While nobody invests in a fund with the intention of losing his or her investment, inevitably, it sometimes happens. Fund investments, like any other investment, can decline substantially in value. When substantial losses occur investors need to make the best out of a bad situation. Often this entails achieving the best and most valuable use of the loss for tax purposes.

Unlike publicly traded securities, fund interests often have limited and/or restricted liquidity. This fact can make crystallization of the tax loss extremely difficult. But even if the fund interest has immediate liquidity, investors may want to stop and consider their tax options for the loss.

A sale or redemption of a fund interest is typically treated as a capital loss to the investor (assuming the partnership interest was held as a capital asset, which is generally the case). Capital losses for a U.S. individual are limited to capital gains plus $3,000 per year as a deduction against ordinary income. Since capital gains are taxable at 20% (assuming a high income earner, plus 3.8% net investment income tax), while ordinary income is taxable at 39.6%, it is usually more advantageous to take the loss as an ordinary loss as opposed to a capital loss.

Investment losses can be taken in several ways depending on the nature of the investment and magnitude of the loss. Fund interests can be sold or redeemed, declared worthless or simply abandoned. As stated above, an outright sale (to a third-party or via redemption), is typically treated as a capital loss. Likewise, a worthless security deduction will generally result in a capital loss if the security is a capital asset in the taxpayer’s hands. However, in order to claim a worthless security deduction the investor must be able to demonstrate that the security has no demonstrable monetary value. Simply showing a large or even catastrophic decrease in value is not enough. The security must be devoid of

value. This is typically demonstrated by some objective event such as bankruptcy, default, revocation of licenses, etc.

Historically, an investor with a large loss in a fund interest (but one that still has some value), could affirmatively abandon its fund interest and claim an ordinary loss for the full amount of tax basis. The IRS had ruled that this was the correct tax treatment in Revenue Ruling 93-80. The investor would abandon its interest by notifying the partnership in writing that it no longer wished to be treated as a partner and was giving up any and all rights to its capital and profits interest to the partnership.

Recently, the U.S. Tax Court ruled that an abandonment loss was more properly treated as a capital loss than an ordinary loss. Pilgrim’s Pride Corp. v. Commissioner, 141 T.C. No. 17 (2013). The Tax Court found that pursuant to Internal Revenue Code Section 1234A the abandonment resulted in a termination of a right with respect to a capital asset and thereby resulted in a capital loss. Many practitioners think the case is wrong on the law but investors need to be aware. This case is good precedent in the Tax Court, however is yet unclear if the IRS will elect to pursue the court’s line of reasoning in its audit process. The IRS did not affirmatively utilize a Section 1234A attack on the transaction at issue in Pilgrim’s Pride. Rather, the issue was briefed at the request of the Tax Court judge. The taxpayer has requested a review of the case by the full court.

The Pilgrim’s Pride case involved the abandonment of stock rather than a partnership interest, but it would be incredibly difficult to distinguish the case in a way that its analysis would not be equally applicable to partnership interests. For those investors that have taken an abandonment loss as an ordinary loss in the recent past or who are considering such action now, a full analysis of this case and its potential adoption by the IRS should be considered.

For more information regarding the utilization of losses or other tax planning matters, please contact your local WS+B advisor.

By Anthony J. Tuths, JD, LLM, Partner atuths@withum.com

withum.comNew Jersey. New York. Pennsylvania. Maryland. Florida. Colorado.

With the termination of Commodity Futures Trading Commission (“CFTC”) Rule 4.13(a)(4) and the contraction of Rule 4.5 which provided relief for certain firms to be registered as commodity pool operators (“CPO”) with the CFTC and correspondingly becoming members of its watchdog agency the National Futures Association (“NFA” or “Association”), many firms are now finding themselves subject to registration and membership which

also opens up the door for examination by the aforementioned authorities. Historically, the NFA would perform an audit of a new registrant within one year of that registrant becoming an active member, followed by recurring audits every three to four years for CPOs (depending on a CPO’s risk factors) and have a duration of approximately one week. As a result of the exemption relief limitation, approximately 600 additional CPO registrations occurred. Time will tell whether the Association has enough resources to examine each of these entities within one year. In the meantime, while awaiting “the call,” previously unregistered CPOs may not be familiar with what to expect for their initial NFA examination.

