Financial Services Insights - June 2012 - Investment Fund Mid-Year Tax Update

Michael_LavemanAs we reach the midpoint mark for 2012, investment managers should start thinking about the vast amount of tax changes and uncertainty that exists for 2012 and beyond. This article is intended to provide a brief overview of some of the issues to consider.


  • 2013 will see an increase in tax rates as well as the elimination of one tax bracket. Currently, there are six brackets (10%, 15%, 25%, 28%, 33% and 35%). These will become five (15%, 28%, 31%, 36% and 39.6%) in 2013.
  • Long-Term Capital Gains tax rate will increase to 20% from the current 15% rate.
  • The special “Qualified Dividend Income” 15% rate will expire and the dividend rate will be the ordinary income rates discussed above. A taxpayer in the highest tax bracket will be hit hard as they will pay tax at a 39.6% rate.
  • Itemized deductions and personal exemptions will be phased out for individuals with high adjusted gross income.  This impacts fund expenses from partnerships treated as “investors” rather than “traders.”
  • The top rate for estate and gift taxes will increase to 55% from the current 35% rate and the exemption decreases to $1 million from the current $5 million exemption


  • Management companies that purchase property face lower Section 179 deduction amounts. In 2011, $500,000 of eligible property was eligible for an immediate tax write off. This amount decreased to $125,000 for 2012 and is set to drop to $25,000 in 2013. In addition, the special 100% bonus depreciation deduction for qualifying property has been reduced to 50% for 2012.
  • In 2013, the Medicare portion of the payroll tax will increase by .9% (from 1.45% to 2.35%) for individuals with wages exceeding $200,000, or $250,000 for married couples filing jointly. Self-employed individuals, including partners of a management company, will also see an increase in Medicare taxes from 2.9% to 3.8% if self-employment income exceeds the above wage thresholds.
  • In 2013 a new 3.8% “unearned income” tax will affect those taxpayers that have modified gross income exceeding $200,000 for single taxpayers and $250,000 for those who are married filing jointly. The unearned tax is considered a surtax which is paid in addition to the regular income tax or Alternative Minimum Tax (AMT) on the same income. The additional tax is not deductible when computing any federal income tax. For most individuals, modified adjusted income will equal their adjusted gross income.
    The 3.8% tax will be imposed on “net investment income” which will include:
    • Income from interest, dividends, annuities, royalties and rents unless such income is derived in the ordinary course of a trade or business
    • Income from a trade or business that consists of trading financial instruments or commodities – this appears to target funds with a 475(f) trader election in effect
    • Passive income from a trade or business – this would include income from a partnership investment where the partner does not materially participate such as an investment in a master limited partner (“MLP”)
    • Net gain attributable to the disposition of property other than from a trade or business. If a taxpayer has a net loss on the disposition of property this cannot offset other income categories above. Thus, a taxpayer can be subject to tax on a grossed-up basis.

      Net investment income may be able to be reduced by allowable expenses but only to the extent that these expenses would be allowable for regular tax purposes. To the extent that a taxpayer has expenses that are itemized deductions reduced by the 2% adjusted gross income floor, these expenses will also not be allowable for net investment income purposes. Investment interest expense is also subject to limitations.

The significance of the above tax changes should not be understated from a tax planning perspective. It is important to consider these rules as the year develops. Classic tax planning would normally include deferring income. However, with these drastic changes, this may not be the case for 2012. As an example in 2012, long-term capital gains will be taxed at 15%. The same long-term capital gain will be taxed at 23.8% in 2012 as a result of tax rate changes plus the “unearned income” tax. 


  • In September 2011, the IRS released proposed regulations on the tax treatment of swaps. These regulations redefined what is considered to be a notional principal contract (“NPC”) for tax purposes and seem to most affect the tax treatment of Bullet Swaps, as well as Credit Default Swaps. It is important to note that NPC tax treatment is extremely complex and could lead to adverse tax results. These proposed regulations are to be effective when finalized.

    Please see our previously issued article on these proposed regulations at 
  • In January 2012, the IRS released temporary and proposed regulations on “Dividend Equivalent” payments. Before the enactment of FATCA in March 2010, 30% withholding was not imposed on a “substitute dividend payment” made to a foreign person pursuant to a swap contract. The FATCA law provided a two-year window (March 2010-2012) where these “substitute dividend payments” would be subject to 30% withholding in limited circumstances. The limited circumstances included cross-in/cross-out transactions where a taxpayer would own the underlying security before or after a transaction in which they arranged to avoid the withholding tax on dividend payments by entering into a swap. The temporary regulations extended the limited scope of the limited applicability from March 18, 2012 to December 31, 2012. The proposed regulations provided seven new categories of transactions which would be considered.

