Prospective Wash Sales: A Competitive Differentiator for Hedge Fund Advertising Post JOBS Act
Getting new business just might have gotten easier for hedge funds. A provision in the recently signed Jumpstart Our Business Startups (JOBS) Act has now lifted the age-old ban on hedge funds publicly advertising and/or marketing themselves. Previously, hedge funds could only publicly discuss investment issues from an educational perspective and were prohibited from divulging performance stats. The SEC has yet to specify marketing/advertising guidelines. However, hedge funds, similar to mutual funds, may soon be promoting themselves by touting impressive performance figures via TV, radio, print and the like.
That’s all well and good but as we all know, past performance figures are not always a clear indicator for future results. Hedge funds will need to find new ways to differentiate themselves and value-added services could make all the difference. Here’s where hedge fund managers running tax-aware portfolio management strategies can have a big leg up on the competition.
Clearly, no one wants to pay a dime more than they need to in taxes. So if a fund can advertise that it can know the tax implications of certain securities transactions pre-trade, this could be a boon for them. Take wash sales for example. A wash sale is when a stock is sold at a loss and substantially identical securities are bought within 30 days before or after the sale. Often unintentionally triggered, this type of transaction can have negative tax consequences – the IRS can disallow the loss and the client may wind up owing taxes on a trading loss. The ability to identify transactions that can result in a wash sale before they happen (what we refer to as prospective wash sales) and then understand how that wash sale could impact realized gains and losses (i.e. what the IRS will consider disallowed losses) could be the deciding factor for some new investors in the market for their next investment.
Identifying prospective wash sales, though, is a highly complex process and requires thorough knowledge and understanding of IRC section 1091 (wash sales). A recent G2 FinTech white paper on the subject, Prospective Wash Sales, focuses on how to detect wash sales pre-trade and demonstrates how this functionality can help a savvy manager extract the maximum tax benefit for his clients. This type of pre-trade tax management ability can help attractive potential clients, especially those well-informed investors who understand that more complex securities, such as derivatives, can create some rather unexpected and nasty tax implications (Avoid Tax Surprises , Barron’s Penta).
Wash Sale, Wash Trade: A Matter of Semantics
With year one of the new cost basis reporting rules mandated by the Emergency Economic Stabilization Act of 2008 (EESA) in full effect, the term “wash sale” has appeared on countless broker-issued 1099-b forms. What with the recent Royal Bank of Canada (RBC) scandal, the term “wash trade” has also appeared splashed all over the front cover of major business publications and newswires like The Wall Street Journal and Reuters. Clearly both terms are similar and even based on the same concept — riskless transactions that have no net economic effect. However, they mean different things to different people.
According to the Commodities and Futures Trading Commission (CFTC), which uses the terms wash sales and wash trades interchangeably, wash sale is a catch-all phrase that means ‘set of riskless trades’ or any trade or set of trades that in aggregate generates no net risk for the entity executing the transactions. An example might be to buy a stock from one broker and sell it short with another broker. There is no immediate economic gain from doing this type of activity, so that immediately begs the question ‘why would anyone do this?’ The answer usually involves tax evasion or market manipulation. In its efforts to help maintain market transparency and fairness, the CFTC is always on the lookout for anyone who is doing a wash trade for any reason. The CFTC believes wash sales are used to circumvent the open market and to do ‘secret’ deals that cut out the ordinary investor.
According to tax accountants and the IRS, “wash sale” pertains to a specific section (1091) of the U.S. tax code. A wash sale is generally described as selling stock at a loss and buying substantially identical securities within 30 days before or after the sale. Section 1091 governs when a wash trade is specifically done to artificially generate short-term capital losses by selling a security and immediately buying it back — thus lowering your tax obligations. The tax code does not prevent you from doing wash trades, but rather forces the taxpayer to pay taxes as if the trades never occurred. (Please visit our Cost Basis Advisory Page at http://g2ft.com/costbasisadvisorypage.html and read some of the white papers, such as Wash Sale Implications of Short Sales and Holding Period Adjustment Methods for Wash Sales we’ve written on the topic of wash sales.)
