Year-End Tax Planning Webinars for Funds and GPs | Part I
Year-End Tax Strategies for Fund Managers
In this webinar, the team presented on the latest legislative tax developments and year-end tax planning strategies for funds and their management companies.
Simcha David:Thank you, Bella. I appreciate the title. Actually, it's Partner-in-Charge of Financial Services Tax at EisnerAmper. I'd like to welcome everybody and I'd like to thank you for joining us on a beautiful fall afternoon here in New York. This is part one of our series, Year-End Tax Strategies for Fund Managers. Before I introduce my colleagues, I just want to let everybody know this is part one of a part three series. Next week we will be having the IRS updates and personal tax considerations for general partners, which will be giving updates from Lisa Capello and Miri Forrester. And part three would be our state and local tax updates for funds and GPs. We know how much fun that's been this year with all the PTECH changes and the like.
So I'm joined today by my colleagues Tom Grotheus and Steve Christiano. Tom is a partner in our financial services tax practice. He's got over 15 years of public accounting experience. He joined us about a year ago from Big Four. We're very happy to have him on board. Steve Christiano is a partner in our international tax practice with a heavy focus on financial services. Both of them have clients ranging private equity fund of funds, Steve more some on the individual side, Tom and the hedge fund side as well, and it's great to have both of them here to present today. So, without further ado, I'm going to hand it over to, I believe Tom to begin.
Tom Grothues:Great, thanks. We'll first dive into hedge fund tax planning. Now is a great time to review your portfolio activity and compare year to date taxable income to book or economic income. A suboptimal outcome is where taxable income is substantially greater than book income. This is especially true when you have an overall economic loss and taxable income. If you have this situation, you may want to consider harvesting losses. A few reminders we want to touch upon to avoid unexpected outcomes when realizing losses. The first is wash sales. Wash sales prevent recognizing a tax loss on the sale of stock when you remain in the same economic position. This occurs when you sell a security at a loss and buy a substantially identical security 30 days before or 30 days after the sale. The loss is deferred until the replacement security is sold.
To avoid triggering a wash sale, you would want to make any repurchase of the security outside of the 61-day window, again, 30 days before or after the sale. If you want to harvest losses but still maintain economic exposure, there are a few strategies to consider. If the exact security name is not critical, the loss security can be replaced with a similar security or an ETF in the same sector. Another strategy is doubling down. Let's say you have 10 shares of ABC stock that has an unrealized loss. You purchase an additional 10 shares of ABC stock. After 31 days, you can sell the first block and realize the loss. However, this does result in having twice the economic exposure for 31 days. Another strategy is entering into a basket swap. If you have a stock with an unrealized loss and wish to add economic exposure to other positions, you could sell the stock at a loss and enter into a basket swap that includes the sold stock as well as additional positions.
If the basket is structured properly, which includes the value of the sold stock making up less than 70% of the basket, it should not be a washed out. There are some other strategies using derivatives as well. Do want to note wash sales apply to options. If the options are on the same underlying security with the same expiration date, that will create a wash sale. Also, an option could be substantially identical with the stock of the underlying security. So, if you sell a stock at a loss and then purchase a call option on the same underlying stock within the 61-day window, it'll be a wash sale. A fund should not rely on wash sales from 1099s, and this is especially true when you have multiple brokerage accounts. Another potential loss deferral adjustment to be aware of are straddles. Straddles occur when you have offsetting positions and actively traded personal property, one with a gain, one with a loss.
Offsetting positions can be any combination that reduces the risk of loss, such as a long security and a short security or a call on a put. The straddle rules were enacted to prevent traders from recognizing a loss in one year and deferring gain to a subsequent tax year. The rules matched the timing of the loss and the gain into the same tax period. If you enter into a straddle and close one leg of the straddle at a realized loss, the realized loss will be deferred to the extent of the unrealized gain on the remaining leg. Also holding period will be terminated when the straddle is entered into, so the loss will either be long-term or short-term depending on how long the position was held prior to entering into the straddle. The use of the identified straddle rule can help prevent some of these issues.
The straddle must be identified on the taxpayer's books and records by the close of the day in which it's established. The loss deferral rules don't apply to the losses recognized on closing part of the straddle. Instead, the losses are capitalized into the remaining leg of the straddle that has the unrealized gain. Also, the identification has the effect of controlling the size of the straddle. If you have an unbalanced straddle, by identifying the straddle, you can match the offsetting shares on a one-to-one basis. Whereas if the straddle is not identified, one share can form a straddle on many offsetting shares.
Simcha David:Yeah, that could be disastrous, Tom, right? You wouldn't want to have that?
Simcha David:I just want to point out before you continue that the Q&A widget on 24 on what you're seeing, you could use that to ask questions to us as a group. We will try to get to some of the questions as we go through the presentation or as we wait for the polling questions to be answered. To the extent that we don't get to your questions here in the presentation, we get a list of all the questions that come through afterwards and we will try to get back to you in a reasonable fashion.
Tom Grothues:All right, great. Okay, so just a reminder that most gains and losses are effective on the trade date. There is an exception for covering short sales at a loss. In order to take a loss on a short sale, it must be settled before the end of the year. Most adjustments we've discussed relate to loss deferrals. There are instances where gains may need to be accelerated, such as constructive sales. Constructive sales occur when you have an appreciated position and enter into an offsetting position, effectively locking in the game. So even though the position is still held, the gain will be taxable. There is an exception to the rule. If the transaction that triggered the constructive sale was closed before the 30th day after the close of the taxable year and the appreciated position is held for an additional 60 days unhedged, the constructive sale rules would not apply.
Another item here to examine within your portfolio are worthless securities. Under 165(g), a loss is permitted if a security becomes wholly worthless during the tax year, as long as the security is a capital asset in the taxpayer's hand.
