Tax implications of fund investing

The idea of pooling resources and spreading risk using investment funds (or funds) is not a new idea. It has been used for a long time and the complexities associated with funds continue to grow. Similar to traditional investments, such as a direct investment in a marketable security, the economic cycles from the Great Depression, to the dot-com era, to the global financial crisis of 2008/2009 impact the success of these vehicles. However, many view access to investment through funds with qualified investment professionals as a valuable diversification tool in the management of their investment portfolio that helps to mitigate the impact of economic cycles. Tax implications of fund investing Introduction

As a taxpayer and an investor, you should you will receive a tax benefit from the Introduction be informed about significant tax and expenses and losses that may be allocated nontax attributes of fund investments to you. The deductibility of some fund level What is an investment fund? and manage your portfolio in a manner expenses may be limited by the itemized consistent with your understanding of those deduction phase-out provisions or added Types of investment attributes. Taking time to understand the back under the alternative minimum tax funds and income tax tax consequences of investing in a specific (AMT) regime. Other expenses from a fund characteristics fund will help you produce a more tax may directly offset income from fund or • Marketable securities efficient result overall. Thoughtful planning non-fund activities. Furthermore, losses • Hedge funds requires an understanding of a fund may be disallowed in the current year if • Private equity/venture capital advisor’s investment strategy and how that you are subject to the passive activity loss • Publicly traded partnerships may impact your personal tax situation, limitation rules. • Real estate funds whether the investment fails or succeeds. • Fund of funds This includes analyzing the tax treatment Failing to understand the character of income and expenses that a fund will pass Investment fund attributes upon contribution of capital, evaluating through to you can lead to unwelcome • Trader versus investor the impact while you hold, and assessing surprises when you receive the final tax entities the consequences upon sale or other information each year. In addition, fund • Passive versus disposition of the fund investment. investments may cause significant state non-passive income For example, before acquiring new fund implications and create foreign reporting • Separately stated activity investments, it is important for you to requirements. Having a clear understanding (including PTPs) understand the character of the income of a fund’s strategy and the tax implications • Qualified small business that may be generated by the fund, as well of investing in that fund allows you to make stock (QSBS) as when you may recognize such income. a more informed investment decision. To • Unrelated business Will the income or gains be subject to the do so, let’s discuss the types of funds that taxable income highest tax rates or will exist, the character traits of each fund, and • State tax reporting the income allocated to you be subject to the tax consequences of investing in each Conclusion preferential tax rates? Furthermore, you type of fund. should discuss with your advisor whether Resources As a taxpayer and an investor, you should be informed about significant tax and nontax attributes of fund investments and manage your portfolio in a manner consistent with your understanding of those attributes.

2017 Essential Tax and Wealth Planning Guide| Tax implications of fund investing 45 Tax implications of fund investing What is an investment fund?

The popularity of funds Investment funds are types of investment Investors in investment funds include Introduction companies that are typically organized pension funds, sovereign wealth funds, continues to grow, and as partnerships. An investment company endowment plans, family offices, high- What is an investment fund? as of December 31, 2015, invests the money it receives from investors net worth individuals, foundations, and on a collective basis, and each investor insurance companies. Funds may be Types of investment it was estimated that generally shares in the profits and losses referred to as alternative investments and funds and income tax 1 in proportion to the investor’s in commonly include marketable security characteristics $3.65 trillion was invested the investment company. The performance funds, hedge funds, private equity funds, • Marketable securities globally into private equity of the investment company will be based and real estate funds. The popularity • Hedge funds 2 on (but it will not be identical to) the of funds continues to grow, and as of • Private equity/venture capital and $2.8 trillion was performance of the securities and other December 31, 2015, it was estimated • Publicly traded partnerships invested into hedge funds. assets that the investment company owns. that $3.65 trillion1 was invested globally • Real estate funds into private equity and $2.8 trillion2 was • Fund of funds The focus of this summary is on investment invested into hedge funds. A more detailed companies organized as partnerships, Investment fund attributes discussion on the different types of funds which are typically described as investment • Trader versus investor available for investment follows. funds. These investment funds are typically entities structured as partnerships for tax purposes, • Passive versus either as limited partnerships (LPs) or non-passive income limited liability companies (LLCs). The • Separately stated activity partnership tax structure is typically used by (including PTPs) investment funds, rather than a corporate • Qualified small business investment vehicle, to allow for the stock (QSBS) investment fund’s income to be taxed at the • Unrelated business investor level and provide for flow-through taxable income treatment of income, expense, gains, and • State tax reporting losses. Although mutual funds are a type Conclusion of investment company, they are typically organized as corporations and will not be Resources addressed in this summary.

1 By Deloitte estimate, based on prorating the $3.5T figure from Preqin data as of June 2015, forward to December 2015. © 2016 Preqin Ltd. www.preqin.com. Note: Venture capital data are excluded from this number. 2 BarclayHedge Ltd. Data as of December 2015, www.barclayhedge.com. 2017 Essential Tax and Wealth Planning Guide| Tax implications of fund investing 46 Tax implications of fund investing Types of investment funds and income tax characteristics

The character of income and loss allocable to investors directly impacts after-tax Introduction returns on investments and can vary significantly between types of funds. What is an investment fund?