A straddle, governed by section1092, is another specific example of a wash sale. In this case, straddles can be used to defer capital gains to a later tax year. A straddle is a pair of wash trades executed at the same time that take offsetting positions. As time passes, one position will accrue unrealized gains and the second will accrue unrealized losses. The taxpayer then closes the position with losses to generate losses at the end of tax year and buys the security back the next day. (Read Tax Implications of Straddles for more information on this topic.)
Constructive sales and dividend farms are other examples of wash sales. A constructive sale is a position with unrealized gains has a wash trade executed to liquidate it at a different account, creating a ‘box’ wherein neither security demonstrates a loss. At a point in the future, the box is paired-off and the gains are taken, but this can be deferred indefinitely. A dividend farm results when two offsetting positions (a straddle) are taken with a dividend-paying so that the short dividends are netted against either 1256 or ordinary gains and the long dividends are taken as qualified.
Regardless of the term used, both the CFTC and the IRS view wash trades or wash sales as some form of abuse, cause for scrutiny and stiff fines. So firms will need to start paying closer attention to how their trading activities might be triggering intended and unintended tax consequences.
Bizarre Wash Sale Scenarios
Sometimes, when a loophole is closed, this can lead to some pretty bizarre wash sale scenarios. Have you ever heard of a long position being used to create a wash sale when the original position was a short sale (or vice versa)?
There is a specific short sale ruling* in Publication 550 that was designed to prevent people from using boxed positions to cheat the wash sale rule. Before the addition of this rule, a taxpayer could circumvent the wash sale rule by using a box. Here is how it works. Buy Stock ABC. Some time passes. Stock ABC shows an unrealized loss. The taxpayer wishes to take the loss but keep the position. However, if they sell the stock at a loss and buy it right back, they get a wash sale. So instead of selling it, they box it, and buy another position long. After 30 days go by, they pair off the box at a loss and bang—a totally legitimate loss.
Pub 550 was enhanced to close this loophole, but it had the unintended side effect of creating some bizarre scenarios. For instance, a strict interpretation of Pub 550 dictates that you have a wash sale if the following occurs: You buy stock XYZ at one broker. However, since you have a large position, when you go to sell it, you decide to use a different broker for the sale. Since you used two different brokers, you must pair-off your two positions. The day after the pair-off, you decide to go short XYZ. A careful reading of Pub 550 states that you have a wash sale even though, in effect, all you did was change your position from long to short.
This stuff is very nasty and most of the time people don’t bother to check for it. However, if this wasn’t part of Pub 550, boxed positions could be used to circumvent the wash sales rule and cheating could run rampant.
* (Please read our white paper: Wash Sale Implications of Short Sales for more information on this topic http://g2ft.com/costbasisadvisorypage.html.)
Finding Your Wash Sales Ain’t Enough, Part 2
Similar to wash sales, straddles affect three critical things: (1) whether you have a gain or loss, (2) the amount of that gain or loss, and (3) whether or not that loss is classified as long-term or short-term. Although both can dramatically affect taxable gains and losses, right now wash sales have been getting lots of press (George Michaels, CEO of G2 FinTech is featured in FTF News: New Headaches for Tax Season). That’s because, for the very first time, brokers are required to report to the IRS partially adjusted gains and losses instead of simply presenting proceeds for securities transactions in 2011 (Emergency Economic Stabilization Act of 2008— EESA). Although brokers might meet the new cost basis requirement per EESA, what they report on the new 1099-b forms is not complete. One of the many things that taxpayers must consider but brokers do not is the affect of straddles on your taxable gains and losses.
A straddle is a set of investment transactions that simultaneously take two offsetting positions on the same underlying security; one of the two positions holds long risk and the other holds short. There are two classes of straddles: basic and identified. These categories differ both in terms of how transactions become associated into straddles as well as the amount of loss that can be disallowed. Either type of straddle can be subclassified as mixed or standard.
