Tax Reporting for Alternative Investments and Private Funds

Alts are commonly structured as partnerships or limited liability companies (LLCs) rather than corporations. These structures are typically taxed as pass-through entities. This generally avoids a second layer of federal income tax at the fund level.

Instead, the fund's taxable activity — including income, gains, losses, deductions and credits — is allocated directly to investors, who must then report their share on their personal or entity tax returns.

Because of this structure, investors may owe taxes even when no cash distributions are received, commonly referred to as phantom income, and reporting requirements are generally more involved than for traditional investments.

This article provides a high-level overview of common tax documents and timelines associated with many of these products. Your tax professional can help interpret how these rules apply to your individual circumstances.

The tax forms you receive depend on the fund structure, investment activity and account type.

Many privately offered Alts funds are organized as partnerships or limited liability companies taxed as partnerships. These may include funds pursuing private equity or hedge strategies, as well as feeder vehicles. Investors in these pass-through vehicles generally receive Schedule K-1 and may also receive Schedule K-3 when the vehicle allocates cross-border tax items.

By contrast, some publicly offered evergreen products, including many interval funds, are organized as corporations and elect treatment as regulated investment companies (RICs). Investors generally receive Form 1099-DIV for reportable distributions.

Investors who sold, exchanged, tendered or redeemed shares in an RIC during the tax year will receive a Form 1099-B. If an investor does not sell, exchange, tender or redeem shares during the tax year, a Form 1099-B generally is not issued for that holding.

Unlike Forms 1099-DIV and 1099-B, Schedule K-1 and K-3 tax forms often arrive after April 15. This can involve practical timing considerations for investors, since it may require filing a tax extension.

Why K-1s and K-3s often arrive later

K-1s and K-3s typically arrive later than traditional tax reporting forms due to the nature of private market and partnership investments. This can include:

• Underlying transaction complexity
• Time required for valuation finalization
• Requirements tied to audited financial statements
• Partnership tax allocation rules under IRS guidelines
  
  

This additional time supports a more accurate, audited allocation of income and gains, so the figures you ultimately file with are verified rather than preliminary. Because of this timing, investors who receive K-1s and K-3s frequently need to file a tax return extension.

• Individuals typically file Form 4868
• Entities generally file Form 7004
   

Keep in mind that an extension provides additional time to complete and file a return, but it does not extend the deadline to pay any tax owed.

Estimated vs. final Schedule K-1s and K-3s

Some funds issue estimated K-1s and K-3s before April 15 to help investors plan for potential tax payments. These estimates are intended as early guidance and tend to be based on preliminary information. As such, they are typically unaudited, rely on assumptions and preliminary valuations, and may differ from the final versions.

Even though estimates may change, they give you and your tax preparer an early, actionable starting point for tax planning well before the final figures are available.

Final K-1s and K-3s are usually released later in the year after a more extensive review and verification process can be completed. Investors should share estimates with their tax preparer early and confirm that final figures are used when filing.

Transferring your position to another account or owner, including through gifting or inheritance, can affect the tax documents you receive and how cost basis is tracked going forward. Ensure you maintain current ownership and contact records after any transfer since a records gap can lead to missing tax documents.

Differences between performance reports and tax documents are common and expected. For tax filing purposes, always rely on official tax documents, not performance reports.

Holding Alts in tax advantaged retirement accounts can offer potential benefits, but it also introduces unique tax considerations. Some Alts generate Unrelated Business Taxable Income (UBTI), often from operating businesses or debt financed income.

If UBTI allocated to a retirement account exceeds $1,000 in a tax year, the account may be required to file IRS Form 990-T and pay tax on that income. Investors should confirm whether their custodian files Form 990-T on their behalf and how state level rules may apply.

Despite this added complexity, many investors still choose to hold Alts in retirement accounts for the potential benefits of tax-deferred or tax-free growth on the remainder of the investment.

Always consult a tax advisor before investing in Alts within a retirement account.

Some Alts funds are required to withhold state income tax on behalf of nonresident investors, based on the fund's income allocations and state-specific rules. This withholding is calculated and remitted by the fund's administrator, not by Bank of America, and it is generally intended to approximate rather than exactly match, your ultimate state tax liability.

Because withholding is often based on estimated allocations early in the year, the amount withheld can end up higher or lower than what you actually owe once your final Schedule K-1 is issued. If too little was withheld, you may owe an additional payment when you file; if too much was withheld, you may be entitled to a refund. Either outcome is a normal part of how multi-state withholding works for these structures, not an indication of an error.

Your Schedule K-1 and any state-specific tax documents will show the amount withheld on your behalf. If the amount withheld looks different than you expected, your tax advisor can help you determine whether an adjustment is needed when you file.

Some funds that earn income in multiple states may require investors to file multiple state tax returns. To simplify this process, some funds offer composite state tax reporting, allowing the fund to file a single return on behalf of participating nonresident investors.

For investors who would otherwise need to file in numerous states, this administrative simplification can outweigh the trade-offs for many, though composite filing often uses the highest marginal tax rate and does not reflect your personal deductions, exemptions or losses, which is why it's worth discussing with your tax advisor. Participating in a composite return does not eliminate your tax liability. Any amount owed is typically collected through a reduction in a future distribution or through the redemption of a portion of your fund shares.

If a fund you're invested in offers composite state tax reporting, you'll be notified directly so you can decide whether to opt in or out. You don't need to track fund-by-fund eligibility yourself.

Discuss composite state tax reporting with your tax professional to determine whether it aligns with your situation.

Eligibility and how to opt in

Composite state tax elections generally apply to traditional drawdown funds and are available only for K-1 filings. When a fund participates, it files the composite return on behalf of eligible investors, who receive an election notice to opt in or out of the program. Eligibility varies by fund and by state and is determined by each fund's state footprint (typically five or more states with generated income) and applicable program rules.

Merrill clients with eligible Alts holdings may receive a consolidated annual tax reporting letter summarizing the forms expected for those holdings. This letter is a supplemental reference, not a substitute for your fund-specific tax documents, and it is designed to help you track what to expect. It lists which tax forms you should anticipate for the year and their expected mailing timeframes. This letter typically arrives in the first quarter of the year and is also available digitally through MyMerrill. Reviewing it alongside your fund-specific documents, and sharing both with your tax advisor, can help you plan for filing season with fewer surprises.