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The Private Investment PartnershipInvestor, Trader or Dealer? How should private investment partnerships be treated? As investors, traders or dealers? The distinction is critical and affects a multitude of issues. This article addresses the tax consequences of investing in U.S. hedge funds and recommends strategies to maximize tax benefits for organizers and investors.
David A. Sussman, J.D.
For more information about this article, contact Mr. Sussman at dsussman@pitneyhardin.com. Authors note: The author wishes to thank Daniel M. Kalosieh, an associate at Pitney, Hardin, Kipp & Szuch LLP, for his assistance with this article.
Executive Summary
The era of saving pennies for a rainy day is long gone. More and more Americans hold more and more of their wealth in the form of securities investments. Such investments may be direct (e.g., stock or bonds) or indirect (e.g., mutual and hedge funds). The tax consequences of investing differ depending on whether an individual invests in the securities markets directly, or indirectly through a mutual or hedge fund. This article addresses the tax consequences of investing in U.S. hedge funds and recommends strategies to maximize tax benefits for organizers and investors.
Mutual vs. Hedge Funds Mutual Funds Mutual funds, which are regulated under the Investment Company Act of 1940 (1940 Act), are corporations that pool money from individual investors. A mutual fund is typically run by professional money managers, who invest the pool in stocks, bonds or other securities. The aim is long-term growth, not capitalizing on short-term market swings. While this article does not discuss the tax treatment of mutual fund investing, Exhibit 1 compares some of the tax consequences of investing in the stock market directly to investing indirectly through a U.S. mutual fund or hedge fund taxed as a partnership.
Hedge Funds On the other hand, a hedge fund is a private investment vehicle (usually organized as a limited partnership) that seeks above-average returns through active portfolio management, rather than long-term growth. Investors tend to be attracted to hedge funds because of the managers flexibility and strategies for earning positive returns in all market conditions. Unlike mutual funds (which are heavily regulated), hedge funds are largely unregulated by Federal securities laws. Hedge-fund interests are generally exempt from the registration requirements of the Securities Act of 1933 (1933 Act) contained in Rule 506 of Regulation D, because they offer interests only to accredited investors (including natural persons who have a net worth exceeding $1 million1). Additionally, hedge funds are generally exempt from the 1940 Acts registration requirements if the investors are limited or are all qualified purchasers (e.g., any natural person who owns not less than $5 million).2 As a result of this relatively unregulated operating environment, hedge funds can make large bets on volatile positions, thereby resulting in big gains or losses. Organization: A hedge-fund organizer (usually an investment adviser or money manager) typically forms the fund as a limited partnership or limited liability company (LLC) (which is taxed as a partnership). In a limited partnership, the investors are generally limited partners (LPs); the organizer is the general partner (GP). In an LLC, the investors are non-managing-members; the organizer is the managing-member. Tax considerations: A host of tax considerations need to be addressed when investing in hedge funds. Critical among these is determining whether the fund is an investor, a trader or a dealer.3 Such status is important in determining the effect of (1) the passive activity loss (PAL) rules; (2) the investment interest expense limits; (3) the limits on deductibility of fund expenses; (4) withholding on foreign partners; (5) the wash sale, straddle and mark-to-market rules; and (6) entity-level taxes in jurisdictions that tax partnerships and LLCs.
Investors, Traders and Dealers The demarcation among investors, traders and dealers for tax purposes is comparatively clear and longstanding. Well-settled guidelines4 provide that an investor is any taxpayer that purchases and sells securities for its own account with the principal purpose of realizing investment income in the form of interest, dividends and gains from appreciation in value over a relatively long period of time (generally, one or more years). Most taxpayers who invest in securities are investors. A trader is an investor whose investment activity is so frequent that it rises to the level of a trade or business. Generally, a trader is not interested in long-term appreciation and is not investing for the dividends or interest that accompany stock ownership; rather, a trader seeks profit on short-term market swings. A dealer is a taxpayer that undertakes securities transactions on behalf of customers.