Section 1092 of the tax code addresses the treatment of straddles. This section of the tax code is a direct result of the infamous Silver Butterfly Case (see Finding Your Wash Sales Ain’t Enough, Part 1 (3/12/2012)), which spotlighted the use of straddles as a tax shelter. Subsequently, auditors have been required to consider section 1092 when analyzing a fund’s or a taxpayer’s gains and losses. Similarly, a tax-aware portfolio strategy must understand the effects of straddles on their holdings in order to consider unintended straddles before they can have a negative tax implication for the firm and the investor. On top of this, firms also need to understand the interweaving of straddles with other taxable events, such as wash sales, constructive sales and qualified dividends. These sections of the tax code can affect each other and, ultimately, how they impact a firm’s capital gains and losses. For more information on this topic, please visit our Cost Basis Advisory Page (http://g2ft.com/costbasisadvisorypage.html) and read G2’s latest white paper: Tax Implications of Straddles.
Finding Your Wash Sales Ain’t Enough, Part 1
The Silver Butterfly Case: A History
Highly pleasurable. Erotic. Butterfly. Straddle. These are all words associated with the colorful history of “tax straddles” in the U.S. A straddle is a set of investment transactions that simultaneously take two offsetting positions on the same underlying security; one of the two positions holds long risk and the other holds short. Historically used to avoid paying taxes, a “tax straddle” uses these two positions to construct a tax shelter in which a taxpayer artificially creates taxable losses in order to offset pre-existing gains from unrelated transactions. Through repeated use of this strategy, gains can be indefinitely postponed from one year to the next.
The most well-known case of straddles abuse is the infamous “Silver Butterfly Case.” The case was based on the actions of two investors, who, in 1973 executed 84 long futures transactions and 84 short futures transactions on silver. By the end of the calendar year, they had both significant unrealized losses and gains on the individual positions with a net profit of close to zero. The IRS decided to audit the firm and subsequently disallowed the losses.
In 1977, the IRS published a ruling (77-185) to support its decision, but unfortunately, there was no support in the tax code for it so the issue went to Washington for resolution.
When the case was brought to Congress, it sparked an epic battle between Dan Rostenkowski (Democratic Representative from Illinois) and Patrick Moynihan (Democratic Senator from New York) where Moynihan and others fought to close this loophole. At the climax of the struggle, when the issue came to a vote, Moynihan exclaimed that before learning about straddles, in particular butterfly straddles, he had assumed:
“a butterfly straddle must refer to a highly pleasurable erotic activity popular during the Ming Dynasty.”
In the end, Moynihan won and Congress added Section 1092 to the tax code via Title V of the Economic Recovery Tax Act of 1981 (ERTA).
Ultimately, Section 1092 of the tax code disallowed losses on the retired leg(s) of a straddle to the extent of the unrealized gain on the non-retired leg(s) at the end of the tax year. (Stay tuned for Part 2 of Finding Your Wash Sales Ain’t Enough).
(Source: g2ft.com)
The Reconciliation Trifecta: Workflow Efficiency, Wash Sale Reporting Accuracy and Cost Basis Compliance
Ah…new rules, new regulations. They are often times met with a mixed and not always favorable reaction. For one thing, they aren’t always easy to write. Just ask the folks over at the SEC and CFTC. In early January of this year, we learned that both regulating bodies have already missed over 140 deadlines in their task to compose all of the new Dodd-Frank rules. Perhaps more importantly, complying with new requirements can be equally daunting, often exposing shaky information systems workflows or introducing inefficiencies. Case in point: the Emergency Economic Stabilization Act of 2008 (EESA 2008) and its requirement that Brokers now include cost basis and holding period information as part of the 1099(b)s they generate for their clients. Let’s take a closer look at this.
Legacy approach for calculating wash sales
The first year of the three-year EESA 2008 rollout has just come to a close, and according to the new reporting requirements, the cost basis on the current version of 1099(b)s now must include adjustments for wash sales. Accurately calculating wash sales is no easy feat, however, in some cases, Brokers make this already complex task more challenging. This happens when they adopt an approach to tax analysis that requires gains and losses to be recalculated before the firm’s wash sale adjustments can be determined. The only way for wash sales data to be accurate is if the gains and losses calculated by the wash sale system first match the gains and losses from the Broker’s system. This simply isn’t always the case, and that spells trouble, let alone redundancies in workflow. Inaccurate reporting to the IRS could potentially lead to painful audits, hefty fines and fewer clients. Incorrect data on wash sale disallowed and re-allowed losses can result in over or underpaying taxes and an undesirable impact on the investor’s bottom line. When firms do not properly reconcile before generating their wash sale results, they open themselves up to the IRS pain-points cited above as well as unhappy clients / investors.
