This article originally appeared on NYSSCPA‘s Tax Stringer online tax publication on December 1, 2016
Hedge fund K‐1s can be voluminous and difficult when determining how to handle the tax treatment of the income and deductions at the individual level. This article will help you navigate K‐1s to understand how certain items would impact the tax treatment at the individual level. The first step in determining the proper treatment of income and expense items is to identify whether the partnership is a trader fund, investor fund, or fund of funds.
Trader Funds, Investor Funds, and Fund of Funds
The determination, which is made at the partnership level, as to whether a hedge fund is a trader fund or an investor fund is based on facts and circumstances. Because there is no definition provided by either the Internal Revenue Code (“IRC”) or Treasury Regulations, the guidance comes from case law or audit manuals. Courts usually look at the nature of the income, frequency and regularity of the transactions and investment intent. Generally, a trader fund is engaged in the trade or business of trading securities. A trader is a professional investor frequently buying and selling financial instruments to seek profit. An investor typically purchases and sells financial instruments with the intent to hold securities for a longer period for capital appreciation. It is important to note that long‐term investment strategies would not necessarily negate a fund from being treated as a trader fund, given other factors to consider.
Fund of funds invest in a number of underlying hedge funds that could be a mixture of both trader and/or investor funds.
Deductibility of Expenses
If a hedge fund is a trader fund, the expenses incurred are deducted under IRC section 162 as ordinary and necessary “above‐the‐line” business expenses reducing adjusted gross income (“AGI”). Such expenses could also reduce state and local income taxes because many states calculate taxable income starting with federal AGI. Hedge fund expenses generally include management fees, professional fees, and other operational expenses.
If a hedge fund is an investor fund, the expenses incurred will be deductible under IRC Section 212 as 2% miscellaneous itemized deductions subject to various limitations. Individual investors will only receive a tax benefit from these expenses if they itemize their deductions, and their total miscellaneous itemized deductions exceed 2% of their AGI.
Furthermore, if an individual’s AGI exceeds a specified threshold amount, the itemized deductions will be further reduced under the Pease limitation. Under the Pease limitation, itemized deductions – other than medical expenses, investment interest, theft and wagering losses – are reduced by the lessor of (1) 3% of the excess of AGI over the specified threshold amount or (2) 80% of the amount of the itemized deductions.
Benefits could be further reduced if the taxpayer is in alternative minimum tax (“AMT”), as the deductions are an “add back” in the AMT computation. Certain states limit or phase out the deduction of itemized deductions as well. Because allowing itemized deductions will reduce state revenue, itemized deduction reform continues to increase. Many states have their own rules limiting the itemized deductions specially designed for high‐income taxpayers. For example, Maine, North Carolina, and Vermont have implemented caps in the past few years. California, Hawaii, Kentucky, Maine, Minnesota, and New York have their own phase‐out rules to limit itemized deductions. As such, a high net worth individual invested in an investor fund most likely will not receive a full tax benefit for these expenses.
For fund of fund K‐1s, the IRS’s position has been that a fund of funds is not considered a trader, even if the fund’s sole investment activity is investing in trader funds. The IRS has ruled that all entity level management fees and expenses incurred directly by the fund of funds are IRC section 212 investor expenses, treated as 2% miscellaneous itemized deductions under Revenue Ruling 2008‐39 (https://www.irs.gov/irb/2008‐31_IRB/ar07.html). Expenses from the fund of fund’s underlying investments will maintain their character, depending on whether the funds are traders or investors.
In general, investment interest expense can only be deducted to the extent of “net investment income” under IRC section 163(d). Form 4952 is completed to calculate the limitation. Investment income is income from investment property that produces portfolio income such as interest, non‐qualifying dividends, annuities, royalties, or net short term capital gains (under IRC section 163(d)(4)(B), investment income generally does not include long‐term capital gain or qualified dividend income – “QDI” – unless there is an election), and income and deductions from a trade or business (for example, a trader fund) that is not a passive activity and in which the taxpayer does not materially participate.
Trader Funds – Interest Expense
For a partner that materially participates in a trader fund, interest expense will be reported directly on Schedule E of Form 1040 as a nonpassive trade or business interest deduction under IRC section 162 (attributable to a trading activity). This interest will not be subject to the investment interest income limitation calculated on Form 4952 because the expense is generated in the ordinary course of the trading partnership’s business. Because this is not considered investment interest expense, none of the net income from the trader fund should be included on Form 4952 as investment income. Note that material participation will be determined at the partner level.
