The private investment partnership - investor, trader or dealer?

How should private investment partnerships be treated? As investors, traders or dealers? The distinction is critical and affects a multitude of issues. This article addresses the tax consequences of investing in U.S. hedge funds and recommends strategies to maximize tax benefits for organizers and investors.

EXECUTIVE SUMMARY

* "Trader" status is most desirables for a private investment partnership (commonly, a hedge fund).

* There are differing tax consequences for an individual who invests in securities directly, or through a mutual or hedge fund.

* Some of the issues affected include the PAL rules, investment interest expense limits, limits on deductibility of expenses, and the wash sale, straddle and mark-to-market rules.

The era of "saving pennies for a rainy day" is long gone. More and more Americans hold more and more of their wealth in the form of securities investments. Such investments may be direct (e.g., stock or bonds) or indirect (e.g., mutual and hedge funds).

The tax consequences of investing differ depending on whether an individual invests in the securities markets directly, or indirectly through a mutual or hedge fund. This article addresses the tax consequences of investing in U.S. hedge funds and recommends strategies to maximize tax benefits for organizers and investors.

Mutual vs. Hedge Funds

Mutual Funds

Mutual funds, which are regulated under the Investment Company Act of 1940 (1940 Act), are corporations that pool money from individual investors. A mutual fund is typically run by professional money managers, who invest the pool in stocks, bonds or other securities. The aim is long-term growth, not capitalizing on short-term market swings. While this article does not discuss the tax treatment of mutual fund investing, Exhibit 1 on p. 614 compares some of the tax con sequences of investing in the stock market directly to investing indirectly through a U.S. mutual fund or hedge fund taxed as a partnership.

Hedge Funds

On the other hand, a "hedge" fund is a private investment vehicle (usually organized as a limited partnership) that seeks above-average returns through active portfolio management, rather than long-term growth. Investors tend to be attracted to hedge funds because of the managers' flexibility and strategies for earning positive remains in all market conditions.

Unlike mutual funds (which are heavily regulated), hedge funds are largely unregulated by Federal securities laws. Hedge-fund interests are generally exempt from the registration requirements of the Securities Act of 1933 (1933 Act) contained in Rule 506 of Regulation D, because they offer interests only to "accredited investors" (including natural persons who have a net worth exceeding $1 million (1)). Additionally, hedge funds are generally exempt from the 1940 Act's registration requirements if the investors are limited or are all "qualified purchasers" (e.g., any natural person who owns not less than $5 million). (2) As a result of this relatively unregulated operating environment, hedge funds can make large bets on volatile positions, thereby resulting in big gains or losses.

Organization: A hedge-fund organizer (usually an investment adviser or money manager) typically forms the fund as a limited partnership or limited liability company (LLC) (which is taxed as a partnership). In a limited partnership, the investors are generally limited partners (LPs); the organizer is the general partner (GP). In an LLC, the investors are non-managing-members; the organizer is the managing-member.

Tax considerations: A host of tax considerations need to be addressed when investing in hedge funds. Critical among these is determining whether the fund is an investor, a trader or a dealer. (3) Such status is important in determining the effect of (1) the passive activity loss (PAL) rules; (2) the investment interest expense limits; (3) the limits on deductibility of fund expenses; (4) withholding on foreign partners; (5) the wash sale, straddle and mark-to-market rules; and (6) entity-level taxes in jurisdictions that tax partnerships and LLCs.

Investors, Traders and Dealers

The demarcation among investors, traders and dealers for tax purposes is comparatively clear and longstanding. Well-settled guidelines (4) provide that an investor is any taxpayer that purchases and sells securities for its own account with the principal purpose of realizing investment income in the form of interest, dividends and gains from appreciation in value over a relatively long period of time (generally, one or more years). Most taxpayers who invest in securities are "investors"

A "trader" is an investor whose investment activity is so frequent that it rises to the level of a trade or business. Generally, a trader is not interested in long-term appreciation and is not investing for the dividend or interest that accompany stock ownership; rather, a trader seeks profit on short-term market swings. A "dealer" is a taxpayer that undertakes securities transactions on behalf of customers.

