A partnership’s classification as an “investor fund” or “trader fund” significantly affects the tax treatment of the partnership and its investors. This distinction has grown even more critical in the wake of the Tax Cuts and Jobs Act (TCJA), enacted in late 2017. In order to align with the tax treatment that’s best suited to your partnership, it’s important that you weigh the essential factors when determining a fund’s classification and classify the fund as an investor fund or a trader fund, accordingly.
The TCJA made several significant changes that affect investors and investment managers, including:
- Suspension of itemized deductions for miscellaneous expenses, including advisory fees and other investment expenses (through 2025),
- A $10,000 cap on state and local tax deductions (through 2025),
- A new limit on business interest deductions, and
- The limitation of excess business loss from a partnership (also through 2025).
These changes amplify the differences between investor fund and trader fund status.
Prior to the TCJA, investors who itemized were able to deduct advisory fees and other investment expenses as miscellaneous itemized deductions to the extent that those deductions exceeded 2% of Adjusted Gross Income (AGI). (Note that this deduction was subject to overall limits on certain itemized deductions for high-income taxpayers). Itemizers also enjoyed deductions on state and local taxes.
By suspending miscellaneous itemized deductions and placing a cap on state and local taxes, the act provided trader funds with a tax advantage. The tax advantage arises from the fact that a trader fund is deemed to be engaged in the trade or business of trading securities, so its partners can fully deduct expenses related to generating trading income (including state and local taxes) as business expenses. An added benefit is that these are above-the-line deductions that reduce a partner’s AGI, which may reduce state taxes as well. Investor funds, on the other hand, generate below-the-line (itemized) deductions, which were substantially curtailed by the TCJA.
The TCJA also established a new deduction limit for business interest expense. In general, the deduction is limited to a taxpayer’s business interest income plus 30% of its adjusted taxable income. This change may have significant implications for highly leveraged trader funds. However, the limit doesn’t apply to investor funds, which incur investment interest rather than business interest. Investment interest expense deductions are generally limited to a taxpayer’s net investment income.
Other Considerations for Trader Fund or Investor Fund Classification
There is a new limitation from TCJA for business loss that is attributable to the trade or business of the taxpayer over the gross income from such trades or businesses. Under the new business loss limitation, any net business loss generated in 2018 through 2025 is limited to $500,000 for married taxpayers filing jointly (or $250,000 for all other taxpayers), adjusted annually for inflation. Any excess loss over the threshold amount will be carried over to the following year as a Net Operating Loss (NOL), subject to 80% of the taxable income limitation. Although guidance from the IRS is still pending, it appears that gains and losses from partnership interests in trader funds would be subject to this new limitation.
Until this new provision came into play, partners invested in a trader fund could use losses from the fund (other than capital losses) to offset various other sources of income such as income from investor funds. The new rules now allow only the business loss to be offset with business income.
Additionally, trader funds are eligible for the mark-to-market election which allows them to report gains and losses on their investment positions as ordinary gains and losses as if they had sold them on the last day of the tax year. The election can be advantageous for funds with substantial unrealized losses since they’re able to deduct such losses and do not need to be concerned about the loss deferrals from wash sales or straddle transactions.
Little Available Guidance for Trader Funds and Investor Funds
Despite significant differences in the tax treatment of investor funds and trader funds, there’s little to no guidance in the tax code or regulations on distinguishing between the two. There are court cases on the subject, but they tend to be subjective and are highly dependent on a particular taxpayer’s facts and circumstances. In general, investor funds tend to buy and hold assets long-term, generating income from interest, dividends, and capital appreciation. Trader funds, on the other hand, trade frequently attempting to profit from short-term swings in the market.
To be considered a trader, a fund’s trading activity must be substantial, which the courts have defined to mean “frequent, regular, and continuous enough to constitute a trade or business.” Factors that influence the determination include:
- Holding periods for securities bought and sold,
- Frequency and dollar amount of trades during the year,
- Extent to which the activity is intended to produce income, and
- Trading activity that is considered substantial versus sporadic.
With the implementation of the new rules discussed above, the question of whether a fund is a trader or investor has become even more important. It is prudent to understand the distinctions between these two funds and properly notify investors about the differences. One thing to keep in mind is that the trader vs. investor analysis at the fund level should be performed on an annual basis. This means that a fund that was classified as a trader fund this year could be considered an investor fund in the following year, if the fund no longer meets the criteria for classification as a trader fund.
Planning Opportunity for Investor Funds
The TCJA limits the ability of investor fund partners to deduct investment-related expenses, though it may be possible for a U.S. investor to avoid these limitations by investing through an offshore feeder fund. If the feeder is structured as a Passive Foreign Investment Company (PFIC) and the investor is able to make a Qualified Electing Fund (QEF) election, then the investor’s net income for federal tax purposes is computed after deducting the PFIC’s expenses, including investment expenses.
A QEF election requires the investor to include income from the PFIC on a current basis but doesn’t allow current taxable losses. Offshore feeders could also be subject to U.S. withholding taxes on certain U.S. source income (such as U.S. sourced dividend income) or effectively connected with a U.S. trade or business income. Nevertheless, this strategy may be beneficial for some partners in investor funds.
As you can see, a fund’s classification as an investor fund or trader fund has significant tax implications. The impact is particularly noticeable now through 2025, while miscellaneous itemized deductions are suspended and state and local tax deductions are limited. As such, funds need to carefully evaluate their investment activities and objectives and determine the appropriate classification.
Although trader fund status offers certain tax advantages, particularly when it comes to expense deductions, the overall tax impact of your fund’s classification depends on its particular facts and circumstances.
Planning is essential if you are to achieve the optimal tax results for your fund and its investors.
Contact your Untracht Early advisor about how we can help you determine the right classification and identify potential planning opportunities.