Similar to other enforcement agencies such as the Securities and Exchange Commission (SEC) and Financial Industry Regulatory Authority (FINRA), the NFA examinations are intended to protect consumers from harmful and potentially fraudulent activities in addition to verifying that member firms are adhering to the rules and regulations of the CFTC and NFA. And like other agencies, the NFA is focusing on a risk-based approach for determining which CPOs should be selected for examination and how often. The NFA can build a risk profile based upon review of a firm’s annual report which is certified by an independent accountant, funds under management, complaints and a firm’s promotional materials.

A useful tool for first time examinees is a self-exam questionnaire located on the NFA’s website at:

www.nfa.futures.org/NFA-compliance/publication-library/self-exam-questionnaire.html

The questionnaire is broken down into subtopics such as: Registration, Supervision, Ethics and Promotional Materials. Needless to say, these are areas of focus for the Association and member firms should be prepared to provide documentation and respond to inquiries in these areas. Additionally, there is a supplemental checklist available specifically for CPOs related

mainly to financial statements and disclosures. Since certification of this questionnaire and its supplemental form is required, there is no reason for firms not to leverage these resources to help prepare for an exam.

Firms who are already audited by an independent accounting firm may feel more at ease when it comes time for a NFA examination. Although the objective of an independent accountant audit vs. an NFA examination is different, the process is similar including an initial request list being provided to the firm prior to an on-site visit. On-site visits would include interviews with management, review of physical records followed by further inquiries of management. At the end of the examination, similar to a management representation letter at the end of a financial statement audit, the NFA would request certain statements from management indicating that they have responded truthfully to all inquiries and are not aware of any issues of non-compliance from other agencies, etc. Findings would be discussed with management including recommendations to address the issues noted as part of the exam (Note: findings are not necessarily indicative of a violation). If violations are noted, the firm might be referred to enforcement.

Some of the common deficiencies noted during NFA examinations relate to:

• Insufficient books and records under Rule 4.7 or 4.23• Lack of supervision and supervisory procedures• Inadequate annual reports• Improper registrations of principals, branches and associated

persons• Non-compliance with NFA Bylaw 1101

While experiencing an NFA examination may be unfamiliar territory, there are steps firms can take to minimize the burden and surprise. Performing your own self-assessment is a start, and the NFA also offers a mock visit from which they will provide recommendations and address any specific areas of concern (to schedule such a visit, contact information@nfa.futures.org). Firms should take advantage of these opportunities to both simplify and accelerate the examination process.

Note: In case you missed it, in 2012, the NFA hosted a webinar discussing regulatory requirements for previously exempt commodity pools – for more information check out:

www.nfa.futures.org/NFA-compliance/NFA-education-training/webinars.HTML#exempt

I’M A CPO, NOW WHAT? SURVIVING YOUR FIRST NFA EXAMBy Jessica Offer, CPA, Manager | joffer@withum.com

ARE YOU A BROKER-DEALER? HAVE YOU CONSIDERED A SERVICE AUDIT REPORT?

Broker-dealers play a key role in the securities and derivatives trading process in the financial services industry. Since the recent recession and failures of several major financial institutions, the demand for strong internal controls and transparency by clients and regulators has never been stronger. Broker-dealers can demonstrate an adequate system of internal controls to their clients by engaging an independent public accounting firm to perform a service audit, namely a Service Organization Controls (SOC 1) examination. SOC 1 examinations (formerly SAS 70s) are performed in accordance to the Statement of Standards for Attestation Engagements (SSAE) 16 for Reporting on Controls at a Service Organization issued by the AICPA (American Institute of Certified Public Accountants). SSAE 16 mirrors its international “assurance” equivalent, ISAE 3402, which was issued by the International Auditing and Assurance Standards Board (IAASB), a standard-setting board of the International Federation of Accountants (IFAC). Continued on back page

