2017 Essential Tax and Wealth Planning Guide
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Tax implications of fund investing
Investment fund attributes
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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Below are some of the requirements in
order for a stock to be considered QSBS.
Requirements
⚫ The stock must be in a domestic C
corporation (not an S corporation or
LLC, etc.), and it must be a C corpora-
tion during substantially all the time the
taxpayer holds the stock.
• The corporation may not have more than
$50 million in assets as of the date the
stock was issued and immediately after.
• The taxpayer's stock must be acquired
at its original issue (not from a
secondary market).
•
During substantially all the time the
taxpayer held the stock, at least 80%
of the value of the corporation's assets
were used in the active conduct of one
or more qualified businesses.
In contrast to being able to receive a full
federal income tax exemption for QSBS
acquired after September 27, 2010 (but
before January 1, 2015), a second alternative
is available to defer gain by rolling over
gains into new QSBS investments. There are
also planning considerations to increase the
ability to take the exclusion to the extent the
amount of the excludable gain exceeds the
exclusion limitation.
Unrelated business taxable income
For tax-exempt investors considering a fund
investment, it is important to understand
the underlying investment strategy and
income that will be generated by the
fund. For example, foundations generally
pay excise tax equal to 1% or 2% of the
net investment income earned by the
foundation during the year. However,
if a foundation is allocated UBTI, such
income is subject to a 35% income tax
rate. Accordingly, tax-exempt organizations
generally try to minimize acquiring
investments that generate UBTI.
Even income that is otherwise not UBTI will
be UBTI if the income is from debt-financed
property. As described above, many HFs
utilize leverage to execute the investment
strategy, thus creating UBTI for tax-exempt
investors. Therefore, depending on the
anticipated amount of UBTI, many tax-
exempt investors will proactively choose
to invest through the offshore HF blocker
corporations to effectively block any UBTI
from flowing through. For tax-exempt
investors, it may be prudent to weigh the
cost of paying tax on UBTI by holding a direct
interest in a partnership HF investment
(which would flow through the UBTI to the
taxpayer) versus the cost of investing directly
in an offshore blocker corporation, which is
subject to 30% withholding on FDAP income
and 35% withholding on ECI. Another activity
that causes UBTI is investments in operating
businesses. Typically, income from operating
businesses is considered UBTI. Many PEFS
and REFS generate operating income, and
thus the income would be UBTI.
Ultimately, tax-exempt entities should weigh
the expected appreciation and benefits of
diversification that investing in underlying
funds can offer against the incremental cost
of paying 35% tax on UBTI.
For tax-exempt investors
considering a fund
investment, it is important
to understand the
underlying investment
strategy and income
that will be generated
by the fund.
2017 Essential Tax and Wealth Planning Guide | Tax implications of fund investing
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