Investment Management

Investment managers face different tax issues from retail traders.

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 register with the regulator in charge.

Managed accounts vs. hedge fund

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

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

With a hedge fund structure, the investment manager is generally an owner/trader of the fund and brings TTS to the entity level. That unlocks other tax breaks like Section 475, too.

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

Carried-Interest Modified In The Act

The Tax Cuts and Jobs Act 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. If the manager also invests capital in the investment partnership, he or she has LTCG after one year on that interest. The three-year rule only applies to the investment manager’s profit allocation — carried interest. Investors still have LTCG based on one year. Investment partnerships include hedge funds, commodity pools, private equity funds, and real estate partnerships. Many hedge funds don’t hold securities more than three years, whereas, private equity, real estate partnerships, and venture capital funds do.

Carried interest in Section 1256 lower 60/40 capital gains may still work as before. The Act did not address this point. IRS regulations might do so in the near future.

Investors also benefit from carried interest in investment partnerships. Had the Act suspended or repealed carried interest outright, investment partnerships without TTS would be stuck passing investment advisory fees (incentive fees) through on Schedule K-1 as non-deductible investment expenses.

For more in-depth information on investment management, read Green’s 2018 Trader Tax Guide.

Consider our investment management services.