Tax Trends in Investment Management: Fund and Adviser Update

The investment management industry is constantly evolving, driven by regulatory changes, market dynamics and innovative financial products. At the recent Cohen Client Conference, we explored several key tax trends impacting mutual funds, ETFs, private equity and hedge funds. Below is an update on these trends and their implications for funds and advisers.

ETFs and Mutual Funds: The Rise of ETF Share Classes

An ETF share class is a new structure that allows mutual funds to offer shares that trade like ETFs. Vanguard pioneered this approach in 2001, and it has gained traction as a way to revitalize traditional mutual funds, which have lagged behind ETFs in overall growth.

Advantages of ETF Share Classes

• Tax Efficiency: Contributions and redemptions in-kind are applied at the fund level, reducing capital gains for all share classes.
• Regulatory Scrutiny: The SEC is closely monitoring these structures to ensure they benefit all shareholders, not only a select few.

Interval Funds: A New Investment Vehicle

An interval fund is a type of closed-end mutual fund that offers to buy back a portion of its shares from investors at regular intervals, such as every three, six or 12 months. This structure allows the fund to invest in less liquid assets like private equity, hedge funds and catastrophe bonds, while providing periodic liquidity to shareholders.

Advantages of Interval Funds

• No Schedule K-1: Investors receive simpler tax reporting.
• State Filings: The fund handles state filings, easing the burden on investors.
• Accessibility: Interval funds are open to all investors — not only those that meet the income and asset requirements needed for private equity.

Challenges and Considerations

• Compliance: Interval funds must adhere to regulated investment company (RIC) tax rules, including gross income, diversification and distribution requirements. This allows the interval fund to issue Form 1099s to its shareholders, as opposed to Schedule K-1s.
• Structuring: Starting as a partnership can help manage underlying assets and income before converting to a RIC.

Private Equity and Hedge Funds: Carried Interest Debate (Loophole or Rule?)

Carried interest allows fund managers to receive a share of profits taxed as capital gains rather than ordinary income, creating a potential significant tax advantage. Critics argue this is a loophole, while others see it as a legitimate application of existing rules.

Recent Changes and Future Prospects

• Current Rules: Profits interests connected to property held for more than three years qualify for capital gains treatment.
• Potential Reforms: Proposals range from taxing all income as ordinary, to modifying Internal Revenue Code (IRC) 1061 to close existing loopholes.
  • NOTE: On Monday, May 13, 2025, the House Ways and Means Committee released “The One Big Beautiful Bill,” which in its current form has no mention of carried interest. Of course, this is still subject to change as the bill continues through the legislative process.

Secondary Market Purchases in the Fund-of-Funds World: Navigating Withholding Requirements

A secondary market purchase in the fund-of-funds world — either private equity or hedge fund — involves buying and selling pre-existing investments. This differs from the primary market, where funds are raised directly from investors. In the secondary market, investors can sell their stakes in the investment to other investors, providing liquidity to the sellers and opportunities for buyers to acquire mature assets with potentially shorter holding periods and lower risk profiles, often at a discount.

Key Considerations for Buyers

• Effectively Connected Income (ECI): Buyers must withhold 10% of the amount realized, including the purchase price and the seller’s share of partnership liabilities.
• Liability for Under Withholding: Buyers are responsible for any under withholding, making due diligence crucial.

Strategies to Mitigate Withholding

• Certifications: Sellers can provide certifications to reduce or eliminate withholding, such as proving they are not foreign or that they did not realize a gain.
• Tax Treaties: Leveraging tax treaties can reduce withholding rates for foreign investors.

The investment management industry is never static. With constant regulatory changes and new financial products, it’s essential to embrace this momentum by staying informed of and adaptable on key tax issues. Whether it’s the rise of ETF share classes, the introduction of interval funds, or the ongoing debate over carried interest, these trends highlight the dynamic nature of the industry.

Contact Lisa Long or a member of your service team to discuss this topic further.

Thank you to our panelists for participating in this session: Franziska Hertel, Partner, Ropes & Gray; James Kaptur, Senior Manager, Cohen & Co; Jay Laurila, Partner, Cohen & Co; and Peter Smith, Senior Manager of Investment Tax, Artisan Partners.

In this blog Cohen & Co is not rendering legal, accounting, investment, tax or other professional advice. Rather, the information contained in this blog is for general informational purposes only. Any decisions or actions based on the general information contained in this blog should be made or taken only after a detailed review of the specific facts, circumstances and current law with your professional advisers.