Limitation on Trader Fund Losses under the CARES Act of 2020

Abstract

Hedge funds are characterized by the significant complexity of their tax attributes. In this article, the authors explain how hedge fund investors might be affected by a limitation on excess business losses codified in a new IRC Section 461(l), introduced as a part of the TCJA of 2017 and later amended by the CARES Act of 2020. In order to allocate business losses, a hedge fund must be a trader fund. They thus discuss what makes a hedge fund a trader fund, whether management and performance fees of a trader fund are deductible as a trade or business loss, and whether trader fund losses constitute passive activity losses. After explaining the relationship between hedge fund losses and business losses, they illustrate with simple examples how the new provisions of the CARES Act under Section 461(l) may affect hedge fund investors. They find that compared to the TCJA some of these new provisions are beneficial while others are detrimental to investors. On balance, Section 461(l) remains punitive, uneconomical, and unnecessary.

Key Findings

• ▪ Hedge funds that engage in frequent, substantial, and regular trading activity and intend to derive profit from short-term changes in security prices, rather than from interest, dividends, and long-term price appreciation, often make a determination that they are trader funds. However, trader fund losses might be subject to a limitation on excess business losses introduced by the TCJA.

• ▪ The CARES Act provided some much-needed clarifications of the excess business loss limitation introduced by the TCJA. On one hand, it excluded capital losses from the calculation of excess business loss, which is good news. On the other hand, it specifically disallowed using trade or business losses, including trader fund losses, to offset income from employment, which is bad news.

• ▪ Trade or business losses, including trader fund losses, can still offset employment income and income from investor activities up to a safe harbor amount. The CARES Act also clarified that excess business losses are carried over to future years when they can offset employment income and income from investor activities, this time without the excess business loss limitation.