Year-end tax-planning considerations for hedge fund managers (2024)

As the calendar year draws to a close, hedge fund managers should consider the tax profile of their funds and the effects of year-end transactions on investors. Tax efficiency can be quite relevant to investors, especially in years when funds may have taxable income that exceeds their book income. Hedge fund managers may also want to analyze trades as certain tax rules may trigger unintended consequences to funds and their investors.

Wash sales, constructive sales and holding periods

Normal trading may have tax consequences that differ from the economic outcome. Purchases or sales prior to year end may result in recognition of unrealized gain under the constructive sale rules or deferral of loss under the wash sale rules. A constructive sale occurs when a taxpayer holds an appreciated financial position and then enters into certain offsetting positions on substantially identical property. This may trigger recognition of gain, though a constructive sale may subsequently be "cured" in certain circ*mstances. Wash sales may be triggered 30 days after the end of the year, if a taxpayer sells an asset at a loss and acquires substantially identical property within a 61-day window. In some situations, the use of certain derivatives, either to replicate existing exposure once the loss has been triggered, or to protect against a decline in value on additional stock purchased, could provide an opportunity to maintain economic exposure without triggering application of the wash sales rules. Basket swaps, if executed properly, could also be used to change economic exposure without causing adverse tax consequences.

Year-end trades may also affect the holding period of an asset, so managers should consider the tax basis of assets that are being traded while reviewing the portfolio in order to fully understand the tax consequences. For example, if a depreciated position's holding period is about to become long-term, it may be beneficial to dispose of the position before reaching this threshold. Similarly, if an appreciated position is about to become long-term, hedge fund managers should consider holding on to that position until a long-term holding period is established to benefit from preferential tax treatment. Managers should also be mindful of the netting rules to ensure that they are using capital gains and losses in the most tax-efficient manner possible. While hedge fund managers may not execute trades solely for these reasons, the tax effect is an important component to consider.

Tax elections

There are various tax elections available for certain taxpayers that hedge fund managers should consider. The applicability of these elections will depend on the trading strategy of the fund.

Mark-to-market election for securities traders under Section 475(f)(1)

The Section 475(f)(1) election allows taxpayers to mark assets to market each year, which will eliminate book-to-tax differences from unrealized securities positions. Tax adjustments like wash sales and straddles generally would no longer apply. This election eliminates the ability to claim preferential tax treatment on gains and losses by treating almost everything as ordinary income.

If a hedge fund manager has significant unrealized economic losses, this election would cause them to be recognized for tax purposes. If a fund has a high volume of trading, this election could also be beneficial as it eliminates some of the administrative burden of tracking book-to-tax differences. This election also potentially eases the manager's investor relations as investor book-to-tax differences are eliminated and tax projections would, in theory, become more straightforward.

The Section 475(f)(1) election is only available to funds that are considered to be active traders rather than investors. The election must be filed with a timely filed extension request (or the timely filed unextended tax return) for the previous year. This provides hedge fund managers a few months at the start of the year to decide if making the mark-to-market election would be beneficial. Hedge fund managers may consider this mark-to-market election for tax year 2017, but must include it when filing their tax return extension, which is due on March 15, 2017,¹ for a calendar-year taxpayer, to be valid for the 2017 tax year.

Revocations to previously made Section 475(f)(1) elections

Last year, new procedures were enacted allowing taxpayers to revoke a Section 475(f) election. The revocation can be made by the due date of the prior-year return (without extension) and is considered an automatic change in accounting method. Hence, hedge fund managers wishing to revoke this election for tax year 2017 and thereafter must make the revocation no later than the filing of their 2016 tax return extension, which is due on March 15, 2017. Hedge fund managers may wish to revoke a 475(f) election to benefit from any future appreciation of long-term capital gains because the 475(f) election does not affect holding period. Taxpayers revoking this election may not make another mark-to-market election for five years after the revocation.

Section 988(a)(1)(B) election

Hedge funds with significant trading in foreign-currency forwards should consider making an election under Section 988(a)(1)(B). This would allow for the treatment of gains and losses from foreign-currency contracts as capital gains or losses rather than ordinary income or loss. This could be beneficial as certain foreign-currency contracts, which would normally be treated as ordinary income for tax purposes, now would be taxed at 60% long-term capital gain rates and 40% short-term capital gain rates. This election needs to be made when the foreign-currency contract is entered. Consideration should be given to whether the forward is or might become part of a straddle, as that would invalidate the election with respect to any gain on such contract, although it would not necessarily invalidate the election with respect to losses.