PAL Rules To the extent losses from passive trade or business activities exceed the income therefrom, Sec. 469 provides that such losses may not be deducted against active income. The excess losses are suspended under Sec. 469(g) until the taxpayer disposes of the activity that generated the losses or, under Sec. 469(b), until he or she generates additional passive activity income.
Definition Sec. 469(c)(1) defines a passive activity as any activity that involves the conduct of a trade or business in which the taxpayer does not materially participate. Generally, under Sec. 469(h)(2), an LP interest in a limited partnership is not material participation. Because an investor partnership is not, by definition, engaged in a trade or business, its losses are not subject to the PAL limits, regardless of whether the partners materially participate in the funds activities. However, trader partnerships and dealer partnerships are engaged in a trade or business; thus, their losses may be passive to the extent allocated to partners who do not materially participate. Temp. Regs. Sec. 1.469-5T(a) provides that a partner materially participates if any one of the following is met: 1. The partner participates in the activity for more than 500 hours during the year. 2. The partners participation is substantially all of the participation in such activity of all individuals (including individuals who do not own interests in the activity) for such year. 3. The partner participates in the activity for more than 100 hours during the year and his or her participation for the year is not less than any other individuals participation. 4. The activity is a significant participation activity for the year and the partners aggregate participation in all significant participation activities during the year exceeds 500 hours. 5. The partner materially participated in the activity for any five of the preceding 10 tax years. 6. The activity is a personal service activity and the partner materially participated for any three tax years preceding the tax year. 7. Based on all the facts and circumstances, the partner participates in the activity on a regular, continuous and substantial basis during the year. GPs and managing-members materially participate in a hedge fund if they meet any of the above factors. Because the GPs and managing-members are the only partners who decide which securities to purchase and when to buy and sell such positions, they materially participate in the hedge fund and, thus, are not subject to the PAL rules. LPs and non-managing-members, on the other hand, do not participate in the typical hedge funds day-to-day operations. In fact, partnership agreements and operating agreements generally preclude LPs and non-managing-members from such active participation.
Exception Temp. Regs. Sec. 1.469-1T(e)(6) provides that an activity of trading personal property for the account of owners of interests in the activity is not a passive activity. Under Temp. Regs. Sec. 1.469-1T(e)(6)(ii), personal property includes any actively traded personal property (e.g., stock and options). Accordingly, the activity is not a passive activity; thus, a trader partnerships GPs, LPs or non-managing-members are not subject to the PAL rules.5 However, dealer partnerships are likely subject to the PAL rules to the extent the partners do not materially participate. The partnership does not qualify for the trader exception, as it does not trade for the accounts of its owners.
Investment Interest Expense Many investors use others property to make investments. An investor may margin an account, in effect, borrowing from a broker to purchase securities. Alternatively, an investor may sell securities it does not own (a short sale), anticipating that they will decline in value. When an investor sells securities short, the prime broker uses another clients stock and effectively loans the securities to the investor. The investor pays the broker a fee to use the margined funds and the stock for short sales; the fee is often interest. Is such interest deductible?
Allowance of Deduction Sec. 163(a) generally allows as a deduction all interest paid or accrued within the tax year on debt. Sec. 163(d), however, limits the deductibility of investment interest to the net investment income of a taxpayer other than a corporation. Under Sec. 163(d)(3), investment interest is any interest paid or accrued on debt properly allocable to property held for investment, including any amount allowable as a deduction for personal property used in a short sale.