Simcha David:Hey, Tom, I just want to spend a minute on this for two seconds because this comes up all the time. We get these questions from our clients. Sometimes it's easy to know when a security is worthless, but the rules are really clear. You must take the loss in the year that the security becomes worthless. Sometimes that's easy to figure out. The fact that it's written off for book doesn't make it worthless. If you wouldn't turn around and sell it to somebody for a dollar, that doesn't make it worthless. So therefore, you really do have to know when it becomes worthless, and that's very important because if you get the wrong tax year and you go back and you took it in an earlier year that's now closed or the opposite, they may close one year and say, you can't go back to that year and disallow it in the age you took it. So, you took it a year or two late.
The year prior is when it should have been taken that year's close. So, you really have to be careful around that. A lot of times that comes up when there's a bankruptcy or things to that extent. When does it actually truly become worthless? So, it's not just, hey, I think it's worthless, it's really got to be worthless, and we have these conversations at year-end all the time, so I just wanted to point that out to everybody.
Tom Grothues:Yep, absolutely. And then when you take that worthless loss, it's treated as having occurred on the last day of the year regardless of any kind of identifiable event in which now it's worthless. So, what this does is it impacts the holding period and affects whether the loss is short-term or long-term. One more item to consider for hedge funds is whether your fund is a trader or investor for 2023. It is an annual test, so the classification can change if the fund strategy or trading frequency has changed significantly. Now's a good time to review that with your tax provider. The main difference between the two is how expenses are treated. Expenses for trader funds are considered trader business expenses and taken above the line. On the other hand, expenses for investor funds are considered portfolio and taken below the line. For most investors outside of corporations, portfolio expenses are not deductible.
All right, so we wanted to highlight a few planning reminders and updates impacting 2023 for management companies and GP entities. First item is bonus depreciation, which has been reduced from 100% deductible in 2022 to 80% in 2023. This will be even further reduced to 60% in 2024. So, you may want to consider planning to acquire fixed assets to take advantage of a higher bonus depreciation. Do want to note that certain states such as New York do not conform to the federal bonus depreciation deduction, so that should be considered in any planning. Also want to mention deduction for business meals in '21 and '22 was 100%. Now in 2023, business meals were only 50% deductible. Okay, so the self-employment limited partner exception. Many fund managers have formed management companies as limited partnerships. Under the statute, limited partners are exempt from self-employment tax, which is the tax consisting of social security and Medicare taxes, on their distributive share of income.
However, the IRS has been contesting this position and there are several ongoing court cases with some involving investment managers. As the statute doesn't define what a limited partner is, the IRS is contending a partner who provides services is not a limited partner. In September, the IRS added a new project on the limited partner exception to self-employment tax, and it's 2023, 2024 priority guidance plan. So, this suggests new guidance may be coming on the issue. So, if you have a management company set up as a limited partnership, you and your tax provider should stay tuned for the release of any new guidance as well as the outcome with respect to the ongoing litigation.
Simcha David:And Tom, this is one of my favorite topics as well, because if you're into the technical side of this limited partner exception, most law firms will tell you, and we've seen this, that from a technical perspective, it is a very sound tax argument that limited partner exception should be able to apply at least to limited partnerships. People try with LLCs and the like. They don't have the same protection. Limited partner exception is hardcoded into the internal revenue code. The IRS does not write legislation. They've been challenging it because they feel that maybe the courts will be more sympathetic or maybe people will just settle because they don't like bad press, which has happened as well. So, there's a number of cases that are out there.
I believe in next week's presentation, Miri Forrester, our tax controversy partner, will be spending some time going through the update as to where solely where the IRS is going to be on that. So just pointing that out, you'll get more of an update on that next week.
Tom Grothues:Absolutely. Okay. So, another item to consider before ERN relates to pass through entity tax state regimes, many states now permit a partnership on an elective basis to pay state taxes at the partnership level instead of the level of the individual partners. This enables the partnership to take a federal deduction for the state taxes paid that is not limited by the $10,000 salt cap. As many management companies are on a cash basis, just want to make sure those PTECH payments are made before year-end to get a federal deduction in 2023. Another item here, New Jersey market-based sourcing. So effective for 2023 New Jersey changed its apportionment and sourcing rules for pass-through entities now requiring income to be sourced using a single factor formula and market-based sourcing for services. So, this means if your fund has New Jersey resident partners, your management company may now have nexus and a filing requirement in New Jersey.
Also, there is no minimum threshold to trigger nexus, unlike California, which is another state that uses market-based sourcing. So now is a good time to review with your tax provider to determine if your management company as well as any other entities may now have nexus in New Jersey or how the change will affect historical sourcing to New Jersey. For 2023, New Jersey is granting relief with respect to estimated tax penalties and interest given the change in law occurred in 2023. And I know more of this will be discussed along with other call updates in part three-
Simcha David:In part three of the series. So definitely tune into part two and to part three.
Tom Grothues:All right, we made our plugs. Okay.
Simcha David:One of the questions somebody put on our Q&A, if a brokerage firm purchases the security from the investor for $1 and the investor takes a capital loss on the sale, will that usually fly with the IRS? Brokerage, any third party... So, if you get a true third party that you're willing to sell the security for a dollar, that's not a worthless security deduction, that's an actual realized loss or realized loss that you're taking because you did a normal actual third party transaction. So that should not be an issue. The issue becomes when you're not ready to sell it, you're holding it, you're saying it's worthless and it might not be actually considered worthless. So good question. But yeah, I think that kind of answers that particular question.
