Question

How do traders treat swap income and expenses and how do investors treat swap income and expense. There is a major difference, what is it?

Answer 1

How do traders treat swap income and expenses

Treasury Regulation Section 1.162-1(a) states that business expenses deductible from gross income include the ordinary and necessary expenditures directly connected with or pertaining to the taxpayer’s trade or business. This issue could become very important for partnerships that take the position that they are traders for income tax purposes. As traders, the net swap payments would be treated as an expense incurred in a trade or business and deductible under Section 162 and Treasury Regulation Section 1.162-1(b) (8). The expense would flow through to the partners and, in effect, would be deductible by the partners. However, if it is determined that the partnership is really an investor and not a trader, the net payments made under the swaps would fl ow through to the partners as investment expenses and would not be deductible at all.

How do investors treat swap income and expense

When determining how to handle the tax treatment of the income and deductions at the investors level. This article will help you navigate and understand how certain items would impact the tax treatment at the investors level. The first step in determining the proper treatment of income and expense items is to identify whether the partnership is a investor fund, or fund of funds.

The determination, which is made at the partnership level, as to whether a hedge fund is a trader fund or an investor fund is based on facts and circumstances. Because there is no definition provided by either the Internal Revenue Code (“IRC”) or Treasury Regulations, the guidance comes from case law or audit manuals. Courts usually look at the nature of the income, frequency and regularity of the transactions and investment intent. Generally, a trader fund is engaged in the trade or business of trading securities. A trader is a professional investor frequently buying and selling financial instruments to seek profit. An investor typically purchases and sells financial instruments with the intent to hold securities for a longer period for capital appreciation. It is important to note that long-term investment strategies would not necessarily negate a fund from being treated as a trader fund, given other factors to consider.

Fund of funds invest in a number of underlying hedge funds that could be a mixture of both trader and/or investor funds.

Difference between traders and investors

Trader Funds: Income and expenses from trader funds may be reported on Schedules K-1 in various ways. Items could be reflected in Boxes 1 through 9b, Box 11F (other income), and 13W. You might also see all trading activity reflected in Box 1 or Box 11F with a footnote detailing each item such as interest, dividends, and capital gains or losses. In this case, you would need to break out such income accordingly on the Form 1040. You might also notice management fees and other trade or business expenses in Box 13W footnotes.

Investor Funds: Investor fund K-1s are generally more straightforward. The majority of income and expenses are reported on the face of the K-1 in Boxes 5 through 9b, Box 11A (portfolio income), and 13K (portfolio deduction 2% floor).