A Better Way – avoiding / eliminating reconciliation issues related to wash sales reporting
Well, how are reconciliation issues avoidable? How can compliance with cost basis reporting be made easier, while also having the means to determine ways to optimize profit and loss with your wash sales calculations? Arguably, the most challenging aspect of accurately determining gains and losses is the complex task of determining lot retirement— identifying which shares are retired every time a stock is sold. A Broker’s system already addresses this, and among other things, accounts for more complex transactions, such as when a series of purchases overtime has been made (as with dollar cost averaging) and/or when a sequence of sales over time has been executed. What’s new for Brokers is the wash sale engine component and how it’s integrated into their workflow process. In the case of wash sale reporting, there is a better way: a streamlined workflow process that feeds existing tax lot retirement data directly into the wash sale system, avoiding the addition of a costly, time-consuming and error-prone reconciliation step that comes along with the act of recalculating gains and losses.
In order to truly know your tax liabilities, wash sale calculators need to be fed accurate lot retirement data in order to properly identify disallowed and re-allowed losses. Otherwise, you are looking at inaccurate information flows both into and out of the system – a dilemma that could raise problems with auditors. The IRS recently announced that it audited more millionaires in 2011 than the previous year—four percent more to be exact. In 2010, eight percent of millionaire earners were audited and the number jumped to 12 percent in 2011. This begs the question: will increased audit pressure on millionaires force hedge funds to re-examine the accuracy of their tax analyses and K-1s? Perhaps now, more than ever before, compliance—accurate, efficient compliance—should be the utmost priority.
MF Global: A Case for Risk Management
Exposure to market risk can lead a firm to either positive or negative results. The challenge lies in knowing which risks to take, which to avoid and what the firm can do to best mitigate its risk. The firm must have a clear understanding of its offerings to provide the best risk management possible. As the offerings change, so do the risks involved. Often firms are driven by the potential for profits and neglect to adjust their risk management programs to account for new product due diligence and associated risk. This was the case with MF Global; as it evolved to become more like an investment bank and exposed itself to market risk, particularly European debt, its risk exposure changed as well.
MF Global began as a traditional broker dealer, meaning that all profits made were based on commissions and there were no overnight positions taken. With this type of model, risk management should revolve around counterparty and settlement risk management. The firm is only open to exposure risk during the time between the buy and sell so market risk is fairly minimal. The most important risks to consider in this case are related to counterparty risk—can the firm afford to borrow on margin and is there settlement or liquidity risk. To defend against these risks, traders should get involved in the risk management of their own trades rather than relying on it to come from the top down. They should diversify investment structures to hedge against counterparty risk.
But as firms diversify the instruments they offer, the risk management provided also gets more complicated. In the case of MF Global, it was trying to become more like an investment bank than a traditional broker dealer and thus opened itself up to the impacts of market risk. When a firm is open to market risk, it then has to consider additional market-related factors coming from outside the firm, for example, inflation and economic issues in other countries such as Greece. To mitigate risk in this new type of structure, firms should have a strong product due diligence process in place to evolve their risk processes as each new product is introduced. Internal financial controls need to be in place in order to avoid what happened to MF Global, which incurred $187 million in trading losses from betting on European debt.
As seen with MF Global, as a firm diversifies and consequently changes its risk profile, the new risks can have devastating effects. MF Global is now a $41 billion bankruptcy, the eighth largest in U.S. history. Most investors will almost always choose the investment with higher returns, instead of the one with better risk management so as profits drive processes, the instruments used to make them must constantly be assessed and reassessed and the risk management program adjusted accordingly.
Cost Basis Reporting – Are You Ready For 2012?
