1. A Global Reach with a Local Perspective
www.decosimo.com
The ABCs Hedge Fund Tax
Elizabeth F. Powell
Tax Manager
2. CONTACT ME
Elizabeth F. Powell, CPA
Tax Manager
elizabethpowell@decosimo.com
423-756-7100
The contents and opinions contained in this article are for informational purposes only. The information is
not intended to be a substitute for professional accounting counsel. Always seek the advice of your
accountant or other financial planner with any questions you may have regarding your financial goals.
3. Hedge Fund Formation
Structure
Domestic/Foreign
LP/LLC/LLP
Some states distinguish between LP and LLC. Potential for
additional fees.
Master/Feeder
Master Fund with two investors – Onshore feeder fund and
an Offshore feeder fund
Mini-Master
Onshore investors are directly invested in in Master fund,
along with an Offshore feeder.
4. Hedge Fund Formation
Capital Contributions
In Hedge Funds, generally money or securities.
General rule is that there is no gain or loss to the
partner or partnership on an exchange of property for
an interest in a partnership.
Exception to general rule for partnerships that would
be treated as an “investment company” if they were
incorporated.
5. Hedge Fund Formation
Capital Interest
An interest which entitles the partner to share in
distribution of partnership assets upon liquidation
Profits Interest
An interest which entitles the partner to share only in
the future profits of the partnership
6. Distributions
Current Distributions
Cash distributions – no gain recognized unless cash
distributed in excess of tax basis of interest
Securities distributions – tax basis of securities
carried over to the investor
Liquidating Distributions
Cash distributions – gain or loss recognized to extent
cash distributed is greater or less than tax basis of
partnership interest
Securities distributions – the securities distributed
take the tax basis of the partnership interest
7. Basic Tax Considerations
Trader vs. Investor
Trader
Engaged in frequent and continuous trading of
financial assets to profit from favorable fluctuations in
the market
Investor
Generally seeks to profit from price appreciation and
income earned on the financial assets they hold.
8. Basic Tax Considerations
Tax Treatment
Trader –
Trading expenses are deductible as ordinary and
necessary business expenses
Above the line deduction for AGI
Deductible for AMT
Investment interest after limitations – reported on
Schedule E (for individuals)
9. Basic Tax Considerations
Tax Treatment
Investor –
Trading expenses are considered investment
expenses
Miscellaneous itemized deductions subject to the 2%
/ 3% limitations
Not deductible for AMT
Investment interest expense after limitation –
deductible on Schedule A
10. Basic Tax Considerations
Trader vs. Investor
Summary of factors to consider:
Intent as evidenced by PPM/OP or LPA
Turnover of portfolio, number of trades
Amount of time spent on activity
Actual results of activity (i.e. long-term vs. short-term)
Ratio of margin debt to portfolio value
Determination is made annually
11. Basic Tax Considerations
Wash Sales
Occurs when you sell or trade stock or securities at a
loss and within 30 days before or after the sale you:
Buy substantially identical stock or securities
Acquire substantially identical stock or securities in a fully
taxable trade, or
Acquire a contract or option to buy substantially identical
stock or securities.
Losses are not deductible
Deferred wash sale attaches to the basis of the
repurchased stock or securities
12. Basic Tax Considerations
Constructive Sales
Transactions that take an offsetting position to an
already owned position
Examples:
Making short sales against similar or identical positions
Entering into futures or forward contracts that call for the
delivery of an already-held asset.
Accelerates recognition of gain
13. Basic Tax Considerations
Section 475 Mark-to-Market Election
Under the MTM rules traders in securities are treated
as having sold all their securities on the last day of
the year at their fair market value
Any gain or loss recognized is taxed as ordinary
income or ordinary loss
Reported on Form 4797
14. Basic Tax Considerations
Advantages to Sec 475 Election
Losses are ordinary trade or business losses rather
than capital losses
Losses are not subject to $3,000 limitation
Net operating losses can be carried back or forward
Eliminates problems of straddles, wash sales,
constructive sale limitations, along with complex bond
calculations relating to OID and market discount
15. Basic Tax Considerations
Disadvantages to Sec 475 Election
Capital gains converted to ordinary income
Eliminates offsetting against Short-term capital losses
Limited ability to carry forward prior capital losses
How is the election made?