Stephen Christiano:Great. Thank you, Bella. And Tom, that was a great recap of some very important year-end planning strategies that people should be considering in the next couple months. So, we're going to kind of switch gears a little bit and start talking about some structuring strategies and ideas of when funds are thinking about various investments and to think about when you're taking on non-US money or raising tax-exempt funds. Also, we'll talk a little bit about offshore investments and things to consider with portfolio companies. So, the first topic that we're going to discuss is the topic in regards to leverage blockers and blocker structures. This is pertinent to your non-US investors and tax-exempt investors. Whenever you're setting up a structure that is a flow through structure that is engaged in a US trader business, you have to understand the tax consequences for your investors that are non-US directly investing in these types of partnerships.
Non-US investors are subject to tax on effectively connected income, so that is when they're engaged in a US trader business from a flow through. Non-US investors could potentially pay up to 37% on that income if it's an individual non-US investor. If it's a corporate non-US investor, you're looking at 21% plus branch profits tax. Also, with tax reform, 864(c)(8) came into play whereby if a non-US investor directly invests in an operating US trader business partnership, that on disposal, typically those capital gains would've been sourced to the residents of a non-US investor, therefore escaping capital gains tax. Now with tax reform, those capital gains would be subject to US tax and therefore creating a taxable event for a non-US investor.
Simcha David:Also, very importantly, your non-US investors do not want to be filing with the US government either. So that's a big thing other than the taxes, right? A lot of times they would rather not do.
Stephen Christiano:That's right. So, inserting a US blocker, which is treated as a C corporation, will alleviate a lot of these concerns. So as Simcha just stated, the non-US investors do not have to file US income tax returns. It blocks all of the ECI attributes or UBTI attributes for your tax-exempt investors and the USC corp will be subject to federal and state income tax. The federal corporate rate is 21% and the states vary, but it also will eliminate any sort of withholding obligations that a US partnership could face if they did have these investors or non-US investors directly invested. So, it's a great strategy and it's something to consider. Now, where does the leverage come into play? Well, the leverage blocker will be owned by typically a foreign partnership. That foreign partnership will have its non-US investors and tax-exempt investors as their partner base.
The foreign partnership could capitalize the US blocker by both equity and debt. Now the debt-to-equity ratio needs to reflect arm’s length principles, so the terms of the debt, the manner in which the US blocker pays interest back to the foreign entity, this all needs to reflect arm’s length principles. And also, the ratio, it can't just be 100% debt. A 70/30, 60/40 ratio typically is something that we would look for. This offers the opportunity to distribute cash out potentially on a tax-free basis to its non-US investors. US sourced interest income is subject to a 30% maximum withholding rate. However, you have this portfolio interest exemption, which the loan would be in registered form. So, you would meet one hurdle of the portfolio interest exemption and then you would have to look at your partner base to determine whether or not your non-US partners directly or indirectly own a less than 10% of the blocker.
If you meet that, then the interest escapes US withholding tax and should be 0% withholding. So that's one way to get money repatriated back out of the blocker into the foreign partnership. Now, if you have a situation where you have non-US investors that do own a greater than 10% direct or indirect interest in the blocker, there's still the possibility that depending on where that non-US investor is resident of, treaties could apply which would reduce that 30% withholding rate to a reduced rate and in some treaties even down to 0% depending on the country. This would also apply for sovereign wealth investors as well. So even if you don't meet the 10% threshold, you could still potentially get a lower US withholding rate. Now, on the blocker side, the blocker will be picking up a K-1. As I stated before, it will be subject to federal and state taxes.
However, you have the interest expense which would be deductible against that flow through income. Now there's certain interest expense limitations, such as related party rules under Section 267 and then there's obviously 163(j) which may come into play, but that's an additional benefit for having a leverage blocker.
Simcha David:And I think Steve, one of the things private equity funds are very focused on is returning capital as quickly as possible because generally they're playing an 8% preferred to their investors and this gives you the opportunity to get cash out of the corporation as an interest and principle payment versus strictly as a dividend, which obviously you're going to say in a minute is subject to a 30% withholding. So, it makes a lot of sense to do the leverage from that perspective as well, from a cashflow perspective.
Stephen Christiano:Definitely, definitely. And that's a great topic to discuss right here with the first bullet point where if you are paying dividends out of the blocker, they will be also subject to a maximum withholding rate of 30% during the life of the blocker. So that can also be reduced depending on where your non-US partners are resident of by a treaty. Now, on exit, there's a couple of different strategies to consider. So, if the blocker is liquidating their partnership interest in this US trader business partnership, they would also want to liquidate the blocker itself by making liquidating distributions and a plan of dissolution. So that would generally be non-taxable to non-US investors on that end. However, the corporate blocker will be subject to federal and state income tax because of the disposal of the partnership interests. So that's where you want to maybe consider deal by deal blockers if you do have significant ECI generating assets in your structure.
Now, the sale of the actual blocker shares however, creates an even better US tax advantage for your partners in the blocker because the sale of shares will be capital gains, but it won't be subject to the 864(c)(8) provisions because it's a sale of stock. So therefore, the capital gains on that transaction will be sourced to the residents of the taxpayer and therefore escaping any sort of US tax consequences for your non-US investors. This will also eliminate any sort of corporate tax liabilities that the blocker could have because of the disposal of a partnership interest. So, you really want to look at that. You really want to think about as far as the exit strategy and when you're negotiating deals on the eventual sale, to think about selling the blocker itself.
Simcha David:And Steve, just one more thing. With your leverage blocker, like I said, you're able to get the cash out really by earmarking it as interest in return of interest and principle. And then towards the end of the life of the fund, even if you have one or two assets or three assets left over, you could put actually a plan of liquidation in place for the C corp. That means you've got about three years to actually liquidate the corp. So, if you know over the next three years you're going to be selling the remainder of your assets, any cash coming out from that point on will be a liquidating distribution. Ultimately, if it goes above what their basis is, it'll be a capital gain like you said, but it won't be subject to the dividend withholding. So, people don't realize that they've got that time span once you put the plan on liquidation for the corporation in place.
