Tax News
The Section 1411 Net Investment Tax is Around the Corner
April 17, 2012
Administrative Actions
Section 1411, which was enacted with the Health Care and Education Reconciliation Act of 2010, will impose a 3.8% tax on net investment income earned by individuals. The tax is designed to mimic the SECA tax imposed on self-employed service providers. One group of taxpayers who will be affected by the tax includes fund managers and investors in private equity and hedge funds. The tax is scheduled to come into effect at the end of this year. What prompted me to write about this tax was a recent news bit by Shamik Trivedi of TNT who reported that the Government will release proposed Section 1411 regulations soon. The article further quoted IRS officials saying that the upcoming guidance will be comprehensive and will answer many questions regarding the tax.

As I suggested above, it is clear that the tax will capture most income derived from hedge funds and private equity funds. This will include both carried interest income allocable to managers and other types of income such as interest and dividends allocated to investors. In this regard, there are a few issues that I think the upcoming guidance should address. First, some practitioners have reasoned that certain fund structures such as foreign QEFs might avoid the tax altogether or at least produce lower net investment tax compared to domestic fund structures. These structures rely on some uncertainties of the definition of dividends in the PFIC/CFC context and also on the peculiarities of QEFs, which allocate income based on E&P. It would be helpful if the upcoming guidance clarifies the application of the tax to offshore funds, other than those treated as partnerships for U.S.purposes. Second, it would be helpful if such guidance clarifies whether, if at all, the trade or business of the manager of the fund, or of the fund itself, has any implication on the imposition of the tax. In a recent NYSBA comment, the NY Bar suggested that depending on the trade or business status, there may be some disparate treatment between single UTP funds (i.e. where a single entity holds both the carry and the management fee) and split UTP funds (where a separate non-trade or business entity holds the carry). Also, the NYSBA pointed out that there should be no difference in the treatment of hedge funds (typically engaged in a trade or business) and private equity funds (typically not in a trade or business but considered merely investors). While logic seems to dictate that, as applied to the investment fund industry, the application of the net investment tax should not be dependent on the particular structure of the fund and on the fund’s trade or business status, a clarification of these questions will be more than welcome.  Lastly, I am curious whether, and if so, how, the tax will apply to certain products such as offshore private placement insurance (OPPI). These products have become popular among high net worth managers and LPs, particularly those participating in hedge funds. Insurance proceeds are generally not taxed and cash surrenders are not treated as a capital asset.  It would be helpful if the upcoming regulations clarify the treatment of these types of insurance contracts as well.
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Tags: net investment tax, offshore private placement insurance, OPPI, Section 1411