure, an S-corporation management structure continued to offer a more established and defensible solution without depending on unresolved statutory gaps in IRC §§1402 and 1411.

Original Blog post on Nov. 17, 2025: Executive Summary

The IRS has recently cracked down on hedge-fund, private-equity, and professional-service management companies that tried to use limited partner status to avoid the 3.8% Medicare-related tax on management-company profits. In several high-profile cases—including Soroban, Denham, and Castigliola—the Tax Court held that partners who actively manage the business are not “true” limited partners under §1402(a)(13) and therefore cannot use LP status to sidestep self-employment (SE) tax.

This white paper explains the structural gap in the tax code that created this issue, why management-company partners fall into the gray zone between SE tax and the Net Investment Income Tax (NIIT), and how the courts and IRS now apply a functional test that looks at what partners actually do, not what their partnership interest is called.

For fund managers, RIAs, and active partners in management companies, the takeaway is clear:
LP status alone does not shield active partners from SE tax, carried interest remains NIIT income, and S-Corporations are the only reliable structure for reducing Medicare taxes.

The paper also clarifies how these rules affect TTS traders, Section 475 income, and investor-level LPs.

White paper: In recent years, several hedge-fund, private equity, and professional service management companies attempted to use limited partner classifications to reduce or avoid the 3.8% Medicare-related tax on management company income. The IRS challenged these positions, and the Tax Court repeatedly ruled that active service partners were not “true” limited partners for purposes of the §1402(a)(13) self-employment (SE) tax exclusion.

This article explains how the statutory gap arose, why management company partners fall into it, how recent cases have resolved these disputes, and what today’s fund managers and traders should understand when structuring their entities.

Partnership tax rules can produce unexpected results when older definitions collide with modern fund structures. The idea of an “active limited partner” highlights this problem. Under IRC §1402(a)(13), a limited partner’s distributive share is generally not subject to self-employment (SE) tax.

At the same time, income from a business in which a taxpayer materially participates is not subject to the Net Investment Income Tax (NIIT) under IRC §1411. When a partner is legally designated as a limited partner but actively participates in the management company, these two rules conflict with the management company’s ordinary income being treated neither as SE income nor NIIT income.

Who This Affects

  • This issue directly applies to partners in management companies—hedge fund managers, RIAs, private equity sponsors, and professional service partnerships.
  • It applies less to sole-proprietor traders with TTS and Section 475, whose trading income is not SE income under long-standing IRS guidance. Trading gains are subject to NIIT.
  • Investors in hedge funds and private equity funds can benefit from this content, too. 

Key Lessons

  • Active managers cannot rely on LP status to avoid SE tax.

  • Carried interest is always NIIT income—never SE income.

  • TTS/475 traders avoid SE tax but still owe NIIT.

  • S-Corporations are the only well-established way to reduce Medicare taxes.

  • IRS and Tax Court apply a substance-over-label “functional test.”

Primer on Self-Employment (SE) Tax

SE tax includes Social Security (12.4%) up to an inflation-adjusted wage base ($176,100 for 2025), and uncapped Medicare (2.9%) taxes, totaling 15.3% on net earnings from self-employment. For employees, there are similar payroll taxes: employees pay half of the Social Security and Medicare taxes, and employers pay the other half. 

Two Paths for the 3.8% “Medicare” Tax

The 2010 Affordable Care Act (ACA) created two parallel mechanisms for imposing a 3.8 percent Medicare-related tax on investment income of high-income taxpayers:

  • The Self-Employment Medicare Tax (2.9% base + 0.9% Additional Medicare Tax = 3.8%) applies to net earnings from self-employment — active trade-or-business income under IRC § 1402.

  • The Net Investment Income Tax (NIIT) (3.8%) applies to unearned or passive income such as capital gains, Section 475 ordinary income for traders, interest, dividends, rents, and Schedule K-1 investment profits under IRC § 1411. NIIT also applies to passive activity income and loss from pass-through entities and investment and trading companies.

  • The NIIT is calculated on the lesser of net investment income (NII) or the amount your MAGI exceeds thresholds: $200,000 for singles, $250,000 for married filing jointly. These thresholds are not indexed for inflation. 

  • Example: a single filer with $500,000 of net trading gains (NII) and MAGI of $600,000. The NIIT threshold for a single filer is $200,000. 
    Calculation: MAGI $600,000, NII $500,000, Threshold (Single): $200,000
    Amount MAGI exceeds threshold: $600,000 − $200,000 = $400,000

    The NIIT is owed on the lesser of:
    •NII: $500,000, MAGI excess: $400,000
    So, the taxable amount for NIIT is $400,000.
    NIIT owed: $400,000 × 3.8% = $15,200.

Congress intended that no income should escape both Medicare taxes — a principle reflected in the legislative history of §§ 1402(a), 1411, and ACA regulations. In practice, however, the statutory definitions sometimes leave a gap for active limited partners.

Earned income should be subject to SE tax, and unearned income should be subject to NIIT. Understanding how Congress drew the line between earned and unearned income helps explain why the limited-partner exception exists.

The Limited-Partner Exception

IRC § 1402(a)(13) excludes a limited partner’s distributive share of partnership income (other than guaranteed payments for services) from net earnings from self-employment.

This rule — dating to the 1954 Code — was designed for passive investors in state-law limited partnerships. It assumes such partners do not materially participate in operations and therefore should not owe self-employment tax. The ACA’s NIIT was not started until 2013.

The “Active Limited Partner”

Modern hedge-fund and private-equity management companies, as well as law firms, blur this distinction. Many managers hold limited-partner (LP) interests for liability protection yet actively manage the business daily.

Partners who materially participate in the partnership’s business but hold only limited-partner interests under state law fall into a statutory gray area:

  • Under § 1402(a)(13), their distributive share is excluded from SE income because limited partners are not considered to earn SE income unless they receive guaranteed payments for services.
  • Under § 1411(b) and Treas. Reg. § 1.1411-4(g)(7)(i), non-passive participation income is excluded from NIIT, which was set up to catch passive activity pass-through and investment income.

This overlap can leave ordinary business income neither SE income nor passive activity NIIT income. I next discuss how hedge fund and private equity firms deal with this issue, as these were the types of companies that recently lost in tax court over it. 

Management Company LP vs. Fund LP: Why the Distinction Matters

In all major cases involving the limited partner exclusion—Soroban, Denham, and Castigliola—the individuals claiming §1402(a)(13) exclusion were owners of the management company (Castigliola is a law firm), not passive investors in a hedge fund or private equity fund LP.