Property Held for Investment Sec. 163(d)(5)(A) provides that property held for investment includes (1) any property that produces portfolio-type income under Sec. 469(e)(1) (Sec. 469(e)(1) property); and (2) any interest a taxpayer holds in a trade or business that is not a passive activity and in which the taxpayer does not materially participate. Sec. 469(e)(1) property is (1) gross income from interest, dividends, annuities and royalties not derived in the ordinary course of a trade or business; or (2) gain or loss not derived in the ordinary course of a trade or business, attributable to the disposition of property held for investment. Under Sec. 163(d)(4), net investment income is the excess of investment income over investment expenses. Investment income includes, under Sec. 163(d)(4)(B)(ii)(I), gains attributable to the disposition of property; Sec. 163(d)(4)(C) defines investment expenses as expenses (other than interest) directly connected with the production of investment income. Such expenses can be significant, thereby decreasing deductible investment interest. However, Sec. 163(d)(3)(B)(ii) provides that investment interest does not include any interest taken into account in computing Sec. 469 passive activity income or loss.
Do the Limits Apply? Investor partnerships produce in-vestment interest. All of the partnerships property is Sec. 469(e)(1) property; thus, all of the partners (including GPs, LPs and LLC members) are subject to the Sec. 163 limits. However, the GPs and the managing-members in a trader partnership do not have investment interest, because the debt on which interest is paid or accrued is not allocable to property held for investment. None of a trader partnerships property is Sec. 469(e)(1) property, because a trader partnership engages in the conduct of a trade or business. Further, the GPs and managing-members materially participate in the partnerships affairs. The LPs and non-managing-members have investment interest, because they do not materially participate. Accordingly, GPs and managing-members in an investment partnership are subject to the Sec. 163(d) limits, but the GPs and managing-members in a trader partnership are not. In each case, LPs are subject to the Sec. 163(d) limits. Dealer partnerships are subject to the investment interest expense limit to the extent interest is incurred on debt allocable to the partnerships investment activities. The limit does not apply to the extent interest is paid on debt allocable to a dealer partnerships trader activities.
Trade or Business Expenses In addition to interest expense, hedge funds invariably incur other expenses. For instance, hedge funds have offices for which they pay rent, brokers to whom they pay commissions, employees to whom they pay salaries and rented or leased equipment for which they seek to deduct depreciation. Instead of paying for these items directly, a fund may pay a management company a fee to provide such services and other administrative support. Usually, the fee is 1%2% of the assets the fund has under management. Whichever arrangement the fund chooses, deductibility of these expenses hinges on whether the fund is an investor, a trader or a dealer.
Are These Expenses Deductible? If the fund is a trader, each individual partner may deduct his or her share of fund expenses (other than interest) as a Sec. 162 business expense. If the fund is an investor or dealer, such expenses would be Sec. 212 miscellaneous itemized deductions, subject to the Secs. 67 and 68 limits. Additionally, if the fund is a dealer, expenses specifically related to the conduct of other trade or business operations are deductible under Sec. 162, not 212.
Wash Sales, Straddles and Mark-to-Market Rules Wash Sales When a taxpayer sells stocks or securities at a loss and, within a 30-day period before or after such sale, acquires substantially identical stocks or securities, Sec. 1091(a) disallows the loss as a wash sale. For this purpose, substantially identical means from the same issuer.6 According to Sec. 1091(d), a loss disallowed under Sec. 1091(a) is added to the adjusted basis of the substantially identical securities purchased. The wash sale rules do not apply to dealers in stock and securities if the loss was incurred in the ordinary course of such business.
Straddles When a taxpayer sells stocks or securities at a loss, the loss is allowed under Sec. 1092 only to the extent it exceeds the unrecognized appreciation in other investments the taxpayer holds that constitute a straddle with the first investment. Sec. 1092(c)(1) defines a straddle as a taxpayers offsetting positions with respect to personal property. According to Sec. 1092(c)(2)(A), a taxpayer holds offsetting positions as to any personal property if there is a substantial diminution of risk of loss from holding such property by reason of holding one or more other positions with respect to personal property (whether or not of the same kind). Under Sec. 1092(a)(1)(B), any loss disallowed under the straddle rules for any tax year may be carried over to the next, subject to the straddle rules for such succeeding year.
