United States

Tax concerns and issues for a hedge fund manager's agenda


At a recent roundtable for financial industry professionals, Rich Nichols and Moshe Metzger discussed  the issues and concerns that should be at the forefront of every hedge fund manager's agenda. Nichols is RSM's national financial services tax practice leader and Metzger is a leading tax partner in the practice, focusing on hedge funds.

According to Nichols, many funds in recent years have organized as state-law limited partnerships to minimize self-employment tax under section 1402 of the

Internal Revenue Code. He noted that there is proposed legislation, as well as longstanding proposed regulations, that would limit or disallow this planning technique by treating all income from the provision of services as self-employment income. "This would be a big overhaul of the section 1402 provision," he said, noting that the proposal could easily be added to any larger tax legislation under consideration in Congress in the coming year or two.

Even without legislation, the IRS is looking for the most attractive cases to challenge taxpayer positions in this area. In the case of Frank Sands, Jr., following an IRS audit, a petition was filed in the U.S. Tax Court asserting that the statutory exemption from self-employment taxes for limited partners should apply. The case involved a typical structure in the investment management industry, with a management company, an operating entity and a general partner. The individual received a substantial amount of compensation from the management entity and the IRS issued a statutory deficiency notice asserting that self-employment taxes on that compensation were improperly omitted. After the taxpayer asserted, simply, that his income was received as a limited partner in a limited partnership, the IRS agreed to cancel the deficiency notice. This can be contrasted with cases involving limited liability companies or limited liability partnerships, not state-law limited partnerships, where the IRS has been more aggressive and has prevailed in some cases. "We will still see different types of structures being set up to minimize the self-employment tax, but that could change if we see any new tax legislation coming down the pike," said Nichols.

Other key issues for hedge fund managers and tax professionals included economic nexus and how states are moving more toward a market sourcing concept, where income will be sourced where an economic  benefit is received, not where the services are actually performed. According to Metzger, the market sourcing concept for the typical hedge fund and associated management company has not hit the tri-state area of New York, New Jersey and Connecticut. However, if companies in those locations have service recipients in another location, such as California where such sourcing rules have been adopted, they should seriously evaluate the need for appropriate state tax filings. Metzger indicated that RSM could help companies in evaluating their current or prospective exposure, particularly as state laws and regulations change.

Mr. Metzger mentioned the recent GAO study criticizing the way the IRS audits, or fails to audit, large and multitiered partnerships, and addressed the question of what items or issues IRS agents tend to look for with a typical hedge fund. "So what exactly are they looking for?"  Metzger asked. "They will be looking at trader and investor issues; they do ask for information with respect to the number of trades, the dollar amounts of trades, and the turnover ratio of the portfolio to evaluate whether the designation as a trader is appropriate. In addition, agents are getting involved in the nitty-gritty of the tax adjustments. So we need to continue our vigilance to make sure everything is recorded and properly reported."

Metzger also mentioned that in light of elevated market prices, portfolio managers holding significant appreciated positions, and looking to reduce their exposure on the long side, should consider a variety of transactions that may reduce or diversify economic risks without gain recognition or other adverse tax consequences.

These roundtable discussions are part of RSM's commitment to deliver the insights, services and resources that our clients need to deal successfully with the full range of business, tax and regulatory concerns. These sessions will be held semiannually with the next one scheduled for the late fall 2015. For more information, or to reserve a place at the next gathering, please email Leslie Baker or call her at 212.372.1509.