Tag Archives: investment management

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.


Investment Management

January 9, 2016 | By: Robert A. Green, CPA

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

SMA or 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 to allocate income and expense. It’s different from offshore hedge funds.

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

TCJA suspended “certain miscellaneous itemized deductions subject to the 2% floor,” including investment fees and expenses. It disenfranchises SMA investors from deducting management and incentive fees. Hedge funds use carried-interest, a profit-allocation provision, to convert incentive fees into reducing capital gains — that’s tantamount to a deduction. (See my blog, New Tax Law Favors Hedge Funds Over Managed Accounts.) TCJA introduced a business interest expense limitation if gross receipts (net trading gains) exceed $25 million per year.

The profit allocation has other tax advantages for the manager: A carried-interest share of capital gains or Section 475 ordinary income is exempt from payroll taxes, whereas advisory fees are subject to payroll taxes (Social Security and Medicare).

With a hedge fund structure, the investment manager is generally an owner/trader of the fund and brings TTS to the entity level. A TTS hedge fund reports management and incentive fees as a business expense on the partnership tax return.

In an SMA, the investor deals with accounting (including complex trade accounting on securities), not the investment manager. In a hedge fund, the investment manager is responsible for complex investor-level accounting, and the fund sends investors a Schedule K-1 that is easy to input to tax returns.

Carried-interest tax break

The carried-interest tax break can be used in hedge funds, but it cannot be used in separately managed accounts (SMAs). If carried interest provisions are included in the fund’s operating agreement and PPM, the general partner investor is allocated a partnership K-1 share of each item of income — let’s say 20% — in place of the fund paying an outside advisor an incentive fee. Generally, the general partner and investors receive tax breaks with carried interest. The advisor gets a share of lower tax rates on 60/40 or long-term capital gains and avoids payroll tax on earned income, and the investor avoids suspended investment expense treatment…

Carried interest is good for investors

Investors are stuck with suspended investment-expense treatment and investment-interest-expense limitations for expenses that pass through an investment partnership. The biggest investment expense is often advisory fees paid to the investment manager.

Carried interest solves this problem for most investors. It reclassifies incentive fees from suspended investment expenses into reduced capital gains, tantamount to a deduction from gross income and net investment income.

Carried-interest modified in TCJA

TCJA modified the carried interest tax break for investment managers in investment partnerships, lengthening their holding period on profit allocation of long-term capital gains (LTCG) to three years from one year…

20% QBI deduction in pass-throughs

Investment management companies are specified service activities, and advisory fees from U.S. clients count as QBI. A “carried-interest” profit allocation of Section 475 income distributed to the management company is also included in QBI. Carried-interest of capital gains is not.

A hedge fund with TTS is like a TTS trading partnership for determining a QBI deduction. Hedge fund expenses are negative QBI, and Section 475 income is positive QBI. Some hedge fund accountants disagree based on their interpretation of Section 864(b). For more information on QBI, see Chapters 7 and 17.

S-Corp SE tax reduction strategy

Although investment managers can’t use profit-allocation clauses on SMAs, they can use the S-Corp SE tax reduction break to reduce social security (FICA) and Medicare taxes on earned income. Reasonable compensation is subject to payroll taxes, but S-Corp K-1 income is not.

Excerpt from Green’s Trader Tax Guide Chapter 13 Investment Management.

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)


Different Types Of Traders

August 31, 2014 | By: Robert A. Green, CPA

“Trading” is a widely used term covering everyone from the casual investor with a dozen trades per year to the active investor with a few hundred, to the business trader eligible for trader tax status with over seven hundred, to proprietary traders using a proprietary trading firm’s capital, to investment managers trading for their investor clients. Let’s take a look at the various types of traders. 

Casual Investor 

Millions of Americans have online brokerage accounts, and they make a dozen or more trades per year. They need to deal with cost-basis reporting on securities and make wash sale loss adjustments and tax treatment for various financial instruments. They can expect to have some issues with consumer tax software and tax storefront services. For example, a local tax advisor may need help knowing where to report forex transactions and how best to handle wash sale reporting on securities. In 2018, the new tax law TCJA suspended investment expenses, except investment interest.

Active Investor 

Many online traders have several hundred trades yearly but fall short of claiming trader tax status (TTS). The Poppe tax court approved 60 monthly transactions, for a total of 720 per year, annualized. Active investors often have another job or business activity and need more time to trade for a living. They have more tax issues than the casual investor, including wash sale loss adjustments and complex tax treatment issues as they trade a wider variety of instruments, and they keep a close eye on TTS qualification. With TCJA suspending investment expenses, TTS is more critical than ever before.

Retail Trader Eligible for Trader Tax Status

A small minority of online traders qualify for trader tax status (TTS). They should master the content in our Trader Tax Center, read Green’s Trader Tax Guide, and consider our full array of services targeted to their unique needs. With proper tax planning, TTS traders can maximize business expense treatment and elect Section 475 MTM ordinary gain or loss treatment. TTS traders are also eligible for a 20% qualified business income (QBI) deduction. They can form an S-Corp to unlock employee benefit plan deductions, including health insurance and a retirement plan. With a TTS partnership or S-Corp, they can do the SALT cap workaround solution. (Read Trader Tax Status in our Trader Tax Center.) The full works!

Proprietary Trader 

Traders needing more capital are attracted to proprietary trading firms, which are known to offer traders far greater leverage in return for low deposits or upfront payments. Prop firms invite traders to join their company in one of two ways. Some prop trading firms register as non-customer broker-dealers, and regulators prefer prop traders as LLC members. These LLC-member traders receive an annual Schedule K-1 with their allocation of net trading gains. Other prop firms interconnect with an education business. After paying for teaching and passing tests, these companies may invite graduates to become independent-contractor (IC) traders earning non-employee compensation reported on an annual tax Form 1099-NEC. (Read Proprietary Trading in our Trader Tax Center.)

Investment Managers 

Investment management is when you trade money belonging to investors in return for compensation, including a share of profits. As you can imagine, handling other people’s money is a serious business, and there is a vast body of investor-protection laws and regulations on securities, commodities futures, and forex. The investment manager may need to obtain various licenses and register with the appropriate regulators. (Read Investment Management Services for more information about regulation.) Investment managers handle two types of investors: separately managed accounts (SMAs) and hedge funds (commodity or forex pools). In an SMA, the client maintains a customer account, granting trading power to the investment manager. In a hedge fund, the investor pools his money for an equity interest, receiving an annual Schedule K-1 to allocate income and expenses. Hedge funds use carried-interest provisions to help investors navigate the suspension of incentive fees as itemized deductions. (Read Investment Management in our Trader Tax Center.)

For more in-depth information on different types of traders, read Green’s Trader Tax Guide.

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


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.