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.

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 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 has business treatment from providing investment management services.) Without TTS, the investor can’t elect and use Section 475 MTM.

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…

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 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 the act

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

In August 2018, the IRS issued proposed reliance regulations (Proposed §1.199A) for TCJA’s 20% deduction on qualified business income (QBI) in pass-through entities. The proposed regulations confirm that TTS traders, including TTS hedge funds, are a “specified service activity,” which means if the hedge fund investor’s taxable income is above a taxable income cap, he won’t receive a QBI deduction. The 2018 taxable income (TI) cap is $415,000/$207,500 (married/other taxpayers). The phase-out range below the cap is $100,000/$50,000 (married/other taxpayers), in which the QBI deduction phases out for specified service activities. The W-2 wage and property basis limitations also apply within the phase-out range.

QBI likely includes Section 475 ordinary income, whereas, TCJA expressly excluded capital gains and losses from it. The 2019 TI cap is $421,400/$210,700 (married/other taxpayers) after adjustment for inflation. Calculate QBI on an aggregate basis on the partner level; some partners will receive a QBI deduction and others will not.

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 likely included in QBI. Carried-interest of capital gains is not 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 at least use the S-Corp SE tax reduction break to reduce social security (FICA) and Medicare taxes on earned income…

Excerpt from Green’s 2019 Trader Tax Guide Chapter 13 Investment Management

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