By Vivek Agarwal, CPA, CISA, CFE Manager

SCOPE OF REPORT/ OPINION TYPE I TYPE II

Period covered Report is issued as of a specified date

Report is issued for a specified period

Fairness of the presentation of management’s description of the broker-dealer’s system Covered Covered

Suitability of the design of the controls to achieve the related control objectives included in the description Covered Covered

Operating effectiveness of the controls to achieve the related control objectives included in the description Not Covered Covered

Does it assist User Auditor in obtaining sufficient understanding of the broker-dealer’s internal controls in order to plan the financial statement audit? Yes Yes

Does it provide the User Auditor with a basis for reducing the assessed level of control risk and thereby reducing substantive procedures? No Yes

FINRA’S 2014 EXAM PRIORITIESBy Donna Nevolo, CPA, Senior Manager | dnevolo@withum.com

The Financial Industry Regulatory Authority (FINRA) has once again published its exam priorities for the current year. Its focus will be primarily in the areas that it has deemed to be of significant risks to investors and to the integrity of the overall market. Its exam priorities highlight four main categories: business conduct, fraud, financial and operational and market regulation.

Exam priorities involving business conduct will include cybersecurity and firms’ abilities to protect sensitive investor information in light of the increasing frequency and sophistication of cybersecurity attacks on our financial institutions. Also, as a follow up to FINRA’s High Risk Broker initiative to identify brokers who have a pattern of complaints or disclosures for abuses, FINRA will be examining how firms are monitoring their hiring and supervision of such recidivist brokers. Conflicts of interest also continue to be a concern and their exams will include an evaluation of firms’ practices regarding conflict management. A few additional business conduct concerns include:

Suitability: there are numerous products on the market today that are very complex in nature and the product information may be challenging for investors to understand. Concerns are also heightened when there is a strong compensation incentive for the firm or registered representatives to recommend these products. FINRA examiners will be reviewing firms’ practices/procedures surrounding the disclosure of the material risks to investors and the manner in which such disclosures are made to the investors. FINRA has identified specific products that pose heightened concerns over investor protection, and its exams will focus on the suitability, marketing and sale of these products.

Initial Public Offerings: As the market for IPOs has increased recently, FINRA will be examining firms in the underwriting business for their compliance with Rule 5131 which was adopted in May of 2011.

Private Placements: The Jumpstart Our Business Startups (JOBS) Act prompted the amendments to Rule 506 of Regulation D, which became effective September 23, 2013, and permitted general solicitation and advertisement for private placements as long as all purchasers are accredited investors. FINRA intends to review how firms have dealt with the new challenges resulting from these amendments surrounding their marketing materials and the need to ensure that they are based on principles of fair

dealing and good faith. FINRA will also review the adequacy of the due diligence performed by firms on their offerings to ensure proper suitability in their recommendations to the investors. A few of the exam priorities identified by FINRA involving fraud include Microcap fraud and insider trading. Both of these areas were a focus in 2013 and continue to be areas of significant concern. FINRA will be looking for policies and procedures to be compliant with FINRA rules and federal security laws regarding speculative microcap and low-priced over-the-counter securities. They will also be determining firms’ abilities to safeguard non-public information and expect to see appropriate information barrier type policies and procedures in place.

Regarding the financial and operational priorities, FINRA examiners will be asking the larger firms to perform a liquidity stress test to determine the resiliency of their liquidity position. Certain firms will also be required to provide documentation of their risk management controls, and tests will be performed to determine their adequacy and whether or not they are functioning as designed. Firms’ abilities to calculate their net capital position and to also prepare GAAP financial statements throughout the year will also be examined. Finally, as a result of the PCAOB’s recent report on deficiencies noted in audits of broker-dealers, auditor compliance with SEC independence rules will be examined.

