Taxation of U.S. Investment Partnerships and Hedge Funds: Accounting Policies, Tax Allocations, and Performance Presentation

Taxation of U.S. Investment Partnerships and Hedge Funds: Accounting Policies, Tax Allocations, and Performance Presentation

by Navendu P. Vasavada

ISBN: 9780470605752

Publisher Wiley

Published in Business & Investing/Accounting, Business & Investing/Taxation, Business & Investing/Investing

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Sample Chapter

Chapter One

The Arcane World of Hedge Funds and Investment Partnerships

What Is a "Hedge Fund"?

So, what is a hedge fund really? A "hedge fund" is an entity that offers "alternative" investments to investors, distinct from "traditional" investments in bonds and equities. A general counsel to the Securities and Exchange Commission (SEC) aptly simplified this as "The term hedge fund is not really descriptive, but just refers to a private pool of institutional capital." One would have expected that in the freewheeling world of the Internet, wiki volunteers would have arrived at a concise definition, in place of a confusing opening attempt at definition: "A hedge fund is an investment fund open to a limited range of investors that is permitted by regulators to undertake a wider range of investment and trading activities than other investment funds, and that, in general, pays a performance fee to its investment manager." In order to identify and decode the nature and character of hedge funds and their secretive "alternative" investment or trading strategies, we shall follow the U.S. SEC's attempt to corral and codify this popular object of perpetual regulatory concern.

In 2004, the U.S. SEC proposed hedge fund regulatory rules to bring most hedge funds into its regulatory net. These were published in the U.S. Federal Register in December 2004 and made effective February 2005, in 46 pages of fine print. The new rules lack both specificity and brevity, stating:

There is no statutory or regulatory definition of hedge fund, although many have several characteristics in common. Hedge funds are organized by professional investment managers who frequently have a significant stake in the funds they manage and receive a management fee that includes a substantial share of the performance of the fund. Advisers organize and operate hedge funds in a manner that avoids regulation as mutual funds under the Investment Company Act of 1940, and they do not make public offerings of their securities. Hedge funds were originally designed to invest in equity securities and use leverage and short selling to "hedge" the portfolio's exposure to movements of the equity markets. Today, however, advisers to hedge funds utilize a wide variety of investment strategies and techniques designed to maximize the returns for investors in the hedge funds they sponsor. Many are very active traders of securities.

The 2005 SEC rules remained in force for barely one year. In June 2006, the U.S. Federal Court of Appeals in the District of Columbia struck down these 2005 SEC Hedge Fund regulatory rules. During the remainder of the administration of George W. Bush's term through 2008, there was no further attempt to pass new legislation to regulate hedge funds.

The Federal Court of Appeals ruling that reversed and cancelled the SEC's hedge fund regulation provides interesting counterperspectives in its official court opinion. The very first line of the court opinion is "Hedge funds are notoriously difficult to define." The court then provided an interesting alternative definition by negation as "Hedge funds may be defined more precisely by reference to what they are not." In light of this federal appeals court reversal, new rules of the type that the SEC sought to enact under its own authority require higher legislative approval from U.S. lawmakers.

During the brief period when the new SEC rules were in force (before they were struck down in court), many large hedge fund managers registered with the SEC, even though they could have avoided such a registration by remaining exclusively offshore entities. This was because U.S. institutional investors indicated their preference to invest with hedge fund managers who registered with the SEC. Thus, SEC compliance was seen by U.S. institutional investors as a seal of good housekeeping, with the advantage of recourse to the U.S. legal system should disputes arise. Those hedge fund managers who operated as exclusively offshore entities risked losing the significant volume of their assets under management from U.S. institutional investors desirous of pursuing alternative investments.

At the time the proposed SEC rules were being actively debated, many neutral economists and policymakers warned that such SEC regulation of hedge funds would likely drive hedge funds to offshore locations without making any meaningful dent in their overall assets under management. Indeed, large European banks and offshore financial hubs might become beneficiaries of tightened U.S. regulation of hedge funds. The SEC regulations imposed meaningful reporting and compliance burdens on hedge fund managers that might have put small hedge fund managers at a cost disadvantage relative to large hedge funds.

U.S. Venture Partnerships

Although hedge funds have obtained media limelight in the past two decades, their plain older cousins, venture-capital partnerships, also organized as U.S. limited partnerships with almost the same exact structure as hedge funds, including the structure of management and performance fees, but they have received less media attention. Contrary to hedge funds, typical Silicon Valley venture partnerships have been objects of admiration for achieving multibillion-dollar companies in a reasonably short time based on entrepreneurial seeds, mostly located in college dormitories and neglected academic university laboratories, mostly in their local geography vicinity, with Stanford University serving as an anchor showcase. The creation of Genentech out of a single molecular biology researcher's lab at the University of California at San Francisco based on an investment of less than $100,000 by Kleiner, Perkins, Caufield & Byers (Kleiner Perkins), and the more recent rapid growth of Google out of a personal project of Stanford University graduate students, also associated with early investment by Kleiner Perkins, would remain showcases.

