The Department of Revenue has extended the comment period until July 20, 2011.
WORKING DRAFT FOR PRACTITIONER COMMENT - 5/23/11
Income Tax
Draft Directive 11-XX
Professionally Managed Funds; Trader Versus Investor Determination
Introduction:
Massachusetts gross income is federal gross income with certain modifications. G.L. c. 62, § 2(d). Generally, the Massachusetts tax law adopts federal partnership taxation principles including the principle that a partner is required to include separately on her return her distributive share of the partnership's income or loss and any item of deduction or credit. G.L. c. 62, § 17(a), (b).
This Directive addresses tax issues with respect to professionally managed investment funds that have third party unrelated investors but which are not mutual funds subject to the registration and regulatory restrictions of mutual funds. Professionally managed funds for this purpose are pooled investment vehicles that are treated as partnerships for federal and Massachusetts income tax purposes and may include hedge funds, venture capital funds, funds of funds and managed futures funds. If a professionally managed fund is determined to be engaged in the business of trading in securities (a "trader fund"), certain fund expenses are determined to be ordinary and necessary business expenses under the Internal Revenue Code ("IRC") § 162. If the professionally managed fund is determined not to be a trader fund and instead is characterized as an "investor fund", certain expenses flow through to the partner investors as IRC § 212 expenses. Massachusetts personal income tax law does not allow a deduction for investment-related IRC § 212 expenses and does not allow a deduction for IRC § 163 investment interest expenses attributable to investor funds. [i] In addition to outlining the factors used to determine a fund's trader versus investor status, this Directive will:
1) provide numerical safe harbors for the determination that a professionally managed fund's primary object is the achievement of short-term income or profit, consistent with tax treatment as a trader fund,
2) outline certain cases in which a fund that does not qualify for the trader fund safe harbors may have the ability to apportion expenses between trader and investor activities,
3) discuss the treatment of management fees in a fund of funds structure.
Issue 1 :
What are the factors used to determine a fund's trader versus investor status?
Directive 1 :
A professionally managed fund may be determined to be a trader fund if the fund:
- is an entity organized and operated to buy and sell securities and is engaged in such trading activity with continuity, regularity and frequency,
- has unrelated third party investors,
- has demonstrated that its primary object is the achievement of short-term income or profit,
- does not pursue a long-term buy-and-hold investment strategy for capital appreciation and income without regard to short-term developments that would influence the price of the securities on the daily market,
- does not impose a redemption restriction on its investors of longer than one year, and
- has not indicated (in investor documents, federal tax documents, or otherwise) an intent or expectation of treatment other than as a trader in securities for federal income tax or other purposes.
Discussion 1 :
In the absence of distinct statutory and regulatory guidance, the courts have applied a facts and circumstances analysis to the determination of trader versus investor status. [ii] In so doing, the trail of cases has developed a recurrent theme of factors the courts rely upon when analyzing the taxpayer's activities.
Generally, in order for a fund to deduct its expenses under IRC § 162 the expenses must be from the active conduct of a trade or business. In Commissioner v. Groetzinger, the Supreme Court held that for a taxpayer to be engaged in a trade or business for purposes of the Code, the taxpayer "must be involved in the activity with continuity and regularity" and the taxpayer's "primary purpose for engaging in the activity must be for income or profit." [iii] In King v. Commissioner, the Tax Court held that the taxpayer was a trader in commodities given his trading was "frequent and substantial" as evidenced by his spending "6 hours per day on trading" and closing over 11,000 contracts in one tax year and 6,000 contracts in the next tax year. [iv]
In Levin v. U.S., the court held that the taxpayer was a trader noting that he "conducted 332 transactions during the tax year" and "devoted virtually his whole working day to his stock transactions" and further, that "the sheer quantity of transactions he conducted also supports a reasonable conclusion that this taxpayer's business was trading on his own account." [v] In Fuld v. Commissioner, the court found that the taxpayers, a brother and sister, were engaged in the trade or business of buying and selling securities given that the brother spent 8 hours per day on trading activities. [vi] The Fuld court rejected the commissioner's argument that the sister was not engaged in business because "she only spent some six hours a day" on trading activities, holding that her activities "were very substantial both in time consumed and the amount and number of securities traded in." [vii] The Fuld court noted in the facts that both taxpayers made sales as high as 1,000 shares per transaction and that the brother and sister respectively executed 347 and 318 sales of securities in the tax year. [viii]
