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 ordinary income 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 interest 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.