TMCnet News
Essential Tax Aspects of Hedge Fund Investments [CPA Journal, The](CPA Journal, The Via Acquire Media NewsEdge) investing universe for high-net-worth individuals has recently expanded to include such alternative investments as hedge funds and other private equity firms. Concurrent with * these new investing opportunities is the trend for CPAs to obtain the certified personal financial specialist (PFS) designation, one aspect of which is demonstrated knowledge of various aspects of investments. The following is a discussion of a tax module that identifies and describes various aspects of taxation of hedge funds in order to aid CPAs as they provide advice to high-net-worth individuals who contemplate investing in hedge funds. Background The investing universe for high-net-worth individuals has expanded, particularly as a result of provisions of the Jumpstart Our Business Startups (JOBS) Act of 2012 that allow hedge funds and other private equity firms to sell directly to "accredited investors"-that is, individuals with more than $1 million in net assets or at least $200,000 in income. In conjunction with these expanded investment opportunities, William M. VanDenburgh ("Advising Individuals on Hedge Fund Investments," The CPA Journal, September 2013, pp. 36-43) describes CPAs as a "crit- ical source of guidance" and one of the few unbiased advisors for individuals who seek investment alternatives that offer greater returns. VanDenburgh's perspective also reflects the current trend for CPAs to leverage their certification by obtaining the certified PFS designation. Membership in the AICPA Personal Financial Planning (PFP) Section has grown 32% during the past five years (G. Chironis, "Regulatory Update: High Standards," California CPA, June 2014, pp. 15-16), indicating the growth in client demand for such services. Reflecting the increased need for guidance on investments, the AICPA recently promulgated its Statement on Standards in Personal Financial Planning Services, effective for services as of July 1, 2014. VanDenburgh focused on hedge fund investments, identifying and describing various aspects of CPA guidance pertaining to such investments. Although he identified tax issues as one aspect of investing in hedge funds, his focus was primarily on other parameters (e.g., a description of the hedge fund industry, hedge fund opportunities, the solicitation paradigm, and a description of accredited investors). The purpose of the current article is to provide a tax module that identifies and describes various aspects of federal income taxation of investments in U.S. hedge funds. As such, it constitutes the essential income tax component of the CPA's knowledge base as it pertains to providing advice to high-networth individuals who contemplate investing in hedge funds as well as venture capital firms. Specifically, this analysis addresses hedge fund organization and its impact on taxation, tax return obligations and format, and investment funds versus trader funds, among other issues. Ibis research is not presented as a treatise about each and every aspect of federal income taxation pertaining to hedge funds and their investors. Instead, it constitutes a description of the essential hedge fund entity tax issues so that a CPA can provide clients with a base of knowledge about the entity in which they might invest. The focus, however, is the individual investor and the income tax issues and consequences they encounter when they obtain a limited partnership interest in a hedge fund. CPAs who wish to develop a more advanced knowledge base should refer to the source cited at the end of this article about tax issues beyond the scope of this article (e.g., straddles, wash sales). Hedge Fund Organization Hedge funds are configured to be tax and administratively efficient. The organizer of a U.S. hedge fund typically organizes the hedge fund as a limited partnership, which is actually a pair of entities, most often configured as- * a limited liability company (LLC), the general partner (GP) manager of ... * a limited partnership (LP) in which the limited partners are nonmanaging investors. Although the GP (LLC) may contribute capital to the hedge fund, the majority of hedge fund capital comes from investments of hedge fund limited partners (LPs). The analysis below assumes that the GP (LLC) does contribute capital to the hedge fund and, therefore, has a partnership capital account. It also assumes that the hedge fund (LP) is an investment fund (and not a trader fund), which is consistent with VanDenburgh's perspective. In other words, individuals are assumed to become LPs in a hedge fund as investors, not traders. The significance of the distinction between investor funds and trader funds is addressed and explained below. Hie GP manages day-to-day operations of the fund, makes investment decisions, and incurs related management expenses. The GP's primary objective is to earn two types of fees: a fixed (management) fee and a performance fee, frequently referred to as a "2/20" compensation structure. The fixed fee-which does not depend upon fund performance-typically ranges between one and two percent of fund assets [i.e., end-of-period net asset value (NAV)], out of which the GP pays management expenses. The more significant fee is the performance fee, which is paid to the GP hedge fund manager by the hedge fund LPs (investors); it is typically 20% of new net profits earned in excess of a predetermined "hurdle rate." The pair of entities obtains 1RS taxpayer identification numbers (by filing 1RS Form SS-4) and often has nominal registered offices in Delaware (the address of the fund's Delaware registered agent) because of its preferable legal system. The pair selects a principal physical place of business, with state income tax laws often factoring into the decision. Connecticut is often selected for the following reasons: * Connecticut securities laws typically exempt a fund from state registration as an investment advisor if the SEC exempts the entity from such registration; * Connecticut (like many states) taxes only resident partners of an LLC or LP on the conduit entities partnership income; it does not tax the LLC or LP pass-through entities themselves; and * Nontax infrastructure also exists to support hedge