Types of investment Marketable security funds Character of income Hedge funds funds and income tax Marketable security funds (MSF) are considerations—MSF characteristics The investment strategy of a MSF directly Hedge funds (HF) are investment funds that investment funds that typically trade in • Marketable securities impacts the character of the income and can use one or more alternative investment stocks, bonds, and other marketable • Hedge funds loss generated by the fund. The character strategies, including hedging against market securities on the behalf of their partners. • Private equity/venture capital of income and loss allocable to investors downturns, investing in asset classes such The purpose of these investments is to • Publicly traded partnerships directly impacts after-tax returns on as currencies or distressed securities, and provide portfolio diversification by pooling • Real estate funds investments and can vary significantly utilizing return-enhancing tools such as capital from investors and investing in a 3 • Fund of funds between types of funds. As a result, having a leverage, derivatives, and arbitrage. Many, broad base of investments. Many MSFs good expectation of this impact is important but not all, HF strategies tend to hedge Investment fund attributes have an investment strategy targeted to a when making investments. MSFs typically against downturns in the markets being • Trader versus investor specific asset class such as small cap, large invest in marketable securities and generate traded. HFs are flexible in their investment entities cap, international, or emerging markets, dividends, interest, tax-exempt interest, options (can use short selling, leverage, • Passive versus while other funds may look to invest more capital gains, foreign taxes, and expenses. derivatives such as puts, calls, options, non-passive income holistically across multiple strategies. 4 Preferential income tax rates are available futures, etc.). There is typically broad • Separately stated activity Leverage is typically not utilized by MSFs. for qualified dividends and long-term capital discretion over investment objectives, (including PTPs) gains. If a MSF is considered in the trade asset classes, and investment vehicles. • Qualified small business Investments in MSFs are relatively liquid allowing investors to contribute cash or or business of trading securities (discussed stock (QSBS) Use of leverage make withdrawals on a frequent basis further on page 57), the expenses can • Unrelated business HFs typically utilize leverage to execute such as monthly. Depending on whether be tax effective and offset an investor’s taxable income their investment strategy. Many HFs will buy a partner’s investment in the MSF is in ordinary income from other sources. • State tax reporting securities on margin to increase the amount an appreciated or depreciated state, as Additional information is available in the of exposure to a strategy. For example, if a compared to the partner’s tax basis in the Individual Income Tax Planning section of Conclusion HF received capital contributions from its MSF, many MSFs will allocate additional the 2017 Essential Tax and Wealth Planning investors of $10,000,000, by using leverage, Resources gains or losses to partners at the time they Guide regarding income tax rates, types of it may be able to borrow $5,000,000 redeem some or all of their interest in a MSF income, and planning considerations. (buying on margin) so that it is able to invest in an effort to eliminate or limit this disparity. $15,000,000. To the extent the HF can borrow assets to purchase more securities,

3 Per http://www.hedgefundassoc.org/about_hedge_funds 4 Per http://www.hedgefundassoc.org/about_hedge_funds 2017 Essential Tax and Wealth Planning Guide| Tax implications of fund investing 47 Tax implications of fund investing Types of investment funds and income tax characteristics

there is greater opportunity for income applies to trading in stocks, securities, To the extent a foreign person is allocated Introduction and appreciation on those securities. It can and options to buy or sell stocks and either ECI or FDAP income, the foreign also create additional risk on the downside securities, including margin transactions person has a US tax return filing obligation. What is an investment fund? to the extent the assets depreciate in and short sales. If the HF satisfies this safe Therefore, foreign investors would prefer value. Similar to buying on margin, lines of harbor exception, it will not be treated to invest through a blocker corporation Types of investment credits are another type of leverage that as engaged in a US trade or business. to avoid being allocated a share of the funds and income tax HFs utilize. HFs may also purchase financial However, if the HF does not satisfy the safe HF’s US income, which would obligate characteristics instruments such as options, warrants, and harbor exception, the fund would generate them to file a US tax return. While a US C • Marketable securities convertible securities to increase leverage effectively connected income (ECI), and the corporation would generally be required • Hedge funds and potential upside. fund would be required to withhold US to pay tax at the highest US tax rate, many • Private equity/venture capital taxes on the foreign investor’s share of ECI. • Publicly traded partnerships Offshore blocker corporations • Real estate funds While most HFs are structured as LPs Even if the HF is not engaged in a US trade • Fund of funds or LLCs, offshore blocker corporations or business, it is still required to withhold are frequently offered as an alternative taxes on fixed, determinable, annual, Investment fund attributes investment vehicle for US tax-exempt and periodical (FDAP) income that is US- • Trader versus investor investors and foreign investors. While a sourced. Dividends and interest income entities partnership investment may be more tax (unless it meets an exception) are generally • Passive versus efficient than an investment in a foreign characterized as FDAP income. The HF must non-passive income corporation, a US tax-exempt investor withhold taxes on a foreign person’s share • Separately stated activity and a foreign investor typically prefer to of FDAP income at a 30% rate unless a treaty (including PTPs) invest through the blocker corporation applies to reduce the withholding rate. • Qualified small business to limit the US income tax exposure and stock (QSBS) filing obligations related to investing in a • Unrelated business HF. Additionally, tax-exempt investors and taxable income pension funds generally prefer to invest • State tax reporting through the offshore blocker corporation Conclusion to “block” the flow of unrelated business taxable income that would otherwise be Resources allocated to them (see discussion on page 60). Generally, a non-US person who is allocated income from a HF that trades in stocks or securities in the United States is not treated as engaged in a US trade or business. This safe harbor exception

