Hedge Funds and Related Tax Considerations: Do You Know What You’re Invested In?– October 19, 2015 by Rob Velotta

Posted by Rob Velotta, CPA, MT, Investment Industry Services Division

Our clients are successful and, as they continue to increase their personal net worth through successfully operating their businesses, a liquidity event or other means, we are finding that they are increasingly being presented with investment opportunities. One of the more common investment opportunities our clients hear about is hedge funds. Clearly, any investment should be evaluated as part of an overall investment strategy and with an understanding of the specifics of the investment, but this article is intended to give an overview of some frequently asked questions related to the tax issues of hedge-fund investing.

What Does a Hedge Fund Actually Do?
The term “hedge fund” can be misleading. Historically, hedge funds invest in publicly traded investments with the goal of earning a positive, uncorrelated return in all markets via the use of “hedge” positions like short sales. Now, the term hedge fund is often used to describe any continuously offered private investment fund. While most hedge funds have a specific strategy that is laid out in the Private Placement Memorandum and Operating Agreement, these documents usually allow the investment manager wide discretion to deviate from that strategy.

How Are Hedge Funds Regulated?
While there are some hedge funds that are registered with the SEC and there are a growing number of alternative strategies mutual funds that have hedge fund-like characteristics, the vast majority of hedge funds is lightly regulated. These non-registered funds fall within exceptions to registration to the extent their capital is raised solely from a limited number of accredited investors. For individuals, this generally includes those $1 million of net worth, excluding the value of the primary residence, or income of at least $200,000 (or $300,000 together with a spouse). These registration exceptions apply to these investors under the assumption that accredited investors are more sophisticated than the general public in terms of the risks of these investments and do not need the protection (and investment cost) that the regulation brings.

How Do Hedge Funds Differ from Private Equity Funds?
Hedge funds tend to invest primarily in publicly traded positions, whereas private equity funds tend to invest in private companies. Accordingly, hedge funds tend to be more liquid as there is more opportunity to redeem out of the hedge fund for cash, although most hedge funds place limits on liquidity and have minimum holding-period requirements via lock-up periods or redemption fees. Hedge fund managers also may have the ability to suspend redemptions under various scenarios.

Tax Structure
Most taxable U.S. investors invest in hedge funds that are structured as partnerships domiciled in the US. Many funds also may be structured in offshore jurisdictions, most commonly a tax-haven jurisdiction like the Cayman or British Virgin Islands. Offshore funds taxed as corporations for U.S. tax purposes are most commonly used for non-U.S. investors or tax-exempt U.S. investors like foundations or IRAs as a blocker for either U.S.-sourced income or unrelated business income tax. U.S. taxable investors in non-U.S. entities may need to address Passive Foreign Investment Company (PFIC) tax treatment or reporting requirements for investing in foreign partnerships.

Compensation Structure of Managers
Most fund managers receive not only an assets under management fee, but also participate in the profits earned by the investment fund via an incentive arrangement. It is this incentive arrangement that entices many quality investment managers to pursue hedge funds instead of different structures that generally only pay a fee based upon assets under management. A common compensation structure in hedge funds is a “2 and 20,” where the manager is paid a fee of 2% of the net assets of the fund and an incentive of 20% of an investor’s performance. For a hedge fund structured as a U.S. partnership, the advisor is typically allocated 20% of all the components of income earned by an investor. For example, if an investor is allocated $100 of long-term capital gains before the incentive, $20 of the long-term capital gain is allocated to the manager and the remaining $80 is allocated to the investor.

Taxability
The activities of a hedge fund become extremely important in evaluating the tax efficiency of a fund. Is a fund generating all short-term capital gain taxed at up to 43.4% or long-term capital gain at 23.8%? How much unrealized gain does the fund have? Is the fund trading derivatives that may cause gains to be taxed at different rates? How are the expenses of the fund being treated (as ordinary expenses or investment expenses subject to limitations of exceeding 2% of AGI and AMT limitations)?

The following examples show how two hedge funds with the same pre-tax performance can have drastically different after-tax performance.

 

* Assumes maximum tax rates of 43.4% for ordinary, 23.8% for long-term capital gain and an investor is in AMT.

Estimates, Tax Planning and Timing
Aside from understanding the taxable income that a hedge fund might generate, investors are often surprised by timing of the receipt of K-1s or other documentation used to prepare tax returns and/or estimated tax calculations. Most hedge funds provide little to no estimated taxable income information, primarily because this information can change drastically upon the receipt of the ultimate K-1. K-1s for direct investing funds are generally available to investors before April 15, but investments in funds-of-funds, or funds investing in other hedge funds, may be extended and not available until closer to September 15. In either scenario, investing in hedge funds may create uncertainty in managing cash flows and tax situations.

Conclusion
Hedge funds are common investments made by high-net-worth individuals and family offices. Work closely with your advisors on the tax concerns associated with these complex investments.

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