Hedge Funds (Portfolio 736)

Tax Management Portfolio, Hedge Funds, No. 736-2nd, addresses the full range of U.S. tax issues that typically arise in the representation of hedge funds.

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Tax Management Portfolio, Hedge Funds, No. 736-2nd, addresses the full range of U.S. tax issues that typically arise in the representation of hedge funds. The purpose of this portfolio is to provide a source of guidance to tax practitioners who regularly advise hedge funds, their portfolio managers and their investors. It also includes descriptions of basic fund prototypes, the relevant regulatory environment, alternative fund structures, and common economic terms and variations thereon.


Andrew W. Needham

Andrew W. Needham, J.D., Georgetown University Law Center; LL.M. (Taxation), Georgetown University Law Center; M.B.A., The Wharton School; B.A., University of Arizona; Member, Executive Committee, Tax Section of New York State Bar Association, American Bar Association, United States Tax Court.

Christian Brause

Christian Brause, First and Second State Examinations in Rhineland-Palantinate, Germany; doctorate in law (Dr. jur.), Johannes Gutenberg University at Mainz; LL.M. (Int. Taxation), New York University School of Law; former Member of the Bar of Frankfurt a. M., Germany; Member of the Tax Section of the New York Bar Association.

Table of Contents

Detailed Analysis

I. Introduction

Introductory Material

A. What Is a Hedge Fund?

B. The Regulatory Environment - A Brief Overview

II. Fund Prototypes

A. Basic Fund Structures

1. In General

2. Single Entity Funds

3. Master-Feeder Funds

4. Parallel Funds

5. Multi-Manager Funds

6. Hedge Funds with Private Equity “Side Pockets”

B. Basic Fund Categories

1. Arbitrage Funds

2. Distressed Securities Funds

3. Event Funds

4. Opportunistic Funds

5. Macro Funds

6. Market Timing Funds

7. Futures Funds

C. The Investor Participants

1. Individual Investors

2. Public Company Investors

3. Tax-Exempt Investors

4. Foreign Investors

III. The Basic Economic Deal

A. In General

B. The Management Fee

C. The Carried Interest

IV. Achieving Pass-Through Treatment for the Fund and Its Affiliates

A. In General

B. Classification as a Pass-Through Entity

1. Before January 1, 1997: The “Kintner” Regulations

2. Current Law: The “Check-the-Box” Regime

a. State Law General or Limited Partnership

b. Domestic LLCs

c. Foreign LLCs

d. Other Foreign Entities

C. Publicly-Traded Partnership Limitations

1. In General

2. The Market Rule

3. The Secondary Market Rule

a. The Problem

b. The Private Transfers Safe Harbor

c. The Redemption Safe Harbor

d. The Private Placement Safe Harbor

e. The Qualified Matching Service Safe Harbor

f. The 2% de Minimis Safe Harbor

4. Qualifying Income Exception

a. In General

b. Safe Harbor Not Available to Certain 40 Act Funds

c. Definition of Qualifying Income

d. Commodities Income

e. QEF Inclusions

f. Interest Income from a “Financial or Insurance” Business

g. Credit Derivatives

D. Choice of Entity for General Partner

E. Choice of Entity for Portfolio Manager

F. Taking the Portfolio Manager Public?

V. Profit & Loss Allocations

A. In General

B. Allocations of “Book” Income

C. Allocations of Taxable Income

1. Nature of the Problem

2. Reverse 704(c) by “Layering”

3. Reverse 704(c) by “Aggregation”

D. The “Stuffing” Allocation

1. Nature of the Problem

2. The “Stuffing” Solution

3. Does Stuffing Have Substantial Economic Effect?

4. Stuffing to Avoid Mandatory 754 Election on Redemptions

VI. Special Tax Issues for the General Partner and Its Members

A. Carry as a Profits Interest

1. Receipt of a Profits Interest as a Tax-Free Transaction

2. The Historical Treatment of a Profits Interests Issued for Services

3. Revenue Procedure 93-27

4. The Proposed Regulations

a. The Basic Conflict between 83 and Subchapter K

b. The Safe Harbor for SHPIs

c. Application to Hedge Funds

5. Should the General Partner and Its Members Contribute Capital?

6. Self-Employment Taxes

B. Carry as a Fee

1. Why a Fee?/ Why Defer?

2. Requirements for Deferral

a. Cash Method of Accounting

b. Constructive Receipt Issues

3. Fee Deferrals by Hedge Funds before Enactment of 409A

4. Fee Deferrals by Hedge Funds after Enactment of 409A

a. Section 409A - In General

b. Does 409A Apply to Fee Deferrals by Hedge Funds?

c. Timing of Deferral Election

d. What if the Employees of the Portfolio Managers Are also “Partners”?

