Tax Reporting and Reconciliation of Hedge Fund...

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Tax Reporting and Reconciliation of Hedge Fund and Other

Alternative Investment Fund K-1sTUESDAY, AUGUST 13, 2019, 1:00-2:50 pm Eastern

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August 13, 2019

Tax Reporting and Reconciliation of Hedge Fund and Other Alternative Investment Fund K-1s

Laura L. Ross, CPA, Partner

EisnerAmper

[email protected]

Yvonne Yang, Tax Director

EisnerAmper

[email protected]

Notice

ANY TAX ADVICE IN THIS COMMUNICATION IS NOT INTENDED OR WRITTEN BY

THE SPEAKERS’ FIRMS TO BE USED, AND CANNOT BE USED, BY A CLIENT OR ANY

OTHER PERSON OR ENTITY FOR THE PURPOSE OF (i) AVOIDING PENALTIES THAT

MAY BE IMPOSED ON ANY TAXPAYER OR (ii) PROMOTING, MARKETING OR

RECOMMENDING TO ANOTHER PARTY ANY MATTERS ADDRESSED HEREIN.

You (and your employees, representatives, or agents) may disclose to any and all persons,

without limitation, the tax treatment or tax structure, or both, of any transaction

described in the associated materials we provide to you, including, but not limited to,

any tax opinions, memoranda, or other tax analyses contained in those materials.

The information contained herein is of a general nature and based on authorities that are

subject to change. Applicability of the information to specific situations should be

determined through consultation with your tax adviser.

5

Tax Reporting & Reconciliation

For Hedge Fund and Other Alternative Investment Fund K-1s

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Laura L. Ross, CPATax [email protected]

Yvonne YangTax [email protected]

Ask the Experts

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• Hedge funds are alternative investments that may use a number of

different strategies in order to earn high returns for their investors.

• In general, the concept it that hedge funds use derivatives and

leverage their investments to reduce risk in addition to holding the

traditional portfolio of stocks, bonds, and cash.

What is a Hedge Fund?

8

Hedge funds use different investment strategies and, thus, are often classified according to investment style.

The following classification of hedge fund styles is a general overview:

• Equity market-neutral• Convertible arbitrage • Fixed-income arbitrage • Distressed securities• Merger arbitrage• Global macro• Emerging markets• Fund of funds

Hedge Fund Strategies

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• Wide range of investments and strategies

• Appropriate for high net worth individuals (Accredited Investors),

institutional investors, retirement plans

• Liquidity

• Varying ownership percentages

Hedge Funds

10

• Management fees – compensation for managing the business of the fund

- 2% standard figure

• Incentive fee/allocation – compensation to General Partners for investment advisory services

- 20% of gross returns

- High Water marks

- Hurdle rates

• Withdrawal/Redemption fees

- Encourage long-term investment

Typical Fees of Hedge Funds

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• Seeks “short swing profits” from trading in securities or commodities

• Activity is regular and continuous

• Able to make an election under IRC Sec. 475

• Reg Sec. 1.469-1T(e)(6) - non-passive for purposes of the passive activity rules

Overview of Fund Types – Trader Fund

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• Holds investments for longer-term appreciation

• Periodic and less frequent trading

• May hold “investments” other than securities and commodities (i.e. private equity)

• Investments in stocks and securities generate “Portfolio” income and deductions (not passive for purposes of Sec 469)

Overview of Fund Types – Investor Fund

13

• Invests in other funds

• Characterization of the income and deductions depend on other funds

• May have its own entity level trading or investing activity

• Diversified portfolio of uncorrelated hedge funds

• Typically more accessible to individual investors and are more liquid

• Two layers of management fees/ incentive fees

• Transparency may be impaired

Overview of Fund Types – Fund of Funds

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• A trader in securities is engaged in the trade or business of trading securities. All items of income and deduction are treated as trade or business income and deductions for federal income tax purposes AND generally, state income tax purposes.

