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Hedge Fund Taxation
Hedge Fund Taxation

Hedge Fund Taxation

Hedge Funds Taxed as a Trader
Hedge funds generally prefer to be taxed as a business actively engaged in
the business of trading (which primarily makes money by buying and sell-
ing as distinguished from an investor who primarily makes money by buy-
ing and holding). A fund is more likely to be classified as a trader if the
turnover in the fund is higher, the gains and losses are primarily short-term
(not long-term), and the return derives primarily from gains and losses, not
dividends and interest.
If a fund is treated as a trader, certain expenses like interest costs on
leveraged positions and management fees are included in net income.
This net income is allocated to investors as described later. These ex-
penses are not reported on individual taxpayers' schedules of itemized
deductions.
Individual taxpayers benefit by not having to report gross income and
investment expenses. First, these expenses are deductible only to the ex-
tent that they exceed 2 percent of adjusted gross income. Second, due to
phaseout limitations on itemized deductions, these investment expenses
may be capped at 5 percent of adjusted gross income (that is, only the ex-
penses that fall between 2 percent and 5 percent of adjusted gross income
are deductible). Third, as long as the hedge fund is treated as a trader,
these investment expenses would reduce taxable income when calculating
alternate minimum tax.
Hedge Funds Taxed as an Investor
A hedge fund characterized as an investor would have to allocate income
before certain investment expenses to investors. The fund would also allo-
cate investment expenses such as financing interest, management fees, and
incentive fees. Investors would be able to reduce taxable income by the
amount of these expenses, subject to the 2 percent and 5 percent limita-
tions described earlier. Individuals would add back these deductions to cal-
culate alternate minimum tax.
Foreign investors invested in a U.S. hedge fund would prefer that the
fund was classified as an investor, not a trader. These foreign investors
would be taxed only on the dividends received by the fund, not interest
or gains and losses. These dividends would be subject to 30 percent
withholding tax. Admittedly, this is a small market because a U.S. fund
capable of attracting sizable offshore investments would probably orga-
nize an offshore fund to allow the offshore investors to sidestep U.S.
taxation.
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