The management company is the entity that provides investment advisory, trading, or portfolio management. Its income—management fees, incentive allocations, and operational revenue (for the law firm)—derives from the partners’ active services.

By contrast, investor fund LPs hold pooled capital and generate investment returns, including capital gains, Section 475 trading income, dividends, interest, and Section 1256 gains.

These investor LPs are the intended beneficiaries of §1402(a)(13), which excludes passive investment income from SE tax. However, this fund LP income is subject to NIIT for the passive investors. 

This distinction is critical: the §1402(a)(13) exclusion was designed for passive investor LPs, not partners in service‑providing management companies.

Courts consistently look to the partner’s functional role, not their state‑law label. When an individual materially participates in generating the partnership’s business income, the limited‑partner exclusion does not apply—even if their interest is titled as a limited‑partner interest under state law.

Treasury and IRS Awareness

The Treasury Department acknowledged this coordination problem in the preamble to the Final NIIT Regulations (T.D. 9644, 2013), promising future guidance to reconcile §§ 1402 and 1411. Over a decade later, no such guidance has been issued.

Chief Counsel Advice 201436049 and Proposed Reg. § 1.1402(a)-2 (62 Fed. Reg. 1702, January 13, 1997) both indicate that the term “limited partner” in §1402(a)(13) should be interpreted more narrowly than its state‑law label. These authorities emphasize evaluating what a partner actually does in the business, not just how their interest is titled.

However, neither source definitively resolves how the SE‑tax exclusion applies when a partner is legally a limited partner but materially participates in the partnership’s operations.

Cases such as Castigliola v. Commissioner, T.C. Memo 2017-62, reinforce this functional approach. In Castigliola, law firm partners who were legally designated as limited partners were nevertheless treated as engaged in a trade or business for SE tax purposes because they actively provided services and materially participated in the operations.

The decision makes clear that the substance of a partner’s activities, rather than the state‑law title attached to their interest, governs the application of the SE‑tax rules. Still, the broader issue remains unsettled because the Treasury has not issued comprehensive regulations coordinating §1402(a)(13) with the NIIT rules under §1411.

📊 Management Company vs. Fund LP — Structural Diagram

The management company is a service business. The fund LP is the investment vehicle.

Management Company (LP or LLC)
• Provides investment advisory + management services
• Earns management fees + incentive/performance allocations (carried-interest)
• Partners are service providers
• Income is business income (SE-tax analysis applies)
• Carried-interest in capital gains, Section 475 trading income, and portfolio income are subject to NIIT, not SE tax

⬇️ Manages ⬇️

Fund LP / Master Fund / Feeder Fund
• Pools investor capital
• Generates investment income (capital gains, interest, dividends)
• LPs are passive investors
• Income is investment income (NIIT applies)

📘 Case-Law Spotlight: How Courts Treat “Active Limited Partners” in Fund Managers

🟦 Soroban Capital Partners LP v. Commissioner (2024)

  • Soroban Capital Partners LP is the management company/RIA, not the hedge‑fund investment vehicle. It earns management fees and incentive allocations and manages multiple fund entities.
  • Individuals classified as limited partners of the management company were full-time investment professionals responsible for generating the firm’s advisory and management‑company income.
  • They claimed the §1402(a)(13) limited partner exclusion to avoid SE tax on their box one ordinary business income.
  • Tax Court held they were not limited partners “as such” under §1402(a)(13) because they were active service partners in the management company.
  • Their distributive shares of ordinary business income were subject to self-employment tax.
  • See “Sec. 1402(a)(13) and limited partnerships,” The Tax Adviser, March 1, 2024 (Beavers emphasizes a functional test—partners who are “limited in name only” do not qualify for the §1402(a)(13) exclusion).

🟦 Denham Capital Management LP v. Commissioner (2024)

  • Denham Capital Management LP is the management company, not the private‑equity fund vehicle. It serves as the General Partner (GP) and investment adviser to a family of sector-focused investment funds.
  • Partners labeled as limited partners were actively engaged in investment advisory, due diligence, portfolio management, and operational oversight.
  • IRS challenged the use of §1402(a)(13), arguing these partners were materially participating in a financial‑services business.
  • Tax Court applied Soroban, concluding these individuals were not limited partners “as such” because they were service partners in the management company.
  • Result: their distributive shares of management‑company ordinary income were included in net earnings from self-employment, even though the entity was organized as a Limited Partnership (LP).

Key Principle from Both Cases

A partner’s functional role and actual services, not their state‑law title, determine whether the §1402(a)(13) limited‑partner exclusion applies.

📘 Call-Out: “Limited in Name Only” — Functional Test Explained

Beavers (The Tax Adviser, March 2024) emphasizes that §1402(a)(13) must be applied using a functional test. A partner qualifies as a “limited partner” only if they are genuinely passive in the partnership’s operations.

If the partner provides services, manages operations, or materially participates in generating revenue, they are “limited in name only,” and the §1402(a)(13) exclusion does not apply. This principle aligns with the holdings in Soroban, Denham, and Castigliola, which all rejected limited partner labeling when the partners were active service providers.

📘 Call-Out: When a Fund Management Company Has Box One Income — TTS and Section 475 Only

Most hedge funds do not qualify for Trader Tax Status (TTS) because their trading activity does not rise to the level of an active trading business. Without TTS and a Section 475 election, gains remain capital gains reported in K-1 boxes 8–13, not box one ordinary business income/loss.

A hedge fund investment vehicle reports box one ordinary business income only if it:

  1. Qualifies for TTS, and
  2. Elects Section 475(f) mark-to-market (MTM) accounting. When a hedge fund uses Section 475 MTM accounting, its trading gains are ordinary income.

Section 475 trading gains are not earned income subject to SE tax; instead, they are unearned income subject to NIIT.

TTS trading business expenses in box 1 reduce SE income for purposes of SE tax. It’s quirky: TTS business expenses are treated as SEI, and Section 475 ordinary income and capital gains are NII.

IRS Tax Topic 429 states, “gains and losses from selling securities as a trader aren’t subject to self-employment tax.” Traders are not considered to be in the trade or business of providing services. Expert treatises make clear that traders with trader tax status, even when reporting ordinary income under Section 475 MTM, do not pay SE tax on that income, distinguishing them from dealers and other service businesses.

Section 475 ordinary income is subject to NIIT under §1411. A Section 475(f) election is available only to traders who qualify for TTS, and TTS, by definition, requires self-directed, active trading. 

Even though TTS traders conduct an active business, the NIIT law explicitly treats trading in financial instruments as investment activity for NIIT purposes. Regardless of the taxpayer’s material participation in a TTS fund LP, TTS/475 income remains NIIT income.

