IRS Gives Relief to Hedge Fund Traders in Securities and Commodities That Have Made a Section 475(f) Election

Stephen Ng of Kaufman Rossin writes that hedge funds looking to revoke a Section 475 mark-to-market election for tax year 2015 may still have time to do so, thanks to a new provision in the annual update to automatic accounting method change guidance. The advance consent procedures previously required took several months for approval or denial, which provided insufficient tax planning opportunity for portfolio managers, Ng writes.

Securities and commodities traders that have an Internal Revenue Code Section 475(f) election in place, whether individually or at an investment partnership level, now have the ability to make an automatic revocation of this election for calendar years 2015 and beyond. In a recent update in Revenue Procedure 2015-14, the Internal Revenue Service Office of Chief Counsel inconspicuously added a new subsection to the mark-to-market accounting method section that now provides for an automatic change to revoke a previously made 475(e) or (f) election. Hedge funds with such an election in place still have a small window of opportunity to make the revocation for 2015. Prior to this new automatic method, taxpayers were required to seek consent from the IRS via an ‘‘advance consent’’ application requesting permission to revoke the 475 election as mandated under I.R.C. Section 475(f)(3). For hedge funds, this required submitting a formal application on Form 3115, Application for Change in Accounting Method, to the IRS along with a user fee of $7,000 (prior to Feb. 2, 2015). The application required a description of the current and proposed method of accounting for securities, as well as a business reason for the election revocation. The consent took several months for approval or denial, which provided insufficient tax planning opportunity for portfolio managers.

Revocation procedure

The new automatic change puts the revocation procedures in line with the old 475(f) election procedures under Rev. Proc. 99-17, as modified. The partnership requesting revocation will need to file a “notification statement” by the original due date of the preceding year return without extensions. The statement can be filed with an extension of time to file the return or with the tax return for the tax year preceding the year of change. The new procedure provides an opportunity window of three and one-half months in the beginning of the tax year to decide whether to revoke the election, mirroring that of the timing to make the 475 election. For revocations effective for the 2015 calendar year, the notification statement must be filed by April 15, 2015. The notification statement must include:

• the name of the taxpayer with a 475 election in place;
• a statement requesting the accounting method change to a realization method; beginning and ending dates for the year of change; the types of instruments subject to the method change; and
• a statement revoking the taxpayer’s 475 election in place.

Form 3115 must then be filed with the 2015 tax return under standard automatic method change procedures described in Rev. Proc. 2015-13, effective for forms filed on or after Jan. 16, 2015.

Background on the 475(f) election for securities and commodities traders

Investment partnerships (IPs) that qualify as a ‘‘trader’’ in securities (as opposed to an ‘‘investor’’ in securities) are eligible to make an I.R.C. Section 475(f) election. What constitutes a trader in securities is beyond the scope of this article. This election allows the IP to avoid the wash sales, straddles and other securities transaction tax rules, since the election requires the IP to mark-to-market all of its trading securities at year-end as if the securities were sold, thereby recognizing all unrealized gain or loss on such securities for the year. In addition, all securities included in the 475(f) trading account will be ordinary in character subject to the highest income tax rates. All losses within the 475(f) account are fully deductible against other types of income. Conversely, capital losses without the election are limited to a $3,000 deduction against other income for individual taxpayers. The Section 475(f) election is required to be made for IPs by the original due date of the preceding year return without extensions. The election can be filed with an extension of time to file the return or with the tax return for the year prior to the election year, which is generally April 15 of the election year. If an extension is filed, consider paper mailing the election certified mail with return receipt card. For a newly formed IP, the election must be placed in its books and records within two and one-half months of the election effective date, and attached to its initial filed tax return. For IPs using fund administrators, provide notice of the IP’s intent on making the election, and provide the administrator a copy of such election, so they have it on file. This provides third-party verification of the election, in case the IRS questions the validity of the election under audit. Before the new guidance introduced in Rev. Proc. 2015-14, once the election was made it was applicable for all prospective years until the IP ceased operations or it was revoked by the IRS. _____ Stephen Ng is a financial services tax manager in Kaufman Rossin’s New York office. Kaufman Rossin provides specialized tax services for clients in the alternative investments industry. Stephen can be reached at sng@kaufmanrossin.com.