WHO TO CONTACT DURING THE LIVE EVENT For Additional Registrations: -Call Strafford Customer Service 1-800-926-7926 x1 (or 404-881-1141 x1) For Assistance During the Live Program: -On the web, use the chat box at the bottom left of the screen If you get disconnected during the program, you can simply log in using your original instructions and PIN. IMPORTANT INFORMATION FOR THE LIVE PROGRAM This program is approved for 2 CPE credit hours. To earn credit you must: • Participate in the program on your own computer connection (no sharing) – if you need to register additional people, please call customer service at 1-800-926-7926 ext.1 (or 404-881-1141 ext. 1). Strafford accepts American Express, Visa, MasterCard, Discover. • Listen on-line via your computer speakers. • Respond to five prompts during the program plus a single verification code. • To earn full credit, you must remain connected for the entire program. Tax Reporting and Reconciliation of Hedge Fund and Other Alternative Investment Fund K-1s WEDNESDAY, MAY 16, 2018, 1:00-2:50 pm Eastern FOR LIVE PROGRAM ONLY
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WHO TO CONTACT DURING THE LIVE EVENT
For Additional Registrations:
-Call Strafford Customer Service 1-800-926-7926 x1 (or 404-881-1141 x1)
For Assistance During the Live Program:
-On the web, use the chat box at the bottom left of the screen
If you get disconnected during the program, you can simply log in using your original instructions and PIN.
IMPORTANT INFORMATION FOR THE LIVE PROGRAM
This program is approved for 2 CPE credit hours. To earn credit you must:
• Participate in the program on your own computer connection (no sharing) – if you need to register
additional people, please call customer service at 1-800-926-7926 ext.1 (or 404-881-1141 ext. 1).
Strafford accepts American Express, Visa, MasterCard, Discover.
• Listen on-line via your computer speakers.
• Respond to five prompts during the program plus a single verification code.
• To earn full credit, you must remain connected for the entire program.
Tax Reporting and Reconciliation of Hedge Fund and
Other Alternative Investment Fund K-1s
WEDNESDAY, MAY 16, 2018, 1:00-2:50 pm Eastern
FOR LIVE PROGRAM ONLY
Tips for Optimal Quality
Sound Quality
When listening via your computer speakers, please note that the quality
of your sound will vary depending on the speed and quality of your internet
connection.
If the sound quality is not satisfactory, please e-mail [email protected]
What is a Hedge Fund? Deconstructing Hedge Fund K-1s
Presenters:
Stacy Palmer, CPA, MBA, MST Suzy Lee, CPA, MST
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What is a Hedge Fund?
Suzy Lee, CPA, MST
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What is a Hedge Fund?
Hedge funds are alternative investments that may use a number of different strategies
in order to earn high returns for their investors.
In general, hedge funds use derivatives and leverage their investments in addition to
holding the traditional portfolio of stocks, bonds, and cash.
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History of Hedge Funds
• Alfred Winslow Jones – first hedge fund in 1949
• Julian Robertson's Tiger Fund
• First stars –George Soros, Bruce Kovner
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Hedge Fund Strategies
Hedge funds use different investment strategies and, thus, are often classified
according to investment style.
The following classification of hedge fund styles is a general overview:
• Equity market-neutral
• Convertible arbitrage
• Fixed-income arbitrage
• Distressed securities
• Merger arbitrage
• Global macro
• Emerging markets
• Fund of funds
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How Hedge Funds are Set Up
• Hedge funds are most often set up as private investment limited partnerships that
are open to the limited number of accredited investors and require a large initial
minimum investment.
• Investments in hedge funds are illiquid as they often require that investors keep
their money in the fund for a certain period of time known as the “lock-up period”.
Withdrawals may also only happen at certain intervals.
• Generally, they are not registered under the Investment Company Act of 1940.
• In general, hedge funds are largely unregulated because they cater to sophisticated
investors.
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Typical Fees of Hedge Funds
• Management fees – compensation for managing the business of the fund
- 2% standard figure
• Incentive fee/allocation – compensation to General Partners for investment advisory
services
- 20% of gross returns
- High Water marks
- Hurdle rates
• Withdrawal/Redemption fees
Encourage long-term investment
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Overview of Fund Types – Trader Fund
• Seeks “short swing profits” from trading in securities or commodities
• Activity is regular and continuous
• Able to make an election under IRC Sec. 475
• Reg Sec. 1.469-1T(e)(6) - non-passive for purposes of the passive activity rules
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Overview of Fund Types – Investor Fund
• Holds investments for longer-term appreciation
• Periodic and less frequent trading
• May hold “investments” other than securities and commodities (i.e. private equity)
• Investments in stocks and securities generate “Portfolio” income and deductions
(not passive for purposes of Sec 469)
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Overview of Fund Types – Fund of Funds
• Invests in other funds
• Characterization of the income and deductions depend on other funds
• May have its own entity level trading or investing activity
• Diversified portfolio of uncorrelated hedge funds
• Typically more accessible to individual investors and are more liquid
• Two layers of management fees/ incentive fees
• Transparency may be impaired
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Trader v. Investor
• A trader in securities is engaged in the trade or business of trading securities. All
items of income and deduction are treated as trade or business income and
deductions for federal income tax purposes AND generally, state income tax
purposes.
• An investor in securities is engaged in activity entered into for profit and all items
of income and deductions are treated as investment income and deductions for
federal income tax purposes and state income tax purposes.
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When is a Taxpayer Engaged in the Business of Trading Securities?
