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Electing Mark-to-Market Tax Treatment in the United States
Section 475(f) of the tax code allows an active securities trader to treat all securities as: generating ordinary income or loss, and if held at year-end, marked to market (treated as sold for fair market value on 12/31 and then repurchased at that value on 1/1). Mark-to-market refers to the procedure followed at year end when all open positions are marked to market value.  In effect a sale of all open positions (long and short) is triggered for tax purposes at year end using the year end market prices.  On the first day of the following year those positions are bought back for the same market value.  his tax treatment flushes out all realized and unrealized gains and losses for U.S. tax reporting purposes.  An active trader may elect MTM for trading gains and losses and use the accrual or cash method of accounting for business expenses.

Should I Consider a MTM Election?
Only someone who qualifies as an active securities trader can elect MTM treatment. Although the MTM election can be made in a year in which you qualify as an active trader, the MTM election once made applies to subsequent years whether or not you are an active trader in later years.

Before Electing Mark-to-Market Tax Treatment
The decision making process is influenced by the fact that this election is a permanent election that can be revoked only with the consent of the IRS.  However you could still establish an investment securities account or an investment company whose positions are outside the scope of the election.   Trades in these other accounts generate capital gain or loss.  Futures contracts (such as most index options) in mark-to-market accounts are still entitled to special tax treatment. MTM is not a preferred accounting method for profitable commodities and futures traders as the default tax rates favor them: 60% long term and 40% short term capital gain. The current maximum blended tax rate on commodities and futures is 23% versus 35% on securities.  Electing MTM converts commodities and futures trading capital gains and losses (60/40 treatment) to ordinary gain and loss treatment (a 12% tax rate increase). But if you have large commodity trading losses before April 15 of the current year, electing MTM will allow the losses to be treated as ordinary.

Some Strategies for Making the Election
1. As the election is specific to the active trader, it is best made by an entity, rather than an individual taxpayer.  An S corporation is easier to liquidate than an individual.  The individual unhappy with his or her election needs to cease trading activities and become inactive (trading in the interim should be conducted through an entity) so that trading status lapses.

2. Make sure you (or your entity) are an active securities trader.  There is no bright line test for trader versus investor status based on what little legal precedent exist. Make sure you have significant portfolio turnover on an annualized basis.  Other factors (use of a margin account, options, futures, and short selling) can support active trader status.

3. The election for an active trader must be made by the original due date of his tax return for the current year with no exceptions. For a new trading entity, you must elect within 75 days of the start of trading activities, and then include the election in the entity's first tax return.

4. If your mix of positions includes both active trading and buying some positions (or taking some shorts), for the longer term you should establish an investment securities account.  This account can be at the same brokerage where your active trading account is maintained.

Compensation Planning
A manager of the offshore fund should ensure that his contracts are prepared so as to allow deferral of management and incentive fees.  Through the use of properly prepared fund documents and the use of outside directors, a fund manager will be to defer for tax purposes substantial amounts of money (e.g., both the deferred fees and earnings on the fees compounded tax free in the fund).

Need Help?
Consultations with veteran fund and international tax attorney Hannah Terhune allow you to customize your legal, regulatory, business and tax plans.  She will discuss business development, tax, accounting, reporting and business strategies that will help you with your fund formation.  Her focus is your long-term success; not selling you services you don't need.  Talk to us at the earliest stages of your plans to avoid wasted time and money.  Our focus on tax and securities law, assists with start-ups, incubators, small hedge funds and family offices, as well as establishing investment advisors. All of our legal work incorporates tax services and planning, with individualized tax, legal services and solutions to meet your  needs. We do not sell or support canned business plans like our competitors.  We offer the best value in the industry, some of the lowest prices in the world, outstanding support and customer service,no-obligation consults and free web and media content so that you can make informed decisions.  You can purchase a 30 or 60 minute consultation or by calling the office at (307) 213-4732.

International Taxes
Hedge funds should be aware of possible international filings if either they own an interest in a foreign entity or have an investor who is a non-U.S. taxpayer.  Non-compliance with international tax filings could result in significant penalties.  For example, a penalty for late filing of a return could be as high as 25% of the unpaid tax.  In addition, FATCA requires non-U.S. financial institutions and non-U.S. entities (including offshore investment funds) to provide information to the IRS identifying U.S. persons invested in non-U.S. bank and securities accounts.  The legislation is motivated by incidents of U.S. persons failing to report foreign-source income for U.S. income tax purposes. A 30% withholding tax applies on any "withholdable payment” made to a foreign financial institution (FFI) unless the FFI agrees with the IRS to take a number of specific steps pursuant to an FFI agreement.  The specific steps are designed to ensure that U.S. persons are identified and U.S. tax is imposed on their investment income.

