Hedge Funds and Taxes: Things Just Got Worse in Minnesota and Other High Tax States

September 18, 2018

Written by Bruce Paulson, Senior Client Advisor at MRA Associates

 

The new tax laws make worse an already rocky relationship between hedge funds and taxes[1]. Mutual funds that hold noncorrelated assets and strategies may gain in after-tax favor when compared to hedge funds whose fees are nondeductible, especially if gross returns from hedge funds remain low. Generalizations, of course, are dangerous. Ask your CPA or advisor to show you how your hedge funds are performing net of fees and tax costs.

Tax Law Changes

The Tax Cuts and Jobs Act (TCJA) is by now old news.  Two changes are relevant to our discussion:

  • 100% repeal of miscellaneous itemized deductions, which for hedge fund investors includes management fees and any other partnership expenses (other than incentive fees). This means investors will pay income tax on gross returns, not net (effectively paying income tax on fees).
  • $10,000 deduction cap on Schedule A for all state and local sales, income, and property taxes. This means effective combined federal and state rates on portfolio-related income will generally be higher.

What these changes mean for highest rate taxpayers in high tax states will depend upon several taxpayer specific factors[2]. If you eliminate the federal deduction for state income taxes, the top combined effective tax rates look like this:

Flow Through Tax Treatment: Different than Mutual Funds

Domestic hedge funds are both like and unlike mutual funds. Both pass through annual income they recognize to their investors. However, one important difference exists. Mutual funds make taxable distributions of net gains; a shareholder pays tax on net realized gains/income, not gross income. Hedge funds do not distribute cash; instead, they provide each investor with a Form K-1 that states the amount of taxable income the investor must report, and the investor pays taxes on that amount. Unless the hedge fund qualifies for so-called “trader status”[3], the investor pays tax on the gross return of the fund; management fees and other expenses incurred by the fund (e.g., accounting fees, legal fees, marketing) are not tax-deductible items at the hedge fund level. This means the hedge fund owner pays tax on fees and costs, giving rise to the phrase “phantom income” – income taxed but from which no income is received.

High Tax State Example – Minnesota

Using Minnesota (e.g., 50.65% ordinary income and short-term capital gains, 33.65% long-term capital gains and qualified dividends), lets compare hedge funds of funds (HFF), hedge funds (HF) and mutual funds, using reasonable assumptions[4] and assuming hedge fund fees or costs do not qualify for so-called “trader” status. We show (by hedge fund standards) a modest level of taxable turnover (trades that create tax) and assume 50% of these gains are long term and 50% short term.  To be fair, we use the same assumptions for the mutual fund, which may or may not be true. To keep it simple, we use 8% gross return.

Phantom income (as % of gross taxable return) is 28% for HFF, 19% for HF and 0% for mutual funds, a major reason for the mutual fund’s higher net after-tax return. The percentages = total fund expenses that are not tax deductible / gross return assumption.

Phantom Income Problem Gets Worse if Gross Returns Fall and Fees Remain Same

Consider now what happens if gross returns fall to 6%, a not unrealistic scenario for hedge funds and mutual funds whose primary role in a portfolio is to provide diversification to equities.

Now, phantom income rises to 37.5% for HFF, 25% for HF and remains 0% for mutual funds.

Is Now a Good Time to Make Certain Changes to Improve Your Net After-Tax Returns?

That’s your decision. A role in most investment portfolios exists for asset classes and strategies that reduce total portfolio volatility and whose fortunes are not linked to the broader equity market, or factors that underlie equity returns. And there are many hedge funds that qualify as “traders”, placing them on par with mutual fund in terms of deduction of fees. With that said, taxpayers with high hedge fund exposure may wish to pause and consider their net after-tax appeal under the new tax laws. It could be the hedge funds make sense pre-tax, using a pre-tax optimizer or other program, but make little sense long term after higher fees, tax costs, and incentives are considered.

These and other questions come to mind:

  • Do asset classes or strategies, hedge funds, or mutual funds that generate a high percentage of recurring ordinary income and short-term capital gains make any sense at all for a resident of Minnesota or other high tax state?
  • Would lower cost “liquid alternatives” replace (or reduce need for) high fee-high cost products that cause their investors to pay tax on income they never receive?
  • Where tax generating hedge funds serve a useful role within a diversified portfolio, would “pairing them” with lower cost, tax loss harvesting equity solutions (separate account or partnership) make more sense than holding hedge funds and active equity managers side by side?
  • If wealth is held across different family generations and within different asset locations (e.g., grantor trusts, non-grantor trusts, charitable remainder, charitable lead trust or other), where (considering income taxes estate taxes, liquidity needs and volatility) should high tax generating hedge funds be held and why?
  • Should hedge fund exposure be accessed through tax-advantaged private placement insurance products (PPLI/PPVA)?

HFF, HF and Mutual Fund Assumptions

Note:  Readers may disagree with our assumptions. It is true that the management fee and other costs for mutual funds used as portfolio diversifiers (“liquid alternatives”) may be higher than 1.00% and other costs higher than 0.00%.; in-fact, this will likely be the case. If so, the advantage of mutual funds over hedge funds declines, most notably (as discussed above) where the hedge fund qualifies as a “trader”. With that said, the mutual funds that we have in mind as substitutes for hedge funds come without incentive fees. The income % and taxable turnover numbers will vary based upon the underlying investment strategy of the mutual fund.

 

[1] Two publications may be of interest. The first, “What Would Yale Do If It Were Taxable”, Aperio Group: https://www.cfapubs.org/doi/pdf/10.2469/faj.v71.n4.2, considers the work of Yale University CIO David Swenson, esteemed by the investment community and a heavy user (over the years) of hedge funds. The authors general conclusion: the long-term tax cost of owning most hedge funds outweighs their diversification advantages. The second, “Warren Buffett’s Hedge-Fund Bet: Understanding the After-Tax Effect”, examines Warren’s now famous 2008 wager with Protégé Partners, that the SP500 Index would outperform any five or more hedge funds Protégé might select over ten years.  Warren won the bet resoundingly pre-tax and his margin of victory was even higher next of tax costs.   https://www.parametricportfolio.com/blog/betting-on-passive-the-buffett-story

[2] These include property tax bills, level (amount) of investment management fees/costs, exposure to AMT and state specific tax rules (if any).

[3] If a hedge fund is characterized as a “trader”, IRC Section 162 allows the hedge fund to deduct its expenses at the fund level; they do not flow through and become itemized deductions.  In general, traders are professional investors, actively engaged in the trade or business of buying and selling financial assets. The term “trader” is not defined in the Tax Code or Treasury Regulations. The test is an annual one.  A fund of funds must address the trader v. investor issue for each K-1 it receives. Furthermore, if a hedge fund does qualify as a trader, it can make an annual election under IRS Section 475 to use what is a called “mark-to-market” accounting.  If this election is made on a portfolio that has unrealized gains at year end, taxable gains are passed on to the investor (even though the fund has not realized such returns). The same is true, though, with unrealized losses.

[4] See details toward end of article