In addition to the substantial size and frequency of trades, the courts have required that the trades must be continuous and regular throughout the tax year. In Paoli v. Commissioner, the Tax Court held that while the taxpayers made frequent and substantial trades, they did not trade on a "regular and continuous basis during the entire year…to constitute a trade or business." [ix] The Paoli court noted that 40% of the taxpayers' trades were in a one month period at the beginning of the year and subsequent months entailed far less extensive trading activities, including no trading activity in November and December. In Holsinger and Mickler v. Commissioner, the Tax Court held that the taxpayers' trades were not "conducted with the frequency, continuity, and regularity indicative of a business" when the taxpayers were found to have traded for less than 40% or 45% of the trading days in the two tax years at issue. [x]
As evidenced by the above case law, the factor that a trader fund must buy and sell securities on a continuous, regular and frequent basis is important in the determination of trader versus investor status. In addition, notwithstanding the Levin decision, the majority of the courts have held that the activities must not only be continuous, regular and frequent, but must also involve active trading that results in short-term profits or losses rather than passive oversight of investments and the garnering of interest, dividends or long-term gains. [xi]
In the 1941 landmark case of Higgins v. Commissioner, the Supreme Court rejected the taxpayer's argument that extensive, continuous and extended investment activities constitute the carrying on of a business. [xii] The taxpayer, a Paris, France resident, had "extensive investments in real estate, bonds and stocks, [and] devoted a considerable portion of his time to the oversight of his interests and hired others to assist him in [rented NY] offices." [xiii] The court held that activities of the taxpayer did not constitute a trade or business as they were "…merely [keeping] records and [collecting] interest and dividends from his securities, through managerial attention for his investments." [xiv] In Levin v. U.S., the court refined the factors of continuity and regularity, holding that the activities and resulting profits must be from "…the very acts of trading…" and not just from managerial oversight of the accounts and passive accumulation of earnings. [xv]
In the 1955 Liang [xvi] case, the Tax Court, citing Higgins, [xvii] decided that a nonresident alien's investment activities did not constitute a trade or business, but rather were investment activities. [xviii] The Tax Court expanded on the Higgins analysis describing an investment account as one in which "securities are purchased to be held for capital appreciation and income, usually without regard to short-term developments that would influence the price of the securities on the daily market," whereas a trading account is one in which "securities are bought and sold with reasonable frequency in an endeavor to catch the swings in the daily market movements and profit thereby on a short-term basis." [xix] The threads of this Tax Court analysis have been followed by the courts through the years, as for example in the 1976 federal case of Purvis v. Commissioner [xx] and the 1983 federal case of Moller v. United States, [xxi] both of which held that the taxpayers were investors and not traders. [xxii] While there are some courts as in Levin that have not included the Liang short-term profit factor in their analysis, the majority do consider this factor, including a line of state tax cases. [xxiii]
Issue 2 :
Are there numerical standards through which a fund may demonstrate that its primary object is the achievement of short-term income or profit?
Directive 2 :
As an administrative safe harbor, the Department will consider a fund to have demonstrated that its primary object is the achievement of short-term income or profit if (a) the average holding period of its assets, based on average fair market value during the tax year, is 45 days or less for the tax year, or (b) at least 80% of its assets, based on average fair market value during the tax year, have holding periods of 30 days or less. The average fair market value must be calculated on a reasonable basis, for example on a daily or monthly basis as opposed to only once or twice during the tax year. The total amount of a fund's cash and cash-equivalents is excluded from the safe harbor calculations.
Example 2a: Fund X has a calendar tax year and the fair market value of the fund's assets fluctuates between $80 million and $120 million depending on asset turnover and investor contributions and redemptions. The fund calculates the fair market value of the fund at the end of each calendar month and determines the average holding period of the assets weighted by each asset's value with respect to the entire fund. The twelve average holding periods are totaled and divided by twelve to determine if the fund's average holding period is 45 days or less.
On January 31 st the fund's assets have a fair market value of $90 million, comprised of 90 securities with a fair market value of $ 1 million each. As of January 31 st, 40 of the securities have been held for 51 days, 11 have been held for 96 days and 39 have been held for 7 days. The average holding period for the month of January is calculated as follows:
$40 million/$90 million = 44.44% x 51 days = 22.66 days
$39 million/$90 million = 43.33% x 7 days = 3.03 days
$11 million/$90 million = 12.22% x 96 days = 11.73 days
Total = 37.42 days
The average holding period for the fund for the month of January is approximately 37 days. The fund calculates the remaining eleven months of monthly holding periods, adds them and then divides by twelve, resulting in the fund's average holding period for the tax year of more than 45 days. Fund X does not meet the standard of having an average holding period of 45 days or less in order to be considered as having demonstrated that its primary object is the achievement of short-term income or profit for this tax year.
