A Hedge Fund Taxation Overview (How is Private Equity Taxed)

A Tax Guide to Hedge Funds Private Equity Taxation & Reporting

Tax Guide to Hedge Funds Private Equity Taxation

While the term hedge fund is one of those types of financial industry phrases that intimidates people — it is usually not as bad as it seems.  In general, a Hedge Fund operates as an LLP or LLC, with some additional complications (2 & 20 and Carried Interest for example). Complicating the issue of the hedge fund is usually deciphering the issues involving taxation and international taxation of certain income involving hedge funds. For example, is the income taxable as ordinary income, or does it receive tax-deferred treatment such as investment income (capital gains or qualified dividends) — and not ordinary income (which can result in a much higher top tax rate).  Further complicating the tax matters is when international private equity funds are involved and even more complex issues arise, such as PFIC, Subpart F, GILTI, and more.  Let’s take a walk down the very basics of hedge fund private equity taxation and reporting.

What is a Hedge Fund

Before diving into the tax implications of having a hedge fund it is important to understand the basics of the hedge fund model. In general, a hedge fund is an investment group led by a Fund Manager (the “Captain” of the ship) and comprised of other professionals performing complex investment analyses and strategies to generate income for the fund. The hedge funds are usually developed as a partnership with one general partner — and several limited partners.

How is the Income Taxed?

In order to evaluate how hedge fund is taxed, it is important to start with the basics. Most hedge funds are structured as limited partnerships or limited liability companies. These types of structures are referred to as flow-through entities – which just means that there are not two levels of tax (entity and shareholder), just one, that flows through to the shareholders/partners. An example of a two-level tax structure is a C-corporation. Investors who are involved in the hedge fund investment receive a K-1 to break down their income and expenses.

2% Management + 20% Performance Fee

In general, there is a certain type of fee structure that hedge funds use, which is referred to as the “two and 20.” The 2% refers to the management fee and the 20% refers to the performance fee with the idea that the fee is structured additionally to try to avoid income tax by basing it on performance and intermixing the income through adding value to result in capital gains and not OI (Ordinary Income).

Hedge Fund 2% Management Fee

The 2% management fee is not based on the fund’s performance, but it’s typically based on the overall concept of the number of assets under management with a particular hedge fund.  Depending on how much a person invests in the fund will determine the amount of management they pay. For example, if an investor invests $10 million into the fund then would have a $200,000 management fee. This is usually taxed to the Hedge Fund as Ordinary Income.

20% Performance Fee (Carried Interest)

Conversely, the performance fees are based on the performance of the fund. If the fund was to gain 5% so that now the fund is worth $10,500,000, then the fund would also charge you 20% of the gain — which in this situation would amount to $100,000. Here is where the fund seeks to avoid ordinary income.

Carried Interest

In the same way that attorneys have good lobbyists to ensure that attorneys’ fees get paid — hedge fund managers also have an arsenal of lobbyists to support their position on carried interest and passive income. Carried interest can be a very complicated analysis, but it is essentially designed to morph what would usually be considered ordinary income into capital gain income.  Thus, instead of being taxed at the ordinary income tax rates, carried interest is taxed at long-term capital gain treatment with a maximum tax rate of 15% or 20%. For many years now, the government has considered closing this type of loophole. The issue stems from the fact that the money being earned is based on the performance of the fund partners, which many people believe should be taxed as ordinary income — similar to the salary and bonus generated for working as an investment manager at a firm — but since it is being mixed and recharacterized in conjunction with the actual performance of the assets within the fund, it is characterized as long-term capital gain rates.

Overseas Reporting

Hedge funds that are located overseas may have a myriad of different international information reporting requirements for the fund and the assets within the fund. While some reporting may be excluded such as usually the FBAR – there are other reporting requirements along with certain potential tax implications. Taxpayers who are out of compliance may want to consider one of the amnesty programs to safely get into compliance and work with a Board-Certified Tax Law Specialist.

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