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Most hedge funds create an interim closing to measure partner gain or loss
AGGREGATE TAX ALLOCATION
Investors were granted some relief from the burden of layered tax allocation. The tax code now permits flow-through tax entities to develop shortcut methods to allocate gains and losses to investors. This shortcut is permitted only for qualified financial assets, which include assets where price quotes or recent trading price information is readily available. The shortcut applies only to securities partnerships. This group includes registered investment advisers, although not many hedge funds are registered in the United States. A hedge fund may also qualify as a securities partnership if at least 90 percent of its assets (excluding cash) are qualified financial assets and the hedge fund is marked to market at least annually.
Most hedge funds are thereby permitted to use aggregate tax allocation. Hedge funds that carry private equity positions may be prohibited from using aggregate tax allocation either because price information is unavailable or they dont mark positions to market until the positions are liquidated. Many of these hedge funds instead use side-pocket allocations (discussed later).
Partial Netting versus Full Netting Allocation
The tax code allows the hedge fund to allocate the aggregate gains separately from the aggregate losses (partial netting) or to aggregate the gains and losses together (full netting) and only allocate the net gain or loss to investors. Partial netting will tend to keep the allocations more in line with the economic gains of the partners. Nevertheless, most hedge funds use the full netting approach to tax allocation.
Using the Interim Closing of the Books Method
To use the aggregate allocation methodology, the hedge fund must track the economic gain or loss of each partner. It is not important to preserve the details about how and when an investor experienced a gain or loss. It is not important whether a partner experience a gain in one month or another (except to maintain a paper trail for the auditors). It is not important which securities were responsible for creating the gain or loss. For all these reasons, the aggregate method reduces the effort required to perform tax allocations.
Most hedge funds create an interim closing to measure partner gain or loss. A hedge fund may create financial statements with interim securities prices to calculate the value of the capital positions. Alternatively, a portfolio accounting system might calculate the economic gains or losses as if interim statements were created. In either case, interim gains and losses are accumulated in memorandum accounts for each partner.
This illustrates the aggregate allocation procedure.
Aggregate Allocation Example
Suppose two investors form a partnership. The first investor holds a 40 percent interest in the partnership and the second investor holds a 60 percent interest in the partnership. During January, the partnership buys two positions. The first position is 5,000 shares of common stock purchased at $9 and worth $12 at the end of January (an unrecognized gain of $15,000). The second position is 5,000 shares of common stock purchased at $16.50 and worth $19 at the end of January (an unrecognized gain of $12,500).
These mark-to-market gains are recorded in a memorandum account for each partner. The calculations of the allocations are shown.
At the beginning of February, investor 3 is admitted as a partner. The new ownership percentages are: investor 1 (25 percent), investor 2 (37.5 percent), and investor 3 (37.5 percent). During the month, the partnership creates a short position of 15,000 shares in position 3 at a price of 9.25. At month-end, the prices of the three positions are: position 1 ($14), position 2 ($20.50), and position 3 ($11), as summarized in Table 10.2a. Notice that the beginning price for Table 10.2a equals the ending price from Table 10.1a, except for the new position, which begins at the cost established during the month.
These gains and losses are entered into the memo balances for the three investors in Table 10.2b. For example, the $10,000 gain on position 1 is allocated 25 percent to investor 1 (an allocated amount of $2,500). This allocated amount is added to the previous memo balance ($6,000see Table 10.1b). The memo balance of $8,500 reflects the prorated amount of unrecognized gain on position 1 during January and February. Similarly, the rest of Table 10.2b includes the unrecognized gains and losses plus any previous gains or losses in each position for each investor.
The ownership percentages do not change in March. The partnership sells the 5,000 shares of position 1 at $15. The ending price for position 2 is $22, and position 3 is marked to market at $11.25. Table 10.3a summarizes the new recognized and unrecognized gains and losses in the partnership. The beginning prices for the March table were the ending prices in February. The ending price for position 1 is the sale price and position 2 and position 3 are marked to market.
The memo balances are updated for the March gains and losses (including both the realized and unrealized amounts).
Allocating the Gain (Partial Netting ) The partnership realized a gain of $30,000 ($6 appreciation from $9 to $15 on 5,000 shares). Suppose the partnership chooses to allocate the gain using partial netting. The first step is to accumulate the gains for each investor. In Table 10.4a, the positions that created gains for each of the partners are totaled. Note that this includes all economic gains, both realized and unrealized.
