Investment funds: 2023 tax planning involves complicated rules, and reporting may be more complex

This blog post was originally published on October 18, 2022 and updated on October 9, 2023.

Although 2023 brings few tax changes that affect investment fund managers, reporting may be more complex and extensive than last year. This follows a trend over the last several years, as Schedule K-1 (Form 1065) reporting requirements have expanded, and funds have become larger and more sophisticated.

The days of K-1 reporting packages that maxed out at three pages are over – plan to spend more time and produce larger packages. In addition, Schedule K-3 requires more detail, and is required for both domestic and international activities.

The following are a few considerations as you think about year-end tax planning for your investment fund.

Start gathering information now

Given the reporting funds are required to complete, start planning and gathering information now. This can reduce the chance of delays in filing your K-1s, which can lead to unhappy investors. Consider these documents:

• Incoming K-1s: If your fund receives a large number of K-1s, communicate with the tax preparers that provide them and establish deadlines to receive them.
• W-9s and W-8s: Assess whether you have current, accurate W-9s and W-8s for all your partners and investors, including current tax domicile and address. Partners may have moved, experienced changes in family situations or passed away. In addition, some of these forms have expiration dates and need to be filled out and signed again. Titles on K-1s must match current information.
• 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 look at and resolve these differences early in the tax preparation process.

Consider state and local taxes

Many states have adopted a pass-through entity tax, the full amount of which can be deducted from federal taxable income. This provides some relief to the $10,000 total cap on federal deductions for state and local income, property and sales taxes. In most states, this pass-through entity tax is elective and has various requirements and consequences. If your business is in a state with this option, consider whether it is advantageous to elect it.

Decisions about state-level pass-through entity taxes are complex. Consult with a tax professional with state and local tax experience to work through the potential implications.

Plan for multistate and federal tax withholding

Many funds have tax reporting and payment requirements in multiple state jurisdictions for non-resident partners, and many have non-US partners which obligates the fund to withhold federal income tax at times.

Withholding for non-resident partners is due by March 15 (even if a filing extension is granted). Often fund managers over-distribute sales proceeds and do not adequately reserve for withholding. It’s important to discuss asset sales and understand the tax compliance responsibilities.

• Report convertible loan interest: Accrued interest on convertible loans is considered taxable income and must be reported on form 1099. This applies even though most companies issuing convertible loans don’t actually pay out the annual interest to the lender.

Report carried interest properly

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 for the treatment of carried interest (the portion of an investment fund’s returns paid to the fund managers or general partners as compensation), released in January 2021, clarified how funds must report carried interest.

Keep in mind a few important points when reporting carried interest:

• Corporations taxed at the entity level are exempt from the three-year holding period.
• RICs, REITs and QEF-PFICs have the option to provide one-year and three-year gain and loss details.
• Partnerships should not recharacterize carried interest gains on the 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. General partners will use the worksheet to calculate any recharacterization at its own level.
• General partners who contribute their own capital into the fund will not trigger this carried interest recharacterization, so each general partner’s capital interest and carried interest must be bifurcated when preparing Schedule K-1.
• 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.

Other tax-reporting considerations

There are a few other reporting requirements to keep in mind.

• Disregarded entity information: You must report disregarded entity information on K-1s, along with the individual beneficial owners’ information.
• 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.
• 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.

Other tax-planning considerations

Investment fund managers should consider these other 2023 tax-planning strategies before the year ends.

• Business changes: Discuss any additional capital raises, acquisitions, significant sales or other business changes with your tax advisor; don’t forget to discuss jurisdiction of those sales, including which states they occurred in.
• Wash sales: Keep in mind January 2024 transactions can affect 2023 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 (QBI): Maximize your QBI deduction.
• Constructive sale rule: You may be familiar with the “constructive sale,” which adds unrealized gains into your taxable income. It occurs when, at year-end (December 31, 2023), a taxpayer is holding 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 2023, 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.

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