In short, TTS/Section 475 income is always NIIT income because NIIT classifies trading in financial instruments as investment activity—even when the taxpayer is conducting an active trading business.

Carried Interest and the NIIT

Carried interest is a profit interest that allocates a portion of the fund’s investment gains to the managing partner. It is categorically different from:

  • Management company box one ordinary business income (the management fee), and

Carried interest income retains its underlying character at the fund level and is reported in K-1 boxes 8–13. These items include:

  • Long‑ and short-term capital gains,
  • Qualified dividends,
  • Interest income, and
  • Section 1256 contract gains or losses,

Under IRC §1411(c)(1)(A)(iii) and Treas. Reg. §1.1411‑4(a)(1)(iii), these categories of income are always included in net investment income (NII). This rule applies regardless of whether the partner is:

  • A limited partner or general partner,
  • Active or passive,
  • Involved in investment management or not.

Because carried interest flows from investment activity and not services, it is:

  • Always subject to the 3.8% NIIT, and
  • Never subject to SE tax.
  • It doesn’t work to claim an “active limited partnership”; it’s NII either way.

In the classic “2 and 20” compensation structure, the management company charges a 2% management fee. It receives a 20% incentive allocation (carried interest) of the fund’s investment income (usually based on new-high-net profits).

The IRS has periodically challenged carried interest as a disguised incentive fee, and some members of Congress have frequently proposed legislation to repeal or further limit carried-interest treatment. Understanding these dynamics is essential when analyzing how carried interest interacts with NIIT and SE tax.

The OBBBA did not change or extend the carried-interest rules created under the TCJA. The three-year holding period under IRC §1061 remains in place, and none of the proposed tightening measures made it into the final bill. As a result, carried interest continues to receive long-term capital gains treatment under the TCJA rules, and OBBBA leaves the existing regime unchanged for private-equity and fund managers.

Even active fund managers pay NIIT on carried interest. The only income potentially affected by the “active limited partner” issue is ordinary business income from the management company or General Partner entity.

Choice of Entity for Traders and Hedge Funds

Entity selection determines how a hedge fund manager’s compensation flows through the tax system.

Many hedge funds adopt a classic structure:

  • A fund LP or LLC that holds investor capital and generates portfolio gains; and
  • A GP/management company responsible for investment management and business operations.

Managers commonly participate in the fund in two separate capacities:

  • Through the GP entity, receiving management‑company income and performance allocations; and
  • Sometimes, as personal investors holding a limited‑partner interest in the LP. Many managers invest personal capital to demonstrate commitment to investors, although the amounts vary widely, and some managers do not invest personally at all.

When managers do invest personally, they may receive a separate investor K-1 reporting only investment results—capital gains, dividends, interest, and Section 1256 gains—never management fee income or carried interest allocations.

Separately, the GP/management company—whether an LLC taxed as a partnership or an S‑Corporation—issues its own K-1 to the manager for GP-level business income. This K-1 is distinct from and unrelated to any investor-level K-1.

(As always, legal entity selection involves governance and liability considerations. Managers should seek counsel experienced in fund law in their state of residence.)

📘 Call-Out: GP / S‑Corporation Election for Payroll‑Tax Optimization

Electing S‑Corporation status at the GP/management‑company level enables managers to:

  • Pay themselves reasonable compensation, subject to payroll taxes, and
  • Receive remaining S‑Corp profits free from Social Security and Medicare taxes.

For S-Corp management businesses, many practitioners use a 25–50% benchmark when evaluating reasonable compensation, but the IRS requires pay to reflect fair market value for services performed.

Remaining profits distributed as S‑Corp dividends are not subject to payroll tax, offering substantial savings compared to partnerships, where active limited partners face increasing scrutiny and SE tax exposure.

This widely accepted planning strategy allows owners to reduce Medicare taxes by receiving income in the form a distributions rather than wages. This method offers a clear, established, and IRS-tested approach to managing payroll‑tax exposure. 

It’s a different matter for trading S-Corps eligible for TTS; they don’t have underlying earned income and therefore don’t need reasonable compensation. They use officer compensation to unlock health and retirement plan deductions.

The Bottom Line

Partner Type

SE Tax

NIIT

Notes

Passive limited partner

❌

✅

Investor LP portfolio income and capital gains are subject to NIIT

Active general partner

✅

❌

Business income is subject to SE tax

Active limited partner (stat. gap)

✅*

❌

*Disputed position under current law

See CCA 201436049 and T.D. 9644 (2013) for IRS and Treasury recognition of unresolved issues. Congressional or regulatory guidance is pending.

Guaranteed payments for services remain subject to SE tax regardless of partner status or participation level.

Outlook

Until Treasury finalizes regulations harmonizing §§ 1402 and 1411, high-income partners who actively manage funds yet hold limited-partner interests occupy a legally ambiguous zone. Practitioners should carefully evaluate both state-law entity status and material participation, as future guidance may reclassify such income for SE or NIIT purposes.

For hedge-fund managers, traders, and their advisors, the safest approach is to treat active management-company income as SE income. Using limited-partner status to avoid SE and NIIT remains risky under the current law.

Disclaimer:
This article is for educational discussion only and not individualized tax advice. It summarizes federal tax law as of 2025 and provides no assurance of outcome in any particular case. Consult your tax advisor about your own entity classification, self-employment exposure, and NIIT obligations.

Sources and Citations

1. Denham Capital Management LP v. Commissioner (T.C. Memo 2024-114)
Full opinion (PDF): https://kpmg.com/kpmg-us/content/dam/kpmg/taxnewsflash/pdf/2024/12/tc-memo-2024-114.pdf
KPMG summary: https://kpmg.com/kpmg-us/content/dam/kpmg/taxnewsflash/pdf/2025/01/tnf-kpmg-report-denham-january-2025.pdf

2. Soroban Capital Partners LP v. Commissioner (161 T.C. 310 (2023))
EisnerAmper overview: https://www.eisneramper.com/insights/tax/soroban-capital-case-1402-a-13-exclusion-1223/
Gibson Dunn analysis: https://www.gibsondunn.com/tax-court-determines-that-limited-partners-are-not-necessarily-exempt-from-self-employment-tax-limits-of-limited-partner-exception/

3. Castigliola v. Commissioner (T.C. Memo 2017-62)
Case summary (Current Federal Tax Developments): https://www.currentfederaltaxdevelopments.com/blog/2017/4/10/tax-court-rejects-limited-partner-claim-in-professional-service-firm

4. NIIT Final Regulations (T.D. 9644, 2013)
Federal Register summary: https://www.federalregister.gov/documents/2013/12/02/2013-28409/net-investment-income-tax

5. IRS Chief Counsel Advice 201436049
Primary source (IRS PDF): https://www.irs.gov/pub/irs-wd/201436049.pdf
Tax Adviser summary: https://www.thetaxadviser.com/issues/2015/jan/tax-clinic-08-jan-2015/

 

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 To Avoid IRS Challenge On Your Family Office

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

Investors may no longer deduct investment expenses, including those passed through from an investment partnership. Restructuring these expenses into a management company might achieve business expense treatment providing it’s a genuine family office with substantial staff rendering financial services to extended family members and outside clients.