Stephen Christiano:Yeah. No, that's a great point. That's a great point. So, another investment structuring consideration for US partnerships that are investing or acquiring stock and portfolio companies is the qualified small business stock exclusion under 1202. This is a huge tax incentive for funds that potentially are acquiring these types of assets. The eligible shareholders are all non-corporate shareholders. Now for partnerships that are owning QSB stock, there's a few other hurdles that they have to go through in order to pass through those benefits to their partners. But individuals, trusts and estates, these are all eligible shareholders for QSB purposes. Now, the stock of a qualified small business stock, it needs to be a C corp first off, it needs to also be acquired directly by a fund for cash. So, you can't just contribute QSB stock into a partnership or buy it from a third party. It must be original issuance from the corporation. The partnership must hold it for at least five years or more than five years, I should say. And also, the C corporation needs to pass a couple of different tests.
So before and immediately after the purchase, the assets of the C corp, their tax basis of those assets must be less than 50 million. So that's one threshold that the QSB entity will need to pass, and that's the gross asset test. And then there's also an active business requirement. So that test is basically testing what is that company actually doing? It must be in a trader business. There are certain businesses that do not qualify for QSB treatment, and that's mostly in the professional services world or service style businesses that even if you meet that gross asset test, it won't be a qualified business for QSB purposes. It's usually a true operating trader business. It can't be a holding company or anything of that nature. So those are a couple tests at the C corporate level that need to be passed in order for this to be considered. Now, also a key element is that not all states conform to the 1202 exclusion, which we'll get into on the next slide.
I know for a fact New Jersey does not conform to the 1202 provisions because so even though if you have a federal exclusion, New Jersey will add that back. So, another thing to think about as far as your partner residencies go. Now, what is the exclusion? So, when you sell, assuming you've met all the different hurdles, when you sell QSB stock, the gain is eligible for exclusion, is limited to the greater of $10 million or 10 times your adjusted basis in the stock sold. It's a huge benefit, a huge benefit. For partners and partnerships, that must be the same partners as of day one that the partnership has when they first invest in the QSB stock. That's a key provision for partners and partnerships. So typically, a close-ended fund that doesn't have a lot of transfers or ins and outs of partners could potentially qualify. The contribution of stock to partnership will lose its QSB status. I think I spoke about that previously. Partners in a partnership, when the partnership disposes of the QSB stock, each partner's pro rata share of gain can be excluded.
You'll see that on footnotes of your K-1s, et cetera, and partners can take that into consideration when they're filing their own tax returns. Now, on the carried interest side, it's important that the GP's interest is vested as of day one of the partnership so that they could potentially get the benefits of the 1202 exclusion as well when they do take their carry on the sale. And then one other provision that's really nice is that if you have a QSB stock, you sell that stock and you want to take those proceeds and reinvest in another QSB stock, you can do that through Section 1045. You have to do that within 60 days. After the sale of a QSB stock. The holding period of the old QSB stock will tack onto to the replacement QSB stock. So for example, if you've only held the old QSB stock for three years and you sell your QSB stock and then you roll it into a new QSB stock and you then sell that replacement stock three years later, you've met the more than five year holding period because you get to tack on the three years from the old QSB stock. So, something to consider as well.
Simcha David:Hey Steve, that carried interest question that always pops up, it's actually a very interesting question number one, because let's say the general partner doesn't have a capital interest. Some take that position; all it needs is a profits interest and the rule is you need to be a partner in the partnership from the day that the partnership owns the QSBS. And so all of a sudden you went from a 0% to a 20% when you sell it because you're getting the carried interest. Did you own that from the beginning? Is that deemed to be as if you were in it from the beginning? So that's always been an interesting technical question. And then obviously there's a question about percentage ownerships changing where 1045 has a particular provision and the question is whether it applies to 1202 as well. So definitely speak to your tax service provider just to make sure what their position is on whether or not at the carried interest you could take the 1202 exclusion.
Tom Grothues:Okay, so another item we wanted to go over that comes up a lot are the tax implications associated with contributing property to a partnership and when a partnership distributes property to its partners. We'll start on the contribution side first. We see this come up often in the launch of a hedge fund. Let's say when an advisor provides services to separately managed accounts and wants to pool the securities into a fund, also see it associated with various restructuring transactions or permitting a specific investor to contribute property in exchange for a partnership interest. So, under 721(A), the contribution of property to a partnership is tax-free. However, there are a few exceptions to be aware of to tax-free treatment. The first is contributing property to a partnership that is classified as an investment company.
An investment company is a partnership in which more than 80% of the value of its assets are held for investment and are marketable stocks or securities. If a partner contributes securities to a partnership that is an investment company and the transfer results in diversification of the transferer's interest, the contribution is taxable. Gain would only be recognized on the appreciated contributed securities; no losses would be recognized. Diversification occurs when a partner contributes assets that are different compared to what the partnership holds or what's being contributed by other partners. This is designed to prevent tax-free diversification of an investment portfolio through a non-recognition transfer of a single or a small number of securities for an interest in a partnership that holds numerous securities.
Simcha David:And this came about Tom because you had these owners of corporations that were extremely successful that their entire wealth was in their one corporate stock that they own. And so, a bunch of them were getting together and putting them all together so they diversified without actually selling their stock. They were able to diversify their portfolio that way, contributing into a partnership. So, we didn't want that. The IRS didn't want to allow that to happen.
Tom Grothues:Absolutely. So, a way to plan around this to achieve a non-taxable contribution of securities to a partnership that is an investment company is to have an investor contribute an already diversified portfolio of securities for the contribution of securities to be diversified. Now more than 25% of the overall value can be invested in the stock or securities of any one issuer and not more than 50% of the overall value can be invested in the stock or securities of five or fewer issuers. And another sort of exception to tax-free treatment is when a partner contributes appreciated property to a partnership in exchange for a partnership interest and subsequently receives a cash distribution triggering the disguised sale rules. Under the disguised sale rules, this type of transaction may be characterized as a sale of property between the partner and the partnership.
