Tag Archives: IM compliance

Incubator Funds

September 4, 2014 | By: Robert A. Green, CPA

An incubator fund is the least expensive and most flexible hedge-fund business plan around! It’s designed for your own money only, and the documents are simplified accordingly. The friends-and-family incubator fund has similar materials to a for-profit hedge fund, minus the compensation clauses.

The incubator fund is generally structured as an investment fund vehicle like a Delaware Limited Partnership (LP) or Limited Liability Company (LLC). Your management company is generally formed in your home state if needed to start. Your attorney should consult with you on various restrictions and a roadmap on how to proceed, so as not to go beyond the bounds of trading your own money or that of friends and family in the incubator fund. The attorney’s heavy lifting on the fund paperwork including private placement memorandum, LLC operating agreement and subscription materials can wait until friends and family join. Compensation clauses are added when you go to the final phase. Your attorney should consider essential licensing, registrations and other plans in Phase I, too.

The benefit of starting an incubator fund is that you can begin generating a historical performance record now and wait on completing the setup of a hedge fund (Phase II) that can be offered to others when the fund has a performance record. This takes considerable start-up risk capital off the table.

Incubator funds can be scaled up to hedge funds or scaled down to a good solution for trading your funds. Many of our incubator-fund clients engage GNMTraderTax for tax compliance services years before they decide to have audited financial statements.

For more information on our incubator fund strategy, read our blog Incubator Funds.

Please contact us.

We look forward to working with you soon.

Robert A. Green, CPA & Darren L. Neuschwander, CPA
Managing Members of Green, Neuschwander & Manning, LLC (GNMTraderTax)


Tax Compliance

| By: Robert A. Green, CPA

Tax compliance includes tax planning and annual tax return preparation, including investor K-1s at year-end. After year-end, general partners of hedge funds need to provide investors with annual income tax reports. Schedule K-1s pass through all items of income, loss and expense, retaining their underlying character of income or loss. Underlying character includes lower 60/40 tax rates on Section 1256 contracts (futures), short-term or long-term capital gains or losses on securities or ordinary income or loss from Section 988 forex.

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

Carried interest remains high on the list of “tax loopholes” facing repeal in discussions for tax reform, but we have written many blogs and articles defending it. Carried interest can be arranged in offshore funds with a mini-feeder structure. There are other nuances in connection with self-employment tax and the ObamaCare 3.8% Medicare tax on unearned income (investment income). We cover all these issues on our blog and in Green’s Trader Tax Guide.

Tax treatment elections
There are different types of tax treatment elections that can be made and it’s important to make the right decisions on time. In some cases, these tax elections should be contemplated in the development process and included in the private placement memorandum. For example, investors with large capital loss carryovers may be searching for hedge funds that will generate capital gains rather than Section 475 MTM ordinary income on securities or Section 988 ordinary income on forex. You can have capital gains treatment on both securities and forex.

Most investors benefit from trader tax status (TTS), so if your fund qualifies, it’s generally a good idea to claim that status. With TTS, the advisor and investors get business expense treatment without passive loss activity limitations. (One exception: non-active owners report investment interest expense as itemized deductions.) That means investors get the full benefit of advisory fees paid “above the line” (from gross income) rather than face many restrictions as itemized deductions below the line. With TTS, the fund is entitled to elect Section 475 mark-to-market (MTM) (on securities only), which exempts the fund from dreaded wash sales at year-end, plus Section 475 receives business ordinary loss treatment, avoiding capital loss limitations. Some managers skip a Section 475 election because they don’t want to be burdened with contemporaneous segregation rules for investments vs. business positions and they don’t want MTM to apply at year-end, so they can defer capital gains to the next tax year(s). Otherwise, they would pass MTM income to investors who might want redemptions to pay taxes and the manager has not yet sold those underlying shares. TTS and Section 475 issues are highly nuanced and often misunderstood, so advisors should discuss them with us in advance. Some hedge funds have TTS and Section 475 MTM on one portfolio, and they properly segregate an investment portfolio without TTS, where they generate long-term capital gains. (Read our blog IRS warns Section 475 traders for more about segregation of investments.)

Our tax compliance service includes everything  you need
Our CPAs plan and prepare tax compliance for hedge funds, management companies and the individuals owning the management company. We help managers plan their tax matters in a way that suits their needs and their investors’ needs. While some tax breaks help both the manager and investors, others may help only one of them, while still others may help one at the expense of the other. For example, if the fund doesn’t qualify for trader tax status, carried interest helps both the manager and the investors. But in a futures fund with lower 60/40 tax rates, carried interest may only help the manager.

Green, Neuschwander & Manning, LLC knows every state very well. Use our professionals to conceive and structure the best tax plans for your fund and get them incorporated into the fund documents; then, use our CPAs to execute those plans and tax elections on a timely basis.

Tax edge: Count on us to handle all the tax matters correctly, including carried-interest tax breaks, the S-corp self-employment tax loophole, the new 3.8% Medicare tax on unearned income, trader tax status/Section 475 MTM accounting, lower 60/40 Section 1256(g) forex tax treatment breaks, forex tax treatment, ETF and ETF option tax treatment, international tax planning including PFIC and QEF elections, mini-master feeders, tax changes and more.

One big tax change started on Jan. 1, 2013: the Medicare 3.8% tax on unearned income, principally investment income. (Read about that in our Trader Tax Center page for Net Investment Tax.)

For more information on our tax strategies for investment managers, see Green’s Trader Tax Guide, our blog and Webinars.

Ready For Help?

Tax compliance, planning and annual tax return preparation services:
Green, Neuschwander will prepare the federal and all required state tax returns for your hedge funds and other investment vehicles. We also can prepare the tax returns for your management companies and your individual return. Click Tax Compliance (Preparation and Planning) and choose Investment Management.

If you have any questions or would like a quote, please email us at info@gnmtradertax.com or call us.

We look forward to working with you soon.

Robert A. Green, CPA & Darren L. Neuschwander, CPA
Managing Members of Green, Neuschwander & Manning, LLC (GNMTraderTax)


Investment Management Update

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


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.