Navigating the Net Investment Income Tax: Key Issues for Investment Funds and Their Partners

By Rodman Chrysler, CPA, New York City

Editor: Alan Wong, CPA

Gains & Losses

Last year, 2013, was the first tax year in which limited and general partners in investment funds had to contend with the 3.8% tax on net investment income. The final regulations for Sec. 1411, which were released in November, significantly changed the treatment of investment income, gains, and losses realized by investor and trader funds. This item summarizes the aspects of the net investment income tax that are most relevant to hedge fund investors and general partners.

A Benefit for Trader Funds With a Sec. 475(f) Election

For net investment income tax purposes, there are three categories of income:

  1. Gross income from interest, dividends, annuities, royalties, and rents other than such income that is derived in the ordinary course of a trade or business that is not a passive activity with respect to the taxpayer or a trade or business of trading in financial instruments or commodities;
  2. Other gross income derived from a trade or business that is either a passive activity with respect to the taxpayer or a trade or business of trading in financial instruments or commodities; and
  3. Net gain (to the extent taken into account in computing taxable income) attributable to the disposition of property other than property held in a trade or business that is not a passive activity with respect to the taxpayer or a trade or business of trading in financial instruments or commodities.

All gains and losses from the disposition of property, including any mark-to-market gains and any losses, are netted in the third category of investment income. An excess loss occurs in category 3 when the netting of gains and losses results in a net loss.

An excess loss may be considered a properly allocable deduction that may be used to reduce income taken into account under categories 1 and 2, but only to the extent allowable for normal income tax purposes. When computing net investment income, an individual investor or general partner in a fund with net trading losses that has made an election to mark its securities to market under Sec. 475(f) can use the excess loss as a properly allocable deduction to offset income from categories 1 and 2. In contrast, an investor (general partner) in an investor fund or a trader fund with a net capital loss that is not a Sec. 475(f) fund would be limited to a $3,000 properly allocable deduction, as this is the amount of net capital loss deduction permitted for regular income tax purposes.

PFICs: Trader Funds and Investor Funds Are Treated Differently

A qualified electing fund (QEF) inclusion of income from a passive foreign investment company (PFIC) for regular income tax purposes is a deemed dividend—an inclusion based on a computation rather than an actual cash distribution. Since the QEF inclusion is not an actual dividend, it is not includible as income under category 1 for net investment income tax purposes. Trader funds must include a QEF inclusion in net investment income under category 2. Investor funds, however, must include a QEF inclusion in net investment income tax only when a cash distribution is received or the PFIC shares are sold. This creates an opportunity to defer the net investment income tax for investors in an investor-type fund.

PFICs: A Complication for Investor Funds and Their Shareholders

The difference in treatment for regular and net investment income tax requires tracking the shareholders' tax basis in the PFIC under either the QEF method or the non-QEF method (Sec. 1291). This creates a burden on the shareholders and the fund. To eliminate this additional tax basis tracking, a taxpayer may elect to include the PFIC income in net investment income when it is included for regular tax. Both an individual and a domestic fund may make this election, starting with the 2014 tax year. A fund will need to get the consent of all of its investors, including, it would appear, those who are not subject to the net investment income tax.

Manager Compensation: Incentive Allocation vs. Incentive Fee

A general partner's profit allocation is generally subject to the net investment income tax, since an incentive allocation, or carried interest, retains the character of income of the underlying fund. However, for principals who are actively engaged in the investment management business, an incentive fee is not subject to the net investment income tax. The Medicare surtax on earned income of 0.9% would apply, instead of the 3.8% net investment income tax. Thus, for managers/general partners of Sec. 475(f) funds or other funds that generate few long-term capital gains, it may be advantageous to take a larger incentive fee over an incentive allocation. 

In the case of a fund that does not generate long-term capital income and qualified dividends, managers should seek to take an incentive fee in lieu of an incentive allocation if the maximum earnings threshold for the 6.2% Social Security tax has already been reached for the year ($117,000 for 2014). For a taxpayer in the highest income tax bracket who has reached the Social Security maximum in 2014, an incentive fee will incur a Medicare tax at an effective tax rate of 3.2% (0.9% Medicare earned income surtax, 2.9% self-employment Medicare tax, and the related self-employment tax deduction). If the compensation for the same taxpayer was structured as an incentive allocation, there would be net investment income tax at the rate of 3.8%. Managers/general partners based in New York City will have to contend with the New York City unincorporated business tax, which will make this strategy less attractive. In investor funds, the switch to fees instead of allocation might have a detrimental tax effect due to the limitation on deduction of portfolio expenses.

Tax Planning Opportunity

Planning to minimize tax must now include the net investment income tax. Both investors and fund managers need to understand the net investment income tax to maximize their after-tax returns. The traditional 20% incentive allocation may not be the most tax-efficient means of compensation to the fund manager. This is especially true in the case of a trader-type fund in which expenses are not subject to the income tax limitation on miscellaneous itemized deductions of 2% of adjusted gross income. Fund managers and investors should consider the options available to them with regard to PFIC income.


Alan Wong is a senior manager–tax with Baker Tilly Virchow Krause LLP in New York City.

For additional information about these items, contact Mr. Wong at 212-792-4986 or

Unless otherwise noted, contributors are members of or associated with Baker Tilly Virchow Krause LLP

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