• An investor in securities is engaged in activity entered into for profit and all items of income and deductions are treated as investment income and deductions for federal income tax purposes and state income tax purposes.

Trader v. Investor

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• There is no definition of trade or business in the IRC

• There is no definition in regard to the business of trading in securities in the Federal Income tax regulations

• The definition of the business of trading securities has evolved primarily from case law

• While industry professionals often look to portfolio turnover as the litmus test for trader status, there is not one reported decision that describes as a key factor the number of times a securities portfolio turns over during the course of a taxable year

• One factor is the manner in which an investment manager describes his investment objective in the private placement offering memorandum

• There are no reported cases regarding a partnership’s status as a trader vs. investor

• Tax preparers make observations about a fund’s trading style and make a determination based upon existing court cases relating to trading activity.

• The determination is done yearly, and the fund may be a trader in one year and not in another. This is not a change in accounting method, so it is relatively easy for the fund to switch back and forth on the designation.

When is a Taxpayer Engaged in the Business of Trading Securities?

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• Traders in securities or commodities were allowed to elect MTM accounting for tax purposes beginning in 1997 (enactment of IRC Section 475(f)

• The statute provides that an election once made, is irrevocable without the consent of the IRS Commissioner

• At the end of each tax accounting period, taxpayers will MTM all of their securities in their portfolio and include the gain/loss for the entire accounting period plus the MTM gain/loss (there are not any unrealized gains/losses) as ordinary income/loss

• There is often a perception that a trader fund will automatically make this election. This is not the case – many, and perhaps a majority of trader funds do not make this election.

IRC Section 475(F) Election –Mark to Market (MTM)

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• Trader – Expenses are deductible under §162 by individual taxpayers "above the line" in arriving at AGI.

• Investor – Expenses are §212 investment expenses, treated as miscellaneous itemized deductions.

• In the past these expenses were subject to the 2% AGI limitation, but they are currently not deductible under the TCJA. They were also subject to the AGI phase-out.

• Swap expense and loss is also defined as §212 investment expense and therefore is not currently deductible. There is some debate in the practitioner community about the accuracy of this determination.

• Some states also limit or do not allow itemized deductions.

Management Fees and ExpensesOther than Interest Expense

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• Fund of Funds

• The IRS has ruled that all entity level management fees of a fund of funds are §212 investor expenses (Revenue Ruling 2008-39), treated as miscellaneous itemized deductions subject to the 2% limitation.

• Could have mix of trader expenses depending on investments in underlying funds.

- It is the government’s position that a fund of funds is not considered a trader, even if solely invests in trader funds.

Management Fees and ExpensesOther than Interest Expense

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• Trader – materially participates – fully deductible as a non-passive trade or business interest expense on Schedule E, not subject to investment income limitations.

• Trader – doesn't materially participate – subject to the investment income limitation, to the extent deductible, treated as non-passive trade or business interest expense on Schedule E, ordinary deduction.

• Investor – subject to the investment income limitation, to the extent deductible - report on Schedule A as an itemized deduction.

• Fund of Funds – typically will be mix of investor and trader treatment. - If fund of funds uses leverage to invest, the interest tracing rules would apply in

determining treatment of interest expense.

Interest Expense

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• Example of Trader Footnote (not materially participating)

• "Interest expense has been included in Box 13H as investment interest expense and is not included in Box 11F. 1040 filer should enter this amount on Form 4952, Line 1. Any deductible interest expense should then be entered on Schedule E, Part II, Column (H).”

Interest Expense

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• General Characteristics

• Investment management fees and entity level expenses will now be shown on Line 13W (formerly 13K).

• Investment interest expense reported in Box 13H will be subject to investment income limitations and be a Schedule A itemized deduction.

• Investor funds are not subject to 163(j), but you may see the information provided as corporate partners may need it.

• The boxes on the face of the K-1, from Box 1 through to the end, will be completed, where applicable. In general, usually contains less footnotes (less specific treatment).

Investor K-1s

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• Management fees will be a nonpassive ordinary business expense.

