2017 Essential Tax and Wealth Planning Guide
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Tax implications of fund investing
Types of investment funds
and income tax characteristics
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
Character of income
considerations-PEF and VCF
Income generated from PEFS and VCFs
is typically dependent on the type of
investment. For many PEFS that are investing
in businesses organized as partnerships,
there will typically be operating income
or losses flowing through to the investor
which are subject to ordinary tax rates.
For PEFS investing in businesses organized
as corporations, any operating income
from that business will not flow through
to the PEF nor to the PEF's investors.
Depending on the type of investments
made by PEFS and VCFs, some funds may
include alternative investment vehicles (AIV)
in their fund structure. An AIV is simply a
fund partnership typically created to allow
tax sensitive investors to invest, side by
side, with the main fund, for example, in
a flow-through portfolio company. The
AIV structure will typically have a blocker
corporation as a limited partner in the
AIV, through which tax-sensitive limited
partners invest.
When a PEF or VCF disposes of a portfolio
company structured as a corporation, the
gain/loss is treated as short-or-long-term
capital gain, depending on the time that
the fund held the investment. When a PEF
or VCF disposes of a portfolio company
structured as a partnership, the ordinary
income portion will be similar to the
amount that would be recognized if the
underlying operating business conducted
by the portfolio company was sold. Such
a disposition results in gain taxed as
ordinary income (to the extent of ordinary
deductions required to be recaptured or to
the extent of gain attributable to assets the
sale of which would be treated as ordinary
income (e.g., inventory), with the remainder
of the gain (if any) being taxed at the
long-term capital gain rate. In some cases,
if the underlying investments are in the
energy industry, there may be unique tax
treatment of certain items for those types
of investments. Lastly, see the additional
discussion on page 59 regarding qualified
small business stock, which may apply for
certain types of PEF or VCF investments.
As a PEF or VCF recognizes items of income,
gain, loss, deduction, and credit, such
items are allocated among its partners
based upon the economic terms of the
LP agreement. Such allocations take into
consideration each partner's rights under
the economic terms set forth in the fund's
LP agreement. Generally speaking, the
allocations will reflect each limited partner's
right to return of capital, preferred return,
and an allocable share of upside gain on the
disposition of an investment.
In addition, the allocations will reflect
the GP's right to return of capital, carried
interest, and upside gain on disposition of
an investment. The character of any item
of income, gain, loss, deduction, or credit
allocated to the GP under the carried
interest provisions of the LP agreement for
a PEF or VCF is determined by the LP and
retains its character when reported by the
GP. Although a GP's carried interest in many
instances is not determined until late in a
calendar year or after the calendar year end,
the timing of when the items are included in
the GP's carried interest coincides with when
the items are recognized by the PEF or VCF.
For example, if the fund recognizes long-
term capital gain on the sale of corporate
stock in January, and such gain results
in an allocation of gain to the GP under
the carried interest provisions of the LP
agreement, then such income is treated as
allocated to the GP in the first quarter and
should be taken into account for quarterly
estimated tax purposes accordingly.
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