In recently issued Rev. Rul. 2008-39, the Internal Revenue Service ruled that a management fee charged by a partnership (or other entity taxed as a partnership) that invests in other partnerships (i.e., a fund-of-funds) cannot be treated as a trade or business expense. Instead, the management fee must be reported to the individual partners in the partnership as an investment expense, which is deductible for regular income tax purposes only to the extent in excess of 2% of the investor’s adjusted gross income and is not deductible at all for alternative minimum tax purposes.

Up until now, many fund-of-funds have treated their management fees as trade or business expenses to the extent allocable to their investments in other partnerships that are actively trading securities. However, the Revenue Ruling holds that management fees (and other operating expenses) of a fund-of-funds are not business expenses even if the fund-of-funds invests entirely in hedge funds that are themselves actively trading securities. Accordingly, fund-of-funds will now be required to report their management fees and other operating expenses as investment expenses rather than as trade or business expenses.

http://nakedshorts.typepad.com/nakedshorts/files/IRS_2008-39.pdf