• Investment interest expense may or may not be subject to investment income limitations depending on material participation and will be a Schedule E nonpassive expense.

• Boxes 11F and 13W will be supported by footnote details and Box 11F may include capital gains/(losses) depending on the Firm preparing the K-1.

• Clues in Identifying Possible Trader K-1 in Footnotes

• "Please note that none of the distributive share items reported on Schedule K-1 are considered as derived from a passive activity under Treasury Regulation Section 1.469-1T(e)(6).”

• "The K-1 has been prepared on the basis of a partner who does not materially participate in the operations of the partnership."

Trader K-1s

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• Entity level expenses are reflected under Box 13W.

• If you see 475(f) income under Box 11F (can only make if trader fund). Could either be trader fund or be invested in a K-1 that has trader fund activity.

• Footnote stating investment interest should go to Schedule E.

Trader K-1s

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• In the view of the IRS, management fees charged by the fund of funds are always §212 investment expenses, however, the character of expenses flowing through from underlying investments will depend on whether those investments are trader or investor funds.

• Investment interest expense will be subject to investment income limitations and may be a mix of nonpassive Schedule E or Schedule A expense.

• The boxes on the face of the K-1, from Line 1 through to the end, will be completed, where applicable, and lines 11F and/or 13W will have supporting statements.

• Character of income and expenses is preserved for all underlying investments.

Fund of Funds K-1s

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• Potential combination of entity level expenses reflected on Line 13, will need to look to supporting statements to find breakdown of §212 deductions and trader deductions.

• Footnote where investment interest is allocated to both Schedule A and Schedule E

• Frequently has items of income and capital gains on face of K-1 and Box 11F (mix of trader and investor). Some preparers will pass through underlying K-1s as is, and some will consolidate for a uniform presentation.

Fund of Funds K-1s

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• §1411(c)(1)(A)(i)

- "Net investment income means the excess of the sum of gross income from

interest, dividends, annuities, royalties, and rents, other than such income

which is derived in the ordinary course of a trade or business not described in

paragraph 2.“

• §1411(c)(2)(B) – Trades and businesses to which tax applies

- "A trade or business of trading in financial instruments or commodities (as defined in section 475(e)(2).”

Bottom Line

• Net income from trader funds is subject to NIIT regardless of whether or not there is material participation as the fund is a specified trade or business per the code.

• Income from investor funds and fund of funds are subject to NIIT.

3.8% Net Investment Income Tax (NIIT) - §1411

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K-1 Examples

2929

Investor K-1

3333

Trader K-1

3838

FOF K-1

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In alternative investments, footnotes to the federal K-1 provide information that may have tax implications for different types of investors.

US Treasury Interest

Interest on US Treasury obligations is exempt for individuals for state purposes but is taxable for federal income tax purposes. The income will be included in Box 5 but a footnote will provide the amount (a state K-1, if provided, should also report this in some manner).

Footnote Reporting

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BOX 5 - INTEREST INCOME

U.S. GOVERNMENT INTEREST INCOME

OTHER INTEREST INCOME __________

TOTAL INTEREST INCOME __________

Footnote Reporting - Example

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Muni Interest

Interest on Municipal obligations is not taxable for federal purposes and should be included in Box 18 Code A.

However, states do not tax individual taxpayers on interest of their resident states (and US instrumentalities). A footnote will provide the states from which the fund has earned the Muni interest and provide either amounts or percentages.

Footnote Reporting

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BOX 18, CODE A - TAX-EXEMPT INTEREST INCOME

FOLLOWING STATES:

CONNECTICUT

NEW YORK __________

TOTAL TAX-EXEMPT INTEREST __________


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• THE FUND IS AN INVESTMENT PARTNERSHIP AND IS NOT SUBJECT TO THE BUSINESS INTEREST LIMITATION. THE FOLLOWING INFORMATION IS PROVIDED TO ASSIST CORPORATE PARTNERS IN COMPLETING FORM 8990 AND CALCULATING THEIR SECTION 163(J) LIMITATION, IF REQUIRED.

