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- U.S. income tax results are great for most hedge fund investments made by nonresidents. Only small portions of the hedge fund’s profits will be taxed.
- U.S. estate tax exposure is huge (40% of the investment’s value) and can be eliminated with a little work.
- A U.S. income tax return will be required every year, whether you invest directly (Goofus) or indirectly through a corporation or trust (Gallant).1
U.S. Hedge Funds and Nonresident Investors
In this episode of the Friday Edition (it sounds like a TV show, right?) we will look at a simple situation: a nonresident buys into a U.S. investment fund that is structured as a partnership.
Let’s call it a hedge fund,2 shall we?
If you are going to buy into a hedge fund and the managers promise to send you a Schedule K-1 every year to report your share of the hedge fund’s profit and loss, I am talking to you.
Pooled Investment Fund
If you are being offered such an investment, go look at Form D on the first page. There, at Item 4 (Industry Group) you will see some checkboxes. Is the box “Pooled Investment Fund” checked? Right underneath it, is the box “Hedge Fund” checked? That’s where we are.
Taxed as a Partnership
Look at the offering documents that you are asked to read. Somewhere in there will be a description of the way the investment fund will be taxed. Here is an example, pulled at random from a quick search on El Google:4
The Master Fund intends to operate as a partnership for Federal income tax purposes. Accordingly, no provision for Federal, state or local income taxes has been provided. Each Member is individually required to report on its own tax return, its distributive share of the Master Fund’s taxable income or loss. On behalf of the Master Fund’s foreign members, the Master Fund withholds and pays taxes on certain U.S. source income and U.S. effectively connected income, if any, allocated from Portfolio Funds to the extent such income is not exempt from
withholding under the Internal Revenue Code and Regulations thereunder.
This simply means that the fund will not pay any U.S. income taxes itself. The fund is a conduit. It earns profits (you hope) and passes those profits5 and the obligation to pay tax on those profits to you, the investor.
You Are a U.S. Nonresident Taxpayer
We are assuming that you, the would-be investor, are a nonresident of the United States for income tax purposes:
- You are not a U.S. citizen;
- You do not have a U.S. permanent resident visa (“green card” in common parlance);
- You do not spend “too many days” in the United States every year; and
- You have not made a special election to be taxed as a U.S. resident.
To keep this write-up short, I am going to ignore the possibility of using an income tax treaty to solve U.S. tax problems.
Default Income Tax Treatment
The default U.S. income tax treatment you will be promised is:
- A small amount of your income from the investment will be subjected to U.S. income tax. This amount is shown in Box 1 (“Ordinary Business Income”) of the Schedule K-1 (1065) you receive every year.
- All (or almost all — I am not in the room when the sales pitch is being made to you!) of the other profits (capital gain on buying and selling securities, interest income) will be tax-free to you;
- Tax withholding will be imposed on the small amount of Ordinary Business Income allocated to you, but not on the massive (relatively speaking) capital gains etc. that you receive.
The promise is generally accurate. These funds have well-paid lawyers writing up the offering memorandum and the tax results are engineered to reflect the promises made to you.
The only reason I hedge (hah!) my opinion here is because different hedge funds invest differently and there may be additional items that will generate taxable income for you. Read the offering memorandum carefully!
Default Estate Tax Treatment
What the hedge fund salesman will not tell you is that your investment exposes you to U.S. estate tax. Well, not you — you are not exposed to the estate tax, because you are dead. Your heirs have the problem, and they will curse your memory while sitting at your funeral, for having made this avoidable error.
The Estate Tax
The “estate tax” is a wealth tax imposed at the time of death. Measure the individual’s personal assets at the time of death. Tax it at a maximum rate of 40%. That’s the estate tax. Whatever is left over goes to the individual’s heirs.
Nonresidents of the United States (Warning! Use a different definition of “nonresident” entirely from the one I described above) are exposed to the U.S. estate tax ONLY on assets that are “located” in the United States.
For Nonresidents, Assume 40% of Asset Value
While there are a number of ways that U.S. residents and citizens can soften the blow of the estate tax, nonresidents are left hanging out in the wind. The first $60,000 of assets are tax-free, and everything above that will be taxable.
In short, your baseline assumption should be “40% of my investment goes to the U.S. government as estate tax if I die”. Heirs. Funeral. Dark epithets about the recently departed. Etc.
