The IRS announced on November 1, 2007 that it opened an inquiry into “suspected tax abuses” by hedge fund and private equity mangers relating to failure to report income or to improperly classify ordinary income as capital gains.  Among the issues the IRS says it is “gathering and analyzing information” for:  failure to file returns, the timing and allocation of incentive income and other items, methods of accounting used to minimize income, and issues related to how investors, traders and dealers report their activities.

In particular importance to managers of “hard money” lending funds and other onshore and offshore debt-holding funds in general, the IRS announced that it is investigating the recognition of income on loans, and whether fund managers have dictated the terms of loans to banks before purchasing loan portfolios.  This last issue is especially important to offshore funds, which could be attacked as carrying on a finance business onshore through use of onshore banks as agents.

The IRS’s announcement came as the Ways and Means Committee approved a bill to tax the carried interest in hedge funds and private equity funds as income from compensation and to end the deferral of fees earned from managing offshore funds. 

We note that the IRS made similar efforts in light of the aftermath of Long Term Capital Management in 1998.  Very little, if anything, emerged from those efforts as the IRS found little to challenge, and, instead, moved on to auditing tax shelters.  This time around, the hedge fund industry’s numbers are much larger and the industry may not escape with as little damage as it did 10 years ago.