This November, the congressional super committee met to discuss tax reform. Despite its efforts to come to an agreement, we’ve been left to move into 2012 with the IRS no more empowered than before to collect additional taxes off of new tax policies. However, cost basis reporting requirements that are already on the books and set to continue to take effect do represent potential revenue streams for the IRS. As a result, firms might be under more pressure than ever before to get up to speed on cost basis reporting and implement the necessary solutions.
The history of cost basis reporting
In 2006, the investigative arm of Congress, also known as the General Accountability Office (GAO), estimated that 38% of capital transactions were erroneously reported. Around that same time, a paper entitled, “Debunking the Basis Myth Under the Income Tax,” by professors Jay Soled (Rutgers University) and Joseph Dodge (Florida State University) postulated that incorrect or missing cost basis data has lost the federal government roughly $250 billion over a 10-year period. Two years later, in an effort to help lower the tax deficit, President George W. Bush signed the Emergency Economic Stabilization Act of 2008 (H.R. 1424). This ushered in a new era of tax reporting requirements that now requires brokers, not individuals, to accurately report cost basis data to the IRS when calculating capital gains.
Come January 2012, firms who haven’t already done so, will need to be ready to put practices into place to remain compliant with these complicated tax regulations or face stiff penalties.
Ignorance is bliss
According to the IRS, when considering penalties, ignorance of the law is no excuse for non-compliance and so is the case with cost basis reporting regulations. Cost basis legislation came into effect decades ago to help protect against tax evasion. Some methods typically used by savvy traders to avoid a hefty tax bill include tax analysis of straddles, wash sales and constructive sales. Because of the sheer complexity of the problem, the IRS delayed enforcing all of the rules pertaining to capital gains taxation. So, businesses that think they can turn a blind eye to the cost basis reporting standard may be hit the hardest. The reporting penalties were increased by 100% under the Small Business Jobs Act of 2010 (P.L. No. 111-240), thus making compliance with this legislation increasingly important, especially for those firms that are trading in higher volumes. With such small margins, if executing a trade leads to a negative taxable event, it could be detrimental to profits. This shows the IRS is serious about collecting.
Now what?
For the first time since the legislation was enacted, custodians and brokers have had to report detailed cost basis information on equities acquired on or after Jan. 1, 2011 to advisors’ clients (on a revised Form 1099-B), as well as to the IRS. Mandatory cost basis reporting will extend beyond equities to mutual funds, DRIPs and most ETFs acquired after Jan. 1, 2012. Additionally, The Emergency Economic Stabilization Act of 2008 (H.R. 1424) requires issuers and intermediaries, as part of their information reporting responsibilities, to submit accurate and timely recognized gains and losses along with cost basis information. These rules shift the burden of calculation for gains and losses from taxpayers to the brokers. Furthermore, for those brokers who report inaccuracies, the penalty of noncompliance is somewhere in the neighborhood of $50 to $250,000.
Firms further behind the technology curve certainly have an uphill battle ahead. Currently, cost basis reporting requirements are typically addressed by outsourcing the task to a third party — which could be quite costly. Furthermore, accountants generally aren’t the biggest fan of change, even when it comes to updating outdated excel spreadsheet processes to sophisticated technology that will make their jobs easier. Firms should focus on investing their resources in solutions that will not only stand the test of time, but will be nimble and flexible enough to adapt and grow with them as future regulations are passed. Getting everyone on board with the change may prove to be the most difficult part.
Many firms already have the necessary solutions in place in order to comply with these new reporting requirements. For those firms who have yet to begin this process, regardless of the manner in which they choose to address cost basis reporting, new software must be implemented as soon as possible. The implementation process for any new software is often lengthy and time consuming, particularly since it must be properly integrated with any legacy systems.
With the next wave of cost basis reporting requirements set to take effect in just a few weeks, firms need to stop burying their heads in the sand and get prepared. Since the bipartisan super committee failed to agree on a 10-year federal deficit reduction plan, automatic across-the-board spending cuts to domestic and defense spending to the tune of $1.2 trillion are now scheduled to kick in by 2013. President Obama has promised to veto any efforts to do away with these automatic cuts. As a result, in 2012, in an effort to close the tax gap and collect more revenue, the IRS will focus heavily on enforcing existing tax regulations . Failure to meet these reporting requirements could potentially result in the imposition of costly IRS penalties and lost business from dissatisfied customers.
