Earlier this month, the IRS issued guidance that may require hedge fund managers to choose between taking their management fees out at the master fund level or denying the funds’ partners a tax deduction for such fees. This guidance, namely Revenue Ruling 2008-39 (the “Ruling”), addressed the issue of whether the management fees paid by the upper-tier partnership in a “fund of funds” structure are “trade or business” expenses or, alternatively, expenses incurred “for the production of income.” The distinction is crucial to many individual investors, because fees incurred in a trade or business are generally deductible without restriction, while fees incurred for the production of income (i.e., in the absence of a trade or business) are subject to substantial limitations on deductibility. For many individual investors, these limitations effectively preclude a deduction entirely. As discussed hereinafter, the Ruling’s characterization of the fees depends on whether the trade or business of the lower-tier partnership is attributable to the upper-tier partnership for purposes of determining whether the upper-tier partnership is engaged in a trade or business.

Facts

The Ruling deals with a fund of funds structure composed of an individual (LP) who owns a limited partnership interest in an upper-tier partnership (UTP), in which the UTP holds only limited partnership interests in several lower-tier partnerships (LTP). The UTP’s activities consist solely of acquiring, holding and disposing of interests in LTPs. The Ruling assumes that (i) the UTP’s activities do not constitute a “trade or business,” but instead constitute the holding of the LTP interests for the production of income within the meaning of Section 212; (ii) the management fee paid by the UTP is an ordinary and necessary expense of carrying on its investment activities; and (iii) that each LTP is engaged in the “trade or business” of trading in securities, and thus the management fees paid by the LTPs are ordinary and necessary business expenses.

Impact of Revenue Ruling 2008-39

Even though the LTP is engaged in a trade or business, and even though in other contexts, the activities of a partnership are attributed to its partners for tax purposes, the IRS concluded that the LTPs’ “trade or business” activities are not attributable to the UTP. Stated differently, the ruling stands for the proposition that the “active” nature of an LTP’s “trade or business” activities are not attributable to that LTP’s limited partner (i.e., UTP) so as to cause such UTP to be treated as engaging in a “trade or business.” The issuance of the Ruling suggests that some upper-tier partnerships in a fund of funds structure may have taken a contrary position in characterizing their management fee expenses.

Broader Significance of the Ruling

While the Ruling addresses only the fund of funds scenario, the reasoning could arguably also apply to the management fee expenses of a feeder fund in a master-feeder fund structure. On the other hand, a master-feeder structure is distinguishable from the fund of funds scenario described in the Ruling, because the sole purpose of the feeder fund is to invest in a master fund, and the master fund then invests all of its assets at the discretion of an investment advisor. Generally, the investment advisor of the feeder fund that made the decision to invest all of the feeder fund’s assets in the master fund is the same (or affiliated) entity that invests the master fund’s assets in securities. If the IRS does decide to apply the Ruling’s reasoning to feeder fund management fees in typical master-feeder arrangements, the negative consequences of having such fees considered expenses “incurred for the production of income” could be avoided by structuring the funds so that all fees are paid at the master fund level (assuming that the master fund’s activity level is such that it is deemed to conduct a “trade or business”).

Lastly, we note that if a UTP’s activities, independent of the activities of any LTP, constitute a “trade or business” (i.e., the UTP’s own activities qualify as being in the business of trading in securities), then management fees paid or incurred by such UTP with respect to its own securities trading activities should be characterized in the same manner as those of the LTPs in the Ruling (i.e., as ordinary and necessary business expenses).