• YOUR SHARE OF INVESTMENT INTEREST INCOME IS:

• YOUR SHARE OF INVESTMENT INTEREST EXPENSE IS:

• YOUR SHARE OF ADJUSTED TAXABLE INCOME (ATI) (FORM 8990, LINE 22) IS:


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• Items noted in Section L are usually presented on a GAAP basis• Section L items

• Capital accounts

• Increases/decreases

• Contributions and distributions

• The underlying financials and investor statements of a hedge fund are also stated on GAAP

Section L of Schedule K-1

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• Ordinary income items on accrual basis

• Capital items marked to FMV

• Expense items on an accrual basis

• All future costs of liquidating funds

Components of GAAP Income

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• Amortization periods of organization costs (15 years vs 1 year)

• Dividend Accruals

• OID

• Accrued accounting fees that have not been billed

• Other Differences?

Differences Between Tax and GAAP

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• Change in unrealized gains on securities

• Wash sales

• Worthless Shorts

• Constructive sales

• Straddles

Adjustments to Tax Items and GAAP Differences

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• Several different methodologies can be used to allocate capital gains in an investment partnership. The most common methods are described in the Regulations for IRC Section 704(c), and are known as full-netting and partial-netting. Another method that can be used is known as layering, which tends to be cumbersome and is not used as often in this environment.

K-1 Income Allocations: Capital Gains

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Example – Typical Book Allocation

500 200 19,000 (1,500) (2,500)

Book Interest Other Total

Own % Interest Dividends Gain Expense Expenses Partner income

GP 0.1 50 20 1,900 (150) (250) 1,570

LP1 0.3 150 60 5,700 (450) (750) 4,710

LP2 0.2 100 40 3,800 (300) (500) 3,140

LP3 0.4 200 80 7,600 (600) (1,000) 6,280

Total Income 500 200 19,000 (1,500) (2,500) 15,700

Sometimes an administrator will present book gain into two components, realized and unrealized gain. This presentation is not an accurate reflection of the starting tax allocation,

and should be avoided.

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• Not allocated by security

• Susceptible to subjectivity• Timing of allocations

• Impact of the incentive allocation

• Timing of tax adjustments

• Qualifications for use

Aggregate Method Qualities

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A and B form a partnership with each contributing $100,000. The partnership buys two stocks. During the course of the year those stocks go up in value so that each partner has a book capital account of $125,000.

K-1 Income Allocations: Full-Netting

Tax Unrealized Book

Basis Gain Basis

A 100,000 25,000 125,000 B 100,000 25,000 125,000

200,000 50,000 250,000

Original Increase FMV of

Investment in Value Investment

NOK 100,000 20,000 120,000 SGP 100,000 30,000 130,000

200,000 50,000 250,000

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Partner C enters in the next period, and contributes $125,000, so all three partners have the same book capital accounts. Additional stock is purchased, and book value goes up another $30,000.


Tax Unrealized Book

Basis Gain Basis

A 100,000 35,000 135,000

B 100,000 35,000 135,000 C 125,000 10,000 135,000

325,000 80,000 405,000



NOK 100,000 20,000 120,000

SGP 100,000 30,000 130,000 IBM 125,000 30,000 155,000

325,000 80,000 405,000

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The partners decide to sell SGP at this point, which has an unrealized gain of $30,000 –when sold this becomes taxable income. What is the most logical way to allocate the $30,000 gain among the three partners?


Tax Unrealized Book

Basis Gain Basis

A 100,000 35,000 135,000

B 100,000 35,000 135,000 C 125,000 10,000 135,000

325,000 80,000 405,000



NOK 100,000 20,000 120,000

SGP 100,000 30,000 130,000 IBM 125,000 30,000 155,000

325,000 80,000 405,000

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The most logical way to allocate the gain is by the amounts of unrealized gain each partner has. This is the basis of the full-netting concept, and it is identified in Regulation 1.704-3.


