Investor versus Trader Status in Funds
By John T. Murray, CPA | Tax Senior Manager | Financial Services Industry Team
With the enactment of The Tax Cuts and Jobs Act comes an elimination of two percent miscellaneous itemized deductions that effect the deductibility of investment expenses. While there have been limitations on investment expenses to individual investors under prior tax laws because of two percent limitations, Pease limitations, and Alternative Minimum Tax (AMT), the new tax law shined a bright light on investment expenses.
In the context of hedge funds, fund of funds, stock funds and similar “alternative investments” funds that produce an annual K-1 for their investors, it is time to re-evaluate the fund’s status as an “investor” or “trader”. The status of trader is an important designation which would allow for the classification of a fund’s investment expenses as currently deductible to individual fund investors as compared to a fund with investor status whose portfolio expenses have become non-deductible to individual fund investors under the TCJA. Further due to frequent trading activity capital gains and losses will likely be short-term and subject to ordinary tax rates.
Differentiation between the two statuses is based on facts and circumstances, including the activity of the fund, fund manager participation, the profit goals of the fund (capital appreciation or short term gains), and income from interest and dividends and long term capital gains.
Generally speaking, based on court case determinations and IRS guidelines, the following attributes can be found in a fund designated as a trader although there is no brightline test:
- Purchase and sale of securities frequently to realize gains on short term market changes
- Actively and continuously managed by fund management or fund personnel
- The activity is continuous and has a meaningful volume of trades ( e.g. portfolio turnover, # days trading activity per annum)
- Income is derived primarily from the sale of securities or similar type assets on a short-term basis (ordinary tax rate) and not from interest, dividends and long-term gains.
The above list of activities by the fund is not comprehensive and the ultimate determination is based on your particular fact pattern. Also, the trader status is not elective and should be evaluated at least annually and include documentation to support the facts. In evaluating your particular position you should look at the whole picture to see if the trader status can be supported. As always, please consult your tax advisor
Additional Resources for Financial Services Companies
- Tax Considerations for Financial Services Businesses
- SEC Best Interest Regulation – Reg BI
- Investment Advisers and Disclosure of Conflicts of Interest Related to 12b-1 Fees
The information contained within this article is provided for informational purposes only and is current as of the date published. Online readers are advised not to act upon this information without seeking the service of a professional accountant, as this article is not a substitute for obtaining accounting, tax, or financial advice from a professional accountant.