Form PF: Regulatory Reporting Requirements Bring New Challenges
It’s official; the SEC and CFTC recently approved the new reporting requirement, Form PF, which calls for advisors to private funds (including hedge funds, private equity, liquidity funds and mutual funds) to report information on trading volumes, liquidity exposure and counter-party risk to the SEC for review by the Financial Stability Oversight Council.
In the wake of the 2008 financial crisis, it’s clear that Congress and the SEC feel they need to step up their game by paying more attention to Wall Street and the financial system. The ultimate responsibility of these regulatory bodies is to keep abreast of the hidden exposures that were not entirely clear in 2008 and in the end decrease market risk and increase transparency. More so, it’s become apparent that the SEC is trending toward expanding the scope of required information to be considered during an audit.
Form PF is one reporting requirement that firms should be ready for in 2012, and it may play an integral role in the further systematization and integration of a firm’s internal operations and external reporting systems. As firms prepare, gathering this detailed information requires careful thought and analysis of data, sometimes from disparate sources.
There were expectations that the SEC and CFTC review of the proposed Form PF would alter the regulation considerably; nevertheless, it’s substantially the same as last February’s ruling that the industry widely regarded as onerous. The CFTC did, however, modify the thresholds for filing and divided them into two tiers: Annual filing – minimum of$ 150 million, and what’s more burdensome – quarterly filing –$ 1.5 billion minimum. This could be mind-numbingly complicated for filers with assets under management above $1.5 billion (who must file the additional sections 2-4 on a quarterly basis), depending on the asset classes traded.
To help prepare, funds will benefit from a systematic approach to the regulation. Reducing the chance for manual errors while simultaneously adding a layer on data integrity cannot be done sans technology. Firms without technology in place to process this data are looking at somewhere in the neighborhood of 10-20 manual hours of labor to properly comply with the requirements depending on the size of the fund. For these reasons, it’s essential to thoroughly understand “the plumbing” and portfolio accounting systems and how they interrelate with each other and develop an action plan now.
To Mark-to-Market, or not to Mark-to-Market
A manager of a hedge fund, like any business owner, has to balance revenues versus operating expenses. For any manager, the three biggest costs are compensation, real estate and professional services. The first two usually cannot easily be changed, but the third will frequently be put under a microscope because, face it, managers can be very cheap.
Professional services fall under two primary categories, accounting and legal. Legal fees are usually sporadic and result from changes in the business such as the opening of a new fund or a law-suit. Although you can haggle with your lawyers over rates, the work ultimately always needs to be done and all the wishful thinking in the world is not going ot bring your counsel’s fees down to where you want them.
Accounting, however, is a different kettle of fees. One of the biggest blocks of expense is annual preparation of investor’s K-1’s. The single biggest factor in the expense for this preparation is the tax analysis portion. Determining exactly how much ordinary, realized, long-term vs short-term, qualified dividends, constructive sales etc. there are can be a huge task with a hefty price-tag. So the manager contemplates a 475 (mark-to-market) election. By signing a single document, that huge pile of fees that you pay to your accounting firm goes away and the K-1 will just show a single number, ordinary income.
So why not pull the trigger? To this, the manager has to ask themselves one question: “do you feel lucky? well, do you?” Because your clients who pay taxes will have a much heavier tax bill than they used to. So if your returns are great, let’s say North of 20%, then your clients will probably grumble a little. However, if your returns are more like 10% (after management and performance fees), and Mr. Obama grabs 40% of that number (after the Bush tax cuts expire), then your poor investor is going to be majorly ticked off. It’s even worse if they live in a state like New York where they grab another 10%. So if you think you can top 20% consistently, then by all means, cut your accounting fees by over half because an after tax return of 10% is going to top any Muni investments your clients might make. But if you think 5% after tax is going to make their day, you can kiss that investor goodbye as they run for the relative safety of a Johnston, RI Muni-bond with an after tax yield of 4.7%, no volatility and an A2 rating (I am not making this up).
