With Net Investment Income, as Many Questions as Answers

Mary Ho, CPA
Published Date:
Mar 1, 2014

Life has become both more complex and simpler for the investor, thanks to the release of the much anticipated final net investment income (NII) tax regulations last November, along with a new set of proposed regulations that provide guidance on the computation of net investment income. Although the regulations clarify many issues, the rules can be complicated in its application and no doubt new questions will crop up as CPAs prepare returns in 2014.

A key piece of welcome news for the financial services industry is the loss allowance provision for trader funds. Trader funds—hedge funds whose trading activity rises to a level of a trade or business—are taxed under Category 2, “gross income from a trade or business of financial instruments.” Not all trader funds are alike, however. There is significant difference between “electing” trader funds and “non-electing” trader funds. Investor funds, in contrast, have a strategy to generally purchase for long term appreciation as opposed to trading profits. There are no clear, objective regulations to distinguish between the two, and consulting competent tax counsel is recommended to categorize the type of fund it is.

A fund may, depending on its strategy and market conditions, choose to actively trade one year and buy and hold in a subsequent year. In this case, the fund is typically a non-electing trader fund the first year and an investor fund the next. A non-electing trader fund can still have the benefit of deducting their expenses “above-the-line,” rather than be subjected to itemized deduction limitations as in the case of investor funds. Gains and losses from the sale of securities are still subject to the normal capital gain and loss rules.

An electing trader fund as the name suggests, requires an election under Internal Revenue Code section 475 and is irrevocable. It is commonly referred to as a 475 fund. This election is recommended for those funds whose strategy is to have turnover at such a high frequency that not only will all realization be short term, but the fund will not include long-term holding as part of its investing plan. The election will require the fund to mark all positions to market at year end and all profit and loss on trading, even if unrealized, will be ordinary income or loss. This loss would qualify as net operating loss should it exceed income.

The final regulations added a subsection for the allowance of losses that is in-line with income tax treatment for losses of trader funds. Non-electing trader funds will see the benefit of up to $3,000 in capital loss allowed for NII purposes; electing traders under section 475 will benefit from any ordinary losses to the extent allowed for income tax purposes. These losses will also be able to offset net investment income from other categories, as revised under the final regulations.

A very important clarification in the final regulations is the availability of loss carryforwards. Excess losses will be carried forward to future years as capital losses and net operating losses, for non-electing trader funds and electing trader funds, respectively, to the extent they are related to net investment income. This means that excess losses from electing trader funds will be allowed as a net operating loss carryforward. For those that have losses carrying from any pre-net investment income tax period, these losses will not be allowed to be carried into a net investment income tax year for NII purposes. Any net operating loss carryforward for income tax purposes will still reduce adjusted gross income, and to the extent this reduces AGI to below $250,000, net investment income tax will not be applicable.

It should be noted that the character of the loss in the year generated follows that loss into future years. Capital losses from investor funds or non-electing funds do not become ordinary loss carryfowards if and when a 475 election is made.

The U.S. Treasury Department has also reversed its original position, and following commentary on the original proposed regulations, now proposes to treat swap income generated by investor funds as taxable under NII, eliminating the recognition difference in treatment between trader funds and investor funds.

The income recognition for subpart F and QEF income remain unchanged for investor and trader funds. Investor funds will recognize such income under NII when the cash payment is received while trader funds will have recognition as income is realized for income tax purposes.

This timing difference for investor funds will mean that basis and E&P tracking will be required. Also required, according to the 2013 instructions for the Form 1065, is a detailed disclosure on K-1’s of various information to enable investors to properly report income. This is the price paid for those who see the timing difference as an advantage for planning opportunities.

An alternative to the recordkeeping for investor funds is the election under Reg 1.1411-10(g), to treat Subpart F and QEF income as NII at the same time as income tax recognition. The election must be made no later than 2014. It will be effective for all future Subpart F and QEF income, and is also available for partnerships. Any partnership that may wish to make the election for the 2013 year must obtain consent from all its partners, including partners of their flow through investors.

Mary Ho, CPAMary Ho, CPA, is a director in the Financial Services Group at EisnerAmper. She has more than 15 years of experience focusing on hedge funds and high-net-worth individuals and frequently advises on all aspects of tax planning and compliance for hedge funds and their related entities, as well as routine tax planning and compliance for the principals. Ho received her B.A and M.S. in accounting from Baruch College. She is a member of the NYSSCPA—where she has served on the Taxation of Financial Instruments and Transactions Committee among others—and the AICPA. She frequently speaks at in-house seminars on investment partnership structuring and other tax topics. She can be reached at 212-891-8038 or mary.ho@eisneramper.com.

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