Under this fairly typical allocation scheme, the realized gain is allocated according to the share each partner has of the total economic gains. The partners have experienced $57,500 in gains in the memorandum accounts. Investor 1 has received $18,500 of that gain, or 32.2 percent. Investor 2 has 48.3 percent of the gains, while investor 3 has 19.6 percent of the gains. These allocations are displayed
The $30,000 realized gain is allocated 32.2 percent or $9,652. Investor 2 receives 48.3 percent or $14,478 and investor 3 receives $5,870.
Full Aggregate Allocation Investor 3 has been invested in the partnership for two months. The gain in February disappeared in March, so investor 3 has made no money from the partnership. (See Table 10.4a.) Because investor 3 missed the gains in January, only 19.6 percent of the gains relate to investor 3, but the investor received 37.5 percent of the losses. Because the gain on positions exceeds the loss on positions, the partnership has economic profits but investor 3 does not. Yet this investor is nevertheless allocated 19.6 percent of the realized gains.
The partnership could also allocate the realized gain based on the net gains for each partner. Table 10.4a also shows the net gain for investor 1 and investor 2. Table 10.4b shows the allocation percentages using the net gain amount. Under the full netting approach, investor 1 receives a 40 percent allocation of the $30,000 realized gain because the $11,000 gain in the memorandum account for investor 1 represents 40 percent of the $27,500 net gain for all investors. Investor 2 is allocated 60 percent and investor 3 is allocated none of the gain because investor 3 has no net gain from the partnership.
Updating the Memorandum Balances Once the realized gains and losses have been allocated to the partners, the memorandum accounts must be updated to reflect that tax allocations that have been made, as shown in Table 10.5. For example, the memo balance for investor 1 in position 1 was $9,750 (Table 10.3b) at the end of March before the tax allocation. The tax allocation of $9,625 was applied (Table 10.4c). The memo balances are similarly updated for investor 2 and investor 3. The memo balances show that investor 1 and investor 2 were allocated slightly less than their share of the gains on position 1. The memo balances carry part of this gain until later realized gains are allocated. Investor 3 has been overallocated gains. This kind of overallocation is common and will be corrected by later allocations, where investor 1 and investor 2 receive a larger portion of future realized gains. Hedge funds carry the amount in different ways, depending on the set of rules they apply to perform the allocation.
Need for More Complete Allocation Rules The allocation in the preceding example is relatively simple because all three partners had gains in their memo balances and because they collectively had larger gains than the $30,000 realized gain. Allocation rules must be complete enough to deal with all possible situations.
For example, it is typical to allocate gains to partners who have positive memo balances and omit partners from the allocation who have negative memo balances. Similarly, losses may be applied proportionately to partners having negative memo balances, omitting allocations to partners with gains in their memo balances.
Sometimes, partners have positive memo balances but the partnership realizes gains greater than the beginning memo balances. In the case, the partnership may allocate part of the gain to match gains in memo accounts. Realized gains allocated when no partners have positive memo balances are usually based the economic ownership percent of the partners. Similarly, realized losses may be allocated according to economic ownership when no partners have negative memo balances.
Other partners may apply the realized gains and losses to the partners with the oldest entries in the memo accounts. This method is sometimes called first in, first out (FIFO). In the preceding allocation example, investor 1 and investor 2 would receive some of the realized gain based on their memo gains in January. The realized gain ($30,000) exceeds the January memo entries ($27,500the total of all the entries.
Hedge funds use many other allocation procedures. There is little discussion of these rules in the published press.4 Investors may be unaware of the particular rules used to allocate taxable gains and losses even though the allocation rules can have a significant impact on the timing of tax liabilities for the investors.
The tax code offers a break to traders of futures and certain commodities. The provision requires the taxable investor to treat 60 percent of all gains (losses) on Section 1256 assets as long-term capital gains (losses), regardless of the holding period. The provision has the effect of lowering the effective tax rate on futures trades. The tax break extends some of the benefit of lower long-term tax rates to an industry that rarely holds an asset long enough to get the benefit of the lower tax rate.
Hedge Funds and Not -for -Profit Entities
The U.S. tax code exempts many kinds of investors from taxation on investment returns. Pension funds, endowments, and foundations may avoid income taxation on most of their activities if they follow the rules set down to grant them tax-exempt status. One of the requirements designed to prevent tax abuse is that not-for-profit organizations may not operate a business within the tax-exempt umbrella. If a tax-exempt entity runs a taxable business, the income from that business is subject to unrelated business income tax (UBIT).