PAL Rules

To the extent losses from passive trade of business activities exceed the income therefrom, Sec. 469 provides that such losses may not be deducted against active income. The excess losses are suspended under Sec. 469(g) until the taxpayer disposes of the activity that generated the losses of, under Sec. 469(b), until he or she generates additional passive activity income.

Definition

Sec. 469(c)(1) defines a passive activity as any activity that involves the conduct of a trade or business in which the taxpayer does not "material]y participate." Generally, under Sec. 469(h)(2), an LP interest in a limited partnership is not material participation. Because an investor partnership is not, by definition, engaged in a trade of business, its losses are not subject to the PAL limits, regardless of whether the partners materially participate in the fund's activities. However, trader partnerships and dealer partnerships are engaged in a "trade or business"; thus, their losses may be passive to the extent allocated to partners who do not materially participate.

Temp. Regs. Sec. 1.469-5T(a) provides that a partner materially participates if any one of the following is met:

1. The partner participates in the activity for more than 500 hours during the year.

2. The partner's participation is "substantially all" of the participation in such activity of all individuals (including individuals who do not own interests in the activity) for such year.

3. The partner participates in the activity for more than 100 hours during the year and his or her participation for the year is not less than any other individual's participation.

4. The activity is a significant participation activity for the year and the partner's aggregate participation in all significant participation activities during the year exceeds 500 hours.

5. The partner materially participated in the activity for any five of the preceding 10 tax years.

6. The activity is a personal service activity and the partner materially participated for any three tax years preceding the tax year.

7. Based on all the facts and circumstances, the partner participates in the activity on a regular, continuous and substantial basis during the year.

GPs and managing-members materially participate in a hedge fund if they meet any of the above factors. Because the GPs and managing-members are the only partners who decide which securities to purchase and when to buy and sell such positions, they materially participate in the hedge fund and, thus, are not subject to the PAL rules.

LPs and non-managing-members, on the other hand, do not participate in the typical hedge fund's day-to-day operations. In fact, partnership agreements and operating agreements generally preclude LPs and non-managing-members, from such active participation.

Exception

Temp. Regs. Sec. 1.469-1T(e)(6) provides that "an activity of trading personal property for the account of owners of interests in the activity is not a passive activity." Under Temp. Regs. Sec. 1.469-1T(e)(6)(ii), "personal property" includes any actively traded personal property (e.g., stock and options). Accordingly, the activity is not a passive activity; thus, a trader partnership's GPs, LPs or non-managing-members are not subject to the PAL rules. (5)

However, dealer partnerships are likely subject to the PAL rules to the extent the partners do not materially participate. The partnership does not qualify for the "trader" exception, as it does not trade for the accounts of its owners.

Investment Interest Expense

Many investors use others' property to make investments. An investor may margin an account, in effect, borrowing from a broker to purchase securities. Alternatively, an investor may sell securities it does not own (a "short sale"), anticipating that they will decline in value. When an investor sells securities short, the prime broker uses another client's stock and effectively loans the securities to the investor. The investor pays the broker a fee to use the margined funds and the stock for short sales; the fee is often interest. Is such interest deductible?

Allowance of Deduction

Sec. 163(a) generally allows as a deducion all interest paid or accrued within the tax year on debt. Sec. 163(d), however, limits the deductibility of "investment interest" to the "net investment income" of a taxpayer other than a corporation. Under Sec. 163(d)(3), investment interest is any interest paid or accrued on debt properly allocable to "property held for investment," including any amount allowable as a deduction for personal property used in a short sale.

Property Held for Investment

Sec. 163(d)(5)(A) provides that property held for investment includes (1) any property that produces portfolio-type income under Sec. 469(c)(1) (Sec. 469(e)(1) property); and (2) any interest a taxpayer holds in a trade of business that is not a passive activity and in which the taxpayer does not materially participate.

