With President Obama re-elected, now is the time for hedge fund managers to consider some important tax issues and potential law changes. The possible expiration of Bush-era tax cuts, enactment of several new provisions, and not much time left in 2012 make for a “perfect storm” in the tax planning world. The following are some key areas to focus on as year-end approaches:
- Increase in individual tax rates – The current individual tax rates in place for 2012 range from 10% and increase to 35% based on taxable income (gross income less allowable deductions). The rates after 2012 are set to increase to a range of 15% to 39.6%. Funds should consider accelerating ordinary income into 2012 to take advantage of the lower brackets.
- Individual long-term capital gains and qualified dividends tax rates – These are currently taxed at a rate of 15%. After 2012, the rates could increase to 20% for long-term gains and ordinary rates for dividends (to a maximum of 39.6%). In addition, both dividends and capital gains will incur the additional Medicare tax, as discussed below. Funds may choose to accelerate dividends and long-term capital gains into 2012 to take advantage of the lower rates. Conversely, deferring loss positions into 2013 to reduce higher rate capital gains is another potential strategy.
- Medicare tax on investment income – Taxpayers will be levied a 3.8% Medicare surtax on their “net investment income” starting in 2013. “Net investment income” includes interest, dividends, royalties, most rents, and capital gains less allowable deductions. The acceleration of investment income and the deferral of investment losses and deductions are again important to consider.
- Medicare tax on earned income – Income derived from management fees could be taxed at an additional 0.9% subject to limitations. Management companies may want to look at ways to reduce their net income in 2013. Payment of expenses such as bonuses, rent, and large capital expenditures that could be paid in 2013 instead of 2012 could help significantly reduce the increased tax burden.
- FATCA update – The Foreign Account Tax Compliance Act (FATCA) will require onshore and offshore funds to report certain foreign asset information to the IRS. A withholding tax of 30% on income from foreign funds could be imposed for failure to provide the required documentation. Documentation and agreement requirements for funds that were due January 1, 2013 have been postponed to 2014. Early planning for the FATCA requirements is recommended, even with the recent relief provisions.
- Trader vs. investor – Fund managers should look at their investment strategy annually to determine if they may be considered a trader for tax reporting purposes. Owners of trader funds have the benefit of portfolio deductions not being subject to the alternative minimum tax (AMT) limitations. While beneficial, trader status is a facts and circumstances determination, and factors such as trading frequency and investment strategy horizon need to be looked at carefully.
- Constructive sales/straddles – Hedge funds may have gain recognition related to holding an appreciated position with an offsetting position in the same security at December 31 (e.g., long and short positions). Many times this is a surprise for hedge fund managers at tax time. Constructive sales may be advantageous in 2012 as gains can be “locked in” at lower capital gains or ordinary income rates. In contrast, straddles are offsetting positions that require a deferral of losses. Deferred losses on straddles carried over to 2013 may be beneficial if rates go up next year.
- 1256 Contracts – Funds that trade future contracts, foreign currency contracts and certain nonequity options are subject to special tax rules for gains and losses. Net gains and losses from 1256 contracts are taxed at 60% long term and 40% short term rates. Also note that all 1256 contract positions are marked to market, meaning that unrealized gains and losses are recognized at 12/31. Due to the favorable 60/40 tax rates, hedge fund managers should look at their trading activity to see whether certain trades qualify as 1256 contracts.
- Wash sales – If a position is sold at a loss and then bought back within 30 days of the previous sale, the loss is deferred. With rates set to rise, fund managers should look at their current and previous years’ wash sale loss deferrals to see if it is beneficial to recognize the deferred loss in future years.
- Form 8938 – For tax year 2011, individual taxpayers were required to disclose information on their holdings of certain foreign investments (including hedge funds). Be on alert for potential requirements for hedge funds. The penalties for failure to comply are significant.
- Hedge fund managers should always make sure that their tax planning strategies are in line with their business/investment strategy.
- While opportunities exist to make some good tax planning decisions before year-end, tax planning should be done throughout the year.
- Due to the uncertainty of tax law changes in the next two months, hedge fund managers should be ready to act fast as some uncertain changes may become finalized.
Warren D. Abkowitz, CPA is a tax partner at CohnReznick LLP. He can be reached at warren.abkowitz@CohnReznick.com or 646-834-4135. Jonathan R. Collett, CPA is a senior tax manager at CohnReznick LLP. He can be reached at jonathan.collett@CohnReznick.com or 860- 368-5228.