Electing a mixed straddle account

Hedge fund managers that use Section 1256 contracts to hedge their risk in non-1256 property should consider making a mixed straddle election. This election allows a taxpayer to mark-to-market all of the positions in the mixed straddle account. Assets are categorized into categories or "buckets" that are marked and netted on a daily basis. This determines the net gain or loss of these assets. There are overall limitations placed on the income from mixed straddle accounts once all the daily netting has occurred. No more than 50% of net capital gains for the year may be treated as long-term and no more than 40% of net capital losses for the year may be treated as short term. If a mixed-straddle account election is not made, taxpayers may be subject to loss limitations or disadvantageous holding period rules with respect to these properties. Similar to the Section 475 mark-to-market election, this election also needs to be filed with the unextended tax return of the previous year (or the extension request, as applicable).

Passive foreign investment companies (PFICs)

Investing through the offshore feeder of a hedge fund rather than the onshore feeder could provide certain tax benefits in some situations. Investor funds, structured as partnerships, must report their expenses as portfolio deductions, which are subject to deductibility limitations at the individual partner level. Investing through an offshore feeder, however, could provide a dollar-for-dollar deduction against income for the investor. There are also certain state tax benefits to investing through a PFIC. For funds taking advantage of one of the aforementioned tax elections, if timed correctly, an investment in an offshore feeder could create a significant tax benefit as well. Additionally, hedge fund managers with grandfathered offshore deferrals coming due in 2017 may want to consider the benefits of investing into the offshore feeder.

Research credit

Hedge fund managers may also want to consider the implications of the new research credit regulations, including whether a large spend in the technology area makes more sense in 2016 or 2017. The final regulations clarify the rules for determining whether software is "internal use software," which is relevant in determining whether the costs of the software development activities are eligible for the research credit. The regulations are generally taxpayer-favorable compared to the prior rules. The research credit is contingent on having income and regular tax from the same trade or business, so a large spend in the R&D area may make more sense in 2017 to the extent managers have grandfathered offshore deferrals coming due in 2017.

US election implications for hedge fund managers

The prospect for significant tax reform is higher than it has been in years given President-elect Trump's stated priorities, coupled with the fact that he will be working with a Republican majority in the Senate and House of Representatives. President-elect Trump's tax plan includes several major changes and is very similar to the Congressional "Blueprint" that was released last June.

President-elect Trump would, as part of his tax reform plan, eliminate carried interest. Currently, hedge fund managers are taxed at a rate of 20% on any long-term capital gains attributable to them as a performance allocation. If this new legislation is enacted, the preferential tax rate may be eliminated, as the Trump plan would tax carried interest at ordinary rates. Trump, however, has also proposed a 15% tax on pass-through income, which is significantly lower than the highest ordinary tax rate. These issues have also been addressed in the Blueprint, which includes a 25% business tax rate for pass-through entities. Time will tell whether either item will pass, but hedge fund managers should keep both items in mind.

President-elect Trump's tax plan also includes overall lower individual tax rates of 12%, 25%, and 33%, and an overall lower corporate tax rate of 15%. Additionally, the plan would limit itemized deductions and eliminate the alternative minimum tax. These and other proposals, coupled with the likely repeal of the Affordable Care Act and its 3.8% tax on net investment income and the additional .9% tax on self-employment income, call for careful tax planning that will be highly contingent on individual facts and circ*mstances.

Next Steps

Although year-round portfolio monitoring is important, as we head into the last few weeks of the year, it is critical to consider a fund's tax profile and the aforementioned matters as they relate to individual facts and circ*mstances. It is important to remember that specific facts and circ*mstances affect the tax issues that have been described. As each fund strategy is unique, there is not always one approach that can be used to maximize tax efficiency. Tax allocations are also affected by the fund's allocation methodology and redemptions that may occur. Next year's anticipated tax reform would likely affect the taxation of hedge funds and their affiliated entities significantly. Managers should consult their tax advisors and consider taxable income implications before making planning decisions.

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ENDNOTES

¹ Note that the unextended filing deadline for calendar-year 2016 partnership tax returns is now March 15th. Prior to 2016, the unextended deadline was April 15th.