Hedge fund managers evaluating whether to make a Section 475(f) election to mark securities or commodities to market may be affected by potential changes to regulations the IRS is reportedly considering, including a "freeze-and-mark" model for Section 475(f).

Background

The existing regime under Section 475(f) allows hedge funds that qualify as traders to elect mark-to-market treatment of their securities and/or commodities. For existing entities, under the current rules, partnerships can elect into Section 475(f) no later than the due date, without regard to extensions, of the original income tax return for the tax year immediately preceding the election year. Taxpayers would file a statement with the extension or tax return, and request a change in accounting method.¹ For example, a calendar-year partnership making the Section 475(f) election for tax year 2016 should attach a statement to the entity's extension or tax return for tax year 2015 that is timely filed on or before April 15, 2016. New taxpayers must make the election by placing a statement in their books and records, no later than two months and 15 days after the first day of the election year. Beginning in 2015, taxpayers may also automatically revoke existing Section 475(f) elections.²

The current rules require existing taxpayers making the mark to market election to calculate a Section 481(a) adjustment as of the last day of the tax year for their old method of accounting. The amount of this adjustment is calculated as the difference between the cumulative taxable income that the taxpayer recognized under its old method of accounting (non-Section 475(f)) versus the amount of taxable income it would have recognized had it always been on its new method of accounting (Section 475(f)). This amount is generally the difference between the fair market value of the securities held and their tax basis as of the last day of the tax year immediately preceding the election year, including any previous tax basis adjustments or deferrals. If this amount is an increase to income, the taxpayer may spread the increase over four years, beginning with the year of change, under the rules of Section 481(a). If the amount is a decrease to income, the taxpayer can recognize that entire decrease the first year that the election is in effect.

There has been a lack of guidance as to the character of this Section 481(a) adjustment. Many taxpayers have taken the position that this adjustment should receive ordinary income or loss treatment. Funds with high trading volume and fairly short-term holding periods sometimes elect to mark to market because their positions rarely result in long-term capital gains and could otherwise produce negative book-to-tax timing differences.

Potential new regulations

According to recent comments from IRS official Robert Williams³ as reported by Tax Analysts,⁴ the regulations being considered would include a "freeze-and-mark" rule whereby the taxpayer would immediately recognize gain or loss upon election. That would eliminate the need for a Section 481(a) adjustment. While a taxpayer would have the flexibility to make this mark-to-market election at any point during the year, this rule would require built-in gain or loss in the assets to retain the pre-election character (long-term, short-term, ordinary, etc.), although gains and losses arising economically after the change would be ordinary. If implemented, this would remove any uncertainty as to the tax character of the built-in gain or loss upon election.

It is unclear when or how taxpayers would notify the IRS that they are making the mark-to-market election given that IRS Service Centers normally process forms only at certain times. It is also unclear as to the timing of recognition of this "freeze-and-mark" amount. The IRS may require taxpayers to immediately recognize the "freeze-and-mark" amount in the year of election, removing the ability to spread a positive adjustment (unrealized gain) over four years. Should these new rules be implemented for Section 475(f) elections, it will be interesting to see if the rules for the newly added automatic revocation of Section 475(f) elections will be changed to conform to the new timing rules for electing into Section 475(f).

Implications for hedge funds

These new regulations would potentially allow for more flexibility as to when a mark-to-market election may be made. It will, however, require taxpayers to take the existing character of income into consideration when computing the "freeze-and-mark" adjustment at the time of election. The new rules will also potentially change the timing of income recognition. The IRS will need to address the transitional period for implementing these regulations for taxpayers that have already made, or plan to make, a Section 475(f) election for tax year 2016.

We would expect the IRS to implement rules enticing more taxpayers to elect into Section 475(f). it is unclear, however, whether these changes will encourage or discourage taxpayers to make the election after the initial year of operations. With the newly implemented revocation rules, the IRS may find more taxpayers electing into Section 475(f) in their initial year of operations and potentially electing out at a later time.

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ENDNOTES

¹ Revenue Procedure 99-17 provides rules and procedures governing elections under Section 475(f). The election is an automatic change under Section 446 and does not require the consent of the secretary.

² Revenue Procedure 2015-14 provides for an automatic method change to revoke previously made Section 475(f) elections. Previously, taxpayers could request permission to revoke the election only as a non-automatic method change.

³ Branch 3 Senior Counsel, IRS Office of Associate Chief Counsel (Financial Institutions and Products). Mr. Williams is retiring this month.

⁴ "IRS considering 'freeze and mark' for trader election," 2016 TNT 12-3 (Jan. 20, 2016).