funds doing business in Connecticut. The Connecticut Hedge Fund Association seeks to promote "a favorable business climate for hedge funds oper- ating within Connecticut" and foster a "better understanding of hedge funds and alternative investment management" (http:// www.cthedge.org). Most states do not impose a state income tax on conduit entities; however, Illinois departs from the norm by imposing an entity tax of 1 .5% on the income of conduit U.S. partnerships located in the state. With regard to annual fee assessments, most states do assess a flat annual fee on LLCs and LPs domiciled in the state. A financial advisor must determine the specific tax environment that is relevant to the hedge fund universe contemplated by an investor. Tax Return Obligations and Format It is important to recognize that hedge fund taxation is at its essence an application of the existing principles of the federal income taxation of partnerships. In providing advice to high-net-worth clients contemplating a hedge fund investment, a CPA must identify and integrate the unique characteristics of hedge funds (particularly the fixed management fee and performance fee paid to the general partner) into the partnership taxation paradigm. The following analysis describes the income tax expectations associated with domestic hedge fonds and investment as a limited partner in such a hedge fund. As a limited partnership, a hedge fund annually files 1RS Form 1065, U.S. Return of Partnership Income, which also includes Schedule B (Other Information), Schedule K (Partners' Distributive Share Items), Schedule L (Balance Sheets per Books), Schedule M-l [Reconciliation of Income (Loss) per Books With Income (Loss per Return) or Schedule M-3 if fund assets exceed a specified amount], and Schedule M-2 (Analysis of Partners' Capital Accounts). In addition, if the hedge fund has foreign limited partners, the fund is the withholding agent for U.S. withholding taxes for each foreign limited partner, files 1RS Form 1042, Annual Withholding Tax Return for U.S. Source Income of Foreign Persons, and remits the withholding taxes. It is typical for each foreign limited partner's withheld taxes to represent a withdrawal from the year-end capital account (net of fixed fees and performance fees). Form 1065. As with all entities that file Form 1065, hedge funds compute their ordinary business income (loss) on the form. The income and deduction items reported on Form 1065 are those that are not "separately stated" elsewhere (i.e., on Schedule K). Because the vast majority of hedge fund income and deductions are those that are reported separately on Schedule K (e.g., taxable interest income, dividends, net capital gains and losses) so that they retain their tax character when allocated to partners, the Form 1065 computation of ordinary business income (loss) does not represent the most significant return of investment hedge funds. To the extent that the fund generates ordinary business income, however, its tax significance is its allocation to the GP and LPs as ordinary income, which is subject to income tax at ordinary rates as well as payroll taxes. In contrast, Schedule K represents the most significant portion of the hedge fund's federal return because it identifies by name and amount each tax item that is to be allocated to hedge fund partners for reporting on their federal income tax returns. Exhibit 1 identifies the Schedule K items of most significance to hedge fund federal income tax reporting. For hedge funds, a unique relationship exists between Schedule K items 4 and 13d. The item 4 management fixed fee allocated to the GP as a guaranteed payment (ordinary income) is equal to the item 13d deduction that is allocated to LPs as a deduction. The LPs are the source of the GP's management fixed fee, which detracts from the LPs' investment returns. In addition, for investment hedge funds, Schedule K item 13d (other deductions) also equals item 20b (investment expenses). Schedule K-l. As a limited partnership, the hedge fund prepares for each partner (the LLC GP and each LP) a Schedule K-l that identifies its share of items reported on the hedge fund's Schedule K. The unique aspects of the GP's Schedule K-l are twofold: * The GP's Schedule K-l will report as item 4 the entire guaranteed payment (management fixed fee) because the management fixed fee is allocated entirely to the GP. The GP reports the guaranteed payment (management fixed fee) as ordinary income on its own federal return and allocates the ordinary income to its members for reporting in their returns. The management fixed fee is also subject to payroll taxes. * The GP's Schedule K-l will not show any "other deductions" on item 13d. For a hedge fund, item 13d constitutes the management fixed fee deductions that are allocated entirely to the LPs because the LPs are the source of the fixed fee paid to the GP. The unique aspects of each LP's Schedule K-l are also twofold: * Each LP's Schedule K-l will not show as item 4 any guaranteed payment, because the guaranteed payment (management fixed fee) is allocated entirely to the GP as ordinary income. * Each LP's Schedule K-l will show as a deduction on item 13d the LP's share of the management fixed fee paid to the GP. Under the assumption that the hedge fund is an investment fund, each LP deducts her item 13d amount in her own federal income tax return as a section 212 miscellaneous itemized deduction and reduces her hedge fund capital account and tax basis by the item 13d amount. If an LP is subject to the alternative minimum tax (AMT), section 212 expenses are disallowed, the result of which is that the LP will not reap a tax benefit from the investment management fee allocated as a deduction. GP performance fee. It is the norm for hedge funds to calculate the performance fee paid to the GP at the end of each calendar year, because partnerships are typically calendar-year taxpayers. The GP performance fee constitutes an internal hedge fund transfer from the LPs to the GP. Typically the hedge fund "transfers" from limited partners to the GP a fraction-usually 20%-of hedge fund profits in excess of the high-water mark (i.e., the highest value achieved by the capital account after fixed management fees since the last point at which a performance fee was