The IRS might assert the family office is managing “one’s own investments,” not for outside clients, so the management company is also an investment company with non-deductible investment expenses. Before you go in that direction, it’s wise to learn the lessons of the Lender Management court case from December 2017, which is one of the first on family offices.

Size matters
A single-family office serves one ultra-wealthy extended family, whereas, a multi-family office handles more than one family. Well-established single- and multi-family offices offer a wide variety of financial services, including wealth management, financial planning, accounting, tax, and personal finance. They have substantial staff and salaries, offices, equipment, and operations — the markings of an independent financial services company.

Family office requirements
A family office management company with underlying investment partnerships can use business expense treatment when it has the following characteristics, borne out of the Lender Management tax court case and earlier case law:

– It’s a functional financial services company with significant staff and salaries, an office, equipment and bona fide operations.
– It operates in a continuous and business-like manner.
– Its staff has expertise that is valuable to its clients.
– A profit-allocation of capital gains is considered advisory fee compensation for services rendered. It gets paid more than just its share of profits based on capital.
– It should be profitable.
– It caters to many extended family members with diverging financial needs. It does not operate with a single mindset but provides customized services to each family member.
– Family members and their investment partnerships are not obligated to use the family office.
– There should not be a majority of common ownership between the management company and investment partnerships (this factor is critical).
– It’s safer to have third-party clients who are not family members (a suggestion, not a requirement).

Small family offices have trouble
If two spouses own an investment partnership and management company, then the family office has 100% common ownership, which fails the requirements. The micro family office renders services exclusively to the spousal-owned investment partnership. The management company does not function as an independent financial services company, with outside staff or an outside office. It does not stand alone as a financial service provider. In the eyes of the IRS, it oversees its own investments. This management company should not use business expense treatment. (Some trader accounting and law firms sold this scheme to traders who do not qualify for trader tax status. I’ve always said it did not work and the Lender court confirms it doesn’t work.)

Management fees and carried interest
Consider this typical example: An investment partnership pays a 0.5% management fee on funds under management of $1M ($5,000 per year). The investment partnership also pays a 20% profit allocation (carried interest) based on performance (say, $50,000 for the year). The investment partnership passes through an investment expense of $5,000 for the management fee, which the investor cannot deduct on their tax return. The profit allocation avoids the investment expense deduction problem because it carves out a share of capital gains on each investor’s Schedule K-1.

The management company reports $5,000 of revenue for the management fee, which gives the impression of being a trade or business. However, that’s not enough revenue to cover expenses, so it lacks presumption of business purpose. The management company also reports capital gains income of $50,000 from the profit allocation of investment income. Total income is $55,000 minus business expenses of $52,000 equals a net income of $3,000. The capital gains help satisfy the presumption of business purpose test. The owner sacrificed the $5,000 deduction in the investment partnership to arrange $52,000 of deductions in the management company. However, the IRS might disallow the entire $52,000 deduction, asserting the management company is also an investment company with non-deductible investment expenses because it did not satisfy the requirements for a family office under the Lender court.

Hedge funds
Assume a hedge fund manager owns the management company, which deducts business expenses. The hedge fund partnership does not qualify for trader tax status, so it’s an investment partnership. Most hedge funds meet this scenario. The management company is genuine, and there is little common ownership because the hedge fund is predominately owned by outside investors. That satisfies the Lender court requirements for a management company.

It might be different for a startup hedge fund before outside investors become limited partners in the limited partnership. Until and unless that happens, the manager is managing his own investments, and it fails Lender. The limited partnership is probably not paying the management company advisory fees including profit allocation in connection with the managers capital.

Lender Management tax court case
In Lender Management v. Comm. (Dec. 16, 2017), the tax court overruled the IRS by awarding business expense treatment to Lender Management. It was a well-established single-family office servicing many family-owned investment partnerships. Lender provided customized investment and management services throughout the year to many different family members, with varying needs, across an extensive family tree. Lender Management and the investment partnerships did not have too much common ownership according to IRS and tax court calculations. Only a few of Lender’s dozens of family members owned the management company.

The IRS was unable to cite attribution rules that should apply to Lender. The Lender case also dealt with how to handle revocable vs. irrevocable trusts in the overlap test for common ownership. The Lender court did not define how much overlap ownership is permitted.

Other tax court cases
In Higgins v. Comm. (1941), the tax court said, “No matter how large the estate or how continuous or extended the work may be, overseeing the management of one’s own investments is generally regarded the work of an investor.”

In Dagres v. Comm. (2011), “Selling one’s investment expertise to others is as much an expertise as selling legal expertise, or medical expertise.”

Trade or business partnerships
In Higgins, replace the words “business” for “investment” and the outcome is favorable: “Overseeing the management of one’s own businesses is generally regarded as the work of a business.” If there is a trading partnership with trader tax status, or a rental real estate partnership with ordinary income, then the management company can look through to the business treatment.

A C-Corp management company
Some families and tax advisors are considering a C-Corp management company to take advantage of the new tax law’s 21% flat rate.

Be sure the management company meets the Lender court requirements for a family office. Otherwise, the IRS does not permit a C-Corp investment company to deduct investment expenses. Section 212 (investment expenses) applies to non-corporate taxpayers, not corporations. A C-Corp with a trade or business is entitled to deduct business expenses in connection with making ancillary investments, like investing treasury capital.

When taking into account the Tax Cuts and Jobs Act, don’t focus solely on the federal 21% flat tax rate on the C-Corp level. There are plenty of other taxes, including capital gains taxes on qualified dividends, corporate taxes in 44 states, and IRS 20% accumulated earnings tax assessed on excess retained earnings, which is any amount above zero for an investment company. (See How To Decide If A C-Corp Is Right For Your Trading Business.)

Apportionment between investment and business partnerships
Family offices might want to consider having more of their underlying investment partnerships achieve business treatment, like trader tax status or rental real estate income. If a family office does not satisfy the requirements, and it services investment partnerships and business partnerships, it might consider using hybrid reporting to apportion business expenses vs. investment expenses.