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foreign investors would prefer to block the Character of income • HFs typically invest in a variety of Introduction income through the corporate vehicle and considerations—HFs financial instruments. The instruments pay the higher tax on the income so that The income generated by an HF is often utilized by HFs include options, warrants, What is an investment fund? they themselves do not have a US tax filing similar to the income generated by an MSF. convertible securities, and joint ven- obligation. Therefore, foreign individuals In addition, HFs may also generate the ture agreements. The taxation of these Types of investment and foreign trusts should understand following types of income: instruments is complex and can vary by funds and income tax the character of the income that will be the type of investment. characteristics • The HFs that trade in regulated futures generated by the HF so that they can • Marketable securities contracts and/or foreign currency identify the investment vehicle that would • Hedge funds contracts will recognize income/loss Private equity and venture best satisfy their needs. • Private equity/venture capital taxed under the provisions of IRC §1256. capital funds To the extent IRC §1256 applies, the • Publicly traded partnerships HFs are traditionally less liquid than MSFs, Private equity funds (PEF) are investment income/loss from these contracts will be • Real estate funds but investors are typically able to acquire or funds that pool capital for investment in recharacterized as follows: 60% classi- • Fund of funds redeem in HFs on a quarterly basis privately-owned businesses at different fied as long-term capital gains/losses at a minimum. Similar to a MSF, partners stages of development. PEFs invest in Investment fund attributes and 40% classified as short-term capital who partially or fully redeem interests in an privately-owned C corporations and • Trader versus investor gains/losses. HF should understand if the HF will allocate partnerships with the ultimate objective of entities additional gains or losses to eliminate the • For HFs that have made an IRC §475 long-term capital appreciation. The PEF will • Passive versus disparity between their economic capital mark-to-market election, investments are enhance the company’s value by working non-passive income account and their tax basis in the HF. marked up or down to their fair market with the management team to increase • Separately stated activity value at the end of the year and ordinary revenue streams, reduce expenses, improve (including PTPs) income or loss is recognized to the extent cash flow, and increase margins. The exit • Qualified small business Foreign individuals of the mark. Many HFs with a trading strategy for the PEF may include selling the stock (QSBS) strategy seeking to profit from swings in investment to a strategic buyer, another • Unrelated business and foreign trusts the daily market movements make an PEF, or possibly taking the company public. taxable income should understand the IRC §475 election. Losses are ordinary The lifecycle of a PEF will be stated in the • State tax reporting character of the income in nature and not subject to capital loss offering documents but is typically 7-13 Conclusion limitations. Also, because short-term years, depending on its investment strategy. that will be generated by capital gains and ordinary income are Resources the HF so that they can taxed at the same tax rate, there is no disadvantage because income is taxable identify the investment at ordinary income rates. vehicle that would best satisfy their needs.

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The investment period of the PEF is typically Lifecycle of a Private Equity Fund Introduction closed to new investors 6-12 months after the initial closing. To the extent that Marketing Investment Holding Exit What is an investment fund? investors acquire an interest in the fund period period period period after the first fund closing, they are often Types of investment Raise Call Manage Dispose of required to pay interest to the fund and the capital capital portfolio investments funds and income tax fund allocates this interest income to the characteristics investors who invested in the first closing. Set up fund Find and make Collect Return capital and • Marketable securities entity structure investments management fees wrap up fund The general partner (GP) will require capital • Hedge funds contributions to be made to the fund over a Offering and Allocate Collect • Private equity/venture capital 3-5 year commitment period. The PEF calls closings carry management fees • Publicly traded partnerships capital commitments in stages as it identifies • Real estate funds Collect Collect carry, investment opportunities or as needed to management fees if profitable • Fund of funds fund management fees and other expenses. Investment fund attributes Capital contributions are made pro rata by extent the PEF earns an aggregate return on Venture Capital Funds • Trader versus investor all partners in proportion to their capital its investment that exceeds the preferred entities commitments, with the limited partners return, management fees, and partnership A venture capital (VCF) is a type of PEF that • Passive versus committing most of the capital and the GP expenses, the GP will be allocated a portion typically focuses on providing equity and non-passive income contributing a small portion of the capital. of the excess profit, referred to as the financing to start-up emerging businesses • Separately stated activity Investments in PEFs are typically illiquid, as carried interest. with a focus on providing its investors above- (including PTPs) capital is locked-up for many years, with average returns. VCFs can be attractive to • Qualified small business infrequent distributions until there is a Some PEFs have started to use debt or investors versus traditional PEFs because stock (QSBS) liquidity event. Investors typically do not have lines of credit to help fund investments in they typically invest in businesses that are • Unrelated business an ability to withdraw their capital. The PEF’s portfolio companies for a period of time less developed. If these less-developed taxable income profits and losses are allocated to the capital between when an opportunity is identified businesses become successful, they may • State tax reporting accounts of the partners as agreed upon in and when the capital can be called from provide for higher growth opportunities. investors. If implementing such a strategy, On the other hand, there is more risk on Conclusion the partnership agreement. The PEF’s profits are typically distributed to all partners based the PEF is generally able to increase the the downside because many of the less- Resources on their respective capital contributions, with internal rate of returns to its investors, but developed businesses may ultimately not a preferred return allocable to the limited this approach can create tax ramifications, be successful. Another difference between partners over the life of the fund primarily specifically for tax-exempt investors, VCFs and PEFs is that investments in VCFs for the use of their capital. In most instances, creating unrelated business taxable are typically equity whereas investments in the GP or a separate management company income (UBTI). See page 60 for additional PEFs can be both equity and debt. is paid an annual management fee. To the information on UBTI.

