2017 Essential Tax and Wealth Planning Guide
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Tax implications of fund investing
Investment fund attributes
2017 Essential Tax and Wealth Planning Guide | Tax implications of fund investing
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
State reporting
Many states with budget shortfalls recently
have chosen to ramp up their tax collection
efforts to help plug budget shortfalls. As
a result, many states have become more
aggressive and have developed enhanced
systems to identify investors who have
a requirement to file a tax return with
the state. Therefore, when considering
acquiring a fund, it is important to
understand whether the fund is expected to
generate state-sourced income.
Funds with state-sourced income generally
disclose to each investor their allocable
share of state sourced income by providing
state K-1s or a footnote included with the
federal K-1 with state specific information.
As an investor, if there is state-sourced
activity, it is important to understand
whether the income creates a state tax
filing obligation and potential liability. To
the extent there might be a state filing
obligation, it is helpful to quantify what the
investor's liability might be and the cost
associated with any additional filings that
might be necessary.
If the fund anticipates that state-sourced
income will be generated, you should
inquire whether the fund will withhold
nonresident taxes on your behalf or
whether the fund will file an entity level
Many states with budget shortfalls recently have chosen
to ramp up their tax collection efforts to help plug budget
shortfalls. As a result, many states have become more
aggressive and have developed enhanced systems to
identify investors who have a requirement to file a tax
return with the state.
return, referred to as a composite tax
return. In many states, the fund can file a
composite tax return and pay the investors'
share of tax liability attributable to the
share of income allocable to the state. By
participating in a state's composite filing,
an investor's tax filing obligation may be
satisfied. Each state has its own specific
rules on which types of investors (individual,
grantor trust, complex trust, partnership,
and corporation) can be included in a
composite return and/or have withholding
performed on their behalf. Therefore,
understanding what the fund plans to do to
address the investor's state filing obligations
will be important for investors to evaluate
the cost of investing in the fund.
MSFs often qualify under special investment
partnership rules providing that their
investment income is not sourced to a
state. Thus, to the extent the taxpayer's
resident state imposes a tax, the investment
income would only be subject to tax in
that state. For REFS, the state-sourced
income allocated to the investors is typically
allocated to states where the property
is located and where rental income is
being received. Many PEFS also generate
state-sourced income to the extent that
the portfolio investments are directly
in operating businesses organized as a
partnership. Most resident states provide
for credits for taxes paid to other states, so
it is important to understand the rules of
your state.
Additional state filings can be costly and
increase an investor's tax exposure.
Therefore, taking the time upfront to
proactively analyze the incremental cost
associated with additional state tax liabilities
and filings will be important to quantify the
potential after-tax return associated with a
fund investment.
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