Originally published in Derivatives Financial Products Report

September 2003

THE IRS HAS ISSUED ITS FIRST AUDIT TECHNIQUE GUIDE TO PARTNERSHIPS. 1 Buried within this massive document is Chapter 12, Syndicated Investment Partnerships (hereafter, together with related discussions in the Partnership Audit Manual, the IRS Hedge Fund Audit Manual or Manual). At the outset, the writers of the IRS Hedge Fund Audit Manual prejudice the issue by using the term Syndicated, thereby linking investment partnerships in the reader’s (IRS’s) mind with syndicated tax shelters.

RAMIFICATIONS OF IRS HEDGE FUND AUDIT MANUAL

This author understands that some IRS districts have staffed teams to audit hedge funds (e.g. the Manhattan District). Thus far, other than compensation-related issues (e.g. in Illinois, Florida), no results of hedge fund audits have surfaced. The author is also aware, though, that there was a small wave of hedge fund audits in the late 1980s (e.g. in the Manhattan District), which involved large amounts of time invested in each audit by the audit team (e.g. analyzing tax allocations). 2 Nonetheless, it is reasonable to expect that there will be a marked increase in hedge fund audits on the theory that once time and effort have been invested in a weapon, that weapon will be used.

Everyone associated with hedge funds should pay serious attention to the IRS Hedge Fund Audit Manual. If a hedge fund is wrong on an issue, it is likely to affect every open year. Not only must the hedge fund file amended returns for the affected open years, but (at least in theory) all, or most, of the members will also have to file amended returns for the affected open years. This is a sure-fire way to lose investors, if not to be forced to close up shop. Thus, if investor vs. trader is the issue (discussed below), it means that the treatment of the fund’s expenses as Section 162 expenses is incorrect. In filing their amended returns, the investors probably lose the benefit of most, if not all, of the deductions, resulting in a higher tax liability (plus interest, and possibly penalties as well).

The IRS Hedge Fund Audit Manual, as discussed below, is an adversarial document that often misconstrues the law and demonstrates a lack of knowledge of the day-to-day workings of the industry. 3 For example, in the Overview section of Chapter 12, the Manual states that:

The partnership agreements generally provide that contributions and distributions can only be made as of year-end, although some funds provide quarterly valuations.

This is a marked mischaracterization of basic components of any hedge fund documentation. In this author’s experience, contributions are typically accepted quarterly, distributions are made as of year-end, and quarterly performance results (and sometimes capital account valuations) are provided. In the industry, however, there is no format prescribed by a regulatory body for drafting a partnership agreement (or similar document), and there are many variations.

HEDGE FUNDS ARE NOT TAX SHELTERS

Hedge funds are structured as a tax-efficient vehicle for professional management of pooled funds. 4 With very limited exceptions, 5 the objectives in structuring a hedge fund do not include obtaining tax advantages that would not otherwise be available to the fund’s investors. Rather, the overarching tax objective is to obtain fiscal transparency—replication of the in vestors’/members’ tax treatment as if they had traded directly.

As a result, a hedge fund is not structured to obtain specific tax advantages not matched by economic results, i.e. the hedge fund is not a tax shelter. For example, many tax shelters are designed to produce fictitious tax losses, 6 but a hedge fund investor is limited to its capital account contribution (and capital account commitments). Losses exceeding the partners’ (or members’) capital are borne either by the general partner (for hedge funds structured as a limited partnership) or by third-party lenders.

