Hedge funds are popular vehicles for hedge fund investors because of the manner in which they are taxed. Hedge funds are usually structured as limited partnerships or limited liability companies. Such entities by default are taxed as partnerships under Subchapter K of the Internal Revenue Code.
The partners in a partnership, and not the partnership itself, are taxed on the partnership’s income. In this manner the partnership is markedly different than a corporation which is subject to double taxation (tax at both the corporate and shareholder level). Because of the manner of taxation, partnerships are referred to as “flow through” vehicles because the income is taxed at the investor level instead of (or in addition to) the entity level.
Yearly LP and LLC Fund Tax Returns
Each year a hedge fund will need to file a tax return with the federal government. In addition the hedge fund will probably need to file a tax return with the state where the manager resides. These issues should be discussed with a hedge fund auditor or accountant, who will typically prepare the partnership’s tax returns. The IRS specifically states with regard to Form 1065:
Every partnership that engages in a trade or business or has gross income must file an information return on Form 1065 showing its income, deductions, and other required information. The partnership return must show the names and addresses of each partner and each partner’s distributive share of taxable income. The return must be signed by a general partner. If a limited liability company is treated as a partnership, it must file Form 1065 and one of its members must sign the return.
A partnership is not considered to engage in a trade or business, and is not required to file a Form 1065, for any tax year in which it neither receives income nor pays or incurs any expenses treated as deductions or credits for federal income tax purposes.
The hedge fund will also need to send each investor a Schedule K-1 so that the investor can prepare its tax returns for the year. The accountant will help the hedge fund manager to prepare these items.
Schedule K-1 can be found here: Schedule K
Other Tax Items
Some other partnership taxation topics which we will be discussing in the future include:
– Gains and losses from securities transactions
– Constructive sales
– 1256 contracts
– Original Issue Discount
– Itemized deductions
– Allocations of the fund’s income, deductions and/or loss
– Passive Activity Losses
– Section 754 Adjustments
– “Stuffing” provisions