Example 2b: Same facts as in example 2a above except Fund X calculates that on January 31 st, 43% of the fund's assets have holding periods of 30 days or less [of the $90 million, $39 million of the assets have holding periods of 7 days]. The fund calculates the remaining eleven months of percentage of the fund's assets having holding periods of 30 days or less, adds them and then divides by twelve, resulting in the fund's percentage of fund's assets having holding periods of 30 days or less being equal to 86%. As the fund's average monthly percentage for the year of assets held for 30 days or less exceeds the 80% alternative safe harbor measure, Fund X will be considered to have demonstrated that its primary object is the achievement of short-term income or profit for this tax year.
Discussion 2 :
As noted earlier in this Directive, there is no bright line standard spelled out in the Code or case law to guide taxpayers or tax administrators in the determination of a fund's trader versus investor status. Some courts have endeavored to utilize numerical standards in analyzing if taxpayers were satisfying the factor of having demonstrated that their primary object was to achieve short-term income or profit.
In Holsinger and Mickler v. Commissioner [xxiv] , the taxpayers traded on behalf of their LLC and testified that their goal "was to profit from short-term swings in the market" and that they closed their accounts "at the end of the day and tried to avoid holding stocks and options overnight." [xxv] In holding that the taxpayers were investors and not traders because they "failed to prove that they sought to catch the swings in the daily market movements and to profit from these short-term changes rather than to profit from the long-term holding of investments," the Tax Court stated that the "documentary evidence, however, paints a different picture." [xxvi] The Court found that the taxpayers "rarely bought and sold on the same day" and further, that "a significant amount of petitioners' holdings was held for more than 31 days." [xxvii] In Mayer v. United States, the Court of Federal Claims also utilized a 30 day standard. [xxviii]
Directive 2 adopts this nascent effort by the courts to provide a numerical standard not as a bright line test but as a safe harbor for taxpayers. In general, the Department will presume that a fund not satisfying this safe harbor is either an investor fund or is a fund engaged in both trading and investing activities based on the factors outlined in Directive 1, unless the fund otherwise demonstrates that it is solely a trader fund. Directive 3 discusses certain cases in which funds may have the ability to apportion trader versus investor fund expenses.
Issue 3 :
May a fund that has not satisfied either of the administrative safe harbors in Directive 2, and which nevertheless claims that it is carrying on a trade or business with regard to at least a portion of its assets, apportion the fund's expenses between longer-term and shorter-term investments and treat such apportioned expenses as investor and trader expenses, respectively?
Directive 3 :
1. Ability to apportion; shorter-term investments of one year or less must constitute a sufficiently material portion of fund's activities
A fund that has not satisfied either of the administrative safe harbors in Directive 2, and which nevertheless claims that it is carrying on a trade or business with regard to at least a portion of its assets, and which satisfies the other factors in Directive 1, may reasonably apportion the fund's expenses between longer-term and shorter-term investments. The shorter-term investments must constitute a sufficiently material portion of the fund's activities to justify a determination that the fund is engaged in a trade or business with regard to at least a portion of its assets in addition to satisfying the other factors in Directive 1. For the purpose of determining if the shorter-term investments constitute a sufficiently material portion of the fund's activities, investments will be treated as shorter-term investments if they have holding periods of one year or less as of year end, excluding the fund's cash and cash-equivalents.
2. Safe Harbor method of apportionment; investments of 45 days or less
Provided that shorter-term investments of one year or less constitute a sufficiently material portion of a fund's assets at year end, as described above in section 1 of Directive 3, a percentage of the fund's expenses may be treated as deductible IRC § 162 expenses. The Commissioner will accept as a reasonable method of apportionment the percentage determined by the ratio that the fund's investments with holding periods of 45 days or less, excluding the fund's cash and cash-equivalents, bear to its total investments as of year end. Under this methodology, investments of holding periods of greater than 45 days will be treated as related to investment activity. Therefore, such expenses will be disallowed IRC § 212 expenses or § 163 investment interest expenses for Massachusetts personal income tax purposes.