Example 1 (based on more than one unfortunate real case). The Bull Fund, LP is organized under the laws of Delaware in 1996 with a trading strategy of small tech stocks, using approximately 4:1 leverage (through margin loans, use of derivatives such as listed single stock options, and swaps). The Bull Fund, LP’s investors have results (net of fees, expenses, and the incentive reallocation to Bull, LLC, the general partner) in 1996, 1997, 1998, and 1999 of 47%, 82%, 107%, and 239%, respectively. In March 2000, the general partner advises the investors that the fund lost their entire capital that month. After liquidating Bull Fund, LP’s portfolio, the fund has net liabilities (to brokers and counterparties) of $100 million. Bull, LLC’s net capital of $20 million is applied to reduce the fund’s liabilities to $80 million. The entire $80 million is borne by the creditors, because Delaware law limits the investors’ liability to their capital contributions. 7

Example 2. Same facts as Example 1, except that Bullissimo, LLC is the hedge fund that becomes insolvent, and Bull, LLC is the managing member. Same result as Example 1, except that Bull, LLC’s liability is limited to its capital contribution (and any further capital contribution commitment), so that the creditors bear the entire $100 million.

Thus, it is unheard of for an investor in a hedge fund (or the general partner or managing member) to obtain a recognized loss exceeding its cash contribution or the adjusted basis of securities contributed to the fund (plus any further capital contribution commitment). Similarly, membership in a hedge fund, because it is fiscally transparent, does not change the character of the income that the investor would have received if it had invested separately.

SPECIFIC ISSUES DISCUSSED IN THE IRS HEDGE FUND AUDIT MANUAL

The IRS authors raise several tax issues on which to challenge the activities of a hedge fund.

Hedge Fund Is Not a Partnership but a Disguised Fee Arrangement

The Partnership Audit Manual contends that a hedge fund structure may be used to shift fee income to a distributive share of partnership capital gain, interest income, etc. as shown in the following example. 8

Example 3. A is a financial advisor who contracts with investor B to manage $20 million of assets. A is to receive 20% of the annual profits as his fee. In Year 1, B earns $4 million and pays A an $800,000 fee, which is a Section 212 expense to B and self-employment income to A. In Year 2, A and B form a partnership in which B contributes $20 million and A contributes zero and receives a 20% profits interest in exchange for managing the assets. In Year 2, the partnership has $4 million of earnings, and A receives $800,000 as his distributive share of partnership income, which is not subject to self-employment tax. B has no income tax effect from the $800,000 incentive allocation to A.

The Manual contends, citing no authority on point, that Section 707(a)’s application leads to recharacterization of the partnership arrangement as a disguised fee arrangement, with the $800,000 distributive share as self-employment income to A and Section 212 expense to B. The Manual’s chief contention is that A has no risk of loss, and therefore, the arrangement is that of compensation for services. If the Manual were correct, this would be major news—not only in the hedge fund industry but also in the oil and gas industry, real estate industry, and anywhere else that a carried interest is used to incentivize individuals. The Manual appears to be implicitly relying on Treasury’s failure (after nearly 20 years) to issue regulations under the disguised services prong of Section 707. 9 As a result, the Manual’s authors apparently feel free to make whatever arguments they choose.

The Manual, however, is not correct. First, there is substantial authority directly on point, providing that the contribution of services, even professional services, in exchange for a profits interest does not convert the transaction into a compensatory arrangement. Thus, in Rev. Rul. 54-84, 10 four persons—the money partner, a lawyer, an oil and gas lease superintendent, and a drilling superintendent—entered into a written agreement to acquire, explore, and develop oil and gas wells. The money partner agreed to furnish all the tools and funds, and to bear any losses, in exchange for half of the profits. The other three individuals (who split evenly the remaining one-half) furnished no capital and agreed only to provide their services. The Ruling held that the relationship constituted a joint venture or partnership even though all the leases were in the name of the money partner. The IRS concluded that the leases were partnership property, it being immaterial for that purpose that title was held in [the money partner]’s name only.