Sec. 469(e)(1) property is (1) gross income from interest, dividends, annuities and royalties not derived in the ordinary course of a made or business; or (2) gain or loss not derived in the ordinary course of a trade of business, attributable to the disposition of property held for investment.

Under Sec. 163(d)(4), "net investment income" is the excess of "investment income" over "investment expenses." Investment income includes, under Sec 163(d)(4)(B)(ii)(I), gains attributable to the disposition of property; Sec. 163(d)(4)(C) defines investment expenses as expenses (other than interest) directly connected with the production of investment income.

Such expenses can be significant, thereby decreasing deductible investment interest. However, Sec. 163 (d)(3)(B)(ii) provides that investment interest does not include any interest taken into account in computing Sec. 469 passive activity income or loss.

Do the Limits Apply?

Investor partnerships produce investment interest. All of the partnership's property is Sec. 469(e)(1) property; thus, all of the partners (including GPs, LPs and LLC members) are subject to the Sec. 163 limits.

However, the GPs and the managing-members in a trader partnership do not have investment interest, because the debt on which interest is paid or accrued is not allocable to property held for investment. None of a trader partnership's property is Sec. 469(e)(1) property, because a trader partnership engages in the conduct of a trade or business. Further, the GPs and managing-members materially participate in the partnership's affairs. The LPs and non-managing-members have investment interest, because they do not materially participate.

Accordingly, GPs and managing-members in an investment partnership are subject to the Sec. 163(d) limits, but the GPs and managing-members in a wader partnership are not. In each case, LPs are subject to the Sec. 163(d) limits.

Dealer partnerships are subject to the investment interest expense limit to the extent interest is incurred on debt allocable to the partnership's investment activities. The limit does not apply to the extent interest is paid on debt allocable to a dealer partnership's trader activities.

Trade or Business Expenses

In addition to interest expense, hedge funds invariably incur other expenses. For instance, hedge funds have offices for which they pay rent, brokers to whom they pay commissions, employees to whom they pay salaries and rented or leased equipment for which they seek to deduct depreciation.

Instead of paying for these items directly, a fund may pay a management company a fee to provide such services and other administrative support. Usually, the fee is 1%-2% of the assets the fund has under management. Whichever arrangement the fund chooses, deductibility of these expenses hinges on whether the fund is an investor, a trader or a dealer.

Are These Expenses Deductible?

If the fund is a trader, each individual partner may deduct his or her share of fund expenses (other than interest) as a Sec. 162 business expense. If the funds is an investor or dealer, such expenses would be Sec. 212 miscellaneous itemized deductions, subject to the Secs. 67 and 68 limits. Additionally, if the fund is a dealer, expenses specifically related to the conduct of other trade of business operations are deductible under Sec. 162, not 212.

Wash Sales, Straddles and Mark-to-Market Rules

Wash Sales

When a taxpayer sells stocks or securities at a loss and, within a 30-day period before or after such sale, acquires substantially identical stocks or securities, Sec. 1091(a) disallows the loss as a "wash sale." For this purpose, "substantially identical" means "from the same issuer." (6) According to Sec. 1091(d), a loss disallowed under Sec. 1091(a) is added to the adjusted basis of the substantially identical securities purchased. The wash sale rules do not apply to dealers in stock and securities if the loss was incurred in the ordinary course of such business.

Straddles

When a taxpayer sells stocks or securities at a loss, the loss is allowed under Sec. 1092 only to the extent it exceeds the unrecognized appreciation in other investments the taxpayer holds that constitute a "straddle" with the first investment.

Sec. 1092(c)(1) defines a straddle as a taxpayer's "offsetting positions with respect to personal property." According to Sec. 1092(c)(2)(A), a taxpayer holds offsetting positions as to any personal property if there is a substantial diminution of risk of loss from holding such property by reason of holding one of more other positions with respect to personal property (whether of not of the same kind). Under Sec. 1092(a)(1)(B), any loss disallowed under the straddle rules for any tax year may be carried over to the next, subject to the straddle rules for such succeeding year.

