Overview of Schedule K-1 for Hedge Fund Investors

Hedge funds are usually established as Delaware limited liability companies (LLC) or Delaware limited partnerships (LP).  In addition to providing investors with a certain amount of liability protection (generally to the extent of their investment), these vehicles are also more tax efficient than other structures like corporations because LLCs and LPs can be taxed as partnerships.  Unlike a corporation which is subject to double taxation (that is, tax at both the corporate level and the investor level), a partnership is only subject to tax at the investor level.

Because hedge funds are taxed as partnerships the investor will report their gains and losses from the hedge fund investment to the IRS via a Schedule K-1.  A Schedule K-1 is the form which partners in a partnership file with their tax return to report their share of income, deductions, credits, etc from the partnership.  The form is fairly straightforward and easy to understand.  The hedge fund manager is responsible for making sure investors in the fund receive the K-1 with enough time to complete their tax returns.  Typically the manager will use an outside firm such as the hedge fund administrator or auditor to complete the K-1s.  The cost of completing the K-1 is borne by the fund and thus will impact the performance results.

It is always a good idea for a start up hedge fund manager to discuss his investment strategy with a tax planner (either the auditor or other accounting firm); the tax planner can also discuss the K-1 with the manager and how it should be completed.  This is important because I have heard it said that if a manager asks three different accounting firms to complete the K-1s for investors, the manager would likely receive three different K-1s.

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