Tax Reform, the CARES Act, and Beyond: Hedge Fund Schedule K-1 for Individuals

By:
Suzy Lee, CPA, MST, and Stacy L. Palmer, CPA, MBA, MST
Published Date:
Jul 1, 2020

In 2016, the authors’ article, “Deconstructing Hedge Fund Schedule K-1s for Individuals,” was published in the TaxStringer. It discussed hedge fund schedules K-1—but much has changed since then. This discussion will review how such changes have affected the presentation of hedge fund K-1s.

In December 2017, the Tax Cuts and Jobs Act (TCJA) was signed into law, marking a significant overhaul of the tax code not seen since the Tax Reform Act of 1986. Many of the TCJA’s provisions sunset at the end of 2025. Then, in March 2020, President Trump signed into law the Coronavirus Aid, Relief, and Economic Security (CARES) Act. This law rolled back some of the TCJA’s provisions.

Among other things, understanding whether you invested in a partnership that is a trader fund, investor fund, or fund of funds still plays an important role in determining the deductibility of your expenses.

Definition of a Trader Fund

The Treasury has not yet defined what constitutes a trader fund or an investor fund. Instead, the determination whether a hedge fund is one or the other is based on facts and circumstances.

Typically, a trader fund is engaged in activities that seek “short swing profits” from trading in securities or commodities. A trader fund generally treats fund expenses as ordinary business deductions under IRC section 162.

Applicable TCJA Provisions

The following sections will discuss provisions of the TCJA that are still applicable following the enactment of the CARES Act.

Fund-level expenses

Prior to the TCJA, investors in an investor fund could deduct advisory fees and other investment expenses as miscellaneous itemized deductions, to the extent such deductions exceeded 2% of adjusted gross income (AGI). Investor funds generated so-called below-the-line (itemized) deductions. 

Starting in 2018, under the TCJA, itemized deductions from miscellaneous expenses, including advisory fees and other investment expenses, are not deductible through 2025. Certain states do not conform to this rule, however, and continue to allow a deduction for portfolio deductions subject to the 2% floor.  There were no revisions under the CARES Act with respect to this.

Investors in a trader fund can still deduct expenses related to generating trading income. Such expenses will be reported as above-the-line deductions that reduce a partner’s AGI, which may reduce state taxes as well.

A fund of funds K-1 could have expenses from both trader funds and investor funds. In this instance, such expenses should be properly reported to investors based on the information provided to the fund of funds on underlying K-1s.

Interest expense

One of the big changes to come out of the TCJA was limiting the interest expense deduction for trader funds. Prior to the TCJA, interest limitations pursuant to former IRC section 163(j) were applied only to certain corporations.

Investment income limitations pursuant to IRC section 163(d)—investment interest expense deductible only to the extent of “net investment income”—were applied to partners in investor funds or nonmaterial participating investors (typically limited partners) in trader funds. A partner who materially participates in a trader fund was able to deduct interest expense fully pursuant to IRC section 162, without any limitation.

The TCJA amendment added IRC section 163(j) in order to reduce business interest expense deductions to the sum of:

  • the taxpayer’s business interest income for the year,
  • 30% (prior to the CARES Act) of the taxpayer’s adjusted taxable income (ATI) for the year, and
  • the taxpayer’s floor plan financing interest.

The business interest expense limitation under IRC section 163(j) applies at the trader fund level.

It’s hoped that the IRS will provide further guidance in this area. This approach generated a potential double limitation for nonmaterially participating partners of trader funds, due to the fact that such partners’ interest expense is limited—first pursuant to  the rules of IRC section 163(j) at the trader-fund level and then subsequently to IRC section 163(d) at the individual level.

The deductible portion of interest expense on a trader fund K-1 is typically reported in Box-13-Code W or Box 11-Code I.

Materially participating partners in trader funds take the interest expense amounts and report the deductible portion on Schedule E of Form 1040 as a nonpassive trade or business deduction. This interest expense will not be subject to the investment interest limitations calculated on Form 4952, since the expense is generated in the ordinary course of business of the trading partnership.

Nonmaterially participating partners in trader funds will report the deductible portion of interest expense on Form 4952 and deduct such interest expenses up to “net investment income.” To the extent deductible, the interest expense will be reported on Schedule E of Form 1040 as a nonpassive deduction.  

The limited portion (nondeductible) of interest expense under IRC section 163(j) is reported on Schedule K-1 in Box 13-Code K: Excess Business Interest Expense (EBIE). If the K-1 reports EBIE, the partner is required to file Form 8990 and report the amount on Schedule A, line 43(c).