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Character of income income portion will be similar to the In addition, the allocations will reflect Introduction considerations—PEF and VCF amount that would be recognized if the the GP’s right to return of capital, carried Income generated from PEFs and VCFs underlying operating business conducted interest, and upside gain on disposition of What is an investment fund? is typically dependent on the type of by the portfolio company was sold. Such an investment. The character of any item investment. For many PEFs that are investing a disposition results in gain taxed as of income, gain, loss, deduction, or credit Types of investment in businesses organized as partnerships, ordinary income (to the extent of ordinary allocated to the GP under the carried funds and income tax there will typically be operating income deductions required to be recaptured or to interest provisions of the LP agreement for characteristics or losses flowing through to the investor the extent of gain attributable to assets the a PEF or VCF is determined by the LP and • Marketable securities which are subject to ordinary tax rates. sale of which would be treated as ordinary retains its character when reported by the • Hedge funds For PEFs investing in businesses organized income (e.g., inventory), with the remainder GP. Although a GP’s carried interest in many • Private equity/venture capital as corporations, any operating income of the gain (if any) being taxed at the instances is not determined until late in a • Publicly traded partnerships from that business will not flow through long-term rate. In some cases, calendar year or after the calendar year end, • Real estate funds to the PEF nor to the PEF’s investors. if the underlying investments are in the the timing of when the items are included in • Fund of funds energy industry, there may be unique tax the GP’s carried interest coincides with when Depending on the type of investments Investment fund attributes treatment of certain items for those types the items are recognized by the PEF or VCF. made by PEFs and VCFs, some funds may • Trader versus investor of investments. Lastly, see the additional For example, if the fund recognizes long- include alternative investment vehicles (AIV) entities discussion on page 59 regarding qualified term capital gain on the sale of corporate in their fund structure. An AIV is simply a • Passive versus small business stock, which may apply for stock in January, and such gain results fund partnership typically created to allow non-passive income certain types of PEF or VCF investments. in an allocation of gain to the GP under tax sensitive investors to invest, side by • Separately stated activity the carried interest provisions of the LP side, with the main fund, for example, in As a PEF or VCF recognizes items of income, (including PTPs) agreement, then such income is treated as a flow-through portfolio company. The gain, loss, deduction, and credit, such • Qualified small business allocated to the GP in the first quarter and AIV structure will typically have a blocker items are allocated among its partners stock (QSBS) should be taken into account for quarterly corporation as a limited partner in the based upon the economic terms of the • Unrelated business estimated tax purposes accordingly. AIV, through which tax-sensitive limited LP agreement. Such allocations take into taxable income partners invest. consideration each partner’s rights under • State tax reporting the economic terms set forth in the fund’s When a PEF or VCF disposes of a portfolio Conclusion LP agreement. Generally speaking, the company structured as a corporation, the allocations will reflect each limited partner’s Resources gain/loss is treated as short-or-long-term right to return of capital, preferred return, capital gain, depending on the time that and an allocable share of upside gain on the the fund held the investment. When a PEF disposition of an investment. or VCF disposes of a portfolio company structured as a partnership, the ordinary

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Publicly traded partnerships (PTP) partnerships or other subsidiaries (often It is important to disregarded for tax purposes) held by the Introduction A publicly traded partnership (PTP) is a publicly traded MLP. understand any partnership that is either traded on an What is an investment fund? established securities market or readily Character of income considerations— additional state filing traded on a secondary market or the Types of investment publicly traded partnerships obligations that may be substantial equivalent of a secondary funds and income tax PTPs are statutorily required to be market. Partnerships that are publicly characteristics separately stated (see page 58 for an created upon making an traded are classified as corporations for US • Marketable securities additional discussion on separately stated investment directly in a federal income tax purposes unless at least • Hedge funds activities). This requirement can be time 90% of the partnership’s gross income is • Private equity/venture capital consuming, which creates additional PTP or indirectly through from sources commonly considered to be • Publicly traded partnerships administrative burden in tax return the use of a partnership. passive or from certain types of businesses • Real estate funds preparation. In addition, PTPs typically have historically conducted in partnership • Fund of funds activities in multiple state jurisdictions. form (qualifying income). PTPs that are Therefore, it is important to understand Investment fund attributes structured as pass through entities pay no any additional state filing obligations that • Trader versus investor corporate level taxes and owners of a PTP may be created upon making an investment entities are called unitholders. directly in a PTP or indirectly through the • Passive versus use of a partnership. non-passive income In order to qualify as a PTP, the fund must satisfy specific income requirements to take • Separately stated activity Typically, PTPs can be efficient from a advantage of these tax efficiencies. Taxes (including PTPs) tax perspective because PTPs frequently are not paid at the fund level but are paid • Qualified small business produce losses (although one needs to by the partners at the partner’s individual stock (QSBS) consider the impact of the passive activity rate on amounts reported to them by the • Unrelated business rules discussed more on page 57) due fund on Schedule K-1. Periodic distributions taxable income to accelerated depreciation. Once PTPs received from PTP investments are generally • State tax reporting are sold, a portion of the gain/loss on not taxed and treated as a return of capital. disposition is taxable as ordinary income/ Conclusion loss and a portion is taxable as capital gain/ Note, the term master limited partnership loss. Also, PTPs commonly make quarterly Resources (MLP) is used interchangeably to refer to distributions of operating cash flow, which a PTP, generally in the natural resource are typically tax-free as long as there is basis industries. An MLP often refers to a tiered in the investment. limited partnership structure in which

operations are conducted by lower-tier

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Real estate funds this special treatment, a REIT must, among considered real estate professionals that Introduction many other requirements, distribute at materially participate in the rental activity.6 Real estate funds (REF) are investment least 90% of its taxable income (exclusive of What is an investment fund? funds that pool capital for investment in capital gains) to its shareholders. As a result, Generally, gain or loss upon the sale of real estate (including direct investment in REITs rarely pay federal income tax, but investment real is taxed as IRC Types of investment property, other real estate partnerships, REIT shareholders will pay tax on amounts Section 1231 gain or loss. Gain is typically funds and income tax real estate investment trusts (REITs) or real distributed as dividends, resulting in one taxed at capital gain rates, except to the characteristics estate operating companies). Traditionally, level of income tax. extent the gain is considered depreciation • Marketable securities REFs include US taxable (usually individuals), recapture. Loss is generally treated as • Hedge funds US tax-exempt, foreign taxable (generally In many instances, REITs may be formed ordinary loss. When REF investments • Private equity/venture capital individuals or corporations), and foreign to facilitate investments by REFs. These are sold, typically any gain is going to be • Publicly traded partnerships tax-exempt investors. Similar to other funds REITs are frequently referred to as private taxed at a 25% rate (to the extent ordinary • Real estate funds operating as partnerships, income and loss or “baby” REITs. These REITs are frequently deductions were taken for tax depreciation) • Fund of funds flows through to the partners resulting in formed to reduce an investor’s exposure to with the remainder of the income being one level of tax at the partner level. Investors state income taxes and attract foreign and taxed at the long-term capital gain Investment fund attributes in REFs may also be subject to the Foreign tax-exempt investors. preferential rate of 20%. • Trader versus investor Investment in Real Property Tax Act (FIRPTA) entities rules.5 REFs often operate similarly to private Character of income considerations— • Passive versus equity and venture capital funds from a real estate funds non-passive income capital commitment and liquidity perceptive. Most REF investments generate taxable • Separately stated activity income or loss from the rental of (including PTPs) Shares of REITs are often traded on public to 3rd parties, and in those cases, rental • Qualified small business exchanges and encourage widespread real estate income is taxable as ordinary stock (QSBS) passive investment in real estate by income. In many instances, real estate may • Unrelated business investors interested in liquidity. A REIT is operate at a loss as a result of depreciation taxable income a special entity for US federal income tax and interest deductions. The deductibility of • State tax reporting purposes that meets certain technical these losses may be deferred as a result of requirements and elects REIT status. the application of the passive activity rules Conclusion The key difference between a regular US (discussed further in the passive versus Resources corporation and a REIT is that a REIT is non-passive section on page 57). Note, the allowed a tax deduction for dividends paid passive activity rules apply to individuals and to its shareholders. In order to qualify for other entities, such as trusts, that are not

