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Tax Sins Hedge Fund Managers Should Avoid

In the competitive world of investing, it could be quite tough to launch your fund, seek capital and then deploy that capital.  But what about keeping it going so that you can reap the rewards?  Although many things happen that are beyond one's control, any of these, by themselves, are enough to cause investors to flee.  They could include a host of things including underperformance to a benchmark, losses over time, volatility, lost faith in management, or even a sudden loss of interest in a certain type of investment style or sector.

When any of these occur, coupled with what I would like to call, “the tax sins hedge fund managers should avoid”, the tipping point of losing an investor might be approaching quicker than you think.

These sins are as follows:

1.Triggering taxable income at high tax rates—in fact, several funds trigger ordinary taxed gains, including both short term capital gains and ordinary dividends.  Unless the mandate of the fund is short term trading, and the investor is fully of aware of this, then high taxed gains are a disservice to investors.
 
Note: Investing in passive indices for the long term will trigger low tax rate income, such as long term capital gains and qualified dividends.
 
2. Incurring virtually useless tax deductions—when investors start to lose money, they start to look under rocks for places to save money.  They then focus on those management fees collected by fund managers.  These fees are reported as “portfolio deductions” on the K1's.  On one's personal tax return, these deductions appear as miscellaneous itemized deductions on Schedule A.  (It gets bad from here as if the investor goes to three lousy barbers.) The itemized deduction gets a first “haircut”—that is, it gets subjected to a 2% of adjusted gross income calculation.  But based on the income of the investor, he experiences a second “haircut”—this one has to do with the general limitation of the amount of itemized deductions allowed to be taken.  If anything is left after this, then the investor possibly goes to the “AMT barber”—the Alternative Minimum Tax calculation, then attempts to make this tax deduction disappear almost entirely.
 
 
As a comparison, investing in passive indices do not produce these fees. Investing in “alternative” investments may be a viable alternative to passive index investing depending on an investor's needs.
 

This next “sin” might actually be the tipping point to destroying the relationship:
 
 
3.Sabotaging the investor's external tax strategies—Here is a simple example of sabotaging:
 
Let's assume that a wealthy “sophisticated” investor is sitting on $50 million in investments.  He manages half himself.  A few years ago, he farmed out the other half, or $25 Million, to a “tax neutral” hedge fund (the “Fund”) whose performance has been up and down.  The investor has been patient despite the Fund's disappointing performance.  This year he has long-term capital gains of $5,000,000 in his own personal portfolio.  The fund reported a flat performance (0%) after accounting for fees, and the investor received a K1 statement resembling the following items:

Portfolio deductions: $500,000 (or 2% of capital).

Unrealized gains: $500,000 (nontaxable).

Short term capital gain: $5,000,000.

Long term capital loss: $5,000,000.

It sounds like the Fund is, indeed, tax neutral. Right? Anyone can see that net capital gains of $5MM less capital losses of $5MM equals zero.

But guess what? The investor nets his personal Long Term Capital Gains against his K1 Long Term Capital. That leaves him with a Short Term Capital Gain from his K1.  The hedge fund just added $1,000,000 of taxes to this client!! We can assume that the portfolio deductions are nearly worthless and that the investor is paying 20% higher tax rate on the capital gains as follows:
[(39.6% – 20%)] x $5,000,000 = about $1,000,000 more taxes.

 
4.Tax Disrespect—after the fund manager receives the withdrawal notice from the investor, some partnership agreements could allow a long term fund investor to be “stuffed” with Short term capital gains!  That means that the investor's outside tax basis becomes equalized with his or her inside basis by the addition of short-term capital gains on his or her K1.  Wow!

Do we think this investor is ever going to return to this fund or ever refer his buddies to this fund?
If the hedge fund manager runs to another fund or wants to launch a new fund, his name will freshly appear in the Private Placement Memorandum. However, carries his reputation from the previous fund.

5.Victimizing investors when another investor leaves—when funds lose investors, the fund manager may have to “rebalance” the fund.  What does that mean?  Very often, it means selling off investments at sub-optimal times in order to raise cash for fund withdrawals (in case there was insufficient cash on hand).  Specifically, it means “shaving” positions so that each position's proportional size within the portfolio equals the same as before the investor left.  This shave causes taxable events that could be undesirable to the remaining investors.

Possible Tax Solutions

What could the fund manager do?

A number of things: convert the short term gains into long term gains by buying puts or collars on the appreciated positions. This extends the holding periods. Or, “box” the short term gains in order to defer the realization (subject rules relating to subsequent market exposure later on). Or just hold the winning positions a little longer so that dividends become “qualified” and gains become long term. Or take losses faster (thereby preventing them from becoming long term ones), if possible. Or cull the portfolio in order to find short term capital losses within the portfolio to help reduce the total amount of reportable short term gains.  And finally, let's leave on a good note with the departing investor — only “stuff” the departing investor with long-term capital gains out of respect and tax fairness.

We must remember that sophisticated, wealthy investors pay high taxes and want their money growing in a risk-measured way. They drive the success of the fund business and deserve respect!  They are paying the fund manager and are tax conscious. When they hold appreciated stocks for long term capital gains, they expect to pay lower tax rates. To them, that's golden.
 
For more information about replacement properties and 1031 exchanges, contact Peter Metz, CPA, Tax Principal of Grassi & Co. at pmetz@grassicpas.com.

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