There is a presumption rule that if a transfer of property and a transfer of money are made within two years of each other, the transaction is presumed to be a disguised sale unless the facts and circumstances establish that the transfers do not constitute a sale. And when you have the situation, tax return disclosure would be required to rebut the transaction as a presumed sale assuming the facts support that position. And then just a few other points to mention when a partner contributes property on a tax-free basis, the partnership's tax basis and holding period in the property carries over from the contributing partner. Also, the built-in gain or loss on contributed property, which is the difference between the fair market value and tax basis at the time of the contribution, will need to be specifically allocated back to the construing partner when the property is sold by the partnership.
So just something that you would have to track going forward in order to make that allocation. Okay, so now let's go over distributions of property from a partnership to a partner. Sometimes we see hedge funds redeem partners with a distribution of securities versus cash. It's also common in private equity fund of funds that they'll distribute certain investment positions. So, distributions of property are generally tax-free, but one key item to be aware of is the tax implications are different between a current distribution of property and a liquidating distribution of property. In a current distribution of property, the tax basis and holding period carries over from the partnership to the partner. The tax basis of the property reduces the partner's tax basis in the partnership, but not below zero.
In a liquidating distribution of property to a partner, the tax basis in the property is adjusted to equal the partner's tax basis in the partnership less any cash received. So, a partner who receives property in liquidation of their partnership interest, the basis the partner will take in that property is the basis they had in the partnership immediately before the distribution. Similar to a current distribution, the holding period of the distributed property carries over from the partnership. Also want to note that a distribution of marketable securities is generally treated as money. However, for investment partnerships this does not apply. So, for a typical hedge fund, a distribution of marketable securities will not be treated as money.
Okay. So, because a partner in a liquidating distribution of property adjusts its basis in the property to equal its outside tax basis in the partnership, this can cause what's called a mandatory basis adjustment under Section 734. A Section 734 mandatory basis adjustment purports to avoid the duplication, that potential acceleration of losses where the partner's tax basis in the distributed property is greater than the partnership's basis in the distributed property by more than 250,000. So, for example, if partner A receive securities with a $10,000 tax basis in a liquidating distribution from an investment partnership and immediately before the distribution partner A has a $300,000 outside tax basis in the partnership, this would cause the partnership to reduce the tax basis of its remaining assets by 290,000 under Section 734.
So, say a hedge fund wants to redeem a partner out of the fund with securities in order to avoid a Section 734 adjustment, it would be prudent to distribute securities with a total tax basis equivalent to the redeeming partners tax basis in the partnership. Another item to note here is that to the extent a partnership is distributing hot assets such as receivables or inventory that is disproportionate to a partner's interest, that distribution could be taxable. Also, when a partner receives a distribution of hot assets, the ordinary tax character associated with the assets will be retained. Just to also just mention here, there are rules around distributions of property that were originally contributed into the partnership with a built-in gain within a seven-year period, as well as making distributions of property to a partner who had contributed other property with a built-in gain to the partnership.
If this occurs, the built-in gain on the property would be taxable upon distribution. And again, as well, just be mindful of the disguised sale rules when distributing property. Okay, so next polling question.
Stephen Christiano:There were a couple of questions that popped up. I'll just take a couple of these. So, there was a question about when a US partnership has ECI from an underlying investment, is the US partnership responsible for withholding under 864(c)(8) for its non-US partners? So, if you have a fund to fund situation and your non-US partner is directly invested in the fund and the fund sells an underlying partnership interest that is in a US trader business, then the fund does have withholding responsibilities for ECI purposes. And what should happen is that the underlying fund that's been disposed of should be reporting certain ECI information up the chain to its upper tier partnership so that the upper tier partnership can do the proper withholding. There was another question on-
Simcha David:Steve, I think there's just one more point on that, Steve. I think that if in a normal situation, not a fund-to-fund situation, there may be a withholding, not actually withholding, there may be a withholding liability on the partnership. If the buyer does not withhold from the seller properly, then when the buyer comes in, there may be on the partnership a requirement to withhold the tax that it should have withheld from the seller. So, you're talking about where it's coming from under underlying, so it'll already be ECI believe under those rules there may be a withholding requirement of the partnership as well, but the rules are very nuanced. So, this is a very general answer to the question.
Stephen Christiano:Yeah, and we'll get into that too a little bit in a few other slides as well with the new withholding requirements on that side too, but yeah. And there was a question on the 1202, it is applied at the partner level, not the partnership level when we're talking about excluding the 10 million of gains or 10 times the tax basis. Great.
Stephen Christiano:So now we're going to start talking about offshore investments, everybody's favorite topic. We're going to get into some CFC conversations as well as PFIX. The IRS has really cracked down on not only reporting requirements, but understanding when a fund goes into an offshore investment, the ownership percentage of that offshore investment and what type of anti-deferral regime a US investor could potentially fall into. So first we're going to kick it off with CFCs. A controlled foreign corporation is a foreign corp that is owned greater than 50% by US shareholders. A US shareholder is defined as a 10% or greater, either direct or indirect shareholder of the foreign corp, and that would be a US citizen, a US green card holder, a tax resident of the US, a domestic partnership C corp, a US C corp, a US trust, or a state as well. The 10% threshold, so a US shareholder that is a 10% or greater partner either direct or indirect in that foreign entity.