For a partner who does not materially participate in a trader fund, interest expense will be subject to the net investment income limitations calculated on Form 4952. To the extent deductible, the interest expense will be reported on Schedule E of Form 1040 as a nonpassive deduction.
If a hedge fund engages in investing and trading activities – for example, a fund of funds – the partnership interest expense must be allocated between the investment activity and trading activity at the partnership level. This will typically be identified in the footnotes of the K‐1 breaking out the portion that should go to Schedule E versus Schedule A.
Investor Funds – Interest Expense
Interest expense from an investor fund will always be considered investment interest and will be subject to the net investment income limitation. To the extent deductible on Form 4952, such interest will be an itemized deduction reportable on Schedule A.
Passive Activity Treatment
In general, a taxpayer has engaged in a passive activity if the activity: (1) involves the conduct of a trade or business in which the taxpayer does not materially participate for the tax year or (2) is a rental activity, regardless of the extent of the taxpayer’s participation in the activity.
A trader fund is engaged in a trade or business; however, pursuant to Treasury Regulations section 1.469‐1T(e)(6), a partner in a trader fund should treat his or her ordinary income or losses from trading activities (excluding income from rental activities or certain passive income from underlying investments, such as investment in publicly traded partnerships) as not arising from a passive activity. As such, generally, an investment in a trader fund as a limited partner will not generate passive income even if such partner does not materially participate.
Ordinary income or losses from investor funds will typically be treated as portfolio income or losses. Fund of funds may have a combination of both passive and non‐passive activity, depending on the underlying investments. Footnotes on the K‐1 should disclose the proper breakout.
Net Investment Income Tax “NIIT” – 3.8% Tax
Treasury Regulations section1411(c)(2)(B) specifically states the NIIT will apply for a trade or business that trades financial instruments or commodities, as defined in IRC section 475(e)(2). As such, net income from trader funds will be subject to the tax, regardless of whether the partner materially participates. Generally, income from investor funds and fund of funds will also be subject to NIIT. Please note, however, that there are a few exceptions from inclusions in NIIT. For example, income inclusion under Qualified Electing Fund (“QEF”) election in Passive Foreign Investment Companies (“PFIC”) or Subpart F income in Controlled Foreign Corporations (“CFC”) are not subject to the NIIT unless a Treasury Regulations section 1.1411‐10(g) election has been made if these investments are held through an investor fund. Guaranteed payments for services are also excluded from NIIT.
Tips to Help Identify Trader vs. Investor vs. Fund of Fund K‐1s
The following summary illustrates, in general terms, how to identify whether a fund K‐1 is a trader, investor or fund of funds.
Trader Funds: Income and expenses from trader funds may be reported on Schedules K‐1 in various ways. Items could be reflected in Boxes 1 through 9b, Box 11F (other income), and 13W. You might also see all trading activity reflected in Box 1 or Box 11F with a footnote detailing each item such as interest, dividends, and capital gains or losses. In this case, you would need to break out such income accordingly on the Form 1040. You might also notice management fees and other trade or business expenses in Box 13W footnotes.
Investor Funds: Investor fund K‐1s are generally more straight forward. The majority of income and expenses are reported on the face of the K‐1 in Boxes 5 through 9b, Box 11A (portfolio income), and 13K (portfolio deduction 2% floor).
Fund of Funds Schedule K‐1s: A K‐1 from a fund of funds could have a mixture of trader and investor fund expenses depending on the investments in the underlying funds. A more complex fund of funds may have activity in all boxes of the K‐1, including Box 1 and 11 (with footnote detail), and Boxes 5, 9b, 11A, and 13K and 13W. In this case, it will be important to break out all items that will have specific treatment at the individual level such as interest, dividends, and capital gains or losses.
Because the treatment of income and expenses can differ significantly depending on the type of hedge fund, it is important to read through all the contents of the K‐1 to determine how it will impact your client. It is also important to identify any additional filing requirements – such as Forms 8886, 8621, 926, 8865, etc. – based on the footnotes provided.