A similar result was obtained in Wheeler. 11 in which a real estate investor and a developer entered into a joint venture. The developer furnished only services, and the investor provided all the funds. The investor was entitled to a return of his capital before the developer was entitled to receive any cash distributions. As in Rev. Rul. 54-84, above, title to the properties was in the name of the money partner. Although there was no formal partnership agreement, the two taxpayers held themselves out as partners and reported their transactions as though they were partners. The Tax Court had no difficulty in dismissing the Service’s objections to partnership status. 12

Although the authorities cited above predated the enactment of Section 707(a), the legislative history indicates that the disguised fee issue arises in an example where a stockbroker becomes a member of a hedge fund and receives an allocation rather than brokerage fees. The objective was to obtain a current deduction in place of the capitalized brokerage fees. 13 In this example, the broker is providing a service normally made available outside the partnership context—as an independent stockbroker—and is not engaged in activities that constitute the normal activity of a hedge fund. In the Manual’s example, A is engaged in the activity of stock picking, the taxpayer’s raison d’etre, and it is not a disguised fee.

The Manual’s attempt to convert any profits interest into a disguised fee—because the same economic result could be achieved through a fee—is an attempt to negate much long-standing law. However, there is no disputing that A’s failure to contribute any capital at all—even though authorized by the authorities cited above—would be to A’s detriment in real life because it shows a lack of commitment by A to the business that he is starting. In actual practice, the typical hedge fund offering memo indicates the capital contribution by the principals. In any event, the Manual’s example is not a real life example if one looks to the hedge fund industry—for one thing, there is only one investor, so there is no pooling of capital.

Investor vs. Trader

A hedge fund is either engaged in the trade or business of trading in securities or an investor in securities—important characteristics flow from the proper characterization. 14 For example, the expenses of a member of a trader fund are deductible as ordinary and necessary business expenses, whereas in an investor fund, expenses are Section 212 expenses subject to various limitations. Since the enactment of Section 475(f), the mark-to-market election for trader hedge funds, 15 which has been availed of by many hedge funds, the importance of the trader vs. investor distinction has taken on an even greater distinction.

Section 475(f) is essentially a one-way street favoring the taxpayer, which is the very nature of any tax election. If a hedge fund is a trader in the election year, Section 475(f) applies in future years, even if the fund is no longer a trader but an investor. The statute thus overrides the general rule in which trader vs. investor status is (at least in theory) tested annually. Moreover, Section 475(f) has been elected for trader hedge funds with losses, thereby converting the loss from capital to ordinary.

The IRS Hedge Fund Audit Manual makes several assertions that indicate a lack of knowledge of the industry and the law. First, one of the factors to consider is [n]ature of the income from the activity — only short-term gains qualify as trading income. The Manual contends that [s]ignificant long-term capital gains, and even dividends and interest, are strong indications of an investor and not a trader.

This is not true. If a taxpayer is a trader in securities, all of its income from trading in securities is trading income. The Manual fails to understand that even an active trader may hold onto its winners and thus generate long-term capital gain. However, some hedge funds have a separate investment securities account (such as for a separate strategy involving, e.g. illiquid distressed debt securities), which will generate investment income and expense. Moreover, the reference to dividends and interest income as being strong indicators of investor status is unsupported by any citing of authority.

The Manual also instructs the agent to examine the fund’s offering document to determine whether it uses capital appreciation or conservation of capital as an objective, and contends that [o]bjectives other than taking advantage of short-term market movements negate securities trader status. This author notes that it is typical that a fund’s reference to its strategy or strategies is hedged with a caveat that the fund may pursue other strategies if the general partner thinks them fruitful. In any event, capital appreciation and conservation of capital are such generalized descriptions that it is hard to make much of them.

What is most interesting about the Manual’s direction to the agent is that no bright-line guidance is provided. The investor vs. trader test is inherently, as the Manual notes, something of a touchy-feely endeavor, and the lack of a bright-line test reflects that. Nonetheless, the well-advised hedge fund manager would analyze its trading to determine whether it is in fact a trader in each year.

Where Is Investment Interest Expense Deductible?

