Question: Why is a hedge fund structured as a LP or a LLC instead of a corporation?

Answer: The short answer is that corporations are subject to double taxation (at the entity and investor levels) and that LPs and LLCs can be taxed as partnerships which are taxed only once (as the investor level).

Question: Should a hedge fund be structured as a LP or as a LLC?

Answer: When hedge funds first started out, they were established as limited partnerships. The purpose of forming the fund as a partnership is so that all of the investors and the manager will be subject to partnership taxation. When LLCs became a more prevalent structure in the 80s, there was not a huge rush to form the funds as LLCs. The central reason is that, as a newly formed entity, the law firms were not sure how the courts would view the statutory liability protections of these new entities. As general case law developed, practitioners became more and more comfortable with the LLC as a practicle entity from a liability protection standpoint. However, it was during this time also that many states either developed LLC applicable tax laws or realized that existing laws applied to LLCs.

The central argument for structuring new funds as LLCs is that at the LLC level, there is no liability. In addition to this, the management company will itself be structured as a LLC which provides very strong liability protection for the managers of the management company. At the entity level, the general partner of a limited partnership is potentially subject to unlimited liability; although the fact that the general partner is itself structured as an LLC should provide managers with ample protection. Even so, it is recommended that when a manager is investing in his own fund, he do so as a limited partner. The idea is to keep the management company sufficiently, but not overly, capitalized.