U.S. To Hit Traders, Money Managers With A Tax Shot To The Gut

[brownsfan019 17]

U.S. To Hit Traders, Money Managers With A Tax Shot To The Gut

 

It's a good news, bad news situation. A financial-transaction tax isn't part of the new Senate and House bills for financial reform, but a carried interest repeal is on the table again.

 

The American Jobs and Closing Tax Loopholes Act of 2010 proposes repealing carried interest tax breaks and closing the self-employment tax loophole for S-corporations, alongside other changes of less importance to traders. This is a new version of the bill passed by the House in December, and is now up for a vote in both the House and Senate. Passage is expected after a fight.

 

What do these changes mean?

Currently, investment managers in hedge funds using profit allocation, otherwise known as “carried interest,” instead of an incentive fee to enjoy lower 60/40 tax rates on futures, and lower long-term capital gains tax rates on securities.

 

If the repeal passes, carried interest income will be re-characterized as ordinary income. Carried interest is different from an incentive fee. The former is considered investment unearned income and the latter is classified as earned income subject to the self-employment tax, currently at 12.4 percent on the Social Security base amount ($106,800) and 2.9 percent unlimited thereafter. The unlimited Medicare portion is a great concern of managers with large carried interest income. The new health reform law will raise that Medicare tax to 3.8 percent starting in 2013.

 

Previous versions of this tax change called for classifying 100 percent of carried interest as ordinary income, but this rendition calls for a 75-percent re-characterization; the remaining 25 percent would retain the underlying income tax treatment for short- or long-term capital gains, 60/40 futures or interest income. If this 25 percent "break" survives, it will still make sense to keep carried interest structured into hedge fund vehicles.

 

Also, unlike previous versions, this bill offers a phase-in period of two years. In 2011 and 2012, half of the carried interest would be taxed at the ordinary income rate, with the remaining 50 percent eligible for capital gains treatment. Finally, in 2013 and thereafter, the 75/25 breakdown would kick in.

 

Tax increases all around

This tax increase for investment managers is even more painful when factoring in other scheduled tax increases. All income tax rates are scheduled to rise in 2011 when the Bush Administration tax cuts expire. Congress and the President want to extend those tax cuts for the middle class only, which excludes the upper income making more than $250,000 per year (filing jointly). The long-term capital gains rate is scheduled to rise from 15 to 20 percent and the ordinary rate shoots up to 39.6 percent from 35 percent. Other significant increases on the horizon: the blended 60/40 futures tax rate (from 23 to 28 percent) and the qualifying dividends tax rate (from 15 to 39.6 percent).

 

An unfair repeal

I think this repeal is a mistake and unfair. Managers risk their time, effort, reputation, brand and sweat equity in their funds, which I believe is tantamount to money. All of this risk capital should be considered capital gains. Funds also pay investment managers management fees, which are reported as earned ordinary income. The carried interest portion is managers’ pro-rata share of return on risk capital, putting them in the same boat as their investors. Proponents of this tax are using convenient (and faulty) logic as a means to their end: to raise taxes where the money is — in hedge funds and on Wall Street.

 

Is there a workaround?

The only legal way an investment manager can avoid the carried interest re-characterization is to personally invest his own money in his hedge fund. The bill contains “abuse provisions” to protect the Treasury from inappropriate behavior, and specifically says loans can’t be used to make cash investments. The new health care tax law beefed up tax avoidance scheme rules that make this type of behavior very dangerous for a taxpayer.

 

Closing the S-Corp loophole

In the past, investment managers for funds and managed accounts have reduced the self-employment tax on advisory fee income with an S-corp tax vehicle. The IRS knows S-Corporations are used in this manner and it insists on reasonable compensation to the owner/manager to pay some self-employment or payroll taxes. Guidelines suggest 30 percent is “reasonable,” which means the owner saves the self-employment tax on the remaining 70 percent of fee income.

