Hedge Fund Taxation: It’s not just about issuing K-1s

Brian Uhlman, CPA
Partner, Raines & Fischer, LLP
May 2014

Most new hedge fund managers know they need professional advice from a number of sources when starting their fund.

One such source is a qualified tax accountant. There are a number of tax planning considerations that need to be addressed when first starting a hedge fund, however, all too often, when it comes to selecting a tax accountant to prepare the year-end tax filings and K-1 forms, a firm is often engaged and then not consulted again until it is time to prepare the tax filings. In some cases, a firm is not even engaged until year-end when the tax filings are due. This can be a big mistake when it comes to new hedge funds, as waiting until year-end to address specific concerns can be costly to both the hedge fund manager as well as the investors. It is best not only to immediately engage a tax accountant when launching your fund, but also to sit down with your tax accountant, discuss the vision of your fund, trading strategies, and types of investors you have so that he or she can be proactive rather than reactive when it comes to tax planning. 

One way to accomplish the task of getting your tax accountant in hand at launch is to select your fund administrator to prepare the fund tax returns and K-1s.

Since the fund administrator is usually selected early in the launch process, this method is fine as long as your administrator is capable of handling your tax issues. There are a number of fund administration companies that are very capable when it comes to the task of fund administration, but are lacking when it comes to tax advice and compliance. If a hedge fund manager wishes for one firm to accomplish both tasks, it is best to select a qualified CPA firm that is experienced in both fund administration AND hedge fund taxation. This gives you a particular advantage in that your administrator already has access to the ins and outs of your trading activities on a monthly basis and can advise you every step of the way. Another common option that hedge fund managers select is to have their audit firm handle preparing the tax filings. While there is nothing inherently wrong with this approach, in going this route you will want to make sure you sit down with your audit firm early in the process, and make sure both you and the audit firm are on the same page when it comes to tax issues that can affect your fund. 

Whether you decide it’s best to select your administrator, auditor, or a separately engaged tax preparer, there are a number of taxation issues that can cause problems if not addressed early in your fund’s tax year.

One issue is the election of mark-to-market tax treatment. This election is not for everyone, but Section 475(f) of the Internal Revenue Code allows active traders to elect to treat all trading gains (or losses) as ordinary income (or loss), and, if held at year end, “marked to market” as if sold at the year-end value. This is especially useful for short-term traders aiming to steer clear of the IRS wash sale and capital loss carryover rules. However, this election cannot just be made at any time. It must be made by the original due date of the previous year’s tax return or, in the case of an initial filing year, within 75 days after the commencement of trading. 

Another issue that may arise is advising the fund manager on the tax issues caused by taking in foreign investors.

When a foreign investor invests in a U.S. hedge fund, there are complex withholding requirements on the U.S. source income allocable to the foreign investor(s). These vary based on the type of income earned, whether the investor’s resident country has any tax treaties with the U.S., and a number of other factors. Often, foreign investors will have questions about this U.S. withholding structure and, without a competent tax accountant in place, a hedge fund manager may not be able to satisfy the prospective investor as to how he or she will be taxed.

Foreign issues are not the only tax queries investors may come up with during the year.

Many hedge fund investors are tax-sensitive and at any time may want to know how much taxable income the fund has the potential to generate at year-end. Hedge funds managers often prepare a tax estimate toward the end of the year to help satisfy this demand, and may even prepare back-of-the-envelope tax estimates during the year for important investors. Here again, the tax accountant will come into play. A fund administrator without tax experience can try to assist with these types of queries, but they are much better handled by an accountant who has experience in the complexities of constructive sales, wash sales, and hedge fund tax allocations.

The above are just a few examples highlighting why a tax accountant is important for any new hedge fund all year — not just at tax time.

There are too many other reasons to list here in this short narrative, but the take-away lesson is to engage your tax accountant right away, and keep them engaged in what is happening in your fund all year round.

Brian Uhlman has a Bachelor of Business Administration from Pace University and a Master of Business Administration from the Stern School of Business at New York University. He is a member of the New York State Society of Certified Public Accountants and the American Institute of Certified Public Accountants. He became a partner in the firm in 2008.