Unrealized Realized Remaining

Gain Gain Unrealized

A 35,000 13,125 21,875

B 35,000 13,125 21,875 C 10,000 3,750 6,250

80,000 30,000 50,000

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Partial-netting is very similar to full-netting. The difference is the gains and losses are allocated separately. This method may reduce disparities faster than full-netting can.

K-1 Income Allocations: Partial-Netting

Tax Unrealized Book

Basis Gain Basis

A 100,000 30,000 130,000

B 100,000 30,000 130,000

C 125,000 5,000 130,000

D 135,000 (5,000) 130,000

460,000 60,000 520,000

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Assume we are allocating $30,000 in realized gains again, but that amount is composed of $34,000 of gain and $4,000 of loss. Loss is first allocated to the partner with unrealized losses, gains are allocated to the partners with unrealized gains.

K-1 Income Allocations: Partial-Netting

Unrealized Allocation Remaining

Gain Unrealized

A 30,000 15,692 14,308

B 30,000 15,692 14,308

C 5,000 2,616 2,384

D (5,000) (4,000) (1,000)

60,000 30,000 30,000

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Layering is the most precise method, but also the most cumbersome. The periodic appreciation or depreciation of each stock tax lot must be tracked simultaneously with each partner’s ownership percentage for each period. When the stocks are sold, each partner receives their exact portion of appreciation or depreciation for each stock.

This method is not commonly used due to the amount of record keeping necessary.

K-1 Income Allocations: Layering

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• A wash sale occurs when

• A loss is sustained upon the sale or disposition of stock or securities,

• And “substantially identical” stock or securities are acquired either 30 days before or 30 days after the date of sale (the 61-day window).

• Or a contract or option to acquire substantially identical stock or securities is purchased

• Treated “as though” you just held the original securities

Wash Sales Overview – Section 1091

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• To prevent taxpayers from artificially recognizing tax losses while maintaining their holdings in the stock or securities sold.

Purpose of the Wash Sale Rules

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• Pursuant to Section 1091(a), the loss is not allowed to be recognized at the time of the sale.

• Pursuant to Section 1091(d), the disallowed wash sale loss is added to the basis of the substantially identical stock or securities, the purchase of which resulted in the wash sale.

• Holding Period of Replacement Stock or Securities — The holding period, under Section 1223(3), includes the holding period of the stock or securities that was disposed of at a loss. In other words, the holding period is “tacked on.”

Tax Consequences of Wash Sales

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• A Constructive Sale occurs when:• A taxpayer holds an “appreciated” position in a security

• And acquires an “opposite” position in the same or substantially identical security.

• Treated as though you sold the appreciated securities on that date, and bought them right back.

Constructive Sales Overview – Section 1259

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• To prevent taxpayers from reducing their exposure to the stock or securities while artificially deferring the recognition of tax gains.

Purpose of the Constructive Sale Rule

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• Treated as if the original position were actually sold.• Recognizes gain only.

• Does not apply to losses.

• End old holding period and start new holding period as of constructive sale date for original position. Therefore when you sell the original position, the date of the constructive sale is deemed to be the date on which the position was acquired.

• Non-Convertible Debt Instruments are exempt from the Constructive Sale Rule

Constructive Sales Rules

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• Impact to General Partner• 3 year look-through rule for long-term capital gains received from

carried interest.

• No guidance available yet on implementation

• Initial language that would have made S-Corps exempt from the rule has been overridden by additional guidance

• General Partners with lower management income may be able to get some advantage from the new qualified business income pass-through deduction

• In general, this deduction is not available for those who provide investment advice, but there is an exception for lower income amounts.

Changes Related to the Tax Cuts and Jobs Act

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• Starting 2018 tax year, taxpayers who have domestic “qualified business income” (QBI) from a partnership, S Corporation, or sole proprietorship are entitled to deduction of the lesser of such QBI or 20% of taxable income over the net capital gain.

• The deduction reduces taxable income, not adjusted gross income at the individual level.