3. Other Reasonable Methods of Apportionment
The Commissioner may accept other reasonable methods of apportionment employed by a fund, provided that: (1) the fund is entitled to apportion its expenses because its shorter-term investments of one year or less, excluding the fund's cash and cash-equivalents, constitute a sufficiently material portion of its activities; (2) the alternative method of apportionment is not inconsistent with the 45 day standard described section 2 of Directive 3 above; (3) the fund uses the same method consistently from year to year; and the fund satisfies the other factors in Directive 1.
Example 3a: Fund Q has $250 million of securities at the end of its tax year, of which $225 million constitute investments held for more than one year. Fund Q is not allowed to apportion its expenses because even if the remaining $25 million of securities are considered trader activities, such activities do not constitute a sufficiently material portion of the fund's activities to justify a determination that the fund is engaged in a trade or business with regard to at least a portion of its assets.
Example 3b: Fund Z has $250 million of securities at the end of its tax year of which securities having $175 million in value have holding periods of more than one year. Of the remaining $75 million of securities, $50 million are securities with holding periods of 45 days or less. Fund Z apportions the fund's expenses between the $50 million of securities with holding periods of 45 days or less and the remaining $200 million of securities. Fund Z expenses attributable to the $200 million in securities will be treated as disallowed IRC § 212 expenses or § 163 investment interest expenses for Massachusetts personal income tax purposes.
Discussion 3 :
Apportionment between trader and investor activities dates back to the 1941 Higgins case (see Discussion 1 above). On the one hand, the Supreme Court in Higgins determined that the taxpayer was not in a trade or business with respect to his bond and stock investment activities, and on the other hand the court held that his real estate activities did rise to the level of a trade or business. [xxix] In rejecting the taxpayer's assertion that his activities constituted a unified business, the court held that "we see no reason why expenses not attributable, as we have just held these are not, to carrying on business cannot be apportioned." [xxx] In 1988, the IRS issued temporary regulations calling for "reasonable" allocation of expenses between IRC § 162 and IRC § 212 activities. Treas. Reg. §1.67-1T(c). [xxxi]
In Directive 3, the Department creates a standard for reasonable apportionment. If the fund's trader activities are not sufficiently material with respect to the overall fund's activities, the fund is essentially an investment fund, and is not entitled to apportionment. In that case, apportionment would result in an unreasonable allocation of the fund's expenses between IRC § 162 and IRC § 212.
Issue 4 :
Are management fees in a "fund of funds" structure deductible under IRC § 162 or IRC § 212?
Directive 4 :
If a fund is a so-called "fund of funds", i.e., its activities consist solely of acquiring, holding and disposing of interests in other funds as a limited partner, its own management fees are deductible by its investors under IRC § 212, regardless of whether it is invested in a trader fund. IRS Rev. Rul. 2008-39. However, the investment fund's distributive share of management fees charged by any trader fund, in which it has an interest, are deductible under IRC § 162.
Example 4: Fund Invest is a partnership with individual limited partners ("LPs") and its activities consist solely of acquiring, holding and disposing of interests in trader funds. Fund Invest charges a 1% management fee to the LPs which is deductible under IRC § 212 and therefore disallowed for Massachusetts personal income tax purposes. The trader funds charge Fund Invest a 2% management fee which is deductible under IRC § 162 and therefore allowed for Massachusetts personal income tax purposes.
Discussion 4 :
Management fees of a trader fund are ordinary and necessary expenses that are deductible under IRC § 162. Management fees of an investor fund are ordinary and necessary expenses of the investment fund deductible under IRC § 212. A fund of funds structure involves tiered partnership arrangements where the lower-tier partnership may actively trade as a trader fund and the upper-tier partnership gathers individual investors and invests in various lower-tier trader funds. On those facts, the lower-tier trader fund charges a management fee which flows to the upper-tier partnership fund and eventually its individual investors as an IRC § 162 expense.
The upper-tier investment fund also charges a fee which flows to the individual investors. In cases where the upper-tier partnership activities consist solely of acquiring, holding and disposing of interests in the lower-tier funds, the upper-tier fund is considered an investment fund. IRS Rev. Rul. 2008-39. The upper-tier investment fund's management fee is not connected to the lower-tier fund's trade or business and therefore is deductible under IRC § 212. Id. As noted, Massachusetts personal income tax law does not allow a deduction for investment-related IRC § 212 expenses.
WORKING DRAFT FOR PRACTITIONER COMMENT - 5/23/11
[i] Massachusetts does not adopt the deductions permitted under IRC § 163 unless they are allowed under section 62 of the Code. G.L. c. 62, § 2(d); Forte Investment Fund v. State Tax Commission, 369 Mass. 786 (1976).
