FOR LIVE PROGRAM ONLY Tax Reporting and Reconciliation of Hedge Fund and Other Alternative Investment Fund K-1s WEDNESDAY, MAY 16, 2018, 1:00-2:50 pm Eastern IMPORTANT INFORMATION FOR THE LIVE PROGRAM This program is approved for 2 CPE credit hours. To earn credit you must: • Participate in the program on your own computer connection (no sharing) – if you need to register additional people, please call customer service at 1-800-926-7926 ext.1 (or 404-881-1141 ext. 1). Strafford accepts American Express, Visa, MasterCard, Discover. • Listen on-line via your computer speakers. • Respond to five prompts during the program plus a single verification code. • To earn full credit, you must remain connected for the entire program. WHO TO CONTACT DURING THE LIVE EVENT For Additional Registrations: -Call Strafford Customer Service 1-800-926-7926 x1 (or 404-881-1141 x1) For Assistance During the Live Program: -On the web, use the chat box at the bottom left of the screen If you get disconnected during the program, you can simply log in using your original instructions and PIN. Tips for Optimal Quality FOR LIVE PROGRAM ONLY Sound Quality When listening via your computer speakers, please note that the quality of your sound will vary depending on the speed and quality of your internet connection. If the sound quality is not satisfactory, please e-mail [email protected] immediately so we can address the problem. Tax Reporting and Reconciliation of Hedge Fund and Other Alternative Investment Fund K-1s WEDNESDAY, MAY 16, 2018 Suzy Lee, CPA, MST, Senior Tax Manager Stacy L. Palmer, CPA, MBA, MST, Principal Untracht Early, Florham Park, N.J. Untracht Early, Florham Park, N.J. [email protected] [email protected] Laura L. Ross, CPA, Partner EisnerAmper, San Francisco [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. TAX REPORTING AND RECONCILIATION OF HEDGE FUND AND OTHER ALTERNATIVE INVESTMENT FUND K-1S Suzy Lee, CPA, MST Stacy Palmer, CPA, MBA, MST Laura L. Ross, CPA Untracht Early EisnerAmper [email protected] [email protected] [email protected] 415.357.4220 973.805.7255 973.805.7147 What is a Hedge Fund? Deconstructing Hedge Fund K-1s Presenters: Suzy Lee, CPA, MST Stacy Palmer, CPA, MBA, MST untracht.com 6 What is a Hedge Fund? Suzy Lee, CPA, MST untracht.com 7 What is a Hedge Fund? Hedge funds are alternative investments that may use a number of different strategies in order to earn high returns for their investors. In general, hedge funds use derivatives and leverage their investments in addition to holding the traditional portfolio of stocks, bonds, and cash. untracht.com 8 History of Hedge Funds • Alfred Winslow Jones – first hedge fund in 1949 • Julian Robertson's Tiger Fund • First stars –George Soros, Bruce Kovner untracht.com 9 Hedge Fund Strategies 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 untracht.com 10 How Hedge Funds are Set Up • Hedge funds are most often set up as private investment limited partnerships that are open to the limited number of accredited investors and require a large initial minimum investment. • Investments in hedge funds are illiquid as they often require that investors keep their money in the fund for a certain period of time known as the “lock-up period”. Withdrawals may also only happen at certain intervals. • Generally, they are not registered under the Investment Company Act of 1940. • In general, hedge funds are largely unregulated because they cater to sophisticated investors. untracht.com 11 Typical Fees of Hedge Funds • 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 untracht.com 12 Overview of Fund Types – Trader Fund • 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 untracht.com 13 Overview of Fund Types – Investor Fund • 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) untracht.com 14 Overview of Fund Types – Fund of Funds • 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 untracht.com 15 Trader v. Investor • 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. untracht.com 16 When is a Taxpayer Engaged in the Business of Trading Securities? • 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 over the last 80 years 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 untracht.com 17 IRC Section 475(F) Election – Mark to Market (MTM) • 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 untracht.com 18 Deconstructing Hedge Fund K-1s Stacy Palmer, CPA, MBA, MST untracht.com 19 Federal K-1s Trader vs. Investor Status • Comparative Tax Treatment – Trader vs. Investor • Examples - Investor - Trader – material participation - Trader – no material participation - Fund of Funds • 3.8% Net Investment Income Tax (NIIT) – IRC §1411 untracht.com 20 Comparative Tax Treatment: Trader vs. Investor untracht.com 21 Management Fees and Expenses Other than Interest Expense • Trader – Expenses are deductible under §162 by individual taxpayers "above the line" in arriving at AGI. - Only trader funds can make a §475(f) mark-to-market election (could be just for some activities within the fund). • Investor – Expenses are §212 investment expenses, treated as miscellaneous itemized deductions. - Subject to 2% of AGI floor limitation and overall AGI-based phase-out of itemized deductions. - Miscellaneous itemized deductions are not allowed for AMT. - Swap expense/loss is treated as a miscellaneous itemized deduction. - Some states limit or do not allow itemized deductions. untracht.com 22 Management Fees and Expenses Other than Interest Expense • 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. untracht.com 23 Interest Expense • 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.