In a bizarre disagreement among colleagues, the Manual disputes the position taken by the IRS forms- writing division on the treatment of investment interest expense. In any hedge fund, the investors, whether limited partners or nonmanaging members, do not actively participate in the fund’s management. As a result, interest expense allocated to them is investment interest under Section 163(d). There is, however, no regulation or similar guidance from IRS Chief Counsel to that effect. Form 4952 (dealing with investment interest) instructs the taxpayer—for any interest attributable to a trade or business in which the taxpayer did not materially participate and is not a passive activity—to enter that part of the interest expense on the schedule where you report other expenses for that trade or business. Thus, the taxpayer is instructed to report the interest on Schedule E as business interest, deductible under Section 162, and not as investment interest.

The Manual disputes the instructions, contending that there does not appear to be any statutory authority for that position. Although the Manual appears to be correct, one wonders why the solution was not to change the instructions to Form 4952. Are taxpayers to be assessed penalties because they relied in good faith on the IRS’s instructions on what is a far from clear statutory provision for which the IRS has not issued guidance?

Treatment of Organizational and Selling Costs

The costs of organizing a partnership must be capitalized, absent an election to amortize them over 60 months. However, costs for syndicating (i.e. marketing) interests in a partnership must be capitalized, without an election to amortize. Chapters 1 and 12 of the Manual appear to contend that hedge funds, as Syndicated Investment Partnerships, should have syndication costs on their books.

The agent is directed as follows:

Where no organization or syndication costs are reflected on the partnership’s books, to determine whether a partner claimed those expenses, which are not deductible by a partner under Section 709. To determine whether there is a first-year fee or guaranteed payment for the organizing partner to compensate for organization costs borne by that partner. To determine whether syndication costs were disguised as organization costs. To determine whether sales commissions have been disguised as management fees, interest, or otherwise. Partnerships with a large number of partners should have significant syndication costs on the balance sheet and a large amount of organization expense being amortized (emphasis added).

Hedge funds have traditionally taken the view that they do not have syndication expenses, since hedge fund managers are forbidden by SEC rules to advertise and may undertake only very limited marketing. Rather, word-of-mouth recommendation is the standard way that investors become members. In the author’s knowledge, no hedge fund has been faced with this issue. However, if the IRS were to successfully assert the issue on audit, it would require an amended return for the fund’s first year, and possibly succeeding years (if disguised fees or guaranteed payments were recharacterized as syndication costs), with similar problems for the members who would have claimed greater deductions than they were entitled to.

Contribution of Securities

The general partner or an investor may want to contribute appreciated securities to a hedge fund. This may or may not be a taxable event to the contributing partner, depending on the application of Section 721(b) (the partnership version of the investment company rules). 16 The agent is directed in Chapter 2 to determine whether contributions of securities to a hedge fund are taxable. Effectively, the agent would have to determine whether the fund was the partnership version of an investment company and whether the investor contributed a diversified portfolio of securities. The Manual gives little guidance on these issues, which can be complex.

CONCLUSION

The IRS Hedge Fund Audit Manual makes for disturbing reading in the hands of any knowledgeable tax advisor to the hedge fund industry. That the issues raised and the egregious errors (of fact and law) made are few may be some small consolation.

1 IRS Market Segment Specialization Program Audit Technique Guide—Partnerships (released December 2002), www.irs.gov/pub/irs-mssp/partnershipsatg12-16.pdf (Partnership Guide). The Partnership Guide is a massive document that appears to be the IRS’s first comprehensive guide to auditing partnerships as an entity, as opposed to audit guidance for specific industries or types of issues (e.g. passive losses).

2 This author was a member of the National Tax Department of an accounting firm with a large hedge fund practice. He understands that the hedge fund audits in issue largely ended with little, if any, significant revenue gain for the IRS, because any reallocation of income would have shifted income from one high-bracket taxpayer to another (the regulatory limitations on who qualifies to be an investor in a hedge fund generally restrict the universe to high-bracket taxpayers). The present regulations provide that a specified method provided by the regulations or any other reasonable method for making allocations may be employed. Reg. 1.704-3(e)(3).