 

Before you get too excited at the prospect of using an S-corp to reduce SE tax on the repeal of carried interest, here’s the bad news. The new bill has proposed to close the S-Corp self-employment tax loophole for S-corps "principally based on the reputation and skill of three or fewer individuals," according to the language of the bill. It appears Congress wants to close the self-employment tax loophole for smaller companies, one-person professionals who use the S-corp to avoid payroll. Many small investment managers have less than three people, and even some of the larger investment managers' reputations are based on a few key managers. Larger S-corps appear to be safe. Investment managers affected by this change may as well remain in an LLC structure filing partnership tax returns, which is usually preferred by their attorneys for governance reasons.

 

Better than a Financial Transaction Tax

These tax changes will collectively raise the income tax bills of profitable investment managers. It’s unfortunate, but better than a nasty, industry-killing financial-transaction tax. A FTT is the worst-case scenario for traders, so its absence from this legislation is something to be thankful for. But I don't trust governments in today's "meltdown" environment.

 

On the bright side, these financial regulations and tax changes should bring more market volatility, so hopefully traders can make back some of the extra costs in trading. The glass is half full, right?

 

Robert A. Green is a CPA and founder and CEO of Green & Company Inc. (GreenTraderTax.com and GreenTraderFunds.com), a publishing company, and Green & Company CPAs, LLC, a virtual tax and accounting firm catering to traders and investment management businesses.

[macdfx 10]

U.S. To Hit Traders, Money Managers With A Tax Shot To The Gut

I read on ET that you were a stockbroker once upon a time, but now trade futures full-time instead. What impact do you think this legislation will have on your bottom line?

[brownsfan019 17]

I read on ET that you were a stockbroker once upon a time, but now trade futures full-time instead. What impact do you think this legislation will have on your bottom line?

 

Too early to say macd. Should this get through then it will be time to examine business structure and tax implications.

 

On the surface a 5% increase in futures taxation isn't the end of the world and that's my primary focus.

[AmCan1 10]

Sam Harris, why do I see your penny stock posts across multiple forums with no real relevance to anything being discussed? Give us a break!

[brownsfan019 17]

Sam Harris, why do I see your penny stock posts across multiple forums with no real relevance to anything being discussed? Give us a break!

 

It's just spam, probably a spam bot.

[AmCan1 10]

Man, that sucks. I just got hit with a dozen responses from LoanPatterns. What a waste of time. Thanks for the heads up.

[brownsfan019 17]

Man, that sucks. I just got hit with a dozen responses from LoanPatterns. What a waste of time. Thanks for the heads up.

 

They've been hitting TL very hard recently so something changed in the coding to open up the forum easier for these bots to hit. It's annoying - hit report post, mark spam and then it should get deleted eventually.

[AmCan1 10]

Thanks for the tip Brownsfan. I'm fairly new to this forum but beginning to get the hang of it. It sucks when you subsribe to a forum and then your email inbox gets inundated with bot spam. I'll start reporting it though and hopefully as a collective group we'll reign it in.

[brownsfan019 17]

Thanks for the tip Brownsfan. I'm fairly new to this forum but beginning to get the hang of it. It sucks when you subsribe to a forum and then your email inbox gets inundated with bot spam. I'll start reporting it though and hopefully as a collective group we'll reign it in.

 

You don't have to subscribe to the threads you post in. You can put 'do not subscribe' in the options below your text. I have mine to default to that.

[AmCan1 10]

Aaahhh... lol.. Thanks again for another great tip. I'm not really that dense or slow in other areas, but maybe when it comes to forums, I am. :crap:

[belindalang26 10]

A stock that trades at a relatively low price and market capitalization, usually outside of the major market exchanges. These types of stocks are generally considered to be highly speculative and high risk because of their lack of liquidity, large bid-ask spreads, small capitalization and limited following and disclosure. They will often trade over the counter through the OTCBB and pink sheets.

[WorldTrader 10]

Speaking of Taxation,

I am going to move my IRA to Roth IRA. I can have them take out the taxes now or pay in the next 2 years. Has anyone done this yet. I would like to keep the trading capitol large so not to pay the 25% now, but otherwise I have to pay in cash over the next 2 years...did I mention CASH.