e. Other Timing Issues

f. Certain Accelerations May Disqualify Entire Plan

g. Effect of Vesting Failures

h. Impact of 409A and 457A When Fund Is Offshore

(1) Section 409A

(2) Section 457A

(a) In General

(b) Substantial Risk of Forfeiture

(c) Nonqualified Entity Defined

(d) Nonqualified Deferred Compensation Plan Defined

(e) Coordination with 409A

(f) Effective Date and Transition Relief

C. Other Tax Issues for Members of the General Partner

1. Vesting

a. Pre-Revenue Procedure 2001-43: The Minority View

b. Pre-Revenue Procedure 2001-43: The Majority View

c. The Current View: Revenue Procedure 2001-43

2. Bifurcation

3. Late Hire/“Catch Up” Solution

4. Capital Shift on Forfeiture of Appreciated Profits Interest

5. Avoiding Local Taxes on Carry

6. Pass-Through Structure for General Partner

VII. Special Tax Issues for Foreign and Tax-Exempt Investors

A. In General

1. ECI


3. Common Exception for Investment Income

B. Application to Hedge Funds

1. Activities of the Fund as a U.S. Trade or Business

2. Tax Effect of Leverage on Investment Returns

C. Structuring the Offshore Feeder or Parallel Fund as a Corporation

1. Purpose

2. Section 269

3. But Offshore Entity Is a PFIC

a. The Income Test

b. The Asset Test

c. The “Look-Through” Rules

d. Investment Usually Not Open to Taxable U.S. Investors

e. What If the Taxable U.S. Investor Makes a QEF Election?

D. The Outer Boundaries of the ‘Trading’ Safe Harbor

1. The Trading Safe Harbor Generally

2. Transactions in Derivatives under the Proposed Regulations

3. Transactions in Derivatives under Current Law

E. Withholding Taxes on FDAP Income

1. FDAP Withholding when Fund Is a Foreign Corporation

2. Pervasive Use of Swaps

F. Investments in Debt Securities

1. Lending as a “Financing” Trade or Business

a. Loan Origination Generally

b. Acquisitions of Outstanding Debt by Distressed Securities Funds

2. Bank Loan Syndication

a. “Virtual” Origination

b. Impact of Origination on 864(b) Trading Safe Harbor

c. Actual Origination: How Much Is Too Much?

d. The “Season & Sell” Solution

VIII. Special Tax Issues for U.S. Individuals

Introductory Material

A. Deductibility of the Management Fee

1. Nature of the Problem

2. Use of a PFIC to Solve the Problem?

B. Deductibility of Interest Expense ( 163(d))

C. Deductibility of the Carry

D. Passive Losses

E. At Risk Limitations

IX. Key Hedge Fund Elections

A. The 754 Election

1. Redemptions

2. Transfers of Fund Interests

3. Stuffing Allocations

4. “Pushing Down” the Basis Step-Up - Possible Benefit to GP Members

5. “Mandatory” 754 Elections

B. The Mark-to-Market Election

1. Section 475

2. Hedge Funds Not Subject to 475

3. May a Hedge Fund Make the 475(f) Election?

4. The Benefits of the 475(f) Election

5. May an Electing Hedge Fund Exclude the “Side Pocket” Securities?

6. Interaction of 475 and 864(b)(2)

7. Trap for the Unwary - 864(c)(3)

8. Is it Prudent to Make the 475(f) Election?

9. Section 1256

X. Reporting of Transactions between Fund and Investors

A. Disguised Sale of Partnership Interests

B. Varying Interests of Fund Investors during Taxable Year

1. Periodic Redemptions/Admissions of New Investors

2. Section 706 Rules

a. Interim Closing-of-the-Books

b. Proration

3. Application of 706 to Tiered Partnerships

C. Distributions of Marketable Securities

XI. Portfolio Investments by the Fund: Recurring U.S. Tax Issues

Introductory Material

A. Swaps

1. In General

2. Is the Swap a Notional Principal Contract?

3. Timing of Swap Payments

a. Timing under 1993 Regulations

b. Timing under Proposed Regulations

c. Timing of Termination Payments

4. Character of Swap Payments

a. Periodic and Non-Periodic Payments

b. Termination Payments

c. Assignments

5. Source of Swap Payments

6. Integration of Swap Payments

7. Credit Default Swaps


B. Market Discount on Distressed Debt

1. In General

2. Application to Distressed Debt

C. Straddles

1. In General

2. Unbalanced Straddles

D. Conversion Transactions

E. Constructive Sales of Appreciated Financial Positions

F. Short Sales

G. Transactions in Foreign Currency

XII. Investing in Hedge Fund Derivatives

A. The Potential Appeal of a Hedge Fund Derivative

B. Section 1260

C. Insurance Wrappers

D. Hedge Funds Disguised as Insurance Companies

XIII. Tax Shelter Reporting and List Keeping

A. In General

B. Disclosure of Reportable Transactions

C. List Maintenance by Material Advisors

D. Application to Hedge Funds

1. Hedge Fund Partnership

2. Hedge Fund Manager

3. Law Firms

Working Papers

Working Papers

Table of Worksheets

Worksheet 1 Single Entity Fund

Worksheet 2 Master-Feeder Fund

Worksheet 3 Fee Deferrals on Capital from Foreign Feeder

Worksheet 4 Sample “Side Pocket” Provision

Worksheet 5 Sample “Mark-to-Market” Definitions of Net Profit/Net Loss

Worksheet 6 Example of Broad Grant to Portfolio Manager in Fund Agreement

Worksheet 7 Sample “Stuffing” Allocations

Worksheet 8 Sample Limitation on Loss Recovery against Incentive Allocation

Worksheet 9 Sample Tax Disclosure for “Onshore” Hedge Fund Feeder

Worksheet 10 Sample Tax Disclosure for “Offshore” Hedge Fund (PFIC)

Worksheet 11 Sample Withholding Tax Provision of Fund Agreement

Worksheet 12 Fortress IPO Diagram





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