3 Because of regulatory constraints against advertising and similar public relations, it is often difficult to obtain information about the hedge fund industry. See, e.g. Pellegrino and Lorence, Use of Derivatives by Hedge Funds (Part 1), 2 Derivatives 6 (November 2000).

4 See, e.g. Pellegrino and Lorence, Part 1, supra note 3, and Part 2, 2 Derivatives 18 (December 2000).

5 The principal advantage is the use by U.S. tax-exempt taxpayers to avoid the unrelated business income tax (e.g. on debt-financed property, Section 514) by buying shares of an offshore hedge fund structured as a C corporation for U.S. income tax purposes. This tax-advantageous result is specifically contemplated by Reg. 1.1091-1(e). Investment by taxable U.S. persons in an offshore hedge fund structured as a C corporation results in passive foreign investment company (PFIC) problems where the fund’s investment in the PFIC extends past the last day of the fund’s tax year, under the rules of Sections 1291 et seq. Because of these tax detriments in investing offshore by taxable U.S. persons, this article will address only issues relating to domestic hedge funds.

6 See, e.g. IRS Chief Counsel Notice, CC-2003-020 (June 25, 2003), dealing with the Son of Boss tax shelter in its various alternatives. BNA Daily Tax Report, 6/27/2003, page G-6; 2003 TNT 124-18.

7 It is unheard of for investors in a hedge fund to commit to liability for the fund’s debts outside the partnership (such as by guaranteeing bank debt). It is assumed for purposes of discussion that no member of any fund has committed to contribute additional capital beyond funds already transferred. If additional capital were committed, but not yet contributed, such amounts could be called on.

8 Based on Examples 1-4 in Chapter 1 of the Partnership Audit Manual. The Manual assumes that all of B’s profits are realized income, whereas in a typical arrangement, part of A’s return would include unrealized gain.

9 See Reg. 1.707-2, Disguised payments for services. The regulation is reserved (meaning that its contents are blank). This author suggests that if this is a burning issue, Treasury’s failure to address it in 20 years is perplexing.

10 1954-1 CB 284.

11 TCM 1978-208.

12 See Sloan and Kraft, Opening Pandora’s Box: Who Is (or Should Be) a Partner? Taxes (March 2001), for an extensive review of the authorities.

13 Chapter 12 of the Manual paraphrases the legislative history. The example’s facts are unlikely to arise today since active trading vitiates the effect of capitalized brokerage fees.

14 This issue is discussed in Pellegrino and Lorence, Part 2, supra note 4. Although some hedge funds are registered with the SEC as nonclearing broker-dealers (to enjoy the much higher leverage that a broker-dealer can employ), such funds do not intend to qualify as a dealer for income tax purposes under Section 475.

15 See Lorence, Use of Derivatives by Hedge Funds (Part 4)—Hedges, 4 Derivatives 12, at 15-16 (July 2003).

16 The issue arises most frequently with what is known as a swap fund, which is a partnership formed to receive large concentrated stock positions with the objective of diversifying the partners’ holdings without triggering a taxable event. The swap fund is a passive vehicle, not to be confused with the type of actively managed partnership discussed here.

This article and other articles herein are provided f or information purposes only. They are not intended to be an offer to engage in any securities transactions or to provide specific financial, legal or tax advice. Articles may have been rendered partly inaccurate by events that have occurred since publication. Investors should consult their advisers before acting on any topics discussed herein.

Purchasers of hedge funds, including hedge fund of funds, should carefully review the fund’s offering materials. Hedge funds and hedge fund of funds have a high degree of risk, including, without limitation, that these funds typically employ leverage and other speculative investment practices, that the ability to make withdrawals typically is very limited, that these funds are not subject to the same regulatory requirements as mutual funds, and that an investor can lose all or a substantial amount of his investment.