Mark-to-Market Rules

The wash sale and straddle rules apply differently to hedge funds characterized as traders, investors of dealers. Investor hedge funds are always subject to these rules. However, special rules apply to dealer partnerships and electing trader partnerships. Sec. 475(a)(1) generally requires dealers (and traders who elect under Sec. 475(f)) to recognize unrealized gains and losses attributable to certain securities that are not inventory and held at the close of each tax year--the "mark to-market" rule. The unrealized gains and losses are ordinary, under Sec. 475(d)(3)(A)(i). The wash sale rules do not apply to losses in positions a taxpayer has marked-to-market, according to Sec. 475(d)(1). Similarly, when a taxpayer marks-to-market certain positions, the straddle rules do not apply to such positions if the offsetting positions must also be marked-to-market.

Withholding on Foreign Partners

U.S. citizens and residents are taxed on their worldwide income. Under Sec. 871, nonresident aliens (NRAs) are taxed on (1) income effectively connected with a trade or business in the U.S. (ECI) or (2) certain fixed or determinable annual or periodical (FDAP) U.S.-source income. A payer's withholding requirements depend on whether the NRA has ECI or FDAP income.

Sec. 1446 provides that if a partnership has ECI and any portion of such income is allocable to a foreign partner under Sec. 704, the partnership is liable for withholding tax. Under Sec. 1446(b)(1), the partnership must withhold an amount equal to the "applicable percentage" of the ECI allocated to the foreign partner. Sec. 1442(b)(2) defines the applicable percentage as the highest tax rate specified in Sec. 1 for noncorporate taxpayers (35% after the Jobs and Growth Tax Relief Reconciliation Act of 2003) and in Sec. 11(b)(1) for corporate taxpayers (35%).

Under Sec. 864(c), ECI is income connected with a trade or business in the U.S. Sec. 864(b)(2)(A)(ii) excludes income earned from trading in stocks and securities for one's own account. Under Regs. Sec. 1.864-2(c)(2)(ii), however, this exception does not apply to a partnership with a principal office in the U.S., unless more than 50% of the partnership's capital and profits is owned by five of fewer partners. Sec. 864(b)(2)(B)(iii) provides that income earned from trading commodities for one's own account is excluded from ECI if the commodities are of a kind customarily dealt in on an organized commodity exchange and the transaction is customary to the exchange.

Sec. 1441 provides that if a partnership does not generate ECI, it is required to withhold a 30% tax on all FDAP (unless this rate is otherwise reduced by an income tax treaty). FDAP income includes interest, dividends, rents and royalties. Regs. Sec. 1.1441-2(b)(1) and (2) provide that FDAP does not include capital gain income.

By definition, an investor partnership is not engaged in a "trade or business" and, thus, is subject to the Sec. 1441 withholding rules. If the partnership does not otherwise incur FDAP income (because all of its income is capital gain), no withholding is required. A trader partnership (which, by definition, is engaged in a trade or business) could likewise avoid withholding if it does not maintain its principal office in the U.S. or a majority of the partnership is owned by five or fewer partners. Such trader partnership would not earn ECI and would not have FDAP income to the extent that its income is derived from capital gains. However, a trader partnership that does not meet the exception for trading one's own account would have ECI and would have to withhold under the strict Sec. 1446 rules. A dealer partnership should always have ECI and, thus, be subject to withholding under Sec. 1446.

State and Local Tax Issues

Many hedge funds are organized, or maintain offices, in jurisdictions that assess a local income tax on entities taxed as partnership (e.g., New York City's unincorporated business tax (7)). Most of these jurisdictions, however, exempt investment partnerships if such partnerships' activities are limited to trading for their own account. (8) Accordingly, investor and trader funds should not be subject to entity-level tax in jurisdictions that tax partnerships, if such (funds limit their activities to trading for their own account. Dealer funds, however, may be subject to local income tax.