5 FIRPTA requires foreign individual, trust, and corporate investors to treat gain or loss on the disposition of a US real property interest (“USRPI”) as if such gain or loss is ECI. 6 Real estate professionals must spend the majority of their time in the 2017 Essential Tax and Wealth Planning Guide| Tax implications of fund investing 53 real estate property business and have a minimum of 750 hours a year. Tax implications of fund investing Types of investment funds and income tax characteristics

Fund of funds Character of income

Introduction The term fund of funds (FOF) refers to an considerations—fund of funds The tax attributes of FOF are similar to investment fund with an investment strategy What is an investment fund? the aforementioned investment funds. designed to hold a series of underlying fund Depending on the investments of FOFs, Types of investment investments versus directly owning stocks, it can be similar to one or more types of funds and income tax bonds, operating entities, and other assets. investments funds. characteristics FOFs are typically structured as LPs or LLCs. • Marketable securities FOF are typically organized by the type of • Hedge funds underlying investment funds; for example, • Private equity/venture capital a hedge fund FOF, private equity FOF, real • Publicly traded partnerships estate FOF, or publicly traded partnership • Real estate funds FOF. Alternatively, it is possible for a FOF to • Fund of funds be setup with investments across multiple Investment fund attributes types of investments, though this is less • Trader versus investor common. One benefit many find with a FOF entities structure is that FOFs provide access to • Passive versus funds investors may not be able to invest non-passive income in directly. For example, many funds have • Separately stated activity contribution minimums for investors. If (including PTPs) an investor can’t meet the contribution • Qualified small business minimum, the investor may be able to gain stock (QSBS) exposure to the fund by commingling its • Unrelated business capital with others in a FOF structure to be taxable income able to meet the contribution minimum • State tax reporting and obtain access. Consideration should be given to the additional layer of management Conclusion and performance fees at the FOF level, in addition to the fees that are being charged Resources by the underlying investment funds.

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Key tax attributes of investment funds include 1) the characteristics of the fund itself and 2) the character of income, expense, gain, loss, and Introduction credits generated by the fund (or allocable to the fund in a FOF setting) and how these amounts impact the investor’s tax liability. Taxpayers may invest in a wide variety of funds but may not be aware of how the investment strategy (e.g., holding securities short or long, trading through What is an investment fund? derivatives, buying dividend paying stocks, purchasing operating company investments, etc.) could impact the character of the income, losses, and deductions generated by the investment. Types of investment funds and income tax The below chart and discussion can assist you in understanding the attributes of funds and the character of income and expenses coming characteristics from the funds. • Marketable securities • Hedge funds • Private equity/venture capital Investment fund attributes Entity characteristics, income/(expense) characteristics, and other considerations • Publicly traded partnerships • Real estate funds Fund of funds * • Fund of funds Marketable Private equity/ security Hedge fund Venture Capital Publicly traded Real estate Investment fund attributes partnership partnership partnership partnerships partnerships • Trader versus investor entities Entity characteristics • Passive versus Classified as a business trading securities Sometimes Sometimes No No No non-passive income Classified as an operating business No No Sometimes Sometimes Sometimes • Separately stated activity Classified as an investor partnership Sometimes Sometimes Sometimes Sometimes Sometimes (including PTPs) State sourced income generated No Sometimes Sometimes Frequently Yes • Qualified small business PTP separately stated activities No Sometimes Sometimes Yes No stock (QSBS) Non-PTP separately stated activities No No Yes Sometimes Yes • Unrelated business taxable income Qualified small business stock No Rarely Sometimes Rarely Rarely • State tax reporting Operating business unrelated business taxable income No Sometimes Yes Yes Yes Debt financed unrelated business taxable income No Frequently Yes Sometimes Yes Conclusion Foreign reporting requirements Sometimes Sometimes Sometimes Sometimes Sometimes

Resources Capital commitments No No Yes No Yes Usage of leverage No Frequently Sometimes Sometimes Sometimes

* Fund of funds can include multiple investment funds in one strategy (hedge funds for example) or can be across investment fund strategies (hedge fund, private equity, publicly traded partnerships, etc.)