EBIE is treated as paid or accrued by the partner in subsequent years, to the extent the partner is allocated current-year excess taxable income (reflected on Box 20-Code AE on K-1) or excess business interest income (on Box 20-Code AF) from the same partnership in future tax years to potentially “free up” those amounts. Such partner would need to file Form 8990 in subsequent years to report the allocated excess taxable income or excess business interest income and compute any deductible amount. 

If a partner never receives excess taxable income in a subsequent year and later disposes of such partnership interest, the partner will increase their outside basis in their respective partnership interest by the EBIE not previously deducted.

Also note that certain states may not conform to the business interest expense limitation pursuant to IRC section 163(j) and therefore not have a limitation for state purposes. 

The business interest expense limitation under IRC section 163(j) does not apply to investor funds that incur investment interest expense for property held for investment under section IRC 163(d). Investor fund partnerships typically report investment interest expense in Box 13-Code H.

Partners in investor funds need to report the interest expense on Form 4952 and go through the limitation of “net investment income” under IRC section 163(d). To the extent deductible on Form 4952, such interest will be an itemized deduction reportable on Schedule A.  

CARES Act

As mentioned, the CARES Act rolled back some of the provisions of the TCJA, including changes to the interest expense provisions, in order to provide relief to taxpayers.

For individuals, the CARES Act increased the 30% of ATI limitation to 50% of ATI for any tax year beginning in 2019 or 2020. Taxpayers may elect not to apply the 50% limitation or elect to use their 2019 ATI in their 2020 tax year to calculate their 2020 IRC section 163(j) limitation.

Partnerships must use the 30% ATI limitation for 2019. The partnership’s ATI limitation increases to 50% in 2020, unless the partnership elects not to have the increase apply. The partnership can also elect to substitute tax year 2019 ATI for tax year 2020 ATI.

Partners can treat 50% of any EBIE allocated to them as automatically paid or accrued to them in their 2020 tax year—that is, the partners can deduct 50% portion of EBIE regardless of the partner’s ATI. The remaining 50% of EBIE is subject to the pre-CARES Act limitations for EBIE: the partner needs to receive an allocation of excess taxable income from the same partnership in future tax years to make this portion deductible.

For example, if a partner receives a K-1 with EBIE of $100 in 2019 from Partnership A, 50% of such amount ($50) can be treated as paid or accrued by the partner in 2020, even if there is no excess taxable income from Partnership A in 2020. The remaining $50 of EBIE from 2019 cannot be deducted until the partner receives excess taxable income in a subsequent year from Partnership A.

The CARES Act added complexity in calculating the limitations for EBIE and carryovers for state tax purposes since some states (notably New York) have decoupled from the Cares Act provisions

Capital accounts in Item L

Beginning in 2020, partner capital accounts are required to be reported on a tax basis (known as the “tax capital reporting requirement”). The method for how the tax basis should be calculated at the partnership level is still unclear.

The IRS recently issued Notice 2020-43 and seeking public comment on two proposed alternative methods for reporting partner tax basis capital accounts. For 2019 K-1s, a partnership can report on tax basis capital or any other allowable method (GAAP, 704(b) book, or other). For 2019, if a partnership does not report Item L on a tax basis, such partnership is required to report any negative tax basis capital in Box 20-Code AH.  

Several factors can contribute to a partner having a negative tax basis capital balance when:

  • a partnership allocates tax deductions or losses in excess of a partner’s tax basis capital account in the partnership,
  • a partnership distributes assets to partners that have a basis in the hands of the partnership in excess of the partner’s tax basis capital
  • a partner contributes property that is subject to debt in excess of the property’s adjusted tax basis to partnership, or
  • distributions are made in excess of tax basis capital balances.

The consequences of a negative tax basis capital account could indicate the potential limitation of deductions and losses your Schedule K-1 due to tax basis or at-risk limitations. It may also indicate that the taxpayer may need to recognize a gain on distributions in excess of basis.

Passive activity

The 2019 K-1 has a new Box 21, asking the partnership to check if such partnership has more than one activity for at-risk purpose. The partnership is required to provide information for partners to figure out at-risk limitation. 

The 2019 K-1 also has a new Box 22. If a partnership conducted more than one activity for passive activity purposes, the partnership is required to provide information separately for each activity to its partners for the passive activity loss and credit limitation.

