Download Are hedge funds a suitable investment for taxable investors?

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“Uninformed decisions may
force [taxable investors] to
pay hundreds of basis points
in tax on phantom income.”
M o rriso n, Brow n, Argiz & Farra LLC
Are hedge funds a suitable
investment for taxable investors?
By Marjorie A. Horwin
Conversely, when the hedge fund
is classified as a trader, the management fees may be deducted fully in
carrying on the trade or business as a
nonpassive deduction under IRC Section 162, not subject to limitations. For
example, if an investor hedge fund
has a gross return of 12 percent and
a net return of 10 percent after fees,
the investor will pay tax on 12 percent.
Alternatively, if a trader hedge fund
has a gross return of 12 percent and
a net return of 10 percent after fees,
the investor will pay tax only on the
net income of 10 percent. For high
net worth individuals, the most taxefficient investment in a hedge fund
captures returns in a form that nets
expenses against income.
Furthermore, if a hedge fund
qualifies as a trader, it may make an
election under IRC Section 475(f)
to use the mark-to-market method
of accounting (MTM). With MTM,
the price or value of a security held
open at year end is treated as if it
were sold at fair market value. When
trader hedge funds make the MTM
election and depreciated securities
reflect unrealized losses at year end,
taxable losses are passed through
to the taxable investor, thus generating a net operating loss. However,
when appreciated securities reflect
unrealized gains at year end, taxable
gains will be passed through to the
taxable investor.
In this scenario, a taxable investor
may lack sufficient funds to pay the
tax liability on the unrealized gains.
The reason is that the funds will not
have liquidity to make distributions
until the investments have been realized. It’s important to note that in
the initial year of the election, the
taxable gain will incorporate multiple years of unrealized appreciation,
creating an even larger tax burden.
The hedge fund industry’s growth
is reflected in the current 10,000
individual hedge funds, with more
than $2.7 trillion dollars in assets
under management. High net worth
individuals, or taxable investors, represent 9 percent of hedge fund investors by type and 3.6 percent of the
total capital invested in hedge funds.
Considering the concentration
of capital that these individuals
maintain in hedge funds, these investments’ performance may have
a material influence on investment
portfolios. The tax-inefficiency of
certain hedge funds may negatively
impact the after-tax returns of a portfolio, due to the factors described
here. Therefore, when deciding to
invest in a hedge fund, consult with
your tax or investment advisor to consider the potential tax ramifications.
Left to right: Marjorie A.
Horwin, Gary M. DuBoff,
Emilio T. Escandon
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i ll u st r at i o n b y N anc y J an u z z i
Hedge funds are the darlings of
the investment world. Their main
allure is that, when executed well,
they generate returns not closely
tied to global stock and bond markets, thus providing diversification
to a taxable investor. However, investing in hedge funds may also
lead to tax inefficiency depending
upon whether the fund’s investment
manager is classified as a trader or
investor. Taxable investors should
take care in the types of hedge
funds they choose, as uninformed
decisions may force them to pay
hundreds of basis points in tax on
phantom income.
Domestic hedge funds are traditionally set up as partnerships or
limited liability companies to insure
that profits are taxed only at the individual level and avoid the double
taxation treatment of a corporation.
However, when a partnership or LLC
pays high management fees to the
fund manager, the result may be
the investor owing more tax on income than he or she actually earns.
When a hedge fund is classified as
an investor, the management fees
are taken as a miscellaneous itemized deduction under IRC Section
212. For taxable investors subject to
the alternative minimum tax these
deductions will be disallowed.
Financial Services Experience
Horwin, 29 years
DuBoff, 35 years
Escandon, 31 years
Website www.mbafcpa.com
Morrison, Brown, Argiz & Farra LLC
Methods of Compenstation Fixed and hourly fees
Professional Services Provided Tax planning and consulting, tax compliance,
assurance (audit services), family office and concierge services, estate and
charitable planning services
Email [email protected]
[email protected]
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225 Northeast Minzner Boulevard, Suite 685, Boca Raton, FL 33432
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561.909.2100
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