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Year-End Tax Update: A look at carried interest and fund tax efficiency

New York (J.H. Cohn LLP) – Another year has passed, but President Obama still has not been able to pass his “Carried Interest” bill.

Advisers, as year-end approaches, will benefit from reviewing pending legislation and other issues, including business structure, operations, and respective portfolios, and considering optimal steps they can take to address these issues before 2012 begins.

President Obama’s proposed American Jobs Act, if enacted, will increase the tax rate paid by an investment manager on incentive allocations (“carried interest”) earned from investment partnerships.

Under the President’s proposal, carried interest would be taxed as ordinary income (subject to the maximum rate of 35 percent under current law), regardless of the character of the income. In addition, this income will be subject to self-employment tax. Under current law, income derived from carried interest is taxed using the rates that related to the type of income recognized, therefore some of the income may be taxed at more favorable capital gains rates of 15 percent, which is also not subject to self-employment tax.

Today, it remains unclear when (or whether) the legislation will be passed. As a result, some managers may choose to recognize a long-term capital gain for tax year 2011 to ensure a maximum tax rate on their incentive of 15 percent.

Other points to consider:

Will Federal tax rates go up in 2012? In December 2010, President Obama passed the 2010 Tax Relief Act which will keep the maximum rate limited to 35 percent through December 31, 2012.

Is your fund tax efficient? Investors are increasingly asking: What is the after-tax return on my investment? Your trading style and trading instruments at times may have positive or negative impacts on taxable income (loss). For example, gains on certain Broad-based Index Options may be taxed as Section 1256 contracts (60 percent long-term capital gain and 40 percent short-term regardless of holding period), as compared to an equivalent Exchange Traded Fund (“ETF”), which is short- or long-term capital gain based upon the holding period.

Another important consideration is a review of unrealized losses on positions held at year-end. As the unrealized losses are not deductible unless the securities are sold, if you have net realized gains during the year, your investors will have to pay tax on the gains reported. It may be beneficial for tax purposes to sell a position during 2011 with an unrealized loss to offset them. If you sell a position to offset gains, you cannot reacquire the same position for 30 days or the loss may be disallowed due to the “wash sale” rules. Any offsetting positions are subject to additional rules that may trigger taxable gains or the deferral of losses, such as “constructive sales” and “straddles.” A careful review of the realized and unrealized positions should be done to ensure an efficient result.

475(f) mark -to-market election for traders can yield significant advantages, and traders should evaluate the potential benefits to determine whether this election should be made in early 2012.  Potential benefits may include a change in the character as well as the amount of taxable income each year.

There has been a lot of buzz about the Foreign Account Tax Compliance Act (“FATCA”). FATCA requires non-U.S. financial institutions and non-U.S. entities (including offshore investment funds) to provide information to the IRS identifying U.S. persons invested in non-U.S. bank and securities accounts. The legislation is motivated by incidents of U.S. persons failing to report foreign-source income for U.S. income tax purposes. A 30 percent withholding tax applies on any “withholdable payment” made to a foreign financial institution (FFI) unless the FFI agrees with the Internal Revenue Service to take a number of specific steps pursuant to an FFI agreement. The specific steps are designed to ensure that U.S. persons are identified and U.S. tax is imposed on their investment income.

For more information, please contact Warren Abkowitz, CPA, JD, MST, a member of J.H. Cohn LLP’s Financial Services Industry Practice, at wabkowitz@jhcohn.com or 646-834-4135.

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