Investors in hedge funds may be subject to higher federal tax rates and the new 3.8% net investment income tax (also known as the unearned income Medicare contribution tax) in 2013. Dividend income received by individuals in the highest income tax brackets is subject to an 8.8 percentage-point increase in federal tax, resulting in a top marginal tax rate of 23.8% on dividend income. Taxes are on the rise for other investment income as well, as most investment income earned by hedge funds is subject to the net investment income tax.
Qualified Dividend Income
More favorable tax treatment of qualified dividend income (QDI) than for ordinary income was made permanent by the American Taxpayer Relief Act of 2012, P.L. 112-240. However, high-income taxpayers must pay a higher tax rate on dividends starting in 2013. The rate upon which QDI is taxed increased for noncorporate taxpayers from 15% to 20%, to the extent the taxpayer’s taxable income from all sources exceeds $400,000 for single filers, $450,000 for married taxpayers filing jointly, $425,000 for heads of household, and $225,000 for married taxpayers filing separately.
Even though the tax rate increased for some taxpayers, the types of dividends that are treated as QDI did not change. QDI generally includes dividends received during the tax year from domestic corporations and qualified foreign corporations, but it excludes dividends from certain tax-exempt corporations. In addition, QDI includes only dividends received with respect to a share of stock that is held for more than 60 days during the 121-day period beginning 60 days before the ex-dividend date (or for certain preferred stock, more than 90 days during the 181-day period beginning 90 days before the ex-dividend date). A dividend is not QDI to the extent a taxpayer is under an obligation, whether pursuant to a short sale or otherwise, to make related payments with respect to positions in substantially similar or related property.
Net Investment Income Tax
U.S. investors in hedge funds that are engaged in a trade or business of trading in financial instruments, including stock or commodities, are subject to the net investment income tax, which is applied to gross income, less deductions allocable to such income, but not reduced by realized or recognized losses, if proposed regulations are finalized in their current form.
The Health Care and Education Reconciliation Act of 2010, P.L. 111-152 , added Sec. 1411 to the Code imposing the tax on certain individuals (as well as certain trusts and estates), effective for tax years after Dec. 31, 2012. The tax is based on the lesser of (1) net investment income or (2) the excess of modified adjusted gross income (MAGI) over a threshold amount. The threshold amount for individuals is $250,000 in the case of joint returns or surviving spouses, $125,000 in the case of married individuals filing a separate return, and $200,000 in all other cases. This tax is in addition to regular federal income taxes. It does not apply to nonresident aliens.
MAGI is defined as adjusted gross income increased by the amount excluded from income as foreign earned income under Sec. 911(a)(1), net of deductions and exclusions disallowed under Sec. 911(d)(6) with respect to such foreign earned income.
Net investment income means the excess, if any, of the sum of gross income from interest, dividends, annuities, royalties, and rent, other than income derived in the ordinary course of any trade or business to which the tax does not apply (Bucket 1); other gross income derived from any trade or business to which the tax applies (Bucket 2); and net gain attributable to the disposition of property other than property held in a trade or business to which the tax does not apply (Bucket 3), over the deductions that are properly allocable to such gross income or net gain.
The tax applies to gross income and net gains derived from a trade or business, if the trade or business is a passive activity (within the meaning of Sec. 469) with respect to the taxpayer, or a trade or business of trading financial instruments (including stock and equity interests) or commodities. Thus, the tax applies to dividend income not derived from a trade or business and dividend income derived from a trade or business to which the tax applies (i.e., a passive activity trade or business, or a trade or business of trading financial instruments or commodities).
Dividend income from the investment of working capital, however, is not treated as derived from a trade or business and is therefore subject to the tax.
The Proposed Regulations
In December, the IRS published proposed regulations (REG-130507-11) addressing the net investment income tax. Some of the provisions most pertinent to hedge funds are:
Dividend income: The proposed regulations clarify that dividend income is generally net investment income and thus subject to the tax (Prop. Regs. Sec. 1.1411-4(a)(1)(i)).
Gross income from dividends includes any item treated as a dividend for federal income tax purposes. For example, deemed dividends under Sec. 1248(a) (as a result of the sale of certain foreign stock) and Sec. 1368(c)(2) (as a result of certain distributions from S corporations) are dividends for purposes of Bucket 1. As explained in the preamble, the proposed regulations provide that substitute dividends made to the transferor of a security in a securities lending or sale-repurchase transaction are treated as dividends for purposes of calculating net investment income under Bucket 1.