Conclusion

For the reasons discussed in this article, organizers and investors may want to ensure that the hedge funds which they organize and in which they invest are classified as trader funds. Why?

* A GP or an LP in a trader fund will not be subject to the PAL rules.

* A GP in a trader fund will not be subject to the investment interest expense limits.

* The partners in a trader partnership can deduct partnership expenses (other than investment interest) as ordinary business expenses, rather than as miscellaneous itemized deductions.

* Partners in a trader partnership should not be subject to (1) ECI withholding if the entity merely trades for its own account or (2) FDAP income withholding to the extent that the entity earns only capital gain income.

* Trader partnerships may be able to avoid the wash sale and straddle rules if they elect to mark-to-market.

* In jurisdictions that impose an entity-level tax on partnerships, a dealer partnership will be subject to such tax, as it does not trade for its own account.

Organizers and investors should ensure that a fund does not engage in dealer activities and that the fund's trading activities are beyond those of a mere investor.

Exhibit 1: Methods of investing in securities

                       Direct investing        Mutual fund investing
                       (C corporations)        (regulated investment
                                                    companies)

Applicable Code          Subchapter C              Subchapter M
sections               (Secs. 301-385)            (Secs. 851-855)

Entity-level         * Taxed on earnings;    * If entity distributes
taxation             maximum rate is 35%     at least 90% of its
                                             income (other than
                                             capital gains), it is
                                             entitled to a
                                             dividends-paid deduction

                                             * Entity taxed only on
                                             investment company
                                             taxable income and its
                                             undistributed net capital
                                             gain

Investor's basis     * Cost                  * Cost (different rules
                                             if shares acquired by
                                             gift or inheritance)

                     * Reduced basis if      * Include "load" fees in
                     distributions exceed    basis
                     entity's earnings
                     and (E&P)

Distributions        * Ordinary income if    * Ordinary income if paid
(other than          out of E&P              out of the fund's
redemptions or                               dividends, interest
liquidations)        * Amount of             or net short-term capital
                     distribution in         gain
                     excess of E&P
                     reduces stock basis     * Long-term capital gain
                                             if distribution made out
                     * Amount of             of fund's long-term gain
                     distribution in         (even if investor held
                     excess of basis is      interest for less than
                     shareholders capital    one year)
                     gain
                                             * Neither capital nor
                                             ordinary if distributions
                                             are return of capital

Allocation of        * None; shareholder     * Tax on undistributed
profits and          not taxed on            long-term capital gain
losses               undistributed           allocated to the
                     earnings and there      investors (even if not
                     is no passthrough       actually distributed),
                     of losses               but investor can increase
                                             basis by 65% of the
                                             allocated but
                                             undistributed long-term
                                             capital gain.

                                             * No allocation of the
                                             entity's capital losses;
                                             losses can be used to
                                             offset capital gain;
                                             excess can be carried
                                             forward for eight years

Sales, exchanges     * Sales: Capital        * Gain an difference
and redemptions      gain or loss equal      between amount realized
                     to the difference       and basis
                     between the amount
                     realized and the        * Special rules exist for
                     adjusted basis          determining basis when
                                             investor not selling
                     * Redemptions:          all shares
                     Generally, capital
                     gain if complete
                     termination of
                     interest; may be
                     dividend treatment
                     in some
                     circumstances

                     Hedge fund investing
                        (partnerships)

Applicable Code         Subchapter K
sections              (Secs. 701-777)

Entity-level         * None
taxation

Investor's basis     * Amount of cash contributed, plus adjusted basis
                     in other property contributed to the partnership

                     * Adjusted for distributions and allocations of
                     profits and losses

Distributions        * No gain or loss recognition on
(other than          distributions to partners to the
redemptions or       extent of their basis in their
liquidations)        partnership interests