• The 20% deduction is also allowed for a taxpayer’s qualified REIT dividends, qualified cooperative dividends, and qualified publicly traded partnership income.

• QBI is net amount of qualified income, gain, deduction, and loss with respect to any qualified trade or business (i.e. US effectively connected income) of the taxpayer. It includes income other than investment income (e.g. dividends, investment interest income, short-term capital gains, long-term capital gains, commodities gains, foreign currency gains, etc.)

• QBI is limited to the lesser of

i) 20% of the taxpayer’s QBI or

ii) the greater of 50% of the W-2 gages with respect to the qualified trade or business or

the sum of 25% of the W-2 wages plus 2.5 % of the unadjusted basis of all qualified property

Changes Related to Tax Cuts and Jobs Act – Pass-Through Entity Deduction

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• The deduction expires after December 31, 2025

• Taxpayers with pass-through income from specified service businesses in the fields of health, law, accounting, consulting, financial services, and brokerage services are not eligible for the deduction.

• Neither “W-2 wage” limit nor the prohibition on specified services businesses applies to a taxpayer with taxable income not exceeding $157,500 ($315,000 in the case of a join return).

• These limitations are fully phased in for a taxpayer with taxable income in excess of the threshold amount plus $50,000 ($100,000 in the case of a join return).

• The calculation of the pass-through entity deduction and related wage and capital limitation is done for each trade or business. If a taxpayer has multiple interests in pass-through entities and each pass-through entity is in a qualified trade or business, such taxpayer will need to keep track of the trade or business income separately.

Pass-Through Entity Deduction

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Pass-Through Entity Deduction

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• Starting 2018 tax year, excess business loss of a taxpayer of a partnership will be limited.

• An excess business loss for the tax year is the excess of aggregate deductions of the taxpayer attributable to trades or business of the taxpayer, over the sum of aggregate gross income or gain of the taxpayer plus a threshold amount ($500,000 for married taxpayers filing jointly; $250,000 for all other taxpayers (indexed for inflation)).

• Limitation at the partner level.

• The excess business loss is treated as part of the taxpayer’s net operating loss (NOL) carryover to the following year (subject to 80% of taxable income limitation). The limitation applies at the partner level.

• The limitation expires after December 31, 2025.

Changes Related to Tax Cuts and Jos Act -Limitation on Losses from Partnerships

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• Rev. Rul. 91-32 re-established gain or loss from the sale of an effectively connected income (ECI) partnership interest by a foreign partner is treated as ECI.

• Applies to sales or exchanges on or after November 27, 2017.

• 10% withholding on sale of non-publicly traded partnership. 10% withholding on sale of PTP is suspended for now (Notice 2018-8) but not for non-PTP.

• Purchaser or transferee must withhold 10% of the realized on the disposition absent certificate from seller. (i.e. If the transferor furnishes to the transferee its US ID and an affidavit certifying that it is not a foreign person signed under penalties of perjury, withholding is not required.)

Changes Related to Tax Cuts and Jobs Act - Sales of Partnership interest with ECI

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• Impact to Funds – Investor Funds• 2% Deductions

• 2% deductions are no longer deductible as of 2019. Management fees and accounting and legal expenses will not longer be deductible by partners of the fund, which will significantly decrease effective return.

• In light of this change, there will be increased pressure to qualify as a trader fund.


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• Impact to Funds – Trader Funds• Interest Expense Deduction

• Interest expense deduction will be limited in a given year to business interest income plus 30% of “adjusted taxable income” which will be determined by a formula based upon EBIT.

• Leveraged funds could find interest expense not deductible in certain years

• Does not apply to businesses with gross receipts of less than $25 million


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This publication is intended to provide general information to our clients and friends. It does not constitute

accounting, tax, or legal advice; nor is it intended to convey a thorough treatment of the subject matter.

This publication is intended to provide general information to our clients and friends. It does not constitute

accounting, tax, or legal advice; nor is it intended to convey a thorough treatment of the subject matter.

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