Navigating the net investment income tax: Key issues for investment funds and their partners

2013 is the first tax year for which limited and general partners in investment funds will have to contend with the 3.8 percent tax on net investment income (NII). The final regulations for section 1411, released Nov. 26, 2013, made significant changes in the treatment of investment income, gains, and losses realized by investor and trader funds.

Aspects of the NII tax most relevant to hedge fund investors and general partners are discussed below. You may find a more extensive explanation of the NII tax in our previous article.

A benefit for trader funds with a 475(f) election

All gains and losses from the disposition of property, including any mark to market gains and losses that a fund may have, will be netted in Category 3: net gain attributed to the disposition of property. An excess loss occurs in Category 3 when the netting of gains and losses results in a net loss.

An excess loss from Category 3 may be considered as a properly allocable deduction and may be used to reduce income taken into account under Category 1: gross income or Category 2: other gross income, but only to the extent allowable for normal income tax purposes. In the computation of NII, an individual investor or general partner in a fund that has made an election to mark to market its securities under section 475(f) of the Internal Revenue Code (a 475(f) fund) with net trading losses would be able to use the excess loss as a properly allocable deduction to offset income from categories 1 and 2. In contrast, an investor (general partner) in an investor fund or a trader fund that is not a 475(f) fund with a net capital loss would be limited to a $3,000 properly allocable deduction as this is the amount of net capital loss deduction permitted for regular income tax purposes.

PFICs: Different treatment for trader funds and investor funds

A qualified electing fund (QEF) inclusion of income from a passive foreign investment company (PFIC) for regular income tax purposes is a deemed dividend—an inclusion based on a computation rather than an actual cash distribution. Since the QEF inclusion is not an actual dividend, it is not includable as income under Category 1 for NII tax purposes. Trader funds, however, are required to take such income into account under Category 2, and investor funds are required to take such income into account for NII tax purposes only when a cash distribution is received, or the PFIC shares are sold. This creates an opportunity to defer the NII tax for investors in an investor-type fund.

PFICs: A complication for investor funds and their shareholders

The difference in treatment for regular and NII tax requires the tracking of the shareholders’ tax basis in the PFIC under either the QEF method or the non-QEF method (section 1291). This creates a burden on the shareholders and the fund. In order to eliminate this additional tax basis tracking, an election is permitted whereby a taxpayer is allowed to include the PFIC income in NII at the time it is included for regular tax. Both an individual and a domestic fund will be permitted to make this election starting with the tax year 2014. A fund will need to get the consent of all of its investors, even, apparently, those to whom the NII tax does not apply.

Manager compensation: Incentive allocation versus incentive fee

A general partner’s profit allocation will generally be subject to the NII tax, since an incentive allocation, or carried interest, retains the character of income from the underlying fund. However, an incentive fee would not be subject to the NII tax with respect to principals who are actively engaged in the investment management business. For this reason, it may make sense for managers/general partners of certain funds, 475(f) funds, or other funds that generate few long-term capital gains to take a larger incentive fee over an incentive allocation.

In the case of a fund that does not generate long-term capital income and qualified dividends, managers should seek to take an incentive fee in lieu of an incentive allocation if the maximum earnings threshold for the 6.2 percent Social Security tax has already been reached for the year ($117,000 for 2014). For a taxpayer in the highest income tax bracket who has reached the Social Security maximum in 2014, an incentive fee will incur a Medicare tax at an effective tax rate of 3.2 percent, but if the compensation was structured as an incentive allocation, the NII tax rate would be 3.8 percent. Managers/general partners based in New York City will have to contend with the municipality’s unincorporated business tax, which will make this strategy less attractive. In investor funds, the switch to fees instead of allocations might have a detrimental tax effect due to the limitation on deduction of portfolio expenses.

Tax planning opportunity

Tax planning with the goal of minimization must now include the NII tax. Both investors and fund managers need to understand NII in order to maximize their after-tax returns. The traditional 20 percent incentive allocation may not be the most tax-efficient means of compensation to the fund manager. This is especially true in the case of a trader-type fund in which expenses are not subject to the miscellaneous itemized tax deduction limitation of 2 percent of adjusted gross income. Fund managers and investors should consider the options available to them with regard to PFIC income.

For more information on this topic, or to learn how Baker Tilly asset management industry specialists can help, contact our team.