2017 Essential Tax and Wealth Planning Guide| Tax implications of fund investing 55 Tax implications of fund investing Investment fund attributes

Investment fund attributes Introduction Entity characteristics, income/(expense) characteristics, and other considerations

What is an investment fund? Fund of funds

Types of investment Marketable Private equity/ security Hedge fund Venture Capital Publicly traded Real estate funds and income tax partnership partnership partnership partnerships partnerships characteristics • Marketable securities Income tax characteristics • Hedge funds Passive income/(losses) No Sometimes Sometimes Yes Yes • Private equity/venture capital Preferential rate qualified dividends Sometimes Sometimes Sometimes Sometimes Sometimes • Publicly traded partnerships Long-term capital gains Sometimes Sometimes Sometimes Sometimes Sometimes • Real estate funds IRC Section 475 mark to market income No Sometimes No No No • Fund of funds IRC Section 1256 foreign currency contracts No Sometimes No No No Income subject to 3.8% NIIT tax Yes Yes Yes Yes Yes Investment fund attributes • Trader versus investor Fund expenses subject to 2% limitation Sometimes Sometimes Sometimes Sometimes Sometimes entities Fund expenses non-subject to 2% limitation Sometimes Sometimes Sometimes Sometimes Sometimes • Passive versus Carried interest Sometimes Sometimes Sometimes Sometimes Sometimes non-passive income Other considerations • Separately stated activity Frequency of liquidity Monthly/quarterly Monthly/quarterly No liquidity Daily No liquidity (including PTPs) • Qualified small business Typical fund life Indefinite Indefinite 7-13 years Indefinite 7-13 years stock (QSBS) Foreign versus domestic Generally domestic Domestic & foreign Domestic & foreign Domestic Domestic & foreign • Unrelated business Typical entity type Partnership Partnership Partnership Partnership Partnership taxable income Frequency of asset valuation Monthly/quarterly Monthly/quarterly No liquidity Daily No liquidity • State tax reporting

Conclusion

Resources

2017 Essential Tax and Wealth Planning Guide| Tax implications of fund investing 56 Tax implications of fund investing Investment fund attributes

Trader versus investor status management fees or fund expenses will not Passive activity versus Introduction be considered in connection with a trade or non-passive activity Typically, funds like MSFs and HFs will business and may be limited by the itemized Ordinary income or loss generated from What is an investment fund? either be determined to be a trader (in the deduction phase-out provisions or added fund investments is typically either passive business of trading securities) or an investor back under the AMT regime. or non-passive. Passive income and losses Types of investment (not in the trade or business of trading are often generated by a rental activity or funds and income tax securities). This annual determination is Typically, most private equity/real estate an operating business in which the taxpayer characteristics based on the facts and circumstances of investment funds are invested in other does not materially participate. Items that • Marketable securities the fund surrounding frequency of trading, operating business, such that the fund are non-passive income include portfolio • Hedge funds holding period, etc. There is no statutory itself is determined not to be in the trade income such as interest, dividends, and • Private equity/venture capital definition of a trader vs. an investor, and or business of purchasing other private gains on stocks and bonds. Investment • Publicly traded partnerships the fund must complete an annual analysis equity or real estate investment funds. activity from marketable security and hedge • Real estate funds to determine whether it is a trader or an Consequently, most management fees funds is almost always not considered • Fund of funds investor for the current year. Typically, a or fund expenses incurred are not in passive income, either because it is portfolio trader is a taxpayer who buys and sells connection with a traditional trade or Investment fund attributes income or because it is trading income. securities with reasonable frequency in business and may be subject to the itemized • Trader versus investor an effort to catch swings in the market deduction phase-out provisions or added entities Passive losses are only deductible by an and profit thereby on a short-term basis. back under the AMT regime, unless the • Passive versus investor to the extent of an investor’s A trader can be engaged in a trade or operating businesses are pass throughs non-passive income overall passive income. If, in a given year, business if the activity is conducted with and it is determined that the expenses are • Separately stated activity an investor has more passive losses than continuity and regularity and with a primary deductible like other expenses incurred (including PTPs) passive income, the excess passive losses purpose of producing economic income or directly in the operating businesses. • Qualified small business can be carried forward indefinitely to profit. A fund that is classified as an investor stock (QSBS) future years. To the extent a taxpayer has typically has less trading activity and seeks • Unrelated business carryforward losses from an investment and to profit from more long-term investments. taxable income the investment is completely disposed of in a fully taxable transaction to an unrelated • State tax reporting If the fund qualifies as a trader, then party, such losses are deductible in the year its activities will be considered in the Conclusion of the disposition regardless of whether the connection of a trade or business. Expenses taxpayer has other passive income to offset such as management fees or fund expenses Resources the losses. The deductibility of carryover will be classified as trade or business losses in the year of complete disposition expenses, fully available to offset an is dependent upon how the investor has investor’s ordinary income from the trader, grouped its passive activities. as well as other sources. Conversely, if the fund is considered to be an investor, any

2017 Essential Tax and Wealth Planning Guide| Tax implications of fund investing 57 Tax implications of fund investing Investment fund attributes