There is an easy way to eliminate the estate tax risk: do not own the hedge fund investment.
I am not telling you to walk away from the investment. I am telling you that you, the human, should not be the owner of the investment. Instead, park the asset in a non-U.S. corporation or in a well-designed, fit-for-purpose irrevocable trust.
Why does this work? Simple tax metaphysics.
- The estate tax is imposed on (U.S.) assets owned by (nonresident) humans when they die.
- When the nonresident human — you — are the shareholder of a non-U.S corporation that owns a U.S. hedge fund investment, you die owning a thing (shares of the non-U.S. corporation) that is outside the United States.
- Since you are a nonresident and the asset you owned at the time of death (the shares of the non-U.S. corporation that owns the hedge fund investment) is outside the United States, there is no way for the U.S. tax system to sink a hook into you or your assets and impose a tax.
In short, for the cost of a few thousand dollars — to set up and run a cheap offshore corporation — you can eliminate hundreds of thousands of dollars of estate tax risk.6
Widows grieve for their husbands and fear for their future. Knowing that they are hundreds of thousands of dollars poorer simply because you, the dearly departed, failed this basic step, means that your cherished memory is not quite so cherished.
Remember. Do not be a direct individual investor in a hedge fund unless you can predict your date of death with precision.
Income Tax Returns
A U.S. income return is mandatory you invest in a U.S. hedge fund that is taxed as a partnership.
The Nontechnical Explanation
Most hedge funds try to carefully configure themselves to be what is called an “investor fund” so that they are treated as passive investor entities. Nevertheless, you should assume you will be required to file an income tax return.
- An individual nonresident is required to file a U.S. income tax return if he or she is “engaged in business” in the United States. This is true even if the amount of income generated from those business activities is zero.
- Trust me, the same results apply for investments via non-U.S. corporations and irrevocable trusts.
- The trigger: look at Box 1 of Schedule K-1 (1065) that you receive from the hedge fund. Does it have a number in it? If so, the U.S. government has been told that the partnership generated income generated from business activities in the United States.
- A partner in a partnership is treated as being engaged in business in the United States if the partnership is engaged in business in the United States.
- We are assuming (remember?) that the hedge fund is taxed as a partner, so even though you might be investing in a limited liabliity company you are a “partner” in a “partnership” for U.S. tax purposes.
Because the hedge fund (as a partnership) is engaged in business in the United States (evidence: a number in Box 1), you are “engaged in business” in the United States and must file a tax return.
The Technical Explanation
Skip this with my permission. This is here because it is sort of fun for me to write. Get technical, remember?
The basic rules7 require (almost) everyone on Planet Earth to file U.S. income tax returns. But discretion to write special rules for nonresidents has been given to the Treasury Department and the Internal Revenue Service.8
Based on the power granted to the IRS, the Instructions to Form 1040NR state four situations in which a nonresident is required to file a U.S. income tax return:9
(i) if the person is a nonresident alien who was ETBUS at any time during the taxable year, even if he had no U.S.-source income and all of his income was exempt from tax;
(ii) if he is a nonresident alien who was not ETBUS during the year but if he had U.S.-source income subject to tax, and less than all of the required tax was withheld at source;
(iii) if the person is the executor or personal representative of a deceased nonresident alien who would have been required to file; and
(iv) if the person represents an estate or trust that is required to file Form 1040NR.
Let’s look at the first of those items: the nonresident is engaged in trade or business in the United States (“ETBUS”) at any time, even with no income or with income that is exempt from tax. Ignore the other three.
A partner is engaged in business in the United States if the partnership is engaged in business in the United States:10
“[A] nonresident alien individual or foreign corporation shall be considered as being engaged in a trade or business within the United States if the partnership of which such individual or corporation is a member is so engaged[.]”
A hedge fund will typically take the position that it is a passive investor, rather than an active trader. You will see the hedge fund assert this position in a footnote to Box 20 of Schedule K-1, usually. Put another way, the hedge fund is saying “We are not engaged in the business of trading securities; we are passive investors.”11
That would seem to be a good position for you, the nonresident investor — to be an investor. Investors are not “engaged in business”. They hold assets and hope to sell later for capital gain.