Leverage in a hedge fund often triggers UBIT. Investment income in tax-exempt organizations is generally not taxed. However, if the investment vehicle borrows money, doing so may trigger UBIT.
To avoid UBIT, tax-exempt investors often invest in the hedge funds with very low leverage. Tax-exempt investors also prefer to invest in offshore hedge funds because the corporate structure stands between the taxexempt entity and the interest.
Side -Pocket Allocations
Certain assets are easy to mark to market. When recent trade prices or market quotes are not available, hedge funds can establish fair value. However, the hedge fund must have a defensible basis for the valuations. When it is impossible to identify periodic mark-to-market value, it would be unfair to investors to allow partners to enter or exit the partnership based on unreliable values.
One solution to the problem is to prohibit investors from entering or exiting the fund. In effect, this is the way that venture capital funds operate because a large part of the portfolio is difficult to mark to market. Such a solution is too restrictive for most hedge funds that carry a portfolio comprised of many assets that can be readily revalued and a small portion that is difficult to price. Instead, those hedge funds might create side-pocket allocations.
To understand side-pocket allocations, imagine first that a hedge fund manager creates a new business unit to contain some private equity positions. The hedge fund awards ownership of this private equity portfolio proportional to the current ownership percentages in the hedge fund and diverts cash to the separate entity to fund the portfolio. As investors in the hedge fund enter and exit, the ownership of the hedge fund can start to diverge from the ownership in the private equity portfolio. Ultimately, the private equity positions are sold and the original investors are paid out based on the original, unchanging ownership percentages.
Finally, imagine that the hedge fund did not set up a separate business but created allocations of return to match the pattern described. That is, the ownership percentages of the assets in the side pocket are fixed. Entering investors gain no ownership stake in these assets, and exiting investors may not redeem their stake in the side-pocket assets. Further, any return on the side-pocket assets is due to the original owners of those assets. In summary, the accountants treat the side pocket the same as if there was a separate legal entity.
QUESTIONS AND PROBLEMS
10.1 One hedge fund manager receives a fee equal to 1 percent of the as sets under management, which the fund reports as an expense to its investors. Another manager receives a distribution from the partnership equal to 1 percent of the assets under management paid to the general partners. Why might a fund manager prefer to receive a management fee as an allocation rather than the same payment as income?
10.2 Referring to the two funds in question 10.1, why might investors prefer to pay the manager a fee instead of granting a special allocation to the general partners?
10.3 Referring to the two funds in questions 10.1 and 10.2, why might investors prefer to pay the manager a special allocation instead of a fee? 10.4 A partner holds a 25 percent stake in an investment partnership.
The partnership reports ordinary taxable income of $1 million and allocates $250,000 to this partner. Assume that this investor pays income tax at the rate of 35 percent and that the corporate income tax rate is also 35 percent. Calculate the tax penalty if the hedge fund had been structured as a C corporation instead of a partnership.
.5 An investor invests in a mutual fund in December. A short time later, the mutual fund distributes a short-term capital gain to all shareholders equal to the short-term capital gains realized by the fund during the entire calendar year. The investor has experienced no appreciation in the value of the mutual fund shares at the time of the distribution. Explain how this tax allocation differs from the allocation at a hedge fund organized as a limited partnership.
10.6 A fund admits a new partner during the middle of a tax year. A short time later, the fund liquidates a position and generates a longterm gain. The fund makes a layered allocation to all investors, including the newest investor. Does the new investor receive a short-term or long-term gain?
10.7 You allocate gains and losses using the aggregate method. You must allocate a realized gain but all of your investors have losses. How should you allocate the losses to the investors?
10.8 A hedge fund pays $30,000 per month for a computer service. Does this mean that the fund should allocate out the expense at different daily rates for February (having 28 or 29 days) than for March (having 31 days)?
10.9 A fund has commissions equal to $1 million annually. How should the fund allocate the expense to the individual months?
10.10 An institutional investor has 10 percent ownership of a hedge fund for the first six months of the year. In the second six months, the institution has only 8 percent of the capital. The fund has an annual expense of $100,000 for a futures exchange membership. How much of the expense should you allocate to this investor for the year?
10.11 Refer to the aggregate allocation example in the text. Allocate the gain on position 1 using the layered method of tax allocation.
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