2017 Essential Tax and Wealth Planning Guide
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Tax implications of fund investing
Types of investment funds
and income tax characteristics
Introduction
What is an investment fund?
Types of investment
funds and income tax
characteristics
• Marketable securities
Hedge funds
• Private equity/venture capital
Publicly traded partnerships
Real estate funds
.
Fund of funds
Investment fund attributes
• Trader versus investor
.
.
entities
Passive versus
non-passive income
Separately stated activity
(including PTPs)
Qualified small business
stock (QSBS)
Unrelated business
taxable income
• State tax reporting
Conclusion
Resources
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there is greater opportunity for income
and appreciation on those securities. It can
also create additional risk on the downside
to the extent the assets depreciate in
value. Similar to buying on margin, lines of
credits are another type of leverage that
HFs utilize. HFs may also purchase financial
instruments such as options, warrants, and
convertible securities to increase leverage
and potential upside.
Offshore blocker corporations
While most HFS are structured as LPs
or LLCs, offshore blocker corporations
are frequently offered as an alternative
investment vehicle for US tax-exempt
investors and foreign investors. While a
partnership investment may be more tax
efficient than an investment in a foreign
corporation, a US tax-exempt investor
and a foreign investor typically prefer to
invest through the blocker corporation
to limit the US income tax exposure and
filing obligations related to investing in a
HF. Additionally, tax-exempt investors and
pension funds generally prefer to invest
through the offshore blocker corporation
to "block" the flow of unrelated business
taxable income that would otherwise be
allocated to them (see discussion on page
60). Generally, a non-US person who is
allocated income from a HF that trades in
stocks or securities in the United States
is not treated as engaged in a US trade
or business. This safe harbor exception
applies to trading in stocks, securities,
and options to buy or sell stocks and
securities, including margin transactions
and short sales. If the HF satisfies this safe
harbor exception, it will not be treated
as engaged in a US trade or business.
However, if the HF does not satisfy the safe
harbor exception, the fund would generate
effectively connected income (ECI), and the
fund would be required to withhold US
taxes on the foreign investor's share of ECI.
Even if the HF is not engaged in a US trade
or business, it is still required to withhold
taxes on fixed, determinable, annual,
and periodical (FDAP) income that is US-
sourced. Dividends and interest income
(unless it meets an exception) are generally
characterized as FDAP income. The HF must
withhold taxes on a foreign person's share
of FDAP income at a 30% rate unless a treaty
applies to reduce the withholding rate.
To the extent a foreign person is allocated
either ECI or FDAP income, the foreign
person has a US tax return filing obligation.
Therefore, foreign investors would prefer
to invest through a blocker corporation
to avoid being allocated a share of the
HF's US income, which would obligate
them to file a US tax return. While a US C
corporation would generally be required
to pay tax at the highest US tax rate, many
2017 Essential Tax and Wealth Planning Guide | Tax implications of fund investing
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