If a taxpayer invests in a PEF or a REF and By separately stating each passive activity, the investor Introduction the taxpayer receives a current year tax estimate, consideration should be given may deduct any current or carryforward passive losses in What is an investment fund? regarding whether any loss estimates are a year of complete disposition of that activity. currently deductible or whether they may Types of investment be passive and the deduction is limited to funds and income tax the extent of projected passive income. Separately stated activities—PTPs relates to that specific PTP investment. If characteristics Furthermore, to the extent you borrow one of the FOFs disposes of that underlying • Marketable securities PTPs are unique because the passive to acquire an interest in a PEF or REF, PTP investment but the other FOF does not • Hedge funds activity limitations discussed above are you should evaluate whether the interest dispose of its investment in the same PTP, • Private equity/venture capital applied separately on a PTP-by-PTP basis. expense may be subject to the passive the taxpayer cannot deduct the suspended • Publicly traded partnerships Thus, a net passive loss from one PTP may loss rules as well. passive losses from the PTP that the first • Real estate funds not be utilized to offset passive income FOF disposed of. Rather, the suspended • Fund of funds from another PTP or any other passive losses must be aggregated with the losses Separately-stated activities–non PTPs source. Rather, a passive loss from a PTP related to the PTP investment that is still Investment fund attributes is suspended and carried forward to offset Many PEFs and REFs separately state held and may be recognized when the • Trader versus investor income in a future year from that same the income and losses of each of their other PTP FOF disposes of the underlying entities PTP. If the partner’s entire interest in the underlying passive activities. A taxpayer PTP investment. • Passive versus PTP is completely disposed of in a fully may decide to separately state the passive non-passive income taxable transaction to an unrelated party, income and losses from a passive activity • Separately stated activity any unused losses are fully deductible in the as it is reported on the Schedule K-1 or (including PTPs) year of disposition. group two or more activities of similar • Qualified small business nature together. By separately stating each stock (QSBS) Care should be given when a taxpayer passive activity, the investor may deduct • Unrelated business invests in a FOF that then invests in PTPs. any current or carryforward passive losses taxable income Typically, the FOF will list the activity of each in a year of complete disposition of that • State tax reporting underlying PTP investment separately. activity. If all investments from a fund are Upon review of the underlying Schedule Conclusion grouped together, all the investments are K-1, it may be determined that the taxpayer treated as a single passive activity, which indirectly invested in the same PTP through Resources could potentially defer the deduction of multiple investment vehicles. To the extent carryforward and current year passive this occurs, the taxpayer must aggregate losses until the disposition of the last the income and losses allocated from investment in the fund. the various partnership investments as it

2017 Essential Tax and Wealth Planning Guide| Tax implications of fund investing 58 Tax implications of fund investing Investment fund attributes

PTP investments are typically held through and administrative work. Therefore, when for QSBS acquired after September 27, Introduction an investor’s brokerage account. The evaluating the rate of return related to 2010, to the point where a complete monthly and year-end statements do not PTP investments, consideration should be exemption from federal income tax on gains What is an investment fund? typically adjust the investor’s tax basis for given to the incremental cost associated from the sale of certain stock is possible. VC the investor’s share of allocable income or with the additional tracking and reporting funds often make investments in companies Types of investment loss from the PTP. Therefore, it is important requirements. that may qualify as a QSBS and having a funds and income tax for the taxpayer to track its tax basis in the good understanding of what investments characteristics PTP, so that the appropriate capital gain may generate QSBS gains could generate • Marketable securities Qualified small business stock (QSBS) or loss can be calculated on disposition. significant tax savings. • Hedge funds It is important to note that the PTP fund Over the years, Congress has provided • Private equity/venture capital will also provide details to the investor a variety of incentives to encourage The chart below summarizes the portion of • Publicly traded partnerships regarding the portion of the gain that will investments in qualified small businesses. the gain from the sale of QSBS that may be • Real estate funds be recharacterized as ordinary in the year Congress believes that targeted relief excluded from income depending on when • Fund of funds of disposition. for investors who risk their funds in new the stock was purchased. The chart also ventures, small businesses, and specialized outlines the effective regular and AMT rates Investment fund attributes As you can see from the description above, small business investment companies will associated with the sale of QSBS. • Trader versus investor the tax rules associated with holding PTP encourage investments in these enterprises. entities investments are complex and can create In the past several years, Congress has • Passive versus additional tax reporting requirements made these incentives even more generous non-passive income • Separately stated activity (including PTPs) Effective regular and AMT tax rates for sale of QSBS held for more than five years • Qualified small business stock (QSBS) • Unrelated business Section 1202 Effective Effective taxable income Stock acquisition period exclusion amount AMT treatment regular tax rate AMT tax rate • State tax reporting Prior to February 18, 50% of the 3.5% of the realized gain will be treated as 14% 14.98% 2009 realized gain an AMT preference item Conclusion After February 18, 75% of the 5.25% of the realized gain will be treated as Resources 2009 and on or before realized gain an AMT preference item 7% 8.47% September 27, 2010

After September 27, 100% of the 0.0% of the realized gain will be treated as 2010 and before realized gain an AMT preference item 0% 0% January 1, 2015

2017 Essential Tax and Wealth Planning Guide| Tax implications of fund investing 59 Tax implications of fund investing Investment fund attributes

Below are some of the requirements in Unrelated business taxable income that causes UBTI is investments in operating order for a stock to be considered QSBS. businesses. Typically, income from operating Introduction For tax-exempt investors considering a fund businesses is considered UBTI. Many PEFs investment, it is important to understand What is an investment fund? Requirements and REFs generate operating income, and the underlying investment strategy and • The stock must be in a domestic C thus the income would be UBTI. Types of investment income that will be generated by the corporation (not an S corporation or fund. For example, foundations generally funds and income tax Ultimately, tax-exempt entities should weigh LLC, etc.), and it must be a C corpora- pay excise tax equal to 1% or 2% of the characteristics the expected appreciation and benefits of tion during substantially all the time the net investment income earned by the • Marketable securities diversification that investing in underlying taxpayer holds the stock. foundation during the year. However, • Hedge funds funds can offer against the incremental cost if a foundation is allocated UBTI, such • Private equity/venture capital • The corporation may not have more than of paying 35% tax on UBTI. • Publicly traded partnerships $50 million in assets as of the date the income is subject to a 35% income tax • Real estate funds stock was issued and immediately after. rate. Accordingly, tax-exempt organizations generally try to minimize acquiring • Fund of funds • The taxpayer’s stock must be acquired For tax-exempt investors investments that generate UBTI. at its original issue (not from a Investment fund attributes considering a fund secondary market). • Trader versus investor Even income that is otherwise not UBTI will investment, it is important entities • During substantially all the time the be UBTI if the income is from debt-financed • Passive versus taxpayer held the stock, at least 80% property. As described above, many HFs to understand the non-passive income of the value of the corporation’s assets utilize leverage to execute the investment underlying investment • Separately stated activity were used in the active conduct of one strategy, thus creating UBTI for tax-exempt (including PTPs) or more qualified businesses. investors. Therefore, depending on the strategy and income • Qualified small business anticipated amount of UBTI, many tax- that will be generated stock (QSBS) In contrast to being able to receive a full exempt investors will proactively choose • Unrelated business federal income tax exemption for QSBS to invest through the offshore HF blocker by the fund. taxable income acquired after September 27, 2010 (but corporations to effectively block any UBTI • State tax reporting before January 1, 2015), a second alternative from flowing through. For tax-exempt is available to defer gain by rolling over investors, it may be prudent to weigh the Conclusion gains into new QSBS investments. There are cost of paying tax on UBTI by holding a direct also planning considerations to increase the interest in a partnership HF investment Resources ability to take the exclusion to the extent the (which would flow through the UBTI to the amount of the excludable gain exceeds the taxpayer) versus the cost of investing directly exclusion limitation. in an offshore blocker corporation, which is subject to 30% withholding on FDAP income and 35% withholding on ECI. Another activity

