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Hedge funds located in taxable jurisdictions are structured

Hedge Fund Taxation

AVOIDING U .S . FEDERAL TAXATION

It is natural to want to avoid paying more tax than necessary. A loophole to someone may be a provision providing greater tax equity to someone else. Whether everyone agrees with the state of the U.S. tax law, it is important to emphasize that this chapter will be talking about legal tax strategies, not (illegal) tax evasion. In fact, the courts are clear that it is permissible to make decisions that result in lower taxation. Hedge funds are generally structured to minimize the tax burden on the investors.

Some investors pay income tax to countries other than the United States. These investors may get little or no credit for taxes paid to the United States. As seen in Chapter 5, offshore hedge funds are structured so that nonresident investors can invest in a managers fund without creating a tax liability in the United States. These investors dont escape income tax. The income must still be reported to the investors taxing authority (to the extent required by the laws governing the investor), but the offshore structure allows the offshore investor to avoid taxation by the United States.

Note that the U.S.-based hedge fund manager must report income in the form of management and incentive fees generated by managing offshore pools of money. The offshore structure allows the investment process to occur outside the United States, but the business of managing the assets usually produces income that is taxable by the United States if the activity occurs within U.S. borders.

FLOW-THROUGH TAXATION

All businesses in the United States must report income to the U.S. Treasury. Many businesses pay corporate income tax on the profits of the business.

The dividends paid by these companies to their investors are taxable (if the investors are subject to tax) even though the dividends are paid from profits after tax. Companies may also retain profits left after paying taxes. These profits may make the shares more valuable and may result in capital gains taxes for investors who sell stock.

Other types of businesses also report income to the U.S. Treasury but pay no tax. Instead, the revenues and expenses are allocated to investors, who must report this income and pay tax on the income if they are taxable investors. These businesses are called flow-through tax entities.

Hedge funds located in taxable jurisdictions are structured (1) to avoid double taxation and (2) to make certain that investors can lose no more than 100 percent of their investment in the hedge fund. This chapter will briefly discuss how partnerships are taxed, because they avoid most corporate income taxes. Several of the flow-through entities are used as the business type for hedge funds.

DOUBLE TAXATION OF CORPORATE INCOME

Certain types of businesses file tax returns and pay income tax on the income of the business. Owners are later taxed on the returns. These profits are therefore taxed twice.

C Corporation

C corporations pay U.S. federal corporate income tax at a maximum rate of 35 percent. In addition, most states tax the income of the corporation. Investors may not deduct these corporate taxes or use the taxes paid by the corporation to reduce their tax liabilities in any way. However, investors do not include this corporate income on any tax form, and a corporation can usually postpone taxation at the investor level indefinitely by retaining all of the after-tax profits. When the corporation makes a dividend payment to investors, the investors must include this payment as income if they are taxable investors.

Limited Liability Corporation

If a limited liability corporation (LLC) elects to be taxed as a C corporation, the income of the business will be taxed twice. However, most LLCs elect to be taxed as a partnership and avoid double-taxation of income.

FLOW-THROUGH TAX TREATMENT

A variety of business types file income tax forms but pay no tax on business income. Instead, taxable items are passed through to investors, who must report them in their own taxable income.

Sole Proprietorship

The income from a sole proprietorship is reported on the individuals tax form. As a result, this business could be viewed as a flow-through tax entity. The income is, however, additionally taxed as self-employment income. The business is owned by one individual, which pretty much rules out this structure for the hedge fund. In addition, a sole proprietorship does not shield the owner from unlimited liability so it is not recommended as a hedge fund structure.

Partnership

All partnerships are taxed the same in the United States and most or all other countries. All the individual accounts (interest, dividends, interest expense, short-term gains, and so on are reported to investors, who must include all the results on their own income tax forms. Although this complicates tax filing, it avoids the double-taxation of investment returns.

Limited Liability Corporation

The limited liability corporation (LLC), as mentioned earlier, may be taxed as a corporation or as a partnership. Most LLCs elect to be treated as a partnership to get flow-through tax treatment. The LLC structure also allows all investors, including the fund sponsors and managers, to limit their liability to their committed investment.

TRADER VERSUS INVESTOR VERSUS DEALER

A hedge fund domiciled in the United States could be taxed as if it is an investor, a trader, or a broker-dealer. This distinction is not important to offshore funds because those investors generally dont pay U.S. income tax. To U.S. domestic funds, the impact on investors can be significant.

