Each year, we send a newsletter to our clients and friends regarding Section 475(f) mark-to-market elections. A 475(f) election must be made by partnerships before March 15th of the year in which the election is to be effective and can be overlooked while people are focused on preparing prior year tax returns and K-1 estimates. A 475(f) election generally allows traders in securities or commodities to convert losses that would otherwise be capital into ordinary losses, which are not subject to the same deductibility limitations as capital losses and generally may be used to offset other income.
Section 475(f) of the Internal Revenue Code of 1986, as amended, provides that a partnership that is, for tax purposes, a trader in securities or commodities may elect to "mark-to-market" its securities and/or commodities positions and treat any appreciation or depreciation as ordinary income or loss. A partnership that is, for tax purposes, an investor is not eligible to make a Section 475(f) election.
An existing calendar year partnership must make its 475(f) election for 2024 no later than March 15, 2024. New taxpayers must make the election no later than two months and 15 days after the start of their year (e.g., April 15, 2024, for new taxpayers that started on February 1, 2024).
The determination of whether to make a Section 475(f) election became more complicated after the tax legislation enacted at the end of 2017. Net operating losses can no longer be carried back and may only offset up to 80% of income when carried forward. Further, the limitations on excess business losses under Section 461(l) may also be applicable.
A Section 475(f) election may be beneficial for a fund experiencing losses in 2024 or possibly for a fund that has significant net unrealized losses coming into 2024.
For losses in 2024, and possibly for net unrealized losses as of December 31, 2023, such losses could be converted into ordinary losses and taken in 2024 (regardless of when the positions are sold).
An additional benefit of the Section 475(f) election is that an electing taxpayer would no longer be subject to the wash sale and straddle rules.
A Section 475(f) election may also be beneficial for a fund that has significant unrealized net gains coming into 2024. For gains in 2024, and possibly for net unrealized gains as of December 31, 2023, such gains would generally be converted to ordinary (which would generally be disadvantageous), but the net unrealized gain as of December 31, 2023, would be included in income evenly over four years (that is, 25% each year for 2024 through 2027, regardless of when the income is actually realized). Even if the election converts long-term capital gains to ordinary income, the deferral benefit may outweigh the character cost (depending on when the positions would otherwise have been sold). However, an increase in tax rates during the four-year period would reduce the benefit.
Conversely, a partnership that already has a Section 475(f) in effect can revoke its election as of January 1, 2024, by revoking its election by March 15, 2024. Any appreciation (and depreciation) after December 31, 2023, would be treated as capital gain (or loss) but the holding period may include the period the securities were held by the partnership while the partnership was subject to a Section 475(f) election.
As noted in our recent newsletter on the Soroban case and the related self-employment tax planning (click here for the newsletter), some funds that have a Section 475(f) election in effect pay an incentive fee to the investment manager rather than an incentive allocation to the general partner. It may be, depending on where the investment manager does business, that an incentive allocation is more tax efficient to the manager/general partner if the existing self-employment tax planning is either limited or unavailable.
Section 475 has many nuances, and a Section 475(f) election should be made or revoked only after careful consideration and consultation with your tax advisors regarding the impact on your fund and its investors.
Originally Published 28 February 2024
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.