assessed, or since its inception if this is a shorter period), less a "hurdle" amount specified in the partnership agreement. From this process emanates a performance fee calculated on "new" profits. The process also results in a new high-water mark. The most common hurdle amount is the short-term Treasury bill rate. Potential investors should be aware of the terminology, although the actual computation of the performance fee is beyond the scope of this article. A hedge fund's CPA would handle this computation and the internal transfer process. This opaque internal process is relevant for potential hedge fund investors because of the unique terminology associated with the process and its tax impact. From the author's perspective, the important conclusion is that, by means of an internal hedge fund process, the performance fee reduces income allocations to LPs (and reduces LP capital accounts and outside basis) and increases allocations to the GP (and increases the GP capital account and outside basis) as a reward for creating "new" profits for the fund and its investors. Another crucial tax aspect is the mandatory transfer, under current federal partnership tax law, of the performance fee to the GP "in kind" so that it retains its nature when allocated to the members of the LLC GP for reporting in their income tax returns. In other words, the performance fee is distinguished from the fixed management fee in that the former is not allocated to the GP as guaranteed payment (i.e., ordinary income). In contrast, the performance fee consists of a percentage (typically 20%) of the various types of income recognized by the hedge fond during the tax year (e.g., long-term capital gains, taxable interest income, tax-exempt income). Furthermore, hedge fund LPs benefit from these provisions of current federal law because income allocations to them on Schedule K-l are net of the performance fee, the result of which is analogous to deducting performance fees from investment income at the source-rather than as a miscellaneous itemized deduction in the case of the fixed management fee. In addition, the one-level-of-taxation tenet of conduit taxation is preserved because the components of the performance fee are allocated in kind to members of the GP for federal income tax reporting and not taxed to the LPs. Allocations to partners. In accordance with IRC section 704(b)(1), the allocation of tax items to partners is based upon their percentage ownership share, unless tiie partnership agreement establishes a specific set of allocation mies that reflect a substantial economic effect. bivestor Fund or Trader Fund? The introduction assumed that the hedge fund is an investment hedge fund, not a trader fund. The following section demonstrates the importance of investors ascertaining the specific nature of the fund in which they contemplate investing: investment fund or trader fund. The federal tax delineation between investors and traders is unambiguous: * Investor. A taxpayer who purchases and sells securities for its own account with the primary objective of realizing income in the form of interest, dividends, and gains from appreciation in values over a relatively long investment horizon-generally one year or more. * Trader. A taxpayer whose investment transactions are so frequent that they constitute a trade or business. Traders typically engage in securities transactions to earn a profit on short-term market fluctuations. The category of hedge fund affects the federal tax treatment of various items. These items and the ensuing tax treatment are described in Exhibit 2. Other Tax Issues CPAs may wish to expand their knowledge of hedge fund tax issues to include more advanced transactions and attributes. The treatise by David S. Miller and Jean Bertrand is an excellent source of information about the impact of two such issues, among a variety of others ("The U. S. Federal Income Tax Treatment of Hedge Funds, Their Investors, and Their Managers," 2011, http://ssm.com/abstract= 1758748). GP receives a profits interest only. If tiie hedge fund is configured such that the GP does not contribute capital to the fund, the GP does not have a partnership capital account and does not share in the distribution of assets upon fund liquidation. Instead, the GP receives a profits interest, which entitles him to share only in future fund income. Miller and Bertrand (p. 90) explain that, under existing law at the time of their research, neither the grant nor vesting of a partnership profits interest is a taxable event if certain requirements are met. The subject has been quite fluid, however, with a subsequent expansion of the requirements for nontaxable treatment to the GP. Subsequent to Miller and Bertrand, proposed regulations were issued to apply to transfers of such profits interests. On February 26, 2014, the 1RS published Treasury Decision (TD) 9659, which adopted the proposed regulations (with modifications) and finalized them in Treasury Regulations section 1.83-3. CPAs advising on a GP's receipt of a hedge fund profits interest should be vigilant about relying upon the most recent authority with regard to such transfers. Other advanced transactions. Miller and Bertrand also provide thorough analyses (including statutory references) pertaining to the tax impact on hedge funds and their investors of the following transactions, which are beyond the scope of this article: * "Mark-to-market" election for traders [IRC section 475(f)] * Regulated futures contracts, foreign currency contracts, nonequity options (IRC section 1256 contracts) * Straddle rules (IRC section 1092) * Short sales (IRC section 1233 short sales) * Unrelated business taxable income for tax-exempt investors [IRC sections 512(a) and (c)]. ? It is important to recognize that hedge fund taxation is at its essence an application of the existing principles of the federal Income taxation of partnerships. Hie performance fee is distinguished from the fixed management fee in that the former is not allocated to the GP as guaranteed payment (i.e., ordinary income). Haroldene F. Wunder, PhD, CPA (inactive), is a professor of taxation in the college of business administration at California State University, Sacramento, Calif. (c) 2014 New York State Society of Certified Public Accountants |