Chapter 11 elaborates upon to the nuances and differences between hedge funds and venture funds, as well as primary aspects of pass-through taxation to taxable U.S. Investors, and concerns regarding Unrelated Business Tax on Income (UBTI) for tax-exempt U.S. investors. Until then, much of the subsequent discussion on hedge funds almost exactly applies to U.S. Venture Funds (or, more appropriately, Silicon Valley venture funds).

We have not separately reviewed U.S. oil and gas partnerships, which were extremely popular in the 1980s. Their popularity was largely fueled by then-prevailing tax credits and deductions from intangible drilling costs and accelerated depreciation. Many investors believed that the tax benefits outweighed their investment cost, even if oil and gas were never found.

Types of U.S. Hedge Fund Entities and the U.S. Tax Code

At origination, a U.S. investment fund makes a primeval choice by typecasting itself into one of the various molds of U.S. federal taxation: It is obliged to seek a U.S. taxpayer ID number as a subchapter C corporation, a subchapter S corporation, a SEC-regulated investment company, or partnership, following the creation of such an entity in a corporate entity-friendly state such as Delaware. Its physical place of business would most likely be a hedge-fund-friendly state, in terms of state securities laws, such as Connecticut.

A subchapter S entity is almost never chosen to structure an investment fund due to the limited number of investors that it can have (at most 100). Its investors/shareholders should be natural persons who are citizens or residents of the United States, which precludes the inclusion of institutional investors and foreigners. Similarly, a subchapter C entity is almost immediately banished from consideration due to its flat 35 percent U.S. corporate tax on all future profits (with the exception for reduced taxation on U.S. source dividends, called the "dividends reduced deduction").

Further, dividends and distributions to shareholders from such a subchapter C entity are double taxed (i.e., taxed once again) in the hands of the shareholders when remitted. The Bush administration softened the blow of double taxation by taxing dividends on holdings of more than 60 days at a reduced tax rate of 15 percent in the hands of the shareholders, under new rules that define such "qualified dividends." It is rare but not unusual to find a maverick fund manager operating what is largely an investment fund in the form of a subchapter C corporation. For instance, Warren Buffett's Berkshire Hathaway Corporation is only nominally an industrial company and is considered by many investors to be a grand mutual fund. Its subchapter C standing attracts double taxation. It remains a puzzle that this brilliantly managed pseudo industrial de facto financial and portfolio investment entity stands out alone as a subchapter C corporation, when every other fund manager is seeking to typecast their entity under the lowest possible tax regime with the lightest regime of regulation.

The SEC regulated investment company, more commonly called a mutual fund, is also a tax pass-through entity. There is no U.S. corporate or state tax at entity level that applies to such a company. However, the constraints of operating a regulated mutual fund under the U.S. Investment Company Act limit the range of feasible and permissible investment strategies. The world of venture capital funds, private equity funds, illiquid-securities funds, and hedge funds is disjoint from the world of SEC-regulated mutual funds. The latter is organized mainly for the benefit of small investors.

The overwhelming majority of U.S. venture capital funds, private equity funds, illiquid securities funds, and hedge funds are formed as pass-through partnerships under the U.S. tax code. Most lawyers would use the expression "investment partnership" as formal representation for a hedge fund as well as its close cousin of Silicon Valley, a venture fund. The latter have become more colloquial terms.

The source income from U.S. investment partnerships is not subjected to paying two layers of tax, as is the case with a U.S. subchapter C entity, by organizing themselves as pass-through partnership entities for the purpose of taxation under U.S. tax law. A U.S. limited partnership or a U.S. limited liability company is permitted to file its tax returns as a partnership, paying no direct corporate tax as would a subchapter C corporation, passing through its taxable income to its partners, who in turn are taxed as individuals. Thus, the income and earnings of the hedge fund or investment partnership are taxed only once, at the relevant marginal tax rate of each partner. Tax-exempt U.S. partners would not be paying any tax. However, the investment partnership must avoid being classified as a U.S. "publicly traded partnership." If such classification were to occur, the partnership would be treated as if it were a subchapter C corporation for federal tax purposes, and would have to pay corporate tax. Further, investment partners who receive cash flows that are considered to be dividends would be taxed once again on such cash flows. Nearly all U.S. investment partnerships, both hedge funds and venture funds, qualify not to be deemed publicly traded partnership due to not having an active secondary market in its partnership interests, and due to producing nearly all of its income comes from "qualifying" sources, that is, dividends, interest, rents, and capital gains.