Hedge Funds Taxed as a Trader

Hedge funds generally prefer to be taxed as a business actively engaged in the business of trading (which primarily makes money by buying and selling as distinguished from an investor who primarily makes money by buying and holding). A fund is more likely to be classified as a trader if the turnover in the fund is higher, the gains and losses are primarily short-term (not long-term), and the return derives primarily from gains and losses, not dividends and interest.

If a fund is treated as a trader, certain expenses like interest costs on leveraged positions and management fees are included in net income. This net income is allocated to investors as described later. These expenses are not reported on individual taxpayers schedules of itemized deductions.

Individual taxpayers benefit by not having to report gross income and investment expenses. First, these expenses are deductible only to the extent that they exceed 2 percent of adjusted gross income. Second, due to phaseout limitations on itemized deductions, these investment expenses may be capped at 5 percent of adjusted gross income (that is, only the expenses that fall between 2 percent and 5 percent of adjusted gross income are deductible). Third, as long as the hedge fund is treated as a trader, these investment expenses would reduce taxable income when calculating alternate minimum tax.

Hedge Funds Taxed as an Investor

A hedge fund characterized as an investor would have to allocate income before certain investment expenses to investors. The fund would also allocate investment expenses such as financing interest, management fees, and incentive fees. Investors would be able to reduce taxable income by the amount of these expenses, subject to the 2 percent and 5 percent limitations described earlier. Individuals would add back these deductions to calculate alternate minimum tax.

Foreign investors invested in a U.S. hedge fund would prefer that the fund was classified as an investor, not a trader. These foreign investors would be taxed only on the dividends received by the fund, not interest or gains and losses. These dividends would be subject to 30 percent withholding tax. Admittedly, this is a small market because a U.S. fund capable of attracting sizable offshore investments would probably organize an offshore fund to allow the offshore investors to sidestep U.S. taxation.

Hedge Funds Taxed as a Dealer

Some hedge funds seek to be treated as dealers to take advantage of more liberal margin rules under Regulation T (see Chapter 8). The hedge funds must mark all their positions to market for tax purposes. Some funds (notably arbitrage strategies) must mark their positions to market anyway because of tax straddle rules as described in Chapter 9. These funds make a mixed straddle election designed to prevent tax abuse because all positions are taxed annually at market value whether gains and losses are realized or unrealized. For hedge funds not required to make a mixed straddle election, the impact of being classified as a dealer is that the fund may not defer unrecognized gains to later tax years.

INTRODUCTION TO ALLOCATION

The general allocation provisions of a partnership are laid out in the partnership agreement. In the absence of special allocation rules, allocations are generally made equal to the relative ownership amounts of the investors. While a fund can use special allocation rules, the allocations must have economic substance. That is, the tax allocations must be consistent with the economic gains and losses realized by the investors.

Income items (including revenues, expenses, gains, and losses) must be allocated at least annually. Funds allocate each break period, that is, each time investors may enter or exit the partnership and the ownership percentage of the partners could change.

Most funds allocate these items as if the fund closed its books at each break period and issued quarterly or monthly income statements. This method is called the interim closing of the books method. As the name implies, the fund may generate equivalent allocations in portfolio software or in subledgers.

ALLOCATION OF REVENUES AND EXPENSES

The first kind of allocation involves most of the income accounts with the exception of gains and losses (the allocation rules for gains and losses are considerably more complicated and are described later). The fund first allocates the amount to each period. This allocation should be made daily. Second, the income amount is allocated to investors, generally proportionate to their ownership percentage.

For example, suppose a hedge fund estimates its annual audit expenses at $48,000 for the 2004 trading year. It would allocate $1311 per day to the fund every day of the year in advance of the actual expense. The accountants would book $3,8032 audit expense for February.

Suppose this hedge fund has three investors. The first partner holds 200 units, the second partner holds 300 units, and the third partner holds 300 units. Therefore, the fund has 800 units outstanding. The first partner owns 25 percent of the fund (200 units/800 units) and is allocated $951 (25% $3,803) for February. The second partner owns 37.5 percent of the fund (300 units/800 units) and is allocated $1,426 (37.5% $3,803) for February. The third partner owns 37.5 percent of the fund (300 units/800 units) and is allocated $1,426 (37.5% $3,803) for February.