Wealthy families diversify their interests and invest in family-owned investment partnerships in securities and commodities, outside hedge funds, private equity funds, venture capital funds, and real estate partnerships and REITs. Consult a tax advisor to learn more about which underlying investment partnerships have investment expense treatment vs. trade or business activities.

Darren Neuschwander, CPA, and Roger Lorence, Esq., contributed to this post.

Carried interest is fair tax law for all investors

September 22, 2015 | By: Robert A. Green, CPA

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Click for Green’s post on Forbes

Carried interest is long-standing tax law that benefits investment managers and investors alike. Historically, carried interest contributed to the growth of the investment management, private equity, real estate and energy industries, and it’s had a positive effect on the overall economy and increasing tax revenues. Carried interest treats all partners the same. It is fair and not withstanding populist politics, the established partnership tax law should be maintained.

If Congress repeals carried interest provisions in investment partnerships, investors will be stuck with large investment expense itemized deductions that generate few tax deductions. There’s the 2% AGI threshold, Pease itemized deduction limitation and non-deductibility for AMT, the nasty second tax regime. Currently, investors have a reduction of capital gains as a share (carried interest) is allocated to the investment manager, which translates to full tax deductibility for investors.

A repeal of carried interest for investment managers will likely lead to the disuse of it in investment operating agreements for investors, which will put a chill on growth in the investment management, private equity and other investment-related industries. That will slow down the economy, choke finance of start-up companies and impair restructuring transactions. In other words, it’s the classic tax-hike/choke-growth policy which reduces tax revenues.

Investment managers are partners too, and they should be treated equally with other partners, the investors. Equal treatment ensures common goals and outcomes. This is, in fact, what happens with carried interest provisions. If investors receive a long-term capital gain, so does the investment manager who’s taking a risk in the transaction. Many pundits and Democratic presidential contender Hillary Clinton are calling for more long-term investment goals with related fiscal incentives. Clinton proposed stretching out long-term capital gain holding periods with graduated long-term capital gain tax rates. Why repeal carried interest, which is this fiscal incentive for investment managers to make more longer-term investments? Investment managers control the underlying transactions; not the investors.

Playing politics
President Obama and Congressional Democrats are campaigning to repeal carried interest; they claim it only benefits rich hedge fund managers and private equity executives, arguing they don’t pay their fair share.

Republican presidential candidate Donald Trump got on the populist bandwagon, riding shotgun probably so he isn’t pigeonholed by voters into the same corner as private-equity-rich-guy Mitt Romney who lost the last presidential election partially due to class warfare issues. It’s funny that Trump probably built a portion of his fortune from receiving carried-interest tax breaks in his real-estate syndication partnerships years ago.

When President Obama called for repeal of carried interest for investment managers in his two presidential campaigns and annual budget proposals, Senator Chuck Schumer (D-NY) objected, saying it singled out the finance industry (hedge funds and private equity) which obviously were concentrated in his state and New York City. Senator Schumer argued that carried-interest tax breaks were used in other industries — including oil and gas and real estate — all around the country, and if repealed, it should be repealed everywhere in all industries.

There are similar tax breaks throughout American industry in areas such as start-ups and tech companies. Companies grant stock options to executives and many executives benefit from lower long-term capital gains after exercising the options (the gain on option exercise is ordinary income). Companies use restricted stock units (RSUs) as another form of executive compensation, and they grant shares for sweat equity, too. How are these pervasive practices much different from carried-interest provisions in the investment management and private equity industries? As Senator Schumer argued, why single out and penalize investment managers and (I argue) investors, too?

The energy industry receives many special tax breaks including master limited partnerships (MLPs) and overly generous depletion allowances which some argue are phantom tax deductions. The real estate industry gets many special tax breaks with REITS and real estate partnerships with carried-interest provisions.

A call for the repeal of carried-interest on investment managers and private equity reminds me of another progressive-Democrat tax proposal for a financial-transaction tax (FTT) — a “small tax” on each purchase or sale transaction in financial markets. (Eleven EU countries are trying to adopt a version of FTT in the EU.) The FTT proposal is another populist attack to win over voters and while the intended targets are rich Wall Street institutions, FTT falls mostly on investors and retirees all around the country. FTT will also put out of business market makers and traders, which will significantly decrease liquidity and cause flash crashes more often. Even President Obama recognized that and it’s the reason why he prefers a tax on financial institution liabilities over a FTT on investors.

Politically motivated populist attacks are a dangerous game. Often a populist attempts to stab his target with a pitchfork, only to miss and stab his constituents in the foot.

Incubator Funds Are An Attractive Strategy

February 10, 2011 | By: Robert A. Green, CPA

(Note, we invented this concept in early 2000s and have set up hundreds of incubator funds since. When we published this blog, we were not offering assurance (audit/attest) services, so we could be involved with assisting on development.)

Update on June 7, 2011:
Our outside attorney takes a more conservative tack with “multi-member incubator funds”, where the owner/manager wants to admit close friends and family too, but without compensation. To better protect the owner/manager against potential claims raised by close friends and family and to give investors additional information warranted, a law firm prefers to use investment management documents, minus the compensation clauses.

——————-

Many traders dream of having their own hedge-fund business but only a small percentage of them actually take the plunge. Why do would-be fund managers hesitate? Probably the biggest reason is start-up costs, often financed by the adviser/founder. Advisers probably can’t rely on investors to contribute toward fund expenses until after they successfully raise money and get fund operations underway, and that can take some time.

In addition to paying between $12,000 and $20,000 to form a full-fledged hedge fund, the new fund manager must plan on accounting and tax preparation for the first year of operations, running anywhere from $1,000 per month for accounting to $4,000 per year for annual income tax preparation (including investor K-1s). Both the start-up and operating costs may seem quite high, especially for a trader who doesn’t yet have investors lined up to help cover these costs.

The GreenTraderFunds incubator fund strategy and package is a great solution to this important start-up cost issue. Incubator formation costs with our attorneys in phase I are only around $3,000. Also, our CPAs perform accounting with performance record for around $1,000 per quarter, and year-end tax preparation for approximately $2,500. That’s a huge savings for the adviser versus starting out with a full-fledged hedge fund.

The main value of this incubator fund strategy is to generate a historical performance record for the fund before spending the lion’s share of the expenditures for accommodating outside investors. You can scale up to a full-fledged hedge fund, or scale down to a personal trading business entity.

It’s difficult to attract outside investors without a good trading performance record, otherwise known as a track record. Institutional investors also want to see a good management and business record of success. They skip start-up managers who have not yet proven themselves as business people, and avoid fledgling managers who may not survive the next down trend.

