Investment Funds: 2021 Tax Planning Means Preparing for Expanded K-1 Reporting


For 2021, there aren’t many tax changes that will affect investment fund managers. However, that may not be the case next year, as some of the tax proposals currently in Congress would have a significant effect on investment funds if they pass.

For this year, though, the most significant changes are around reporting requirements. The following are a few considerations as you think about year-end tax planning for your investment fund.

Be prepared to spend more time on K-1s

You can expect Schedule K-1s to be significantly more involved, which will result in more pages to your K-1 reporting package, rather than the one to three pages of years past. In addition, the newly released Schedule K-3 requires more detail, and it is required for 2021 if there are international activities. Overall, be prepared to gather and report more information.

Below are the top four areas to pay attention to around Schedule K-1 (Form 1065) reporting this year.


1. Report carried interest properly

The U.S. Department of the Treasury and the Internal Revenue Service (IRS) released final regulations for the treatment of carried interest in January 2021 (carried interest is the portion of an investment fund’s returns paid to the fund managers or general partners as compensation). The 2017 Tax Cuts and Jobs Act (TCJA) mandated that, for the gains that general partners or fund managers receive to be taxed at a capital gains rate, the fund must hold the assets for more than three years.

The final regulations clarified how funds must report carried interest, and that RICs, REITs and QEF-PFICs have the option to provide one-year and three-year gain and loss details.

You can read more about the final carried interest regulations in this blog post. The most important points to keep in mind are:

  • Partnerships should not recharacterize carried interest gains on the Schedule K-1s they issue. Instead, all long-term capital gains and losses will require a worksheet attachment that includes the details related to the carried interest rule for the general partner to use in the calculation of any recharacterization at its own level. See the IRS’s recently published Section 1061 Reporting Guidance FAQ for more information.
  • Each general partner’s capital interest and carried interest must be bifurcated when preparing Schedule K-1, as general partners who contribute their own capital into the fund will not trigger this carried interest recharacterization.
  • Corporations taxed at the entity level are exempt from the three-year holding period.
  • IRC 1256 and 1231 gain/loss, qualified dividends, and IRC 1092(b) mixed straddle gains/losses are treated as capital gains regardless of how long they have been held.


2. Use tax basis capital reporting for partners

Beginning with tax year 2020, funds had to report each partner’s capital account on a Schedule K-1 using a tax basis capital method. Last year, the IRS didn’t penalize partnerships for errors in reporting partners’ beginning account balance, as long as “ordinary and prudent business care” was taken following the instructions. For 2021, there is no penalty relief.

That means each partner’s beginning tax basis capital account balance can be computed using one of these methods:

  • Modified Outside Basis Method
  • Modified Previously Taxed Capital Method
  • Section 704(b) Method, as described in the instructions, including special rules for publicly traded partnerships


3. Include disregarded entity information on K-1s

As a reminder, disregarded entity names, types and Taxpayer Identification Numbers must be included on all K-1s, along with the individual beneficial owner’s information. The IRS issued a useful FAQto help clarify reporting on disregarded entities.


4. Report disposition of partnership interests

Schedule K-1 box 20 codes AB and AD are used for non-corporate taxpayers that have disposed of their partnership interest. Any capital gain or loss on disposition will be reclassed to ordinary for the amounts shown. Tax preparers should be on the lookout for these amounts, which will affect the tax calculation.

Other tax-reporting considerations

There are a few other reporting requirements to prepare for.

  • Opportunity zones: Qualified Opportunity Funds that invest in Opportunity Zones must provide additional information to the IRS through Form 8996. Funds must report the value of business properties, the census area tract number for each property, the value of investments allocated to each area, each investments’ current valuation and other information.
  • REIT dividends: Break these out on Form 1099s, because regulated investment companies that receive qualified REIT dividends can report those as Section 199A dividends. That means S corps, partnerships and individuals can deduct up to 20% of this income as qualified business income (QBI).
  • Effectively Connected Income (ECI): Partnerships and other parties that are the recipient-transferee of a disposed partnership interest that includes ECI may have to withhold 10% of the realized net gain.
  • W-9s and W-8s: Assess whether you have current W-9s and W-8s for all your investors. Some of these forms have expiration dates and need to be filled out and signed again.
  • Reconciling 1099s: As 1099s come in, they need to be reconciled with the fund’s records. Brokers may record transactions differently from the way the fund has recorded them. It’s a good idea to have your tax professional review and resolve these differences early in the tax preparation process.

Other tax-planning considerations

Investment fund managers should also consider these other 2021 tax-planning strategies before the year ends.

  • Business loss deduction: Deduction of aggregate trade or business losses for tax year 2021 returns to the $500,000 limit (the Coronavirus Aid, Relief, and Economic Security Act temporarily repealed that limit for tax years 2018, 2019 and 2020).
  • Business interest expense: The Internal Revenue Code’s Section 163(j) limitation on allowable deductions for business interest expense returned to 30% of the taxpayer’s (individual or business entity) adjusted taxable income, after rising to 50% for 2020.
  • Wash sales: Keep in mind January 2022 transactions can affect 2021 wash sales. The Wash Sale rule is triggered if “substantially identical” securities are purchased within 30 days before or 30 days after the sale of another security at a loss.
  • Qualified business income: Maximize your QBI deduction. Most likely, your tax advisor has explored this area with you. The rules haven’t changed since last year.
  • State and local tax: Many states adopted the state and local tax deduction limitation work-around, effective for 2021, which provides an above-the-line federal tax deduction that was essentially eliminated under TCJA of 2017. Most are typically elective by the partnership and binding on the partners. Investors may inquire with fund managers about available options.
  • Constructive sale rule: You may be familiar with the “constructive sale,” which adds unrealized gains into your taxable income. It occurs when a taxpayer is holding at year-end (December 31, 2021) appreciated property (e.g., stock), while also holding a short position with respect to the same or “substantially identical” property. During January and February of 2022, these circumstances can help you avoid the constructive sale rule:
    • offsetting position is closed within 30 days after the end of the year,
    • appreciated financial position is held throughout the 60-day period beginning on the date such transaction is closed, and
    • during that 60-day period, the taxpayer does not enter into certain transactions that would diminish the risk of loss during that time on such position.

As federal lawmakers continue to debate potential tax changes, it’s important to keep watch on the developments (read our blog post for the latest updates) and to consult with your tax professional.

Contact your Kaufman Rossin tax advisor to learn more about what these year-end tax-planning considerations may mean for you and your investment firm as you prepare for the upcoming tax season.

Chad Ribault is a Tax-Financial Services Principal at Kaufman Rossin, one of the Top 100 CPA and advisory firms in the U.S.

Stephen Ng, CPA, is a Tax-Financial Services Principal at Kaufman Rossin, one of the Top 100 CPA and advisory firms in the U.S.

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