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 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.