Offshore Hedge Funds
Offshore funds are organized as corporations or trusts for marketing, tax, and legal reasons.  If U.S. investors invest in or effectively control an offshore fund, complex U.S. tax rules (and complicated U.S. filing requirements) are operable (e.g., controlled foreign corporations, foreign personal holding companies, and passive foreign investment companies (PFIC) and need attention.  Although an offshore fund generally does not have state tax issues, some states require partnerships to file state partnership tax returns if they have partners that are state residents.  This could result in an offshore fund (e.g., one with a check-the-box election in effect and a New York feeder hedge fund as an investor) being required to file a state tax return even if it has no U.S.-source income and no ECI. Some of the issues are manageable, others are not and the offshore fund may be better off skipping or significantly limiting the presence of U.S. investors. Learn More About Offshore Hedge Funds

U.S. tax-exempt investors prefer offshore funds because of tax considerations. Under U.S. law a tax-exempt investor (such as an IRA, an ERISA-type retirement plan, a foundation, or an endowment) is liable for income tax on "unrelated business taxable income" (UBTI or UBIT) notwithstanding its tax-exempt status.  This tax exposure exists when a U.S. tax-exempt investor invests in a fund that trades on margin.  In those cases where complete investor confidentiality and privacy are necessary, an offshore fund should not accept any U.S. investors (tax-exempt or otherwise) and the fund manager should not be located in the United States.

Master Hedge Funds
A master fund allows a fund manager to manage money for a broad spectrum of investors.  The master fund is organized as an offshore corporation or trust (but can be taxed as a partnership only for U.S. tax purposes via a check-the-box election filed on Form 8832). A fund manager can pool money from country-specific feeder funds in the master fund.  Trading gains are allocated to the feeder funds based on the percentage of assets under management.

International Traders
Many international traders own U.S.-brokerage accounts and wonder if they will owe U.S. taxes.  When a nonresident trader has a U.S. brokerage account, only interest and dividends earnings are subject to U.S. withholding tax.  No U.S. withholding tax should apply to capital gains.  Many brokerages will withhold taxes anyway. Nonresidents (individual or business) can file for a tax refund using a Form 1040NR and then properly structure their U.S. focused trading to prevent mistakes in the future.  In most cases, U.S. tax liability does not arise.  However, ownership in a "landed" U.S. business activity can trigger a U.S. tax bill and filing. If a nonresident trader owns a U.S.-brokerage account and spends more than 183 days in the United States (meeting either U.S. substantial presence test), U.S. source net capital gains are subject to U.S. tax.  Most U.S. tax treaties contain provisions that reduce or eliminate tax on capital gains.  The trader could also make a mark-to-market election for the trading activity to be taxed at lower rates.  Being part of a U.S. proprietary trading firm business on a K-1 or W-2 basis triggers exposure to U.S. taxation.

U.S. Taxes
The United States taxes citizens, businesses and residents on worldwide income. It also taxes nonresident individuals (meaning no green card or long-term U.S. presence) and businesses on U.S. source income at tiered rates based on net taxable income. Most other U.S. source income is taxed at a flat 30% rate through payer withholding. Withholding taxes often are reduced or eliminated in the case of payments to residents of countries with which the U.S. has an income tax treaty. In addition, certain statutory exemptions from withholding taxes are provided. Income of a non-resident alien individual or foreign corporation that is effectively connected with the conduct of a trade or business in the United States is subject to tax at the normal graduated rates based on net taxable income.

Deductions are allowed in computing effectively connected taxable income (ECI). Withholding taxes often are reduced or eliminated in the case of payments to residents of countries with which the U.S. has an income tax treaty.  In addition, certain statutory exemptions from withholding taxes are provided. U.S. source non-ECI connected capital gains of non-resident alien individuals and foreign corporations generally are exempt from U.S. tax, with two exceptions: (1) gains realized by a non-resident alien individual who is present in the U.S. for at least 183 days during the taxable year, and (2) certain gains from the disposition of interests in U.S. real estate.  The source of income received by non-resident alien individuals and foreign corporations is determined under rules contained in the Internal Revenue Code (Code).  Interest and dividends paid by a U.S. citizen or resident or by a U.S. corporation generally are considered U.S. source income.

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