Mark-to-Market Rules The wash sale and straddle rules apply differently to hedge funds characterized as traders, investors or dealers. Investor hedge funds are always subject to these rules. However, special rules apply to dealer partnerships and electing trader partnerships. Sec. 475(a)(1) generally requires dealers (and traders who elect under Sec. 475(f)) to recognize unrealized gains and losses attributable to certain securities that are not inventory and held at the close of each tax yearthe mark-to-market rule. The unrealized gains and losses are ordinary, under Sec. 475(d)(3)(A)(i). The wash sale rules do not apply to losses in positions a taxpayer has marked-to-market, according to Sec. 475(d)(1). Similarly, when a taxpayer marks-to-market certain positions, the straddle rules do not apply to such positions if the offsetting positions must also be marked-to-market.
Withholding on Foreign Partners U.S. citizens and residents are taxed on their worldwide income. Under Sec. 871, nonresident aliens (NRAs) are taxed on (1) income effectively connected with a trade or business in the U.S. (ECI) or (2) certain fixed or determinable annual or periodical (FDAP) U.S.-source income. A payers withholding requirements depend on whether the NRA has ECI or FDAP income. Sec. 1446 provides that if a partnership has ECI and any portion of such income is allocable to a foreign partner under Sec. 704, the partnership is liable for withholding tax. Under Sec. 1446(b)(1), the partnership must withhold an amount equal to the applicable percentage of the ECI allocated to the foreign partner. Sec. 1442(b)(2) defines the applicable percentage as the highest tax rate specified in Sec. 1 for noncorporate taxpayers (35% after the Jobs and Growth Tax Relief Reconciliation Act of 2003) and in Sec. 11(b)(1) for corporate taxpayers (35%). Under Sec. 864(c), ECI is income connected with a trade or business in the U.S. Sec. 864(b)(2)(A)(ii) excludes income earned from trading in stocks and securities for ones own account. Under Regs. Sec. 1.864-2(c)(2)(ii), however, this exception does not apply to a partnership with a principal office in the U.S., unless more than 50% of the partnerships capital and profits is owned by five or fewer partners. Sec. 864(b)(2)(B)(iii) provides that income earned from trading commodities for ones own account is excluded from ECI if the commodities are of a kind customarily dealt in on an organized commodity exchange and the transaction is customary to the exchange. Sec. 1441 provides that if a partnership does not generate ECI, it is required to withhold a 30% tax on all FDAP (unless this rate is otherwise reduced by an income tax treaty). FDAP income includes interest, dividends, rents and royalties. Regs. Sec. 1.1441-2(b)(1) and (2) provide that FDAP does not include capital gain income. By definition, an investor partnership is not engaged in a trade or business and, thus, is subject to the Sec. 1441 withholding rules. If the partnership does not otherwise incur FDAP income (because all of its income is capital gain), no withholding is required. A trader partnership (which, by definition, is engaged in a trade or business) could likewise avoid withholding if it does not maintain its principal office in the U.S. or a majority of the partnership is owned by five or fewer partners. Such trader partnership would not earn ECI and would not have FDAP income to the extent that its income is derived from capital gains. However, a trader partnership that does not meet the exception for trading ones own account would have ECI and would have to withhold under the strict Sec. 1446 rules. A dealer partnership should always have ECI and, thus, be subject to withholding under Sec. 1446.
State and Local Tax Issues Many hedge funds are organized, or maintain offices, in jurisdictions that assess a local income tax on entities taxed as partnerships (e.g., New York Citys unincorporated business tax7). Most of these jurisdictions, however, exempt investment partnerships if such partnerships activities are limited to trading for their own account.8 Accordingly, investor and trader funds should not be subject to entity-level tax in jurisdictions that tax partnerships, if such funds limit their activities to trading for their own account. Dealer funds, however, may be subject to local income tax.
Conclusion For the reasons discussed in this article, organizers and investors may want to ensure that the hedge funds which they organize and in which they invest are classified as trader funds. Why?
Organizers and investors should ensure that a fund does not engage in dealer activities and that the funds trading activities are beyond those of a mere investor. |
