Recent changes to tax law have signaled the end of miscellaneous itemized deductions, and many investors are feeling the impact on their personal tax returns. Now that we have had a year to digest the impact of tax reform, investment fund managers need to begin taking note of areas where individual investors have been most affected in relation to investment companies. In tax years prior to 2018, miscellaneous itemized deductions were allowed on Schedule A of an individual’s 1040. These deductions were commonly referred to as 2% Floor Deductions, because the tax payer had to have miscellaneous itemized deductions in excess of 2% of their Adjusted Gross Income in order to deduct these expenses.
Commonly called portfolio deductions, investment advisory and management fees and expenses are considered to be miscellaneous itemized deductions, even though they would be ordinary expenses in other contexts. For instance, fees paid to an accountant to conduct an audit or prepare a tax return would be an ordinary business expense for an operating trade or business, like a manufacturer or retailer. For most investment companies, fees of this nature, and investment advisory and management fees and expenses, are passed through to investors in investment funds as miscellaneous itemized deductions.
The elimination of the deduction for miscellaneous itemized deductions had little effect on the tax returns of many taxpayers as miscellaneous itemized deductions rarely exceeded the 2% limitation in a significant way. This is not necessarily the case for individuals holding investments in hedge funds and other investment companies or holding large brokerage accounts. For those taxpayers, investment advisory and management fees and expenses, which can be very substantial in dollar, have become totally nondeductible.
As a result of this change, the market is seeing a trend towards investments in lower fee-based vehicles. Hedge funds and other similar type investment companies are beginning to see investors pushing back against fees. Adding to this situation is the overload of information. Investors are often unaware of exactly how these expenses were limited in the past and are making investment decisions not only based on actual changes in their taxable income, but on perceived limitations as well.
In response, investments companies have begun to consider ideas to address this problem, and the following approaches are being commonly utilized:
- One approach is to adopt “trader fund” status if the fund qualifies. Unlike most investment companies, trader funds are considered to be in the trade or business of dealing in securities, meaning that the income and expenses of the fund, including investment expenses, now qualify as ordinary business deductions for the fund and are fully deductible by investors. Though there is no hard and fast bright-line test to adopt trader status, funds must be in the business of engaging in frequent trading in order to take advantage of short-term market swings. The majority of their income must be related to short-term gains and losses, with short holding periods and high portfolio turnover. Of course, only a limited number of funds will meet these qualifications.
- Another strategy is to redesign fund fee structures. Funds may choose to lower management fees and increase incentive allocations. Incentive, or performance, allocations are often earned by managers when the fund meets certain, predetermined thresholds. However, when the fund doesn’t meet the thresholds necessary to earn the incentive allocation in a given year, the fund managers receive no compensation. Unfortunately, this approach is often not viable for many fund managers, though some have been considering a more hybrid method whereby they lower management fees as low as they possibly can and still operate effectively and use higher incentive allocations to make their funds more attractive for investors.
The loss of the miscellaneous itemized deduction serves to make many investment companies much less attractive options for investors going forward. Investors are targeting investment companies and strategies that have lower and/or deductible fees where the majority of compensation is performance based. In order to remain competitive, hedge funds will need to rethink their fee structures and, perhaps more importantly, be able to highlight the real, competitive advantage that they bring to the table.
We can help:
- Evaluate and optimize fee structures under current tax law.
- Determine potential alternate strategies to traditional management fee structures.
Contact a member of the Elliott Davis Investment Companies team for assistance.