When net means gross, and other things hedge funds should know for 2013.

• Author: Chen, Sam

Investors in hedge funds may be subject to higher federal tax rates and the new 3.8% net investment income tax (also known as the unearned income Medicare contribution tax) in 2013. Dividend income received by individuals in the highest income tax brackets is subject to an 8.8 percentage-point increase in federal tax, resulting in a top marginal tax rate of 23.8% on dividend income. Taxes are on the rise for other investment income as well, as most investment income earned by hedge funds is subject to the net investment income tax.

Qualified Dividend Income

More favorable tax treatment of qualified dividend income (QDI) than for ordinary income was made permanent by the American Taxpayer Relief Act of 2012, P.L. 112-240. However, high-income taxpayers must pay a higher tax rate on dividends starting in 2013. The rate upon which QDI is taxed increased for noncorporate taxpayers from 15% to 20%, to the extent the taxpayer's taxable income from all sources exceeds $400,000 for single filers, $450,000 for married taxpayers filing jointly, $425,000 for heads of household, and $225,000 for married taxpayers filing separately.

Even though the tax rate increased for some taxpayers, the types of dividends that are treated as QDI did not change. QDI generally includes dividends received during the tax year from domestic corporations and qualified foreign corporations, but it excludes dividends from certain tax-exempt corporations. In addition, QDI includes only dividends received with respect to a share of stock that is held for more than 60 days during the 121-day period beginning 60 days before the ex-dividend date (or for certain preferred stock, more than 90 days during the 181-day period beginning 90 days before the ex-dividend date). A dividend is not QDI to the extent a taxpayer is under an obligation, whether pursuant to a short sale or otherwise, to make related payments with respect to positions in substantially similar or related property.

Net Investment Income Tax

U.S. investors in hedge funds that are engaged in a trade or business of trading in financial instruments, including stock or commodities, are subject to the net investment income tax, which is applied to gross income, less deductions allocable to such income, but not reduced by realized or recognized losses, if proposed regulations are finalized in their current form.

The Health Care and Education Reconciliation Act of 2010, P.L. 111-152, added Sec. 1411 to the Code imposing...