    Many industry comment letters have responded negatively to the dividend equivalent regulations primarily because they are written extremely broadly and seem to go beyond the legislative intent on stopping abusive tax avoidance through the use of swaps. As one example of this broad interpretation, “equity-linked instruments” including futures, forwards, options, equity-linked notes, and other contractual arrangements could fall under the dividend equivalent rules.

    Please see our previously issued article on these proposed regulations at 


  • The IRS issued proposed regulations February 8, 2012 with respect to the new 30% withholding regime on certain payments made to Foreign Financial Institutions (“FFIs”) and Non-Foreign Financial Institutions (“NFFEs”) which do not enter into an agreement with the IRS. The IRS expects to issue a draft FFI agreement this summer. It is anticipated that this will be an online process. Registration under FATCA should be completed by June 30, 2013. FATCA reporting will begin for the 2013 tax year while actual withholding will begin in 2014 for Fixed or Determinable Annual Periodic Payments (FDAP), such as U.S.-sourced interest or dividend income, and in 2015 for gross proceeds of the sale of U.S. securities. Withholding on a certain type of payments known as pass-through payments will be delayed at least until 1/1/2017.

    It is likely that most foreign hedge funds and private equity funds will need to enter into an agreement with the IRS to become a “participating FFI” in order to avoid the onerous 30% withholding. In addition, to the extent that an investor in a particular fund does not provide required information, they will be subject to withholding under the “recalcitrant” investor rules.  A key part of FATCA will be the information gathering process to understand where a fund may have an ultimate U.S. owner. The IRS has issued revised W-8 series which will be used to collect this data. In addition, the IRS will also issue revised Form 1042-S to allow for FATCA reporting.

    As the industry and advisors continue to dissect the nearly 400 pages of proposed regulations, there are several items funds should consider now:
    • Consider who in the organization should take responsibility for FATCA. The proposed regulations require designating a “responsible officer” for FATCA compliance.
    • Start-up funds and funds updating their fund documents should consider adding in FATCA language which addresses the need to collect additional data from shareholders/partners as well as the potential for FATCA withholding.
    • Any side letters should be carefully reviewed to make sure FATCA is taken into account.
    • Have a plan in place as to how to gather information from investors once the new W-8 series are issued.
    • Consider which service providers can assist with FATCA registration, gathering and reviewing new W-8 forms, annual reporting, and any required withholding calculations.
  • Form 8938 – Statement of Specified Foreign Financial Assets – became effective for the 2011 tax year for specified individuals to report certain foreign assets. Form 8938 is required to be attached to the individual’s federal income tax return. Although similar to Form TDF 90-22.1 (FBAR), the 8938 does not replace the need to file the FBAR report by June 30.

    The IRS put out a useful comparison of Form 8938 and the FBAR report. This can be viewed at

    Proposed Regulations also state that beginning for the 2012 tax year, certain domestic corporations and partnerships may also need to file if they satisfy three conditions:
  1. The domestic corporation or partnership has an interest in a special foreign assets meeting the threshold tests as prescribed for individuals.
  2. The entity must be “closely held.” A domestic corporation is closely held if a specified individual owns at least 80% of the corporation’s stock, by vote or value, on the last day of the corporation’s year. A domestic partnership is closely held if a specified individual owns at least 80% of the capital or profits interest on the last day of the year. Direct, indirect, and constructive ownership rules apply in determining closely held status.
  3. Must meet either (a) or (b)
    (a) At least 50% of the corporation’s or partnership’s gross income for the taxable year is passive income or at least 50% of the assets held at any time during the year are assets that produce or are held for the production of passive income.
    (b) At least 10% of the corporation’s or partnership’s gross income for the taxable year is passive income or at least 10% of the assets held by the corporation or partnership at any time during the taxable year are assets that produce or are held for the production of passive income, and the corporation or partnership is formed or availed of by a specified individual with a principal purpose of avoiding the reporting obligations with respect to the statute.
    Please see our previously issued articles on Form 8938 at 

The above issues represent just part of the tax issues managers need to consider. The near future may or may not hold the passage of carried interest legislation, comprehensive or limited tax reform, or an extension of the Bush tax cuts. Establishing a plan to review tax issues mid-year as well as before year-end will help create maximum tax efficiencies and planning opportunities as well as reduce compliance surprises.

Financial Services Insights - June 2012

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