In general, trader funds and investor funds do not produce passive activity income or losses (except income from rental activities or certain passive income from underlying investments, such as investments in publicly traded partnerships).  

Certain K-1s provide detailed activity statements for each passive activity or may provide footnotes for this purpose.

Based on facts and circumstances, passive activities from partnerships may be aggregated at the individual level. However, once the passive activities are aggregated, they need to be consistently applied in future years. Plus, partners may not be able to bifurcate activities into smaller pieces if separate activities are not provided by partnerships.

Passive activity income and loss may be separately tracked for each activity. Carryover losses would also need to be tracked by separate activity.

If, during the taxable year, a taxpayer disposes of the entire interest in a passive activity, any current or suspended passive losses from such activity and any losses realized on the disposition of such activity are treated as though they’re from a nonpassive activity, to the extent they exceed the taxpayer’s net income or gain from such passive activity for the year. 

For example, if passive activity A is aggregated with passive activity B, and passive activity A is liquidated in a later year and has suspended passive losses, such losses could be locked up until passive activity B is disposed.

Tips to Identify Trader Funds, Investor Funds, and Fund of Funds

The following are general illustrations to assist in identifying whether a K-1 is from a trader, investor, or fund of funds.

Trader funds

Income and expenses from trader funds could be reflected in Boxes 1 through 9b, Box 11-Code I (other income), and Box 13-Code W (other deductions). You may also see all trading activity reflected in Box 1 or Box 11-Code I with a footnote detailing each item (such as interest, dividend, and capital gains or losses).

Certain K-1s will specify whether the fund is a trader fund.

Some K-1s will indicate that items on Schedule K-1 are not from a passive activity under Treasury Regulations section 1.469-1T(e)(6). This would typically indicate a trader fund.

If Schedule K-1 has items in Box 20-Code AE (excess taxable income), Box 20-Code AF (excess business interest income), or business interest expenses [with a footnote indicating an IRC section 163(j) limitation], such K-1 could be from a trader fund.

Investor funds

Investor fund K-1s are generally more straightforward. Income and expenses are reported in Boxes 1 through 9b, Box 11-Code A (portfolio income), and 13-Code W (formerly deductible portfolio deduction subject to the 2% floor). 

As previously mentioned, the TCJA suspended all itemized deductions subject to the 2% floor. Individual taxpayers may no longer deduct the amounts reflected as portfolio deductions in Box 13-Code W for federal income tax purposes; however, some states still allow these deductions.

If Schedule K-1 has an item in Box 13-Code H (investment interest expense), this could be a clue that such K-1 is from an investor fund. Note, though, that trader funds could report interest expense that is not subject to the IRC section 163(j) on Box 13-Code H

Fund of funds

A K-1 from a fund of funds could have a mixture of trader and investor fund expenses. It’s imperative to break out all items that will have specific treatment at the individual level, such as interest expense and fund-level expenses. For example, interest expense from trader funds should be reported on Schedule E and interest expenses from investor funds should be reported on Schedule A. Portfolio deductions from investor funds are not deductible until 2026.

Takeaway

The TCJA has created seismic changes that have had a huge impact on partnership reporting. The TCJA continues to be amended in the current environment, as evidenced most recently by the CARES Act. It’s hoped that the IRS will still offer more guidance in certain areas.

The K-1 presentation will continue to evolve as IRS issues new guidance and additional disclosure rules. Certain K-1s growing larger, with many pages of footnotes. It’s more important than ever to make sure you read through and understand the contents of the K-1s and all of the supporting footnotes in order to facilitate proper reporting.


Suzy Lee, CPA, MST, is a senior tax manager at Untracht Early LLC. She has experience in tax advisory services for the asset management industry in private equity funds, commodities and futures, brokerage firms, investment advisors, hedge funds, and multinational financial services organizations, with over 20 years of experience in public accounting. She has spoken at various CPE tax seminars. She can be reached at (212) 324-0303 or slee@untracht.com. 

Stacy L. Palmer, CPA, MBA, MST, is a Principal at Untracht Early LLC with offices in Florham Park, N.J., New York City, Massachusetts and Orlando, Fla. Stacy has 20 years of experience in public accounting. She works with high net worth individuals and also specializes in corporate taxation in the financial services and hedge fund industry. She was an adjunct professor of individual taxation at Fairleigh Dickinson for several years and has spoken at several CPE tax seminars. Stacy also serves on the board for the Morris/Sussex NJSCPA chapter. Ms. Palmer can be reached at spalmer@untracht.com.

 
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