It’s all about IRA, Section 1256, wash sales, and PTET!

I write this blogpost on April 7 2023, roughly a week before the US tax filing deadline. So here’s a reflection on how OptionAgent helps to minimize taxable gains on your fund investment, and extra steps you can take to further improve your tax situation.

Of course it has to be stated upfront that for tax reasons an investment in the fund from a retirement account (IRA or Roth IRA) is the ultimate best. While an IRA can allow invested money to grow tax-free and only incurs a taxation at the time of a qualified withdrawal, a Roth IRA can even avoid taxation at the time of a qualified withdrawal, making all capital gains over the full lifetime of the account tax-free. A comparison of both can fill (more than 1) article by itself, so suffice to say here that it is possible to invest (Roth) IRA money into our fund. But likely, if your IRA custodian is a large financial institution, they won’t provide you the option to invest in a private hedge fund. The solution is to open a ‘self-directed IRA’ with a specialized trust custodian, do a tax-free rollover of (some of) your IRA cash, and then instruct the new custodian to invest in our fund. As an investor you can have separate taxable and tax-free capital accounts in the fund simultaneously. Both are accounted for separately with the IRA capital account growing tax-free. We can refer any investor to one of several self-directed IRA custodians we have worked with already to successfully setup such investments in our fund.

In the remainder here we’ll just consider the case you are investing from a taxable account.

All investors in the fund are limited partners in the Fund’s Limited Partnership (OptionAgent Capital Partners LP) legal entity. This means any gains from the fund to the investor are received out of the LP entity. The LP entity files an informational tax return each year to report the aggregate capital gains and the distribution to each limited partner based on their % participation in the fund. But since a Limited Partnership legal entity is a pass-through entity for taxation, the fund itself does not pay taxes on the gains of each investor. Rather, next to the Form 1065 filed by the fund as part of its informational tax return, we provide a Schedule K1 to each investor outlining their share distribution from the partnership. The investor is then to report this as part of their own tax return.

Now you may reasonably think, since the fund follows a very active trading strategy in financial call & put options, that fund taxation is based 100% on short-term realized capital gains, taxed at the tax payer’s marginal tax rate. However that’s not the case. The OptionAgent fund invests typically (and actually exclusively to date) in the kind of options that are traditionally used by institutional investors to hedge existing equity portfolios. Probably because of very successful lobbying by the finance industry in the past, the IRS has a special designation for these type of financial instruments: “Section 1256” contracts.

Rather than being taxed based on realized gains, these contracts are taxed “marked-to-market”. Literally it means that taxation occurs based on the comparison of the aggregate value in the portfolio of these contracts at the end of year vs start of the year. So yes the bad news is you are taxed on both realized and unrealized capital gains. But the much better good news is that no individual sales are reported, only the annual aggregate gains, AND that those aggregate gains are always taxed at a 60% long-term rate and 40% short-term rate, irrespective of the holding period of any position within the portfolio of ‘Section 1256’ contracts!

Secondly, again since no individual sales are being tracked, wash sale rules do not apply. A wash sale results when a sale of a financial instrument is followed by a purchase of a fundamentally similar instrument less than 30 days later. This would occur very frequently in any active trading strategy. The wash sale rule limits the ability to take long-term capital gain losses even when an asset was held for over a year. As wash sales ripple through the year (eg if you use a covered call strategy where each month you sell a new covered call on the same underlying stock) it is frequently the reason why portfolios need to revert to cash towards the end of the year, and keep it in cash until end of January of the next year, as the 30-day rule is both forward and backward-looking. But again, no individual sales reported with ‘marked-to-market’ so no wash sale reporting either for OptionAgent!

The 60/40 tax treatment can make a huge difference for an investor’s federal tax filing (many states such as California do not have a lower tax rate for capital gains so then there is no advantage for the state tax filing). Let’s take an example of a $100,000 gain in the fund for an investor at the highest 40.8% (37% + 3.8% tax on net investment income) bracket and likely then also with a 23.8% (20% + 3.8% on net investment income) long-term tax rate: the investor would pay $30,600 ($60Kx0.238+$40Kx0.408) in federal taxes on those $100K gains from OptionAgent, while a similar (realized) gain from a similar active investment strategy in other instruments would result in a $40,800 tax bill. That’s a savings of over $10K, or 25% (=10.2/40.8), annually in federal taxes! And of course much more as time progresses due to compounding.

IRS Form 6781 is used to report gains from ‘Section 1256’ contracts. Filing your federal taxes for OptionAgent gains is as simple as copying onto this form the amount we report to the investor on the Schedule K1. The form instructs to calculate the 60% LT / 40% ST split, and then those two numbers go onto the investor’s Schedule D form and are added to LT & ST capital gains from other sources.

But wait, there’s more if you live in a high-tax state…

When congress enacted the TCJA (Tax Cuts and Jobs Act) in 2017, the SALT (State and Local Tax) deduction became limited to $10K, known as the ‘SALT cap’. In states with high state and property taxes, this is a severe setback for tax payers who itemize deductions as any amount above $10K from the aggregate of state and property taxes can no longer be deducted from federal income. If “married filing separately”, each spouse is even limited to only $5K!

However the SALT cap only applies to personal income, not entity income… As a workaround several high tax states (California, New York, New Jersey, and others) instituted the ability to tax income received from a pass-through entity, such as the Limited Partnership of the OptionAgent fund, at the entity level. This then lowers the ‘distribution’ on the Schedule K-1 for the investor and thus the federal reportable income, effectively still yielding a 100% federal tax deduction for the amount of state tax paid.

Here’s how it works in case of an investor who resides in California, subject to California state tax. In the taxable year itself, by June 15, the fund needs to do a state filing in which it reports the limited partners (investors) who elect to use the PTET provision (as the default is that taxes are NOT paid at the entity level). We thus ask each of our investors who are subject to California state tax if they want to make use of this provision prior to June 15 (we would inform fund investors in other states who may benefit from PTET as well but the specifics here apply to California). If they do, then by June 15 of the taxable year the fund pays $1,000 or 50% of the prior year’s amount, whichever is higher, of the state taxes from the fund source to California. The California PTE tax rate is a flat 9.3%. The remaining tax due is then paid again by the fund by the tax filing deadline of that taxable year, i.e. by ~April 15 the year afterwards. Both transactions are recorded as withdrawals from the investor’s capital account in the fund.

The investor can then claim the PTET paid by the entity for the taxable year as a credit (not a deduction, so a 100% dollar for dollar benefit) on that year’s tax return, making it a zero operation for state tax. If the credit is higher than the state tax due, the remaining credit carries over to the next year. In California, you claim the PTET credit on state tax Form 3804-CR.

Since the PTET resulted in withdrawals from your capital account, this will also result in a lower Schedule K-1 distribution for the years in which the amounts were paid by the fund. And thus a lower reportable income for federal taxes, providing effectively still a 100% deduction for state taxes paid on the investor’s federal income, bypassing any limitation from the $10K SALT cap.

The above procedure stays in effect at least until 2025 and presents a major opportunity to lower taxation from gains obtained from a fund entity as OptionAgent vs similar gains made in an individual brokerage account.

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