                     * Capital gain on money distributed in
                     excess of basis

                     * If a partner contributes built-in gain property
                     and within seven years of such contribution, the
                     partnership makes a distribution to such partner,
                     the contributions triggers gain (but not loss), to
                     the extent of the lesser of the: (1) excess of
                     the fair market value (FMV) of property
                     (other than money) received in the distribution,
                     over the adjusted basis of the distributee's
                     partnership interests; and (2) "net
                     precontribution gain" that the distributee
                     partner would recognize if all of the property
                     contributed by the distributee within seven years
                     of the distribution and held by the partnership
                     is distributed by the partnership to another
                     partner

                     * If a partner contributes built-in gain or loss
                     property and within seven years of such
                     contribution, the partnership distributes the
                     property to any partner, the contributing partner
                     will recognize either the gain or loss that such
                     partner would have recognized had the partnership
                     sold the property at its FMV

Allocation of        * Taxed on allocable share of partnership's
profits and          taxable income and/or loss, regardless of whether
losses               earnings are distributed

Sales, exchanges     * Sales: Generally, capital-gain treatment
and redemplions      (ordinary income to extent interest is attributable
                     to partnership inventory and/or unrealized
                     receivables)

                     * Liquidating distributions: Generally, same as
                     current nonliquiditing distributions, except that
                     (1) payments made to a partner in liquidation of
                     his or her interest may be deemed a "distributive
                     share" or "guaranteed payment"; and (2)
                     distributions attributable (in whole or part)
                     to unrealized receivables may result in ordinary
                     income treatment to the distributee

(1) Sec 1933 Act Rule 501(a)(6).

(2) See 15 USC Section 80a-3(c)(1) and -3(c)(7).

(3) A fourth type of hedge-find partnership is a "fund of funds," a hedge fund that primarily invests in other hedge finds (although such entities may and often do--also invest in securities directly). The tax status of a fund of funds is usually determined by the status of the funds in which it invests. If the underlying funds are deemed "investor" partnerships, the fund of funds will be an investor partnership; if the underlying funds are "trader" partnerships, the fund of funds will be a trader partnership.

(4) For a detailed analysis of the factors used to determine whether a taxpayer is an investor of trader, see Robert P. Groetzinger, 480 US 23 (1987); Frederick R. Mayer, 32 Fed. Cl. 149 (1994); Joseph A. Moller, 721 F2d 810 (Fed. Cir. 1983), cen. den.; Stephen Marrin, TC Memo 1997-24, aff'd, 147 F3d 147 (2d Cir. 1998); Leonhard F. Fuld, 139 F2d 465 (2d Cir. 1943); Fernand C. A. Adda, II) TC 273 (1948). aff'd per curiam, 171 F2d 457 (4th Cir. 1948), cert. den.; Chang H. Liang, 23 TC 1040 (1955); see also Shapiro, "Private Securities Partnerships--The Trade or Business Issue Examined," 56 Tax Notes 85 (1992).

(5) See the Example at Temp. Regs. Sec. 1.469-1T(c)(6)(iii).

(6) According to Marie Hanlin, 38 BTA 811 (1938), aff'd, 108 F2d 429 (3d Cir. 1939), '"[s]ubstantially identical' imports approximation to identity, not mere similarity--means 'in the main.' It imports something less than precise correspondence; it's 'economic correspondence exclusive of differentiations so slight as to be unreflected in the acquisitive and proprietary habits of holders of stocks and securities.'"

(7) See NYC Administrative Code Section 11-503(a).

(8) See, e.g., NYC Administrative Code Section 11-502(c)(4).

Author's note: The author wishes to thank Daniel M. Kalosich, an associate at Pitney, Hardin, Kipp & Szuch LLP, for his assistance with this article.

David A. Sussman, J.D.

Associate

Pitney, Hardin, Kipp & Szuch LLP

Morristown, NJ