The net investment income tax generally is imposed on an investor when the income is taken into account for federal income tax purposes, not when the cash related to that income is distributed by the flowthrough entity (i.e., partnership). A different rule applies with regard to investments in controlled foreign corporations (CFCs) and passive foreign investment companies (PFICs) that have made a qualified electing fund (QEF) election, which may require current inclusion in federal taxable income regardless of whether the income is in fact distributed. For investments in CFCs and QEFs, the net investment income tax applies when there is a distribution of the net investment income.
The above rule could produce administrative complications because the taxpayer will need to track two types of taxes with different timing. The proposed regulations include an election that would result in consistent treatment for both purposes. If the taxpayer makes the election, net investment income is taken into account for purposes of the net investment income tax at the same time as the income is taken into account under the federal income tax rules applicable to CFCs and PFICs.
Passthrough entities and trade or business income: The proposed regulations specify that in the case of an individual, estate, or trust that owns or engages in a trade or business directly, the determination of whether gross income is derived from the trade or business is made at the individual level. In the case of an individual, estate, or trust that owns an interest in a trade or business through one or more passthrough entities for federal income tax purposes, the determination of whether gross income is derived in a passive activity trade or business is made at the owner level. But the determination of whether gross income is derived in a trade or business of trading financial instruments or commodities is made at the entity level.
Thus, dividend and other income derived from a partnership’s trade or business of trading financial instruments retains its character as it passes from the partnership to the taxpayer-partner, whether or not the taxpayer-partner, as an individual, is engaged in a trade or business of trading financial instruments. An example in the proposed regulations also specifies that if dividend income is derived from a lower-tier partnership that is not engaged in a trade or business, the income is not derived from a trade or business even if it passes through an upper-tier partnership that is engaged in a trade or business (Prop. Regs. Sec. 1.1411-4(b)(3), Example (1)). Therefore, an investor in a hedge fund that is engaged in a trade or business of trading in financial instruments or commodities would be treated as if the investor, as an individual, is engaged in that trade or business for purposes of applying the net investment income tax.
Properly allocable deductions: The proposed regulations also describe properly allocable deductions that may be taken into account in determining net investment income. Generally, the amount and timing of deductions for federal income tax purposes also apply for purposes of determining net investment income. Deductions for losses under Sec. 165 are taken into account only in computing net gain under Bucket 3, however, and only to the extent of net gains. Any properly allocable deductions in excess of gross income and net gain for a tax year cannot be taken into account in determining net investment income in any other tax year, except as allowed for income tax purposes, and in no event can a net operating loss be taken into account in determining net investment income in any other tax year. Therefore, if a hedge fund that is not treated as engaged in a trade or business recognizes a net loss, that net loss is permanently disallowed for purposes of the net investment income tax.
This exclusion of certain losses from properly allocable deductions results in adverse tax consequences for hedge funds that are engaged in a trade or business of trading financial instruments or commodities. It is clear from the Code that dividend income derived from a trade or business of trading financial instruments is included in net investment income under Bucket 1. However, the proposed regulations provide further that for a trade or business of trading financial instruments or commodities, all other gross income that is not gross income described in Bucket 1 is gross income described in Bucket 2.
The proposed regulations specifically state that any mark-to-market gain under Sec. 475(f) and any realized gain from the disposition of property held in such a trade or business is classified as other gross income under Bucket 2 (Prop. Regs. Sec. 1.1411-4(c)(2)). Thus, Bucket 3 does not apply to any fund engaged in a trade or business of trading financial instruments or commodities. As a result, gross gain, rather than net gain, is included as net investment income for such funds, with no offset for losses, and subject to the net investment income tax.
However, hedge funds that are not engaged in a trade or business of trading financial instruments or commodities are generally subject to the net investment income tax on the net gains from the disposition of stocks and securities. In other words, investors in funds not engaged in such a trade or business are able to reduce their income subject to the tax by the losses recognized during the tax year. It is not clear whether the different treatment of funds engaged in a trade or business of trading financial instruments or commodities versus funds not engaged in such a trade or business was intended. Funds and investors should be mindful of this issue, as it may be addressed in future guidance.
The proposed regulations would be effective for tax years beginning after Dec. 31, 2013. The IRS expects to finalize the regulations in 2013 but has stated that taxpayers may rely on the proposed regulations for compliance purposes for tax years beginning after Dec. 31, 2012, when the tax took effect.
Mary Van Leuven is senior manager, Washington National Tax, at KPMG LLP in Washington, D.C.
For additional information about these items, contact Ms. Van Leuven at 202-533-4750 or firstname.lastname@example.org.
Unless otherwise noted, contributors are members of or associated with KPMG LLP. This article represents the views of the author or authors only and does not necessarily represent the views or professional advice of KPMG LLP. The information contained herein is of a general nature and based on authorities that are subject to change. Applicability of the information to specific situations should be determined through consultation with your tax adviser.