If you have other US shareholders that own 10% or greater, and collectively they own greater than 50% of that foreign corp, you're into CFC territory. So, for example, if you have five US partners that each own 11% of let's say a foreign partnership and a foreign partnership wholly owns a foreign corp, because you have US investors that indirectly own greater than 50% and they're all above that 10% mark, you've created a CFC situation. Now the funnest topics that we talk about in the offshore space is downward attribution, which is very, very complex, but part of tax reform. They repealed Section 958 before which now you could have a scenario where you have a foreign owned structure and within that foreign structure you have both US subs and foreign subs that are both owned by a common foreign parent. Now, on the face of it, you may not think that you have a CFC scenario.
In our example here you have a US investor that owns 10% and a foreign investor that owns 90% and a foreign parent. Now, that foreign parent owns a 100% of a domestic C corp and a foreign C corp. Now, with downward attribution, what happens is that because this foreign parent owns both a US and a non-US sub, it attributes the US ownership up to the foreign parent and down to the foreign corp, thereby the US C corp or US sub is now constructively owning that foreign corp 100%. And because it's greater than 50%, you've now turned that FC, foreign corp into a CFC. Now, you may now say, well, I don't directly own that CFC or I indirectly own that CFC. This is purely due to downward attribution. I may not have an issue, but again, we have to look at the definition of a US shareholder, which talks about a 10% or greater, either direct or indirect interest.
Now, because you have a CFC due to downward attribution, you now have to look at your US investor base to determine whether or not those CFC attributes could affect your US investors. In our example, you have a 10% or greater investor. So therefore, they are a US shareholder for CFC purposes and could potentially have phantom income pickups because of the CFC situation due to downward attribution.
Simcha David:And of course, Steve, the IRS decided to really get strong on CFC enforcement as they did this repealed to 958 before, which created in some of these structures just a massive... They probably can't even identify the CFCs that come because of this and some of the crazy scenarios that come out of it, and it's been difficult for clients to really be on top. And even if you have good faith and you try to be on top, if you've got a complex structure, it's very hard. So, it's important that you're in touch obviously with your tax service provider to really identify the CFCs. As we know, I'm sure you're going to get to, the failure or the penalty for failing to file a proper 5471 is high. I'm not going to steal your thunder on that. So go ahead.
Stephen Christiano:And I would definitely say that in acquisitions where I see this often is acquisitions of foreign structures where you have a foreign holding company and you could have 100 foreign subs, but then there's this little US arm of that structure, which is a C corp, or it could be just one US C corp that's in the structure. It could just be a sales office in the US or some other research facility that will taint the entire structure for this downward attribution scenario. So really, really important to analyze that. And the 5471 filing requirements, missing a 5471 filing requirement is a $10,000 penalty. So, you can imagine if you have a lot of these types of structures where you could have 50 CFCs, because of this scenario, the penalties are very, very significant. Please keep an eye on that and please talk to us as well about that.
What are the consequences of CFC status? So, this is where the IRS does not like US taxpayers deferring income offshore. When you have a CFC scenario, you potentially have to pick up phantom income under either the subpart F regime, which is generally your passive income. So, if you have a foreign company that's generating interest, dividends, capital gains, et cetera, that will fall under the subpart F bucket. And then you have this guilty regime, which is more or less your active trader businesses overseas that a US taxpayer would potentially have to pick up that income as well. So, you're really not getting around phantom income when you do have a CFC scenario. And the CFC, you would have to calculate and annualize on a US tax principle basis and flow that information up to your 10% or greater US investors. And this is regardless of distributions as well.
Now, for just one more point on the US investor side is that there are potential elections that a US investor could take or could make on phantom income from a CFC, especially when a CFC is in a tax paying jurisdiction overseas, so it's definitely something to look at and consider at the individual investor level. Now we get into PFICs. So even if you're out of the CFC regime, you could fall into the PFIC regime and a passive investment or a passive foreign investment company is a PFIC if it meets one of two tests. So, the first test would be a gross income test, and that's 75% or more of your income is passive income, which again, is interest dividends, capital gains, could potentially be rents, et cetera. That is one test. If it fails that test, it will be considered a PFIC for the year. The PFIC test is an annual test, so you have to test your foreign subs or foreign entities in your structure on a yearly basis.
The other test is an asset test, which is at least 50% of your assets are passive income producing. So, if you have investments in securities or investments in other foreign entities that are producing passive income, you could potentially breach that test. One thing that always trips up funds is that cash is treated as passive for the purpose of this asset test. So, when you're raising money or investing money into a foreign corp and that foreign corp has not disposed of that cash right away, you potentially have this PFIC scenario in the first couple years. There is, however in structures, a look through rule, which could be helpful when you have a foreign holding company that invests in a foreign sub and that foreign sub as an active trader business. If the foreign holding company owns a greater than 25% interest in that foreign sub, you could consolidate those assets for PFIC testing of the foreign holding company, which potentially takes you out of the PFIC regime for that holding company.
There's various exceptions for foreign corporations that are actively involved in the insurance business and banking industry. That's a whole other code section and probably a whole other presentation on that. We're not going to really get into that today, but just to keep that in mind.
Simcha David:And we find that, Steve, that cash in venture capital funds, you find that a lot also, right? Because generally those companies don't tend to have a lot of assets. They're starting out and you're making investments and it's a foreign company. You would like to trip up the PFIC test or trip into even though... What do you mean it's an operating entity? Yeah, it is, but it doesn't really have much operations yet and it's really got your cash and flow coming in. So, you can end up tripping that up and you trip that up in one year, even if it turns into a non-PFIC in the future. I'm sure you're going to get into this. Once a PFIC, always a PFIC. So, let's continue on, but it can be pretty extreme.