But the fact that there is a number in Box 1 of Schedule K-1 is sufficient to disprove that position, even slightly. The existence of ordinary business income proves the existence of business operations in the partnership, and that triggers your income tax return filing requirement.
What Income is Taxed?
U.S. taxpayers are taxed on income earned worldwide. As a nonresident, only your U.S. source income has the possibility of being taxed, and sometimes U.S. source income is not taxed at all.
U.S. Source Income
Let’s assume you, as an individual, invest in the hedge fund. The only income reported on this U.S. income tax return will be your income from U.S. sources.
If the only U.S. investment you hold is the hedge fund investment, then the numbers on the Schedule K-1 that you get will show up on on your U.S. income tax return, and nothing else.
The income from U.S. sources (reported on the Schedule K-1 you receive) may or may not be taxable.
- The “ordinary business income” (Box 1 on Schedule K-1) will be taxable. This income will be reported on Form 1040NR, Line 18.
- Capital gain should not be taxable (Boxes 8 and 9a). This is because the hedge fund (and you) are taking the position that you are a mere investor — not a trader — and that the capital gain is not taxable in the United States. This is where you are going to make most of your money.
- Interest should not be taxable (Box 5). As a general principle, interest earned from U.S. sources by nonresidents will not be taxable.
- Dividends from U.S. stocks will be taxable at 30% (Boxes 6a and 6b). That is the default rule, and we are assuming that you are not entitled to a lower tax rate by reason of an income tax treaty.
There will other numbers reported on Schedule K-1 that are probably irrelevant to your U.S. income tax return. These will report investment expenses that cannot be used as a tax deduction, alternative minimum tax items, perhaps information related to foreign tax credits, and the like. You will need a competent income tax return preparer to help you figure out what matters and what does not.
All of your investments and income outside the United States are omitted from the U.S. tax return. The U.S. tax system cannot tax that income.
That’s a brief overview of what a seemingly simple hedge fund investment entails. Don’t take my word for it — go hire someone and get help with this. Needless to say, this is not tax advice and I don’t know your situation, so do not rely on what you read here.
And here’s a bit of comfort for you. Even though it is daunting to get right, you will only have big problems the first year. Future tax years will be simpler. Once the data entry problems have been solved for the first year’s tax return, future years will look largely the same. The tax return preparation will be simpler, faster, and cheaper.
(Subtle sales pitch: Our team can help you get this problem squared away.)
See you in a couple of weeks.
- “Goofus and Gallant”, for those of you who did not spend their childhood in the United States, were a pair of mythical boys whose actions instilled “correct behavior” into malleable children, by way of Highlights magazine. Goofus, of course, showed us what not to do, while Gallant invariably did the right thing.↩
- To my mind the phrase “hedge fund” is largely meaningless. The managers of these funds use a seemingly infinite variety of investment strategies. Occasionally they will even use strategies that involve hedging investment risk.↩
- “Get technical” is a good thing.↩
- Found in this document for a Credit Suisse hedge fund. Do your own search and you will find hundreds of examples. ↩
- Profits after paying the investment manager handsomely for managing your money, of course.↩
- Trusts are vastly more expensive to set up and operate. And not all trusts are suitable for the purpose of preventing U.S. estate tax on the investment. I love trusts and they are astonishingly powerful, but I would probably tell you to not spend the time/money for “the right kind of trust” just for a hedge fund investment. So don’t just say “Oh, I have a trust, problem solved.” I’m betting you don’t have the right kind of trust. Technical jargon, if you want to chase rabbit trails: use an irrevocable trust, do not have a retained interest in the trust assets, and avoid giving anyone a general power of appointment over the trust assets.↩
- IRC §6012.↩
- IRC §6012(a).↩
- Instructions to Form 1040NR (2015), page 5.↩
- IRC §875(1).↩
- Digression. Someone who deals in stocks and bonds for a living is either a dealer, an investor, or a trader. Dealers are investment banks and the like; ignore that. An investor is someone who generates profit on interest, dividend, and securities held for capital appreciation. A trader is someone who profits from exploiting daily price fluctuations. It’s not always easy to distinguish between an investor or trader. Investors have capital gain taxed at favorable rates, so it is a better position to be in. Traders generate business profit from buying and selling securities, so everything is taxed as ordinary income. Hedge funds deliberately place themselves in one camp or the other. You are probably buying into an investor fund.↩