Recent Tax Rulings Affecting Hedge Funds

The Internal Revenue Service (“IRS”) has recently issued new rulings and regulations that have an impact on tax filings by many hedge funds.  The new rulings deal with the deduction of investment interest expense for trading funds and fund-level expenses incurred by fund-of-hedge funds.

Investment Interest Expense

The ruling recently issued by the IRS regarding investment interest expense will not dramatically change how trader funds report investment interest expense.  Rather Revenue Ruling 2008-38 clarifies the position taken by the majority of the hedge fund industry for trader funds.

Many trader funds would take the position on the Schedule K-1s issued to its investors stating that investors that do not materially participate in the fund’s activity can deduct investment interest expense from trading activities as an ordinary business expense subject to the investment interest expense limitation.  Prior to this new guidance issued by the IRS, there was question regarding where this deduction should be claimed on an individual’s tax return.  The new ruling states that investment interest expense incurred on debt allocable to property held for investment, subject to the investment interest expense limitation, is now deductible in computing ordinary income or loss from partnerships on Schedule E.

Fund-of-Hedge Fund Expenses

There has been much debate regarding how fund-of-hedge fund expenses are deducted by many tax professionals and fund managers.  Some have taken the position that a fund-of-funds is in the business of investing in other investment partners, others have taken the position that a fund-of-fund invests in other funds, while many others are somewhere in between.  However, this gray area has now been cleared up by guidance issued by the IRS.

The IRS has recently issued Revenue Ruling 2008-39 which addresses how fund-of-hedge funds expenses are deducted in arriving at taxable income, specifically how management fees are deducted.

In the past, many managers have bifurcated their fund-level expenses between ordinary and portfolio deductions based upon the type of funds that they invest in.  For example, if 60 percent of the fair value of the fund’s underlying investments are invested in trader funds with the remaining 40 percent in investor funds, the manager would take the position that 60 percent of its fund-level expenses were deductible as trade or business deductions and 40 percent as portfolio deductions.  However, Revenue Ruling 2008-39 states that a fund-of-hedge funds invests in and disposes of interests in other funds.  The conduct of holding the investments in other funds is deemed to be holding limited partnership interests for the production of income within the meaning of Internal Revenue Code §212.  Expenses incurred within the meaning of §212 are treated as portfolio deductions.  Portfolio deductions are only deductible to the extent that they exceed 2 percent of adjusted gross income and are not deductible in arriving at alternative minimum taxable income.

Filing Deadlines

The IRS has issued Temporary Treasury Regulations §1.6081-2T which reduces the extension period for partnership tax returns.  Prior to these treasury regulations, partnerships were allowed an automatic six-month extension of time to file its partnership tax return.  Under the new regulations, partnerships will only be granted an automatic five-month extension which creates additional stress and pressure on fund-of-hedge fund managers to issue their Schedule K-1s.  The new regulations are effective for applications of extension of time to file returns after July 1, 2008.

If you would like to discuss how these changes will affect your fund or would like to discuss other issues that face your fund, please feel free to contact Sean Tafaro or Michael Callahan at (303) 753-1959.

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