Although a trader may have lots of experience, it is quite likely that under federal securities and futures laws, he will not be able to use quantitative measures of his success to attract potential investors in his new fund. Showing past and prior performance may be allowable under certain restrictive conditions and with using the appropriate disclaimers and disclosures. Keep in mind that prior performance may be apples and oranges compared to a new fund’s trading program too. It’s important to discuss these matters with attorneys experienced in investment management.

Our GreenTraderFunds incubator fund plan deals with these issues. We discuss prior and past performance and how it may or may not be useable. We help devise a trading program for attracting investors later on that’s both realistic and appropriate for investors. Our CPAs and accountants prepare a historical performance record for the incubator fund to be used later on in the full hedge fund documents.

Starting your hedge fund business with an incubator fund can save you over $20,000 during your first year of operations. A full-fledged hedge fund formation, with 12 months of accounting and year-end tax preparation, might cost approximately $30,000 with GreenTraderFunds (a great price). The second year’s accounting and tax will cost approximately $18,000. The GreenTraderFunds incubator fund package costs approximately $9,500 during your first year of operations, and $6,500 in the second year.

Our plan allows you to create a stellar — and marketable — performance record that conforms to all industry and accounting standards. When you are confident that investors are ready to join, you can engage GreenTraderFunds to prepare your investor offering documents and other legal paperwork, using our outside attorneys.

Choosing the wrong team can be a nightmare. Some attorneys are overworked, others sell cookie cutter documents and some can be very difficult to deal with. Attorneys may be done with you when they complete the documents, but GreenTraderFunds sticks with you for the life of your business in many areas of your operations. Some websites offer a document service, but they don’t have attorneys to review the documents, which can lead to trouble. Other sites promise a full solution, but they don’t have the experienced attorneys and CPAs. We have earned the trust of our clients since the founding of Green & Company CPAs in 1983.

Lower start-up costs
Most law firms want to sell you the blue prints and build the hedge fund all at once; they make more money that way. At GreenTraderFunds, we place our clients first and customize a flexible plan that allows you to build your fund in two separate phases. By using our incubator fund strategy, you break down the start-up process and related costs while avoiding redundancy: The two-step process usually costs no more than doing everything at once. We also design the fund with accounting and tax strategies in mind too. Some attorneys have complex terms that are hard to account for, which raises your fees.

• Phase I: Incubator. Create your hedge fund and management company (if needed) as legal entities. You begin building the fund’s performance history by trading with your own funds. This phase usually costs around $3,000. These figures are for setting up onshore funds (you pay state filing fees directly); the price for offshore entities is somewhat higher (and involves the use of offshore legal counsel).

For approximately $1,000 per quarter, GreenTraderFunds will prepare your fund accounting, which includes the performance record. We use FundCount software; your cost is a small license fee. FundCount has fantastic reports; we design the entire reporting system with you and our attorneys. We prepare your annual income tax returns for the fund and the management company. We can also prepare your individual income tax returns as well, all combined for an attractive price. Many important tax breaks from the fund and management company flow through to your individual tax return, so it’s best to use us for the entire tax preparation work.

• Phase II: Completion. Using our GreenTraderFunds outside attorneys, we prepare your offering documents, investor agreements, and other legal paperwork, and you begin accepting outside investors. For special-purpose funds and offshore funds, we also work closely with some outside law firms to provide Phase II services at excellent prices and customer service. We call the shots on tax strategies and much more, so their work fits nicely into our designs.

You can use the incubator strategy with any type of hedge fund. Whether you have a securities fund, commodities/futures fund, forex (currency) fund, onshore, offshore, master/feeder fund, or mini-master/feeder, our incubator strategy can save lots of money in your startup period.

The cost advantage of our Incubator Fund strategy is tremendous. Of course, if you already have investors lined up, you’ll want to skip the incubator phase and have the complete fund set up all at once. However, if you would prefer to move ahead in two steps, the initial cost savings are significant.

Separately managed accounts
Some of our clients prefer to start their investment management business as separately managed accounts rather than a hedge fund. We advise clients on licensing, investment adviser registrations, regulations, accounting methods, tax and business matters. We can form their management company, handle their investment adviser registrations, structure and prepare their advisory agreements, handle their investor accounting and offer tax advice to their investors. We have everything you need for separately managed accounts, with both onshore and offshore investors.

Establish a marketable track record
Unless you’re well known as a successful trader in the financial services industry, with some pedigree, chances are you won’t attract investors into your hedge fund until you can boast an excellent performance record. Of course, if you are thinking of starting a hedge fund, you probably have already had success trading your own accounts or trading professionally. Although prior experience in the markets is very valuable in many ways to a hedge fund manager, one thing it usually cannot provide are hard figures that can be presented to potential investors. Securities laws make it very difficult to use a manager’s prior performance figures to promote a new fund.

The problem with advertising prior performance is the fund manager must show that it is truly representative of what an investor could reasonably expect from the fund. Quite simply, the manager must demonstrate that prior apples are equivalent to present oranges. This is not easy. Trading one’s own personal account or trading as part of a team at a large hedge fund are significantly different from trading in a startup hedge fund.

Creating a prior performance record is difficult and costly. Prior performance records must be audited for accuracy in accordance with GAAP (Generally Accepted Accounting Principles) and verified according to the standards established by the Chartered Financial Analyst Institute (AIMR-PPS and GIPS). The cost of hiring a specialized firm to perform verifications according to CFA Institute standards is quite high. An even greater obstacle, however, is that attorneys are very reluctant to allow the figures to be used in offering documents. Even if you pay accountants to verify that your figures conform to GAAP and AIMR-PPS / GIPS standards, most attorneys still will not include these prior performance records in offering documents because it exposes them to potential litigation from disgruntled investors.

If you have a great prior record and you plan to use the same trading program and environment in your new fund, it may well be worth the effort and cost to pursue this option. You will have to document that your prior trading strategies and working environment are very similar to your future fund trading strategy and environment. In the majority of cases, however, prior performance simply is not representative. And when it is, it is still quite possible that the potential benefits of verifying prior performance do not justify the associated trouble, expense and potential legal exposure.

Happily, the incubator fund is an attractive solution to the prior performance problem. Not only is our incubator fund economical, it generates a historical fund performance record that can be used to attract potential investors. Unlike prior performance — the manager’s investment success prior to starting the fund —historical fund performance doesn’t require verification. The historical performance record of the Incubator Fund is the record of the fund itself.

