IRS Limits Management Fee Deductions for Funds of Funds
August 25, 2008
A ruling last month by the Internal Revenue Service, limiting the ability of investors in funds of hedge funds to deduct management fees from their federal income taxes, could prompt some managers and their investors to either redo their tax forms or challenge the decision.
The question at the core of Revenue Ruling 2008-39 is whether funds of funds, because of their investments in underlying hedge funds, can categorize their own management fees as "trader expenses." In deciding that, for tax purposes, funds of funds should be considered investors and not traders, the IRS said that the fees must be treated as miscellaneous itemized investment expenses under Section 212 of the Internal Revenue Code.
Investors previously could deduct all or a portion of a fund of funds' management fees as a business expense. Now, for a fund of funds investor to deduct the fees, the total amount, when added to other, similar expenses, must make up more than 2 percent of the individual's adjusted gross income--and overall itemized deductions are subject to a "phase out" based on that income. If the investor is subject to the alternative minimum tax, the fees may not be deductible at all.
"Fund of funds and their investors have availed themselves of the status of the underlying funds in which they invest for purposes of determining their tax status," explained Joseph Pacello, a tax principal in Roseland, N.J.-based accounting firm Rothstein Kass who spoke at a recent conference on hedge funds and alternative investments hosted by the New York State Society of Certified Public Accountants (NYSSCPA) in New York. "While the IRS had never made a hard-and-fast rule on deductibility of management fees, it became a common industry practice to rely on the trader status of the underlying funds."
According to David Untracht, senior tax principal and co-founder of accounting firm Untracht Early in Florham Park, N.J., some funds of funds took a bifurcated approach to deducting management fees, depending on how their assets were allocated. "They would deduct the fees proportionate to the relative capital invested in underlying funds which were either traders or investors," said Untracht at the NYSSCPA conference.
The IRS ruling, which marks the first time the agency has addressed the tax status of funds of funds, will likely only have an effect on high-net-worth individuals who have until now benefited from the loophole that gave them trader status, according to tax experts. As tax-exempt entities, institutional investors--endowments, pension funds and insurance companies--won't be affected.
Funds of hedge funds, which select portfolios of individual funds to reduce investment and market risk, typically charge a flat annual management fee of 1 percent to 2 percent of the value of the assets under management. That fee is in addition to those charged by the managers of the underlying funds.
A Filing Dilemma
Fund of fund managers who have already filed K1s--their version of income tax forms--with the IRS find themselves in a quandary: They could submit an amended form reflecting the change in fee deductions or attempt to retain their trader status by disputing the ruling. Fund of fund managers typically rely on their administrator or accounting firm to prepare the K1s, which are then used by investors for their own tax returns.