[ii] Levin v. U.S., 597 F.2d 760, 765 (Ct.Cl. 1979)("Neither the code, the regulations, nor the courts have yet provided a precise definition as to when an individual taxpayer's behavior is that of a trader rather than an investor…"); Higgins v. Commissioner, 312 U.S. 212, 217(1941)("To determine whether the activities of a taxpayer are 'carrying on a business' requires an examination of the facts in each case").
[iii] 480 U.S. 23, 35 (1987).
[iv] 89 T.C. 445, 450, 459 (1987).
[v] Levin at 765; cf., Field Serv. Adv. Mem., FSA 199947006, (1999) (criticizing Levin, "we do not believe that merely entering into 300 trades a year is sufficient to cause one's trading activities to rise to the level of a trade or business").
[vi] 139 F.2d 465, 467 (1943).
[vii] Id. at 468.
[viii] Id. at 467.
[ix] T.C. Memo 1991-351 (1991)(326 trades involving $9 million worth of securities).
[x] T.C.M. 2008-191 (August 11, 2008).
[xi] See Field Serv. Adv. Mem., FSA 199947006, (1999) which notes in a footnote that the Levin court made "no mention …..as to whether [the] taxpayer intended to profit from long term capital appreciation, or whether he intended to profit from the short term swings in the market. To the extent that Levin implies that one may be a trader engaged in a trade or business merely by deriving one's entire income from one's investments, and devoting one's entire workday to stock transactions, the weight of authority is otherwise."
[xii] Higgins at 218.
[xiii] Id. at 213.
[xiv] Id. at 218.
[xv] 597 F.2d at 765.
[xvi] Liang v. Commissioner, 23 T.C. 1040 (1955).
[xvii] Id. at 1045 for the proposition that "whether activities undertaken in connection with investments are sufficiently extensive to constitute a trade or business is a question to be decided on the particular facts" and for the conclusion that the taxpayer's agent "did no more than was required to preserve an investment account for his principal."
[xviii] This was a favorable holding for the taxpayer who could then avail himself of the capital gain exemption allowed to nonresident aliens under 1939's IRC sec. 211(b)(only allowed if the transactions did not constitute a trade or business).
[xix] Id. at 1043,[ emphasis added].
[xx] 530 F.2d 1332 (9 th Cir. 1976).
[xxi] 721 F.2d 810.
[xxii] See also, Mayer v. U.S., 32 Fed. Cl. 149(1994); Estate of Yaeger v. Commissioner, 889 F.2d 29 (2d Cir. 1989); IRS Tax Topic 429, Traders in Securities (one factor for a taxpayer to attain trader status is that he "must seek to profit from daily market movements in the prices of securities").
[xxiii] Gilligan v. Taxation Div. Director, 11 N.J. Tax 414 (Tax Ct. 1991)(taxpayer not a trader regardless of full-time and substantial volume of activities because holding periods on average were 8.8 months); Marrinan v. Taxation Div. Director, 10 N.J. Tax 542 (Tax Ct. 1989)(taxpayer was found to be a trader when 90% of his trades were on a daily basis); Appeal of Robert M and Ann T. Bass, No. 87A-1552-CB, California (January 25, 1989)(partnership was not a trader because "securities were not bought and sold in order to profit from short-term swings in the market prices"). See also, Deveau v. Commissioner, 51 Mass. App. Ct. 420 (2001)(partnership was an investor because its secured notes were short term and not purchased on a frequent or daily basis); Rosse v. Commissioner, 430 Mass. 431 (1999)(taxpayer was not engaged in a trade or business because he did not intend of making "quick sales on the entities in which he invested").
[xxiv] T.C.M. 2008-191 (August 11, 2008).
[xxv] Id. at 8-9.
[xxvi] Id.
[xxvii] Id.
[xxviii] 32 Fed. Cl. 149, (1994)("…relatively long 'at least thirty days' holding periods of most of the securities involved…").
[xxix] Higgins at 218.
[xxx] Id.
[xxxi] "If a taxpayer incurs expenses that relate to both a trade or business activity (within the meaning of section 162) and a production of income or tax preparation activity (within the meaning of section 212), the taxpayer shall allocate such expenses between the activities on a reasonable basis." The temporary regulations were also simultaneously proposed as final regulations but have yet to be adopted.