Stephen Christiano:So, funds have various options to make certain elections on PFICs to make them a little bit more advantageous to its US investors. So, one of the elections that I'm sure we've all heard of is the qualifying electing fund election, otherwise known as the QEF election. Now, in order for a US investor to make a QEF election, the PFIC must be willing to provide a signed annual information statement. On that information statement, they must have specific language that it will allow its shareholders to inspect the books and records of that PFIC. It also must be signed as well. So, for your records, you must have signed PFIC statement in order to make a valid QEF election. On the informational statement, you'll have two categories of income that a US investor will need to pick up. You'll have ordinary earnings, and you'll have net capital gains.
Now, net capital gains will be treated as long-term capital gains for a US investor. Ordinary earnings will be treated as ordinary income for a US investor and that US investor effectively agrees to report their pro rata share on their own US income tax return. Now, if you have a US partnership that has a bunch of underlying PFICs, the US partnership would be considered the first US shareholder in the chain of ownership. Currently, a US partnership can make a QEF election and then pass through that income to its US investors. And then the PFIC reporting essentially stops after the first US shareholder makes that QEF election. That could change in the future, but currently US partnerships can continue to make QEF elections. Now, by making a QEF election, you are picking up phantom income regardless of distributions. So, US investors will pay tax on this, but it's a lot better than the default treatment, which we'll get into in the next couple slides. There is another election-
Simcha David:People may want to negotiate when you're going into a deal that you can actually get that statement, going back to what you said, that the foreign company does have to give you a PFIC statement, and they don't all agree to do that. So, depending on how much of a company you're buying or et cetera, that may be part of the negotiation that if you do a turn out to test as a PFIC for US tax purposes, that they would be able to give you that. For some reason, companies do push back on that sometimes, especially larger companies that you're buying a smaller share of.
Stephen Christiano:And what's important too is you want to make sure that when you first know that you've gone into a PFIC investment that you make the QEF election in the first year. Like we said, PFIC testing is done on an annual basis. Once you make that QEF election, it protects you on a going forward basis. So, if you made a QEF election in the first year of the PFIC, in year one, it's a PFIC. In year two, maybe it's not a PFIC, you can then treat that as a typical foreign corporate investment without any sort of PFIC attributes. So really important that in year one when you know that you've invested in PFIC, you make that election. Another election available for US taxpayers is the mark-to-market election. This will only pertain to marketable stock that is considered a PFIC. So typically, or generally foreign mutual funds are PFICs.
So, if you're invested in those types of funds, the mark-to-market election could come into play. By marking the PFIC stock on a yearly basis, a US taxpayer is picking up ordinary income on the difference between the ending fair market value and their adjusted cost basis. So, you will pick up ordinary income and let's just say in year one, you pick up ordinary income. In year two, it's a loss. You could pick up an ordinary loss up to the income that you previously had picked up. Also, on the sales of these types of PFICs, the gain will be treated as ordinary, but keep in mind that a US taxpayer's basis in PFIC stock will continually increase as they're picking up income on a yearly basis. So very important to track your tax basis in these funds.
And losses, as long as you have what we would call reverse inclusions, which is your ordinary income pickups along the way from earlier years, losses on the sale of a mark-to-market fund could also potentially be treated as an ordinary loss if you've had ordinary income pickups in the past. Anything in excess of your ordinary income would be treated as a capital loss if you're in a loss situation. Now, these elections are important because by default, if you decide not to make any elections on PFICs, by default, you're under 1291 default treatment. And this allows a taxpayer to not pick up any phantom income along the way of when they're holding a PFIC stock. However, it has very harsh tax consequences when that PFIC either makes distributions to a US taxpayer or you sell that PFIC stock. So, the IRS essentially penalizes a US taxpayer for holding this PFIC stock. They penalize it across the holding period by charging interest and also throwback tax on the eventual sale of that stock.
So, you could hold a PFIC that you've never made a QEF election on or a mark-to-market election on for five years. You sell it at a gain, that gain will be treated as ordinary income and will be subject to the throwback tax and interest charges for essentially deferring that income over the course of the holding period. Now, there's definitely elections out there that can be made to purge the 1291 taint and get into the QEF regime. We're not going to really go into detail on that today, but just note that by not making any elections, you're by default into this pretty harsh 1291 regime.
Simcha David:And it's interesting because the whole reason for the PFIC rules was because what people were doing was they were saying, "Hey, why should I invest here in the United States, let's say in stocks or whatever it is, in passive investments and pay tax on an annual basis. Let me throw it onto a foreign corp, right? And therefore, it stays outside on a zero tax jurisdiction, it grows tax-free and when I bring it back, I'll pay tax on it." And the government's like, "No, we don't want you doing that." And so anytime the government tries to fix something, so they put this PFIC regime in place, it was very structured how they fixed it. And of course, what that happens in our situation is you may actually invest in an operating company, but you trip into the rules because the definition is very structured. But those are the consequences. And so, we need to be aware of them and we need to be aware of the extremity of not making an election and then at the same time, knowing that we could possibly fix it with the different elections that you mentioned.
Stephen Christiano:And what's interesting with the 1291 regime as well is that if you don't make an election on the PFIC when you first invested in it and it's a 1291 PFIC, and then let's say year two, three, four, five, it's not a PFIC, that 1291 taint follows that investment throughout the life of the PFIC. So that once a PFIC, always a PFIC rule, that's where that typically will come into play and you're still under 1291 regardless of whether it's a PFIC or not a PFIC when you actually either repatriate that money back or sell that investment. So very important to analyze this. Now, if you want to get out of the CFC regime, PFIC regime, there is a tool to do that. You can make check the box elections on your foreign entities. That could be potentially CFC investments or PFIC investments. Check the box elections, that's purely from a US tax perspective, it does not change the legal entity or the legal classification or how it's treated in its local jurisdiction.