The bottom line is the majority of those wishing to start a hedge fund are better off skipping prior performance and setting up an Incubator Fund. If you want to avoid dealing with the cost, uncertainty and risk of crafting a prior performance record, you can use an incubator fund to generate the historical performance record that will appear in the fund’s offering documents. You only need a regular annual financial audit in accordance with GAAP. And even if you change the fund’s trading strategy in the future, there is no requirement for verification to CFA Institute standards.

An incubator fund is flexible
Your life is easier during the incubator process. Since you don’t have investors in your incubator phase, it’s much easier to prepare your accounting and NAV reports. There are no complex investor-level accounting issues. Annual tax preparation is also a snap; it’s almost as easy as preparing tax returns for any trader entity. This saves you money and reduces your work and time with our professionals. Since most complications arise when investors come into the fund, an incubator fund can save you many headaches while you are getting your fund’s business operations in order.

You have time to fine-tune your business plan with an incubator fund. When your incubator fund is successful and you’re ready to meet with prospective investors, it’s time to complete your hedge fund business plan and incorporate it into your offering (disclosure) documents. With the time afforded you in the two-step process, you can benefit from hindsight and experience. Maybe you want to change brokers, take soft dollars (or skip them), or change other operations like management team, systems and more. Since you can tweak your hedge fund business plan before preparing your offering documents, those documents will be more representative of your revised operations than if you created them on day one. Since these offering documents are the way you fulfill your disclosure obligations, the incubator approach provides added legal and compliance protection.

The incubator can be valuable even if you decide not to complete the hedge fund. If the incubator fund is successful and can attract outside investors, you will probably decide to move forward with a hedge fund and management company. If, however, you decide not go ahead and complete the fund, you can still take advantage of the entities created in the incubator phase, since they’re designed to accommodate business trading as well as hedge fund trading. You can use one or both of these entities to gain important tax benefits, such as retirement and health insurance deductions. Business traders often need an entity to create “earned income” in order to deduct contributions to retirement and health-insurance plans. Learn more about GreenTraderTax business entity tax strategies and retirement-plan strategies. This built-in contingency plan helps ensure that you receive the maximum value for every dollar spent with us.

The incubator fund allows you to start big or small. Many traders ask about the amount of money they should start with in their incubator fund. There is no minimum investment, though you probably will want to start with at least $25,000, which is the minimum required to establish a pattern day-trader account at a direct-access broker. To attract serious outside investors, you will want to consider trading $100,000 to $1,000,000 or more.

Incubator fund restrictions
Under federal and state laws, you’re not allowed to accept compensation in any form from investors, including yourself, during the incubation period. Nor can you accept funds from outside investors, except (in limited cases) from family and close friends. It is permissible to charge investors (and your own and related accounts) for their share of expenses, such as brokerage and bank fees or professional fees, incurred by the incubator fund while they were a member. Since you’re subject to fiduciary duty rules even with non-paying investors (which means you can be sued for losing their money), you should consult with an attorney before accepting other people’s money into your incubator fund.

The bottom line
Starting your own hedge-fund business can be your ticket to financial freedom. However, it is a reality that most new businesses, including hedge funds, fail in the first year of operations. As you start your fund, plan wisely. If you decide on a low-cost, low-risk vehicle for getting your fund off to a solid start, talk to us about an incubator fund.

Investment Management Update

February 8, 2011 | By: Robert A. Green, CPA

Forbes

New Tax Law Strokes Hedge Fund Managers

After tense moments in the great tax debates of 2010, two important tax breaks for hedge funds and investment managers survived repeal efforts from Congress and the White House. Although Democrats tried hard to repeal “carried interest” tax breaks for investment managers, along with a related repeal of the S-Corp self-employment (SE) tax reduction breaks for professionals (including investment managers), Republicans saved the day with a successful filibuster blocking cloture on tax increases. We covered that drama on our blog and in our podcasts.

Finally, in the year-end lame-duck session of Congress, after Republicans won majority in the House in the midterm elections, Congress agreed to extend all Bush-era tax cuts for two additional tax years (through Dec. 31, 2012), along with other important “tax extenders” too. There was no time or votes to include repeal of carried-interest and the S-Corp SE tax breaks. With a new Republican-controlled House in 2011 and 2012, it’s unlikely that carried-interest or the S-Corp SE tax break will be repealed during this session of Congress.

This translates to good news for investment advisers. Managers can continue to start up new hedge funds and structure in a “profit allocation” clause, so they receive performance income — it’s not compensation or pay — based on their profit allocation share of each income tax-category in the fund. The carried-interest tax break means the manager/partner receives a special allocation (his share) of long-term capital gains and qualifying dividends taxed at lower tax rates (currently up to 15 percent), futures gains taxed at lower 60/40 tax rates (currently up to 23 percent), and short-term capital gains taxed at ordinary income tax rates but not subject to separate SE tax rates (currently up to 15.3 percent of the base amount currently at $106,800, and 2.9 percent unlimited Medicare tax portion thereafter). That’s meaningful tax savings too. Carried-interest tax breaks can be good for investors as well.

It’s different with separately managed accounts. Although investment managers can’t use profit-allocation clauses on these accounts, they can at least use the S-Corp SE tax reduction break, which becomes even more important with incentive fees being 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 filing a partnership tax return, earned income passes through to the LLC owners subject to SE tax, unless an owner is not involved in operations (which is beyond the scope of this content).

Investment managers can only use profit allocation with investment funds and not on separately managed accounts, 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, meaning no special allocations are allowed.

That makes S-Corp elections a wise choice for management companies focused on reducing 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 subjected to SE tax anyway.

Check with us about these strategies, as there are some states such as California that have higher franchise taxes on S-Corps, but usually materially less than the possible SE tax savings. New York City taxes S-Corps like C-Corps and those tax rates are high.

An existing LLC or C-Corp can file an S-Corp election (Form 2553) by March 15th of the current tax year. The IRS automatically grants late relief under a special Revenue Procedure, up until the due date of the tax return including extensions. Check with us about your home state too.

This article is just a recap on the recent saga of two important tax breaks for investment managers. There are plenty of other important matters to consider too, including trader tax status and Section 475 MTM accounting, lower 60/40 Section 1256g forex tax treatment breaks, international tax planning including PFIC and QEF elections, mini-master feeders, good offshore fund destinations, other tax and regulation changes and more. 

Carried interest repeal back again

May 25, 2010 | By: Robert A. Green, CPA

The good news is a financial-transaction tax (FTT) isn’t part of the new Senate and House bills for financial reform and tax changes, but there is, of course, some bad news: The carried interest repeal is on the table again.