2017 Essential Tax and Wealth Planning Guide| Tax implications of fund investing 60 Tax implications of fund investing Investment fund attributes

State reporting Many states with budget shortfalls recently have chosen Introduction Many states with budget shortfalls recently to ramp up their tax collection efforts to help plug budget have chosen to ramp up their tax collection What is an investment fund? efforts to help plug budget shortfalls. As shortfalls. As a result, many states have become more Types of investment a result, many states have become more aggressive and have developed enhanced systems to funds and income tax aggressive and have developed enhanced characteristics systems to identify investors who have identify investors who have a requirement to file a tax • Marketable securities a requirement to file a tax return with return with the state. • Hedge funds the state. Therefore, when considering • Private equity/venture capital acquiring a fund, it is important to • Publicly traded partnerships understand whether the fund is expected to return, referred to as a composite tax income would only be subject to tax in • Real estate funds generate state-sourced income. return. In many states, the fund can file a that state. For REFs, the state-sourced • Fund of funds composite tax return and pay the investors’ income allocated to the investors is typically Funds with state-sourced income generally share of tax liability attributable to the allocated to states where the property disclose to each investor their allocable Investment fund attributes share of income allocable to the state. By is located and where rental income is share of state sourced income by providing • Trader versus investor participating in a state’s composite filing, being received. Many PEFs also generate state K-1s or a footnote included with the entities an investor’s tax filing obligation may be state-sourced income to the extent that federal K-1 with state specific information. • Passive versus satisfied. Each state has its own specific the portfolio investments are directly As an investor, if there is state-sourced non-passive income rules on which types of investors (individual, in operating businesses organized as a activity, it is important to understand • Separately stated activity grantor trust, complex trust, partnership, partnership. Most resident states provide whether the income creates a state tax (including PTPs) and corporation) can be included in a for credits for taxes paid to other states, so filing obligation and potential liability. To • Qualified small business composite return and/or have withholding it is important to understand the rules of the extent there might be a state filing stock (QSBS) performed on their behalf. Therefore, your state. obligation, it is helpful to quantify what the • Unrelated business understanding what the fund plans to do to investor’s liability might be and the cost taxable income address the investor’s state filing obligations Additional state filings can be costly and associated with any additional filings that • State tax reporting will be important for investors to evaluate increase an investor’s tax exposure. might be necessary. the cost of investing in the fund. Therefore, taking the time upfront to Conclusion proactively analyze the incremental cost If the fund anticipates that state-sourced MSFs often qualify under special investment associated with additional state tax liabilities Resources income will be generated, you should partnership rules providing that their and filings will be important to quantify the inquire whether the fund will withhold investment income is not sourced to a potential after-tax return associated with a nonresident taxes on your behalf or state. Thus, to the extent the taxpayer’s fund investment. whether the fund will file an entity level resident state imposes a tax, the investment

2017 Essential Tax and Wealth Planning Guide| Tax implications of fund investing 61 Tax implications of fund investing Conclusion

With a solid understanding of the various types of funds and how specific attributes of the funds impact your tax position and tax compliance Introduction obligations, you can make more informed investment decisions. Considering that the ordinary tax rate is currently 39.6%, the net investment income tax rate is 3.8%, and many states/localities have income taxes, it is not uncommon for investment returns to be potentially taxed as What is an investment fund? high as 50%.

Types of investment Below are some actions you may consider taking and questions you may consider asking before making an investment: funds and income tax characteristics Review the investment strategy Understand the timing when periodic Ask for a sample prior year Schedule • Marketable securities and tax consequences section of economic and tax information will be K-1. If the fund is new, ask for a • Hedge funds the offering documents or private delivered. representative Schedule K-1 from a • Private equity/venture capital placement memorandum. similar fund. • Publicly traded partnerships • Real estate funds Understand the character of the Assess how the income allocated from If a tax-exempt investor is making the • Fund of funds income likely to be allocated from the investment impacts your facts investment, what, if any, UBTI can be Investment fund attributes the investment. and tax posture. anticipated. • Trader versus investor entities Understand anticipated state sourced Inquire whether the fund is a Inquire about foreign filings and • Passive versus income expectations and whether the domestic fund or foreign fund to expected type and volume. non-passive income fund will file a composite return or evaluate reporting requirements. • Separately stated activity submit withholding on your behalf if (including PTPs) there is state sourced income. • Qualified small business stock (QSBS) For marketable security and hedge For private equity and real estate For private equity and real estate • Unrelated business funds, understand provisions for funds, understand anticipated timing funds, understand whether the taxable income being able to redeem capital. of capital calls and estimated fund activities will be separately stated • State tax reporting life. on Schedule K-1.

Conclusion As taxpayers seek to diversify their portfolios, we anticipate that opportunities to invest through funds will continue to grow. Therefore, Resources understanding the tax consequences associated with the investments will allow you to proactively plan and enhance your investments.

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