ALLOCATION OF GAINS AND LOSSES LAYERED ALLOCATION

Partnerships and other entities that are flow-through tax entities must report income items to investors as if they hold proportional amounts of the business as a sole proprietorship. For most income items, this is relatively straightforward. If an expense is incurred in a month, it is booked in the same month that investors received the benefit of that expense. In the preceding example, accrual accounting may allow the accountant to time the recognition of the expense to match the benefits of the expense to the cash payment.

In contrast, gains and losses are not recognized for tax reporting until positions are liquidated. Therefore, the accounting gain or loss may be reported long after the gain or loss was achieved. This is true for individuals and it is true for the investors in a flow-through tax entity. So the realized gains must be allocated to the investors who were invested when the gains occurred, and the realized losses must be allocated to the investors who were invested when the losses occurred.

To illustrate layered allocation, consider a simple example before advancing to a more complete scenario. Suppose two investors formed a partnership that bought a stock. The stock appreciated, but the partnership retained the stock and carried an unrecognized gain on the position. A third partner was admitted and the stock was sold shortly thereafter at the previous appreciated price. The partnership must allocate the gain to the initial two investors and not to the new investor. The allocation should replicate the effect of the two investors individually owning proportionate amounts of the position and experiencing a gain (eventually realized). The newest investors allocation should match buying a reapportioned amount of the stock and selling it for no gain or loss.

Layered Tax Allocation Example

Now consider a multiperiod example to demonstrate how the layered allocation is actually calculated. Suppose the partnership was owned 40 percent by investor 1 and 60 percent by investor 2 in January. The partnership buys 10,000 shares of XYZ common during the month of January at 25. The position is worth $30 per share at the end of January. The partnership has a $50,000 gain (10,000 $5 gain) allocated 40 percent to investor 1 (40% $50,000 = $20,000) and 60 percent to investor 2 (60% $50,000 = $30,000).

Suppose the partnership admits a third partner at the beginning of February. After the new partner enters, investor 1 owns 25 percent of the fund3 and investor 2 and investor 3 each own 37.5 percent. During Febru

ary, XYZ advances to $35. This $50,000 unrecognized gain is allocated $12,500 to investor 1 (25% $50,000) and $18,750 each to investor 2 and investor 3 (37.5% $50,000).

During the month of March, XYZ stock is sold at $32. No changes have occurred in the partnership stakes. The $30,000 loss (at least, it is a loss on the month) is allocated $7,500 to investor 1 (25% $30,000) and

$11,250 each to investor 2 and investor 3 (37.5% $30,000). The scenario has three investors in the stock with a cost basis or layer each of three months (although investor 3 didnt participate in the first layer). As a result of these layers, investor 1 reports a gain of $25,000 ($20,000 plus $12,500 plus -$7,500). Investor 2 reports a gain of $37,500 ($30,000 plus $18,750 plus -$11,250). Investor 3 reports a gain of $7,500 ($18,750 plus -$11,250). The gain allocated to the three investors

($25,000 plus $37,500 plus $7,500) equals the $70,000 gain realized on XYZ common (from $25 to $32 on 10,000 shares). The partners are allocated gains as if they owned a proportionate position in XYZ directly. Needless to say, this methodology puts severe demands on the tax accountants to keep track of each of these cost layers. If there are many investors and many positions, and if investments are held for many periods, the data needs and computational effort to produce tax returns can be enormous. To make matters worse, smaller funds in the past have done these calculations by hand in spreadsheets, requiring duplicate efforts to maintain positions and partnership allocations.

Problems with the Ceiling Rule

All three partners reported gains in our example. If the third investor had entered the fund at the end of February, the decline in price in March and subsequent sale would have caused a loss for that partner. The hedge fund would have had two partners reporting gains and a partner reporting a loss on the same position. This is a violation of the ceiling rule, which prohibits partners from reporting a loss greater than the loss on the securities.

The hedge fund might argue that the allocation does not violate the ceiling rule if all partners report gains or all partners report losses during the tax year. Other hedge funds would alter the layered allocation, first skipping the allocation to partners that would violate the ceiling rule and then adjust future allocations, realigning the tax allocations to match the economic gains of each investor overall.



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Previous Issues

200605-16A hedge fund, in contrast, carries a portfolio of investment securities

200605-15Hedge funds may be organized as corporations, especially outside the United States

200605-14Some hedge funds have trouble revaluing certain kinds of assets at the end of each period

200605-13Hedge funds are affected by many laws and regulations

200605-12The most common measure of portfolio risk used by practitioners and academics

200605-11Investors commit funds to a particular investment for a variety of reasons

200605-10Hedge funds face many limits on leverage they can employ

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