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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foreign investors would prefer to block the
income through the corporate vehicle and
pay the higher tax on the income so that
they themselves do not have a US tax filing
obligation. Therefore, foreign individuals
and foreign trusts should understand
the character of the income that will be
generated by the HF so that they can
identify the investment vehicle that would
best satisfy their needs.
HFs are traditionally less liquid than MSFs,
but investors are typically able to acquire or
redeem interests in HFs on a quarterly basis
at a minimum. Similar to a MSF, partners
who partially or fully redeem interests in an
HF should understand if the HF will allocate
additional gains or losses to eliminate the
disparity between their economic capital
account and their tax basis in the HF.
Foreign individuals
and foreign trusts
should understand the
character of the income
that will be generated by
the HF so that they can
identify the investment
vehicle that would best
satisfy their needs.
Character of income
considerations-HFs
The income generated by an HF is often
similar to the income generated by an MSF.
In addition, HFS may also generate the
following types of income:
•
•
The HFs that trade in regulated futures
contracts and/or foreign currency
contracts will recognize income/loss
taxed under the provisions of IRC §1256.
To the extent IRC §1256 applies, the
income/loss from these contracts will be
recharacterized as follows: 60% classi-
fied as long-term capital gains/losses
and 40% classified as short-term capital
gains/losses.
For HFs that have made an IRC §475
mark-to-market election, investments are
marked up or down to their fair market
value at the end of the year and ordinary
income or loss is recognized to the extent
of the mark. Many HFS with a trading
strategy seeking to profit from swings in
the daily market movements make an
IRC §475 election. Losses are ordinary
in nature and not subject to capital loss
limitations. Also, because short-term
capital gains and ordinary income are
taxed at the same tax rate, there is no
disadvantage because income is taxable
at ordinary income rates.
HFs typically invest in a variety of
financial instruments. The instruments
utilized by HFs include options, warrants,
convertible securities, and joint ven-
ture agreements. The taxation of these
instruments is complex and can vary by
the type of investment.
Private equity and venture
capital funds
Private equity funds (PEF) are investment
funds that pool capital for investment in
privately-owned businesses at different
stages of development. PEFS invest in
privately-owned C corporations and
partnerships with the ultimate objective of
long-term capital appreciation. The PEF will
enhance the company's value by working
with the management team to increase
revenue streams, reduce expenses, improve
cash flow, and increase margins. The exit
strategy for the PEF may include selling the
investment to a strategic buyer, another
PEF, or possibly taking the company public.
The lifecycle of a PEF will be stated in the
offering documents but is typically 7-13
years, depending on its investment strategy.
2017 Essential Tax and Wealth Planning Guide | Tax implications of fund investing
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