• There is no definition of trade or business in the IRC
• There is no definition in regard to the business of trading in securities in the Federal Income tax regulations
• The definition of the business of trading securities has evolved over the last 80 years primarily from case law
• While industry professionals often look to portfolio turnover as the litmus test for trader status, there is not one reported decision that describes as a key factor the number of times a securities portfolio turns over during the course of a taxable year
• One factor is the manner in which an investment manager describes his investment objective in the private placement offering memorandum
• There are no reported cases regarding a partnership’s status as a trader vs. investor
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IRC Section 475(F) Election –Mark to Market (MTM)
• Traders in securities or commodities were allowed to elect MTM accounting for tax
purposes beginning in 1997 (enactment of IRC Section 475(f)
• The statute provides that an election once made, is irrevocable without the
consent of the IRS Commissioner
• At the end of each tax accounting period, taxpayers will MTM all of their securities
in their portfolio and include the gain/loss for the entire accounting period plus
the MTM gain/loss (there are not any unrealized gains/losses) as ordinary
income/loss
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Deconstructing Hedge Fund K-1s
Stacy Palmer, CPA, MBA, MST
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Federal K-1s Trader vs. Investor Status
• Comparative Tax Treatment – Trader vs. Investor
• Examples
- Investor
- Trader – material participation
- Trader – no material participation
- Fund of Funds
• 3.8% Net Investment Income Tax (NIIT) – IRC §1411
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Comparative Tax Treatment:Trader vs. Investor
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Management Fees and ExpensesOther than Interest Expense
• Trader – Expenses are deductible under §162 by individual taxpayers "above the line" in arriving
at AGI.
- Only trader funds can make a §475(f) mark-to-market election (could be just
for some activities within the fund).
• Investor – Expenses are §212 investment expenses, treated as miscellaneous itemized
deductions.
- Subject to 2% of AGI floor limitation and overall AGI-based phase-out of
itemized deductions.
- Miscellaneous itemized deductions are not allowed for AMT.
- Swap expense/loss is treated as a miscellaneous itemized deduction.
- Some states limit or do not allow itemized deductions.
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Management Fees and ExpensesOther than Interest Expense
• Fund of Funds
• The IRS has ruled that all entity level management fees of a fund of funds are §212
investor expenses (Revenue Ruling 2008-39), treated as miscellaneous itemized
deductions subject to the 2% limitation.
• Could have mix of trader expenses depending on investments in underlying funds.
- It is the government’s position that a fund of funds is not considered a
trader, even if solely invests in trader funds.
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Interest Expense
• Trader – materially participates – fully deductible as a non-passive trade or business
interest expense on Schedule E, not subject to investment income limitations.
• Trader – doesn't materially participate – subject to the investment income
limitation, to the extent deductible, treated as non-passive trade or business
interest expense on Schedule E, ordinary deduction.
• Investor – subject to the investment income limitation, to the extent deductible -
report on Schedule A as an itemized deduction.
• Fund of Funds – typically will be mix of investor and trader treatment.
- If fund of funds uses leverage to invest, the interest tracing rules would
apply in determining treatment of interest expense.
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Interest Expense
Example of Trader Footnote (not materially participating)
• "Interest expense has been included in Box 13H as investment interest expense and
is not included in Box 11F. 1040 filer should enter this amount on Form 4952, Line 1.
Any deductible interest expense should then be entered on Schedule E, Part II,
Column (H).”
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K-1 Tips
• If trader fund - ask client about level of involvement in investment.
• Read the K-1 and supporting statements/footnotes carefully!
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Investor K-1s
General Characteristics
• Investment management fees and entity level expenses will be 2% miscellaneous
itemized portfolio deductions in Box 13K – BIGGEST CLUE!
• Investment interest expense reported in Box 13H will be subject to investment
income limitations and be a Schedule A itemized deduction.
• The boxes on the face of the K-1, from Box 1 through to the end, will be completed,
where applicable. In general, usually contains less footnotes (less specific
treatment).
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Trader K-1s
General Characteristics
• Management fees will be a nonpassive ordinary business expense.
• Investment interest expense may or may not be subject to investment income limitations
depending on material participation and will be a Schedule E nonpassive expense.
• Boxes 11F and 13W will be supported by footnote details and Box 11F may include capital
gains/(losses) depending on the Firm preparing the K-1.
Clues in Identifying Possible Trader K-1 in Footnotes
• "Please note that none of the distributive share items reported on Schedule K-1 are considered
as derived from a passive activity under Treasury Regulation Section 1.469-1T(e)(6).”
• "The K-1 has been prepared on the basis of a partner who does not materially participate in the
operations of the partnership."
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Trader K-1s
• Entity level expenses are reflected under Box 13W.
• If you see 475(f) income under Box 11F (can only make if trader fund). Could either
be trader fund or be invested in a K-1 that has trader fund activity.
• Footnote stating investment interest should go to Schedule E.
• Should always ask client about their level of participation!
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Fund Of Funds K-1s
General Characteristics
• In the view of the IRS, management fees charged by the fund of funds are always
subject to the 2% AGI limitation, however, the character of expenses flowing through
from underlying investments will depend on whether those investments are trader or
investor funds.
• Investment interest expense will be subject to investment income limitations and
may be a mix of nonpassive Schedule E or Schedule A expense.
• The boxes on the face of the K-1, from Line 1 through to the end, will be completed,
where applicable, and lines 11F and/or 13W will have supporting statements.
• Character of income and expenses is preserved for all underlying investments.
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Fund of Funds K-1s
• Potential combination of entity level expenses reflected as 2% deductions under Box
13K and deductions under Box 13W, if invested in trader funds.
• Footnote where investment interest is allocated to both Schedule A and Schedule E
(if invested in trader funds).
• Frequently has items of income and capital gains on face of K-1 and Box 11F (mix of
trader and investor).
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Comparative Tax Treatment of Trader vs. Investor
Status affects deductibility of portfolio expense and eligibility of making Section 475(f)