July 16, 2012 The Tax Lawyer

Federal Income Tax Treatment of Hedge Funds, Their Investors, and Their Managers

Vol. 65, No. 2 - Winter 2012

David S. Miller & Jean Bertrand

Abstract

    The structure of a hedge fund is generally designed to be tax and administratively efficient, and is largely dependent upon the classes of investors— for example, U.S. taxable, foreign, and U.S. tax-exempt—the asset classes, and sometimes upon the jurisdictions in which the individual investment management professionals will be located—such as structuring necessary to minimize the New York City unincorporated business tax.

    A group of individual investment professionals will manage the hedge fund’s portfolio and will also function as its general partner. In most cases the investment professionals will form two entities, both treated as partnerships for U.S. federal income tax purposes: one entity—the “investment manager”—to manage the portfolio and receive management fees—that is, the “2” in a 2/20 compensation structure—and a different entity—the “general partner”—to receive incentive compensation in the form of a carried interest—the “20” in a 2/20 compensation structure.

    The individual investment professionals will often be limited partners in both entities but pay self-employment tax only on their interest in the entity receiving the management fees—the investment manager—and then only with respect to their general partnership interest in the investment manager.

    They will not typically pay self-employment tax with respect to the income and gain allocated to them under the carried interest held by the general partner entity. In addition, individual investment professionals located in New York City will typically pay New York City unincorporated business tax only on the earnings of the investment manager—the management fees.

    There are five common hedge fund structures. This Part describes those structures, the rationale behind each structure, and the situations for which each structure is best suited.

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