Treatment of Investment Interest Expense Allocable to Partnerships Trading Activity

Editor: Stephen E. Aponte, CPA

Hedge funds are private investment partnerships that seek to maximize returns through active portfolio management rather than long-term capital appreciation. Their activities go beyond mere investing and constitute trading. The typical hedge fund Schedule K-1 discloses that the partnership’s trading activities constitute a trade or business, and the distributive share items are not considered to be derived from a passive activity under Temp. Regs. Sec. 1.469-1T(e)(6). The K-1 will also instruct partners who do not materially participate in the partnership that the interest expense attributable to the partnership’s trading activities is subject to the Sec. 163(d) investment interest limitation, and the allowable ordinary loss should be reported as nonpassive on Schedule E, Part II.

Until this year, the tax professionals preparing the individual returns of hedge fund investors who have followed this treatment of investment interest have had to rely on FSA 200111001. The conclusions of this field service advice are based on the statutory construction of Secs. 163 and 702 and temporary regulations under Sec. 469.

However, the IRS revisited the issue in 2008 with the release of Rev. Rul. 2008- 12 on March 10 and the concurrent release of Announcement 2008-65 and Rev. Rul. 2008-38 on July 3. Together these rulings confirm the proper tax treatment of investment interest expense allocable to a partnership’s trading activity.

Rev. Rul. 2008-12

The issue posed in Rev. Rul. 2008-12 is whether a noncorporate limited partner’s distributive share of interest expense incurred in the trade or business of trading securities by the partnership is subject to the Sec. 163(d) limitation on the deduction of investment interest. The facts are that an entity taxable as a partnership is engaged in the trade or business of trading securities for its own account and incurs indebtedness in its trading activities. LP is a noncorporate limited partner who does not materially participate in the partnership’s trading activity, and LP‘s distributive share of partnership items includes interest expense on indebtedness incurred in the partnership’s trading business.

The analysis of Rev. Rul. 2008-12 for the most part follows that of FSA 200111001, although the ruling does not refer to the latter. The deductibility of interest expense is governed by Sec. 163. Under Sec. 163(d)(1), the deduction for investment interest for noncorporate taxpayers is limited to the amount of net investment income for the taxable year. Investment interest is any interest that is paid or accrued on indebtedness properly allocable to property held for investment. Sec. 163(d)(5)(A)(ii) provides that “property held for investment” includes “any interest held by a taxpayer in an activity involving the conduct of a trade or business” that is “not a passive activity” and “with respect to which the taxpayer does not materially participate.”

A passive activity is generally any activity that involves the conduct of a trade or business in which the taxpayer does not materially participate. However, a special exception exists under Temp. Regs. Sec. 1.469-1T(e)(6) whereby the activity of trading personal property for the account of owners of interests in the activity is not a passive activity, regardless of whether such activity is a trade or business activity.

For this purpose, personal property is defined under Sec. 1092(d) as any personal property of a type that is actively traded. Regs. Sec. 1.469-4(a) provides that a taxpayer’s activity includes any activity conducted through a partnership. Under Temp. Regs. Sec. 1.469-2T(c), an interest in an activity includes both an interest in property used in an activity and an interest in an activity held through the partnership.

The partnership’s activity of trading securities involves the conduct of a trade or business, which is not a passive activity. Because LP does not materially participate in the partnership’s trading business, LP‘s interest in the partnership’s trading activity is an interest in an activity that is property held for investment under Sec. 163(d)(5)(A)(ii). Therefore, LP‘s distributive share of the interest expense allocable to the trading activity is investment interest and is subject to the investment interest limitation in Sec. 163(d)(1). Furthermore, the partnership must separately state the interest expense allocable to its trading business because the deductibility of the expense could be limited by the degree of participation by each partner.

Announcement 2008-65

Following the publication of Rev. Rul. 2008-12, a number of taxpayers inquired as to where the investment interest deduction of a partner who does not materially participate in a trading partnership should be reported on the partner’s return. Should the interest deduction allowable after the application of the Sec. 163(d) limitation be reported on Form 1040, Schedule A, as an itemized deduction, or could it be used in computing ordinary business income or loss on Schedule E, Supplemental Income and Loss?