It's purely for US tax purposes so you can turn a corporation into a flow through entity by making a check the box election. This will get you out of any of the CFC or PFIC regimes. The only entities that you may not be able to make a check the box election on are what the IRS defines as per se corporations. There's a list of them. It's by country. So important to take a look at that whenever you're incorporating a new entity in an offshore jurisdiction. Also, a foreign entity must have an EIN in order to make a check the box election. So, another important point when you're considering this. Now, some of the advantages of making a check the box election is that you can flow through losses to your partners. Whereas when you have a PFIC or you have a CFC investment, even if they are loss making, those losses won't flow through to your shareholders or to your partners. But when you open up the structure via the check the box election, everything will pass through.
So, some further US withholding considerations, which is a pretty hot topic these days, is the 1446(F) withholding considerations, which this will apply to transfers of both non-PTP and PTP interests by foreign partners. So, when you have a foreign partner that's selling their interest or transferring their interest, the buyer, the transferee will potentially have to withhold a tax equal to 10% of the amount realized on that transfer, which is typically the purchase price. This is a fairly new regime, but there are multiple exceptions that could apply that will reduce that 10% withholding in certain circumstances. If the buyer does not abide by these withholding requirements, effective in 2023 is now this secondary withholding obligation, which then falls onto the partnership itself, which then they would apply the withholding on subsequent distributions to the transferee and remit that back to the IRS to claw back that 10% that should have been withheld in the first place.
This will only apply in scenarios where you have a US partnership or a partnership in general that has ECI generating assets. This goes back to the 864(c)(8) provisions. So, if you do have ECI within your structure and you have a non-US partner selling their interest, you have to be aware of this. Now, there's various certifications that the buyer has to provide to the underlying US partnership to certify that they've gone through the steps of 1446(F), they've filed the appropriate forms, which is the 8288 series, so that the partnership gets comfortable that they don't have to withhold on any subsequent distributions. Also, new for 2023 is that PTPs do fall into this withholding requirement. So, if you have PTPs owned by non-US investors, PTPs are in the scope for US withholding tax. And the brokers in that scenario should be withholding on any sales of PTP interests and then filing the appropriate 1042-S forms for their non-US investor base.
Simcha David:And of course, your legal documents should obviously have language in there that would allow you to get the information necessary when someone sells an interest to a third party in terms of the withholding. It's very important.
Tom Grothues:I'd say the other thing too, that the 10% on the amount realized is the purchase price as well as the relief of liability. So that withholding can be a lot higher than what the substantive liability will be for that foreign seller. So again, just something to consider even on the structure side for hopefully being able to avail one of those certificates to either eliminate or reduce that withholding.
Stephen Christiano:Makes the blocker structure even more likely in that scenario to get around this as well.
Tom Grothues:Absolutely. Okay. So, I think we'll close here with a legislative update. So, house republicans have introduced bills that would restore the expensing of research and development costs. Under current law, domestic R&D costs are amortized over five years and foreign R&D costs are amortized over 15 years. Another provision is to reestablish a 100% bonus depreciation ineligible fixed assets. And another provision would be to ease the 163(j) limitation where interest expense would be limited on earnings before amortization and depreciation. Democrats who control the Senate would probably be looking for an expansion of the child tax credit, maybe an adjustment to the salt cap as well. But at this point it's probably not likely these provisions or any major tax legislation gets done before the end of the year.
Simcha David:And here we were hoping that they would all see the need for this because this is good for business, but unfortunately the divide sometimes is too wide to get anything productive then.
Tom Grothues:And then a note on wash sales and digital assets, so under current law wash sales only apply to securities. Cryptocurrencies are considered property for tax purposes. Therefore, many take the position that wash sales do not apply to cryptocurrencies. In Biden's fiscal year 2024 budget plan, there is a provision that would make cryptocurrencies and other digital assets subject to the wash sale rules. Also, Senator Gillibrand along with the Republican senator, reintroduced the bill over the summer that would subject digital assets to the wash sale rule. So, if you trade in digital assets, just something to keep your eye on going forward.
Simcha David:And you need a special rule for that, Tom, very quickly, because the wash sale rules only apply to securities and under the RIS's current policy, digital assets are generally not securities. So, you need a special hold for.
Tom Grothues:Yep. Okay. And then we also want to highlight that under the Corporate Transparency Act of 2020, certain corporations and partnerships will be required to provide beneficial owner information to the Financial Crimes Enforcement Network or FinCEN. New entities formed in 2024 have 30 days to file the report and for existing entities, reports are due January 1st, 2025. If you have any questions on what entities may need to provide beneficial owner information to FinCEN, just we advise you speak with your legal counsel, but did want to highlight it. And last thing to mention here is the IRS is focused on expanding its audits of large partnerships and high-income earners. The IRS has already started to open audits of 75 of the largest partnerships in the US.
Simcha David:Thank you, Tom. I just want to reiterate to everybody; I see there were a lot of questions in the Q&A. We did try to answer some of them as we were going through them directly to those who were asking the questions. If we didn't hit your question, we will get a list of them and we will be happy to try to answer them in the next couple of days.
Simcha David:So let me just do that one really quick, Bella and then I'll give you the last minute to finish up. So, everybody knows clawbacks. Generally, if you're in private equity, you would know this. Clawbacks generally are for the GP if they took too much incentive. Generally, the clawback is less tax distributions that would otherwise go to the GP if they took a tax distribution earlier, if they were entitled to it and somehow under the new rules they found that that didn't sound nice. And so, I believe there's a provision in there that says that if you are going to do your clawback that way, you're going to have to give notice to the investors what the clawback would've been with and without that provision in place. But definitely something to be aware of coming out of the new private fund advisor rules. Okay, go ahead Bella.
Simcha David:Okay. Well, thank you everybody for joining us. I think, Bella, you have a few last-minute things to talk about and it was great having everybody on board. Bella.
Transcribed by Rev.com
Year-End Tax Planning Webinars for Funds and GPs | Part II
Year-End Tax Planning Webinars for Funds and GPs | Part III
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