Hello again and welcome to the Friday Edition. Every other Friday, you get some international tax . . . ermmm . . . stuff from me, Phil Hodgen. You subscribed, so don’t blame me. 🙂
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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.
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.
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.
We are assuming that you, the would-be investor, are a nonresident of the United States for income tax purposes:
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.
The default U.S. income tax treatment you will be promised is:
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!
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” 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.
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.
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.
A U.S. income return is mandatory you invest in a U.S. hedge fund that is taxed as a partnership.
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.
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.
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.
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.
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.
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.