Exam priorities regarding market regulations will focus on firms’ testing and controls related to high frequency trading (HFT) and other algorithmic trading systems. Additionally, as a result of the substantial growth in HFT strategies in today’s market, examiners will be focusing on potential abusive algorisms, manipulative trading schemes, momentum ignition strategies, sponsored participant activity initiated from outside of the United States, and other cross-market or cross-product manipulations. Based on previously noted deficiencies in Large Options Positions Reporting (LOPR), examiners will be assessing the firms’ supervisory controls from the front-end trading to the back-end clearance process. Finally, FINRA will be utilizing its newly developed surveillance tool to determine firms’ practices over compliance with their obligation to execute transactions with the best available market prices for their customers.

The areas noted above are not all inclusive of those listed by FINRA. A complete listing FINRA’s 2014 exam priorities can be found at 2014 Regulatory and Examination Priorities Letter.

For more information regarding FINRA exam priorities 2014, please contact your local WS+B advisor.

SOC 1 reports focus on controls of the broker-dealer that would be relevant to an audit of a client’s financial statements. Two types of reports can be issued: a Type I and a Type II. Key differences between them are as follows:

Continued on back page

RE

LIA

NC

E B

Y

CL

IEN

T’S

(U

SE

R)

AU

DIT

OR

:

1411 Broadway, 9th FloorNew York, NY 10018

Return Service Requested

Finance That Matters is published by WithumSmith+Brown, PC, Certified Public Accountants and Consultants. The information contained in this publication is for informational purposes and should not be acted upon without professional advice. To ensure compliance with U.S. Treasury rules, unless expressly stated otherwise, any U.S. tax advice contained in this communication is not intended or written to be used, and cannot be used, by the recipient for the purpose of avoiding penalties that may be imposed under the Internal Revenue Code. Please contact a member of the Financial Services Group with your inquiries.

As can be seen from the above table, a Type II report is the preferred route as it includes testing of the operational effectiveness of controls. It thereby provides the auditors of the user entities with a reasonable basis to evaluate the Internal Controls over Financial Reporting (ICFR) of the broker-dealer.

CONTROLS SURROUNDING

►Client Account Setup and Maintenance ►Authorization and Processing of Client Transactions ►Processing of Income and Action Transactions ►Reconciliation of Funds and Securities to Depositories and other Custodians ►Client Reporting and Billing ► IT General Controls – Physical Security and Environmental Controls ► IT General Controls - Logical Security ► IT General Controls – Data Backup & Retention ► IT General Controls - Change Management ► IT General Controls – Computer Operations

KEY STEPS INVOLVED IN ISSUING A SOC 1 REPORT

READINESS ASSESSMENT (NON-ATTESTATION) ►Can be performed by the Service Auditor or Management ► Involves understanding of existing processes and relevant controls ►Control weaknesses and gaps in controls are identified ►List of control objectives and underlying control activities formulated

ARE YOU A BROKER-DEALER? HAVE YOU CONSIDERED A SERVICE AUDIT REPORT? Continued from inside page

REMEDIATION OF CONTROL GAPS ►Performed by Management ► Identified control gaps remediated ►Controls in place and operating effectively ensured ►Management reviews the design and operating effectiveness of the control objectives and related control activities ►Management prepares written assertion and description of its system

SOC 1 TYPE I OR TYPE II EXAMINATION (ATTESTATION) ►Performed by the Service Auditor for a specified date (Type 1) or for the defined audit period (Type II, typically annually, but generally not less than 6 months) ►Auditor to provide opinion on:

■ The description was fairly presented ■ The controls were suitably designed to provide reasonable

assurance that the control objectives would be achieved if the controls operated effectively

■ Type II Only: The controls were operating effectively to provide reasonable assurance that the control objectives were achieved

► Issuance of SOC 1 Report

If you are a company in need of SOC 1 report services or would like to understand how such SOC reports can assist you in your business, please reach out to Vivek Agarwal (vagarwal@withum.com) or your local WS+B advisor.

Learn more about our SOC Services by visiting www.withum.com/serv_soc.shtml