Details of this joint effort between the House of Representatives and Senate were released last week. The “American Jobs and Closing Tax Loopholes Act of 2010” (H.R. 4123) proposes repealing carried interest tax breaks and closing the self-employment (SE) tax loophole for S-corps, alongside other changes of less importance to traders. This is a new version of the bill passed by the House in December, and is now up for a vote in both the House and Senate. As of this writing, nothing has been passed yet, but passage is expected after a fight. 

There are also heated objections from the venture capital and real estate industries, who don’t want to be lumped with hedge fund managers. They argue their case is different on carried interest because they’re more long-term players in less lucrative industries than hedge funds, and this tax will hurt their vital industries. Congressional leaders are considering subjecting only 60 percent of their carried interest income to the ordinary rate, while leaving it at 75 percent for hedge fund managers.

Perhaps Blue Dog Democrats have an eye out to austerity measures being passed around Europe to tackle run away social and entitlement benefits, and they’re considering the upcoming midterm elections and the political danger of more deficit spending on entitlements.

What do these changes mean? 
Currently, investment managers in hedge funds using profit allocation — otherwise known as “carried interest” — instead of an incentive fee enjoy lower 60/40 tax rates on futures (a blended maximum rate of 23 percent), and lower long-term capital gains tax rates on securities. (If held over 12 months, the maximum rate for the latter group is 15 percent.) 

If the repeal passes, carried interest income will be re-characterized for the investment manager as ordinary income. Carried interest is different from incentive fees. The former is considered investment unearned income and the latter is classified as earned income subject to the SE tax. Currently, the SE tax rate is 12.4 percent on the social security base amount ($106,800) and 2.9 percent unlimited thereafter. The unlimited Medicare portion is a great concern of managers with large carried interest income. Also starting in 2013, upper-income taxpayers’ investment income will be subject to the 3.8-percent Medicare tax. Whether treated as carried interest investment income or as re-characterized ordinary earned income, the adviser will owe that 3.8-percent Medicare tax on that income. 

Previous versions of this tax change asked to classify 100 percent of carried interest as ordinary income, but this rendition calls for a 75-percent re-characterization; the remaining 25 percent would retain the underlying income tax treatment for short- or long-term capital gains, 60/40 futures or interest income. 

If this 25 percent “break” survives, it will still make sense to keep carried interest structured into hedge fund vehicles. Managed accounts have management and incentive fees taxed at ordinary rates and subject to SE tax. They don’t fall in the category of carried interest. Hedge funds require more compliance costs than managed accounts. Traditionally, tax benefits have been one of the pros of hedge funds and that edge should remain if this bill is passed as stated. 

Also, unlike previous versions, this bill offers a phase-in period of two years. In 2011 and 2012, half of carried interest would be taxed at the ordinary income rate, with the remaining 50 percent eligible for capital gains treatment. Finally, in 2013 and thereafter, 75 percent of the carried interest would be taxed under the new rules. 

Tax increases all around
This tax increase for investment managers is made even more painful when other scheduled tax increases are factored in. All income tax rates are scheduled to rise in 2011 when the Bush Administration tax cuts expire. Congress and the President want to extend those tax cuts for the middle class only, which excludes the upper income making more than $250,000 per year (filing jointly). The long-term capital gains rate is scheduled to rise from 15 to 20 percent and the ordinary rate shoots up to 39.6 percent from 35 percent — returning to the Clinton Administration tax rates. The blended 60/40 futures tax rate will rise from 23 to 28 percent. The alternative minimum tax (AMT) rate will stay at 28 percent. The qualifying dividends tax rate will rise from 15 to 39.6 percent — back to the ordinary tax rate. The President wants to fix the dividend rate only, using the 20 percent revised capital gains rate. 

An unfair repeal 
Personally, I think this repeal is a mistake and unfair. Managers risk their time, effort, reputation, brand and sweat equity in their funds, which I believe is tantamount to money. All of this risk capital should be subject to capital gains taxes and not ordinary rates. Funds also pay investment managers management fees, which are reported as earned ordinary income. The carried interest portion is managers’ pro-rata share of return on risk capital, putting them in the same boat as their investors. Proponents of this tax are using convenient (and faulty) logic as a means to their end: to raise taxes where the money is — in hedge funds and on Wall Street.

Is there a workaround? 
The only legal way an investment manager can avoid the carried interest re-characterization is to personally invest his own money in his hedge fund. The bill contains “abuse provisions” to protect the Treasury from inappropriate behavior, and specifically says loans can’t be used to make cash investments. The new health care tax law beefed up tax avoidance scheme rules that make this type of behavior very dangerous for a taxpayer.

Closing the S-corp loophole
In the past, investment managers for funds and managed accounts have reduced the SE tax on advisory fee income with an S-corp tax vehicle. The IRS knows S-corps are used in this manner and it insists on reasonable compensation to the owner/manager to pay some SE or payroll taxes. Guidelines suggest that the 30 percent is “reasonable,” which means the owner saves the SE tax on the remaining 70 percent of fee income. 

Before you get too excited at the prospect of using an S-corp to reduce SE tax on the repeal of carried interest, here’s the bad news. The new bill has proposed to repeal the S-corp SE tax loophole. According to Thomson Reuters, “… the bill would address the situation where service professionals have been avoiding Medicare and Social Security taxes by routing their self-employment income through a corporation where (1) an S corporation is engaged in a professional service business that principally based on the reputation and skill of 3 or fewer individuals or (2) an S corporation is a partner in a professional service business.” 

It appears Congress wants to close the SE tax loophole for smaller companies — one-person professionals who use the S-corp to avoid payroll. Many small investment managers have less than three people, but larger ones might not be affected here. Unless, Congress hangs their hat on “principally based on the reputation and skill of 3 or fewer individuals.” Even some of the larger investment managers have their reputation based on a few key managers.

Investment managers affected by this change may as well remain in an LLC structure filing partnership tax returns, which is usually preferred by their attorneys for governance reasons. Partnership returns are also better than S-corp tax returns. The owner/manager can use administration fees rather than payroll which have added compliance costs. Partnerships can use special tax allocations to owners, whereas S-corps may not. 

Better than a FTT
These tax changes will collectively raise the income tax bills of profitable investment managers. It’s unfortunate, but better than a nasty, industry-killing financial-transaction tax. A FTT is the worst-case scenario for traders, so its absence from this legislation is something to be thankful for. But I don’t trust governments in today’s “meltdown” environment. Bank taxes and/or a potential FTT is being coordinated on a G-20 level and it may be absent from this legislation for that reason too. The Administration wants a bank “fee” (i.e., tax) and they have said no to a global FTT. 

Looking on the bright side, these financial regulations and tax changes should bring more market volatility, so hopefully traders can make back some of the extra costs in trading.

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