New York (HedgeCo.net) – As 2010 begins to wind down, this is an opportune time not only to launch 2011 planning, but also to review legislation and amendments that may impact hedge funds, their managers, and their investors.  These considerations include potential tax increases, mark-to-market election, and surprise audit mandates.

Among the tax issues to consider:

• Tax rates may be going up in 2011.  As of now, the highest Federal individual tax rate is 35 percent per the Growth and Tax Relief Reconciliation Act of 2001. However, since the Act is set to expire at the end of 2010, it will increase the highest Federal tax rate to 39.6 percent, provided Congress does not pass another tax act. The highest tax rate on long-term capital gains is 15 percent for 2010 and is set to increase to 20 percent in 2011. As a result, some managers may seek to accelerate gains before year end.

If that is not enough for managers to worry about, Congress has been trying to increase taxes via a change in the character of “carried interest” (or “incentive fee”).  Congress’s desire to continue to change laws on how carried interest is taxed has managers continually evaluating their options on how to minimize taxes.

• The 475(f) mark-to-market election for traders can yield significant advantages. Another important issue that should be evaluated annually is whether an Internal Revenue Code Section 475(f) mark-to-market election for traders should be made (note: the election is not available for funds classified as investor status). This election can yield significant advantages. Many taxpayers are unaware of a provision that gives fund managers and other securities traders the opportunity to mark to market stocks and other securities. According to the mark-to-market method of accounting for taxation, any security held by an electing trader is treated as sold for its fair market value on the last day of the year. The result is that the taxpayer includes in gross taxable income any gains or losses on securities including any unrealized gains or losses that exist at the end of the year.One of the most significant benefits of a 475(f) election is that traders who incur losses can use them to offset other taxable income without restrictions that apply to capital losses. Section 475(f) essentially changes the character of taxable income from capital to ordinary. Without this election, deductible losses for individual taxpayers would be limited to capital gains plus an additional $3,000 with the balance available to be carried forward. If the election is made, losses will be considered business losses that can add to or create a net operating loss that can be carried back 2 years and forward 20 years. Another key advantage is that in most situations, taxable income and book income become equal under 475(f), eliminating book/tax differences that may arise (i.e., constructive sales, wash sales, and straddles).

  It is important to note that once the election is made, it cannot be revoked unless a formal request is made to the IRS by filing Form 3115.

  One last tax consideration to think about before year end is a portfolio review to determine if there are any positions you may wish to realize for tax purposes, especially if you want to coordinate it with a pending tax increase. Generally, unrealized losses on positions held at year end are not deductible for tax purposes until the securities are sold. If you have net realized gains from positions sold during the year, your investors will have to pay tax on the gains reported.  As such, after a careful evaluation on whether or not to minimize the taxable gains, it may be beneficial for tax purposes to sell a position with an unrealized loss to offset them.

  If you do decide to dispose of a position to offset gains, remember that you cannot reacquire the same position for 30 days or the loss may be disallowed due to the “wash sale” rules. In addition, if you have any offsetting positions in your portfolio, there are additional rules that may trigger taxable gains or the deferral of losses, such as “constructive sales” and “straddles.”

In addition, surprise audits may be in store for you by year end. This is a good time to be reminded that SEC custody rule amendments may require you to have a surprise audit conducted by year end. The amendments are intended to safeguard client assets held by Registered Investment Advisers. Among the key amendments to remain cognizant of are:

• Advisers that have custody of client assets and maintain those assets with an independent qualified custodian must undergo a surprise examination of client assets by an independent public accountant that is registered with and subject to regular inspection by the Public Company Accounting Oversight Board (PCAOB).
• Advisers to unregistered pooled investment vehicles that are subject to annual audits are exempt from surprise audit requirements if they deliver their audited financial statements to clients within 120 days (180 days for a fund of funds). Upon liquidation of an unregistered pooled investment vehicle, advisers must obtain a final audit and distribute such financial statements promptly.
• An adviser required to obtain a surprise examination must enter into a written agreement with an independent public accountant and ensure the first examination occurs prior to December 31, 2010. The independent accountant must file Form ADV-E with the SEC within 120 days of the date selected for the surprise exam.
• Advisers are now required to have the independent custodian mail statements directly to clients. The adviser must have a reasonable belief that the qualified custodian sends account statements directly to clients after “due inquiry.” Prior to the amendment, if the adviser underwent a surprise examination, they could send the quarterly statements to clients and be in compliance with the custody rules.

An adviser that maintains possession of client assets itself or with a custodian that is not “operationally independent” from the adviser must undergo a surprise examination and receive an internal control report (such as a Type II SAS 70 or an examination on internal control conducted in accordance with AICPA AT 601). Both must be performed by an independent public accountant that is registered with and subject to regular inspection by the PCAOB.

For more information on these and other amendments and legislative changes that may impact your positions, please contact Phil Mandel, CPA, CFP, partner and co-director of J.H. Cohn’s Financial Services Industry Practice, at pmandel@jhcohn.com or 973-403-7986, or Jay Levy, CPA, partner and co-director of J.H. Cohn’s Financial Services Industry Practice, at jlevy@jhcohn.com or 646-254-7412.