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  2. What is an INSTRUMENT? • 1) A tradeable asset or negotiable item such as a security, a debt instrument, commodity, derivative or index, or any item that underlies a derivative. An instrument is a means by which something of value is transferred, held or accomplished. 2) A legal document such as a contract ex: option.

  3. INSTRUMENT cont’d • Basically, any asset purchased by an investor can be considered a financial instrument. Antique furniture, wheat and corporate bonds are all equally considered investing instruments; they can all be bought and sold as things that hold and produce value. Instruments can be debt (bond) or equity (stock), representing a share of liability (a future repayment of debt) or ownership.

  4. THE PLAYERS IN THE MARKET • The INVESTMENT VEHICLE (hedge fund, private equity fund, VC fund, or mutual fund). • Investment Manager/Advisor/GP • paid a management fee for investing your money. • The Investor - you, your retirement plan etc. • Other Service Providers: • Prime Brokers and Custodians • Fund Administrators • Broker/Dealer • Auditors and Tax Consultants • Attorneys

  5. Why is taxation important in the Investment Industry? • Character of income • (rate difference) • Deductibility of expenses • Timing of gain and losses • Reporting of tax basis income • Schedule K-1s • Form 1099

  6. Character of Income • Section 1221- Defines Capital Asset • Section 1222- Defines long term versus short term • Section 1(h)- long term assets are generally taxed a maximum rate of 15% • Sec. 988 – Foreign Currency G/L – Ordinary • Sec. 1256 – 60/40 & MTM • Sec. 1260 Character

  7. Deductibility of Expense • How an investor can deduct an expense depends on how the investor is classified in its dealings with buying and selling investment instruments. • Classification • Investor • Trader • Dealer

  8. Characteristics - Investor • Investors are those that seek capital gains on their investments. • Investor- is not defined in the Code or Regulations. (Look to caselaw. E.g. Holsinger) • Typically Purchase and hold investments • Investors look for capital appreciation, interest and dividends • Rare to have separate offices of personnel to assist in trading activities • Infrequent trades, longer-term trades, and or irregularity of investment activity

  9. Characteristics - Trader • Traders are professional investors that regularly buy and sell financial instruments. • Not defined in the code or regulations. (Purvis case) • Activities occupy time and labor of the taxpayer • Frequent and short-term trades • Treat activity as a trade or business • Activities generate a substantial portion of the taxpayer’s income

  10. Characteristics - Dealer in Securities • Section 475(c) defines a dealer in securities as “a taxpayer who regularly purchases securities from or sells securities to customers in the ordinary course of a trade or business; or • regularly offers enter into, assume, offset, assign or otherwise terminate positions in securities with customers in the ordinary course of a trade or business.” • a dealer generates profits from a markup or commission.

  11. Dealer vs. Trader • A dealer has “customers”, otherwise a person who trades securities with the intention of reselling those securities could claim to be holding property for sale and claim ordinary losses on the disposition of securities. • A trader has no “customers” because it does not conduct transactions with identifiable persons, but rather buys or sells securities in the open market. • Makes profit through the change in the market not through mark-up pricing on instruments or commissions.

  12. Impact of Distinction • Investment Expenses: • Investor – Investment Expenses are treated as itemized deductions and subject to the 2% of AGI limitation. • Trader – Investment expenses are deducted “above the line” with no limitations. • Dealer- Allowed to deduct investment expenses against ordinary income

  13. Distinction in Income • Ordinary versus Capital • Investor - will take advantage of capital gain rates • Trader - may take advantage of capital gain rates • Dealers of Securities are subject to the mark to market regime and are required to recognize gain or loss based in the FMV of the non-inventory securities held at the end of the year. (ordinary income only) • Section 475(a) and Section 475(d)(3).

  14. IRC Section 475(f): M-T-M for Traders In Securities or Commodities • For any person who is engaged in a trade or business as a Trader in securities and who elects to apply Section 475(f) • The person shall recognize gain or loss on any security held in connection with trade or business at the close of the tax year as if the security was sold for its FMV on the last business day of the year

  15. Tax Implications • Once M-T-M at the end of the year, the M-T-M gain or loss will be treated as ordinary income or loss and any losses are deductible in full against ordinary income from sources such as wages, salary and dividends • Trader has the opportunity to segregate stock purchases not made as a trader into a separate account the day the investment is made. Long-term capital gains rates would apply if these are long-term investments.

  16. Investment Entity Vehicle • LLC • S corporation • C corporation • Partnership • (see handout)