The announcement answers this question by concluding that, following the analysis of Rev. Rul. 2008-38, the limited partner described in Rev. Rul. 2008-12 would properly report the allowable amount of his or her distributive share of the trading partnership’s interest expense on Schedule E. Furthermore, the interest deduction should be specifically identified on a separate line in Part II, Line 28, column (a) as “investment interest,” followed by the name of the partnership, and the amount should be entered in column (h).

Rev. Rul. 2008-38

The facts presented in Rev. Rul. 2008- 38 are similar to those of the earlier ruling, where a partnership is engaged solely in the trade or business of trading securities for its own account and LP, an individual, owns an interest as a limited partner and does not materially participate in the partnership. In the first fact pattern, LP is allocated $200 of interest expense but only $150 of investment income. The ruling refers to the analysis provided by Rev. Rul. 2008-12 in stating that the interest expense is subject to the investment interest limitation under Sec. 163(d)(1), and therefore only $150 of the allocable investment interest is currently deductible and the remaining $50 is disallowed and carried forward to the subsequent tax year.

Significantly, the ruling further states that LP‘s distributive share of interest expense allowed under Sec. 163(d)(1) is deductible in arriving at LP‘s adjusted gross income pursuant to Sec. 62(a)(1). Under Sec. 702(b), the character of any item of loss or deduction allocated to a partner is determined as if the item were incurred in the same manner as incurred by the partnership. Since the interest expense is attributable to the partnership’s carrying on of its trade or business of trading securities, LP‘s share of that expense is treated as a trade or business expense under Sec. 62(a)(1). Therefore, LP‘s distributive share of interest expense is deductible in arriving at LP‘s adjusted gross income and does not constitute an itemized deduction.

In the second fact pattern, LP also incurs an additional $100 of investment interest expense outside the partnership on indebtedness allocable to securities held for investment. The IRS uses this example to demonstrate that when an individual has investment interest expense attributable both to property described in Sec. 163(d)(5)(A)(i) and to property described in Sec. 163(d)(5)(A)(ii), and the individual’s total investment interest expense is greater than his or her net investment income, the net investment income must be allocated to the different categories of interest expense using a reasonable method.

The ruling states that one reasonable method is to allocate the net investment income to the two categories of investment interest in proportion to the relative amounts of interest expense within each category (the pro-rata method). LP‘s total investment interest expense is $300, and, under Sec. 163(d)(1), LP is allowed to currently deduct only $150. Two-thirds ($200 ÷ $300) of LP‘s total investment interest expense is attributable to LP‘s interest in the trade or business of trading securities, and one-third ($100 ÷ $300) is attributable to securities held by LP for investment.

Therefore, two-thirds of LP‘s $150 of net investment income is allocated to LP‘s distributive share of the partnership’s interest expense and one-third is allocated to LP‘s other investment interest expense. As a result, $100 of LP‘s allowed $150 investment interest deduction reduces LP‘s adjusted gross income under Sec. 62(a) and is reported on Schedule E, and the remaining $50 constitutes an itemized deduction under Sec. 63(d) and is reported on Schedule A. The $150 of disallowed investment interest expense carried forward to the next tax year includes $100 of investment interest attributable to LP‘s interest in the partnership’s trade or business (an interest described in Sec. 163(d)(5)(A)(ii)) and $50 attributable to securities held by LP for investment (within the meaning of Sec. 163(d)(5)(A)(i)).

Conclusion

With the release of Rev. Rul. 2008-12, Announcement 2008-65, and Rev. Rul. 2008-38, the IRS has confirmed the proper tax treatment of a noncorporate limited partner’s distributive share of interest expense on debt allocable to a partnership’s trade or business of trading securities for its own account. The interest expense is subject to the investment interest limitation of Sec. 163(d)(1) if the limited partner does not materially participate in the trading activity, and for an individual taxpayer the allowable deduction is reported as a nonpassive ordinary business loss on Schedule E. Furthermore, a taxpayer’s investment interest expense from investing and trading activities must be accounted for separately using a pro-rata or some other reasonable method.

Tax practitioners need to verify that their tax preparation software appropriately calculates the allowable interest expense allocable to trading activity and separately identifies the deduction on Schedule E.

EditorNotes

Stephen E. Aponte is senior manager at Holtz Rubenstein Reminick LLP, DFK International/USA, in New York, NY.

Unless otherwise noted, contributors are members of or associated with DFK International/USA.

For additional information about these items, contact Mr. Aponte at (212) 792-4813 or saponte@hrrllp.com.