Overview of the Tax Issues Affecting Hedge Funds
One of the most important aspects of the hedge fund structure are the tax aspects as they relate to the hedge fund, the manager and the investors. This article will detail the important tax aspects which are relevant to most hedge funds. Please note that any of these individual tax aspects may or may not apply to certain hedge funds – for information on a particular fund’s tax attributes, refer to such fund’s private placement memorandum. Please also note that this article is not seeking to provide any sort of tax advice to managers or hedge fund investors, please see our disclaimer for information on IRS circular 230. [The following article deals with domestic hedge fund taxation. We will provide another article on offshore hedge fund taxation in the future.]
Internal Revenue Code
For domestic hedge funds the Internal Revenue Code (the “Code” or “IRC”) provides the laws which govern the taxation of investors at the federal level. The Internal Revenue Service has promulgated regulations which augment and give color to the IRC provisions. The individual states also tax codes which will apply to investors depending on a number of factors including residence – this article will not discuss this topic and we urge those interested to discuss state tax issues affecting hedge funds to discuss these issues with a hedge fund tax attorney or tax accountant.
Hedge Funds Taxed as Partnerships
The most important tax attribute of hedge funds is that they are taxed at partnerships. Being taxed as a partnership is advantageous (vis a vis corporate taxation) because all profits and losses of the fund “pass through” to the investors and thus there is no “double taxation” which is case with corporations. This “pass through” treatment means that hedge fund investors record all of their income on Schedule K-1 (see overview of Schedule K-1).
Subchapter K Taxation
All items of profit, loss and deductions are allocated to investors for the fiscal year as determined by the General Partner. As hedge funds are taxed as partnerships, the manner in which items of profit and loss will be allocated to investors according to the provisions of Subchapter K of the IRC.
Preparing and Filing a Tax Return
The fund will prepare and file a tax return each year, however, any taxes will be paid by the investor and not by the fund. The fund’s tax return, and the investors’ Schedule K-1s, are usually prepared by the accounting firm which provides the hedge fund audit each year. The tax returns and K-1s are usually provided to investors prior to April 15 in order for the investor to properly file his tax returns. Sometimes the fund will not be able to get the K-1s to the investors in time and thus such investors generally will file an extension with the IRS.
Other Tax Issues for Hedge Fund Investors
As we discussed above, the profits and losses of a hedge fund “flow through” to the hedge fund investors. Expenses are also passed through and the amount of the expenses passed through will depend on whether the hedge fund is a “trader” or an “investor” in securities during the year. This designation is subject to change every year and depends on a number of items. The different treatment is discussed below, but basically trader classification is better for the investors.
If the fund is characterized as a trader – the investors may deduct their share of the fund’s expenses.
If the fund is characterized as an investor – the investors may only deduct their share of the fund’s expenses if that amount (plus any other “miscellaneous itemized deductions”) exceed 2% of the investors adjusted gross income.
Passive Activity Losses
Generally an investment in a hedge fund is not deemed to be a passive activity and so investors will not be able to use any profits from the fund to shelter losses from the investors other investments.
State and Local Taxation Issues
Investors may be required to file state or local income tax returns in addition to federal tax returns. The investor should discuss an investment in a fund with their tax professional.
Taxation of Hedge Fund Operations
Trader or Dealer Classification?
Hedge funds are typically classified as traders or investors instead of dealers. This classification allows the hedge funds recognized long-term and short-term capital gains and losses, which as we discuss below have tax advantages.
Unrelated Business Taxable Income (UBTI)
As we’ve discussed previously in an article on hedge funds and UBTI, tax exempt investors are subject to additional rules on UBTI. If the fund uses leverage (in a domestic only fund structure), the tax exempt investor may be subject to tax on the UBTI that is a result of the leverage.
If the fund has an appreciated financial position with respect to an asset and then enters into a “constructive sale” with regard to that asset, then the fund would be taxed on its “appreciated financial position” with respect to that asset. A “constructive sale” would occur if the fund entered into financial contracts which had the effect of taking all of the economic risk out of owning the asset (for example, entering into a futures contract on a like asset). There are a variety of rules surrounding constructive sales that are fact specific, please discuss this issue with your attorney if you have any questions.
[HFLB Note: more information to be forthcoming on the following issues: discussion of capital gain and loss, mark to market election, Section 1256 Contacts, original issue discount, and other hedge fund tax concepts and issues.]
Publicly Traded Partnership Status
Under the IRC, if a partnership is publicly traded, it will be taxed as a corporation. This is generally never be an issue provided that the interests in the fund are not traded on an established securities market and are not readily tradable on a secondary market.
Opinion on Partnership Status
Some hedge funds get an opinion from counsel that the fund will be taxed as a partnership for federal income tax purposes. Generally only the very large hedge funds receive these opinions (I am guessing because the large law firms which prepare their documents “package in” the opinion to justify the high set up fees). An opinion on partnership status is probably not necessary and most hedge funds do not receive such an opinion.
Audit of the fund
There is always the possibility that the hedge fund could be audited. The hedge fund manager would represent the fund as the “tax matters partner” if the fund was to be audited. If the hedge fund was audited, then the IRS may also audit the investors in the fund.
Notes and Conclusion
There are many tax issues which arise in the hedge fund context. The discussion above is a general discussion of some of the major tax concepts applicable to hedge funds. This summary does not take into account some of the tax issues applicable to non-traditional hedge funds such as commodity pools, real estate hedge funds and other pooled investment vehicles. It is very important to read our disclaimer and to understand that we are not providing tax or other legal advice by publishing the above article.
Please contact us if you have any questions on this article or if you are interested in starting a hedge fund. Other related hedge fund law articles include: