Surprise IRS Hedge Fund Ruling Could Mean Big Tax Bills

November 6, 2002 (PLANSPONSOR.com) - Investors who put money into hedge funds through life insurance policies could get hit with a hefty tax bill after the government ruled that the hedge fund returns are not tax free.

That’s despite assurances from insurance companies when they sold the product that the returns would be sheltered from the tax man, the Financial Times reported.

The Internal Revenue Service (IRS) ruling, issued in response to an insurance company request, is a major hit for the hedge fund industry, which is already facing an investigation by the US Securities and Exchange Commission (SEC).

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To maintain the tax-free status, hedge managers will have to set up separate funds to be sold purely through insurance companies, the Financial Times said. This will make it more complicated for hedge funds to tap into smaller, private investors through annuity products.

“This is pretty embarrassing for insurance companies that set up the arrangement that did not get a favorable ruling and will make it more complicated for hedge funds,” Lee Sheppard, a contributing editor to Tax Notes, a weekly tax journal, told the Financial Times.

Normally, hedge fund gains for US investors are taxed as ordinary income. By wrapping hedge fund investments into tax-favored life insurance or annuity contracts, life insurance companies believed the returns could be sheltered, according to the Financial Times.

Insurance companies can bring small investors into hedge funds, which otherwise have to register with the SEC in order to be able to sell directly to individuals.

Hedge fund managers said the IRS’s private ruling, has left investors uncertain about the tax implications.One hedge fund manager said it was still unclear whether investors would be hit with large tax bills.

The SEC is investigating hedge funds following a spate of fraud cases and the spread of hedge fund products to retail investors, who regulators fear might not understand the risks associated with such sophisticated products, according to the Financial Times. (See  SEC Widens Hedge Fund Probe ).

IRS Says Ignore Sunset on 415 Limit Calculations

October 18, 2001 (PLANSPONSOR.com) ? Defined benefit plan administrators should assume that the liberalized dollar limit under Section 415 remains in effect for plan years after December 31, 2010, Internal Revenue Service officials said this week.

As a result, when figuring projected defined benefit amounts, plan sponsors should ignore a sunset provision enacted this summer as part of tax-cut legislation that calls for a return to earlier laws as of 2011, the IRS said in Revenue Ruling 2001-51.

Tax code Section 404(j) provides that benefits or contributions in excess of Section 415 limitations are not taken into account in computing allowable deductions under Section 404(a).

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“Until further guidance is provided, a participant’s benefit will be tested for the satisfaction of the Section 415 limitations using the limits currently in effect and applicable to the participant,” IRS said.

The sunset provision has caused controversy in the employee benefits industry because many defined benefit plan calculations have a scope of several years and professionals have been uncertain how to treat the sudden law change in 2011.

The Economic Growth and Tax Relief Recovery Act of 2001 increased under tax code Section 415 the maximum defined benefit from $90,000 to $160,000, indexed for inflation.

It also upped annual contributions to a defined benefit plan from $35,000 or 25 percent of compensation in 2001 to $40,000 or 100 percent of compensation beginning in 2002.

For purposes of nondiscrimination testing, increased benefits provided to an employee under a defined benefit plan as a result of Section 415 increase must be included as increases in the employee’s accrued benefit and most valuable optional form of payment, and in the computation of both the normal and most valuable accrual rates for any measurement period that includes the year of the increase.

Increased contributions to defined contribution plans must be taken into account for the plan year for which the increased allocations are made or purposes of nondiscrimination testing, IRS said.

 

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