New taxpayers must place election statement in their
books or records no later than two and fifteen days of the
beginning of the tax year for which it is effective
Existing taxpayers must attach statement to their U.S.
federal income tax return or extension for the tax year
immediately preceding the election year
16. Basic Tax Considerations
Section 1256 Contracts
Only available for regulated futures contracts
A regulated futures contract is a contract based on a
system of marking to market and traded on a qualified
exchange
Gain/Loss is 60% long-term and 40% short-term
Swap contracts
Cross-border swaps will no longer escape withholding
Tax as Notional Principal Contracts
Specifically excluded from Section 1256 treatment
17. Basic Tax Considerations
UBTI – Unrelated Business Taxable Income
Big concern for tax-exempt investors
Taxable Income from business activities unrelated to
the tax-exempt purpose of the organization
Generally not an issue for trading partnerships due to
exemptions for interest, dividends, rents, capital
gains, etc.
Debt-financed income – income from property
acquired or carried with debt
Real estate, some securities portfolios, fund of fund with line
of credit
18. Hedge Fund Tax Allocations
Economic Allocations
Fair Value
Break period accounting
Operating results
Investment Income
Interest and dividend income
Operating expenses
Trading results
Realized gains
Change in unrealized
19. Hedge Fund Tax Allocations
Capital Gain Allocations
Allocating Capital Gains and Losses
Layering method
Aggregate method
Fill up/down
Allocate realized gain to withdrawing partners in order
to remove the unrealized gains associated with their
interest
20. Hedge Fund Tax Allocations
Reallocations
Performance Fee
Comes into play when return exceeds a specified
benchmark
Carried Interest
Most commonly seen in Private Equity or Real Estate
funds
21. State and Local Tax Considerations
Nexus
Apportionment
Departure from Pass-through Treatment
Entity-level Income Taxes
Withholding and Estimated Tax Payments
Composite Filings
22. Foreign Investors
Non-resident Withholding
ECI
Income effectively connected with a trade or business
in the U.S.
Subject to 35% withholding
FDAP
Fixed, Determinable, Annual or Periodic
Interest, Dividends, Royalties
Maximum withholding at 30%
Some treaty rates may be lower
23. Foreign Investors
FIRPTA
Foreign Investment in Real Property Tax Act
All direct and indirect rights to appreciation in real property
interest
Gross proceeds are subject to 10% withholding
FATCA
Foreign Accounts Tax Compliance Act
FFIs and NFFEs required to report to IRS information
about accounts held by U.S. taxpayers
Must enter into a special agreement with the IRS or be
subject to 30% withholding on payments of U.S. source
income
24. Foreign Investments
Reporting of foreign investments
Foreign Partnerships
Form 8865
Foreign Corporations
Form 5471
Disclosures
Form 926
25. Foreign Investments
PFICs (Passive Foreign Investment Company)
A non-U.S. corporation is a PFIC if either
75% or more of its gross income is from passive sources
50% or more of its average gross assets generate passive
income or are held to generate passive income
Consequences
No long-term capital gain treatment when sold
Gain is allocated over holding period of stock, with gain
allocated to current year taxed at ordinary rates and
Gain allocated to prior year:
Taxed at highest ordinary income rates
Interest charge imposed
26. Foreign Investments
Avoiding PFIC punishment
QEF election (Qualified Electing Fund)
Taxed currently on share of net capital gain and
ordinary earnings
No flow-through of losses
PFIC must provide PFIC Annual Information
Statement
Must make QEF election on timely filed return
27. Foreign Investments
Avoiding PFIC punishment
MTM election (Mark to Market)
Stock must be marketable
Unrealized appreciation is taxed as ordinary income
annually
Losses are allowed only to extend of prior year
inclusions