Hedge funds that pursue computerized high-frequency trading strategies and decide to count the trading profits as operating income, as opposed to capital gains, would be trading partnerships. This is not a preferred form of structuring, except for trading partnerships that incur significant expenses and desire to offset these expenses directly with trading income.

Organizing a Typical U.S. Hedge Fund

The hedge fund manager, formally the general partner to the hedge fund, a U.S. limited partnership (LP), is typically a U.S. limited liability company (LLC), which for U.S. tax purposes may elect to be taxed as a partnership. The most popular U.S. state for formation of the hedge fund general partner LLC and LP pass-through partnership entities is Delaware. This is primarily because the relatively small state of Delaware has positioned itself among the 50 states as a friendly regime for corporate domicile, with well-developed corporate laws and longstanding corporate case history in the state court system.

Delaware itself is a taxable state and imposes corporate tax on Delaware entities having a physical business presence in the state. For this reason, nearly all U.S. general partner entities establish a principal place of business in a U.S. state other than Delaware, which does not impose corporate taxes on LLC entities that are pass-through partnerships for U.S. federal tax purposes. Connecticut is one such popular state for Delaware entities setting up their principal place of business for hedge fund management and operations. Thus, such a general partner LLC pass-through entity does not pay either federal or state corporate tax on its income. All of the general partner entity's items of income are taxed only once, when passed through to its partners.

The hedge fund manager, that is, the general partner, charges fund management fees to its limited partners. The details of such fees, contractual provisions, as well as tax consequences both to the limited partners and the general partner are described later. The general partner is responsible for the day-to-day operations, administration, and overall management of the fund, and incurs management expenses.

Thus, a typical U.S. hedge fund structure is a pair. The hedge fund sponsor organizer sets up two entities, usually in the state of Delaware. The first is typically a Delaware LLC (limited liability company) that becomes the general partner of the second entity, a Delaware LP (limited partnership). The general partner entity is governed by a private operating agreement of the LLC signed by its members, who are its partners. LLC members are granted limited liability by the State of Delaware. At a minimum, the LLC agreement establishes the voting powers of members, designation of a manager (who could be a member), power of attorney and authority delegated to the manager, and profit sharing among members. The limited partnership entity is governed by its agreement of partnership. Delaware and other states do not require the operating agreement of the LLC or the partnership agreement of the LP to be filed, so they remain private documents in private domain. For a limited partnership, Delaware requires a sparse one-page formation document, "Certificate of Limited Partnership," provided on its Web site signed by an authorized representative of its general partner LLC entity, such as its manager or member. Similarly, the general partner entity, the LLC, files a sparse one-page formation document provided on the Delaware state Web site, "Limited Liability Company Certificate of Formation," signed by an authorized person who is either a member or simply an appointed or employed manager.

The GP/LP pair immediately obtain taxpayer identification numbers from the Internal Revenue Service (IRS) by filing the appropriate IRS Form SS-4, which requires clear identification of the type of entity in a check box. The LLC can elect to be either a subchapter C corporation or a partnership for the purposes of U.S. taxation. The LLC entity (which is general partner to the LP) wisely elects to be taxed as a pass-through U.S. partnership to avoid double taxation that a U.S. subchapter C corporation would face. The pair of entities is required to have nominal registered offices in the state of Delaware, which is really the physical address of its Delaware-registered agent named on the certificate of formation. The pair of entities appoints such a state agent prior to seeking entity formation, for which the agent charges a modest annual fee. The state of Delaware charges a modest initial filing fee, which at this time is $200 for an LP and $90 for an LLC. Subsequently, the LP and LLC that are formed in the State of Delaware are not required to file an annual report but are required to pay an annual flat tax of $250.

The pair subsequently establish a common physical place of business, which is typically in the state of Connecticut for hedge funds. For Silicon Valley venture partnerships, the physical place of business is in the state of California. (Silicon Valley venture partnerships have no particular affinity for Delaware and might elect to form their LP and LLC pair in Nevada or California.) They are required to make Delaware-like filings in their state of domicile and business presence, as a "foreign" out-of-state entity that is doing business in the state.


Excerpted from "Taxation of U.S. Investment Partnerships and Hedge Funds: Accounting Policies, Tax Allocations, and Performance Presentation" by Navendu P. Vasavada. Copyright © 0 by Navendu P. Vasavada. Excerpted by permission. All rights reserved. No part of this excerpt may be reproduced or reprinted without permission in writing from the publisher. Excerpts are provided solely for the personal use of visitors to this web site.
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