The IRS has allocated significant resources to increase the number and scope of audits of hedge funds. IRS hedge fund audits are conducted by large audit teams that include specialists, technical advisors and IRS counsel. The IRS also applies an “enterprise” approach in which it simultaneously audits a related group of entities. In the case of hedge funds, this means that the IRS may simultaneously audit master funds, feeder funds, and fund manager entities. Hedge fund audits also commonly include IRS interviews of key officers and employees. In addition, the IRS may seek information directly from the hedge fund’s prime brokers and counterparties.
IRS hedge fund audits are also generally conducted under the complex partnership procedures of the Tax Equity and Fiscal Responsibility Act of 1982 (“TEFRA”). Under TEFRA, “partnership items” are audited exclusively at the partnership level. The “tax matters partner” of the partnership serves as the primary point of contact with the IRS and has a duty to inform other partners of certain events. Procedural issues often arise, including, but not limited to, issues relating to the statute of limitations, whether an issue is a partnership item, suspensions of interest, and the deposit required to pursue an action in certain courts. In addition, the following are examples of substantive issues that may be raised in a hedge fund audit.
“Trader” Versus “Investor”
A fund that buys and sells stocks, securities or other financial instruments may be classified as a “trader” or an “investor” for tax purposes. Trading is considered a trade or business; investing is not. If the fund is classified as a “trader,” a U.S. taxable investor in the fund may deduct its share of certain management fees and other fund expenses “above the line.” If the fund is classified as an “investor,” these expenses are deductible only as itemized deductions that are typically severely limited or disallowed entirely. To be classified as a “trader,” the fund must be prepared to show that it profits from short-term market movements, and not from capital appreciation or long-term price trends.
Foreign feeder funds are subject to U.S. income tax to the extent they earn income “effectively connected with a U.S. trade or business.” Although “trading” is treated as a trade or business, there is a safe harbor for trading in stocks, securities and certain commodities for one’s own account, even if the trading is carried on in, or managed from, the United States. However, the trading safe harbor does not apply to a U.S. lending business. Generally, a lending business is deemed to arise from originating loans, but not from purchasing loans that someone else originated. Therefore, funds have sought to avoid a U.S. trade or business by purchasing loans from an originator at least a minimum period of time after origination (so-called “season and sell”). The key issue is whether the originator is acting as an agent of the foreign fund. Similar U.S. trade or business issues can arise in the context of loan refinancings or modifications, and debtor-in-possession loans.
A hedge fund’s foreign feeder generally is subject to a 30 percent U.S. withholding tax on dividends paid on stocks of U.S. issuers. In lieu of direct investment in U.S. stocks, funds have invested in derivatives referencing U.S. stocks, including “total return swaps.” Until recently, payments under such derivatives were generally not subject to U.S. withholding tax. In 2010, Congress enacted section 871(m) to address the dividend withholding issue. Under section 871(m), dividend-based payments on securities lending, sale-repurchase transactions, and specified notional principal contracts are now subject to U.S. withholding tax.
Structured derivatives present the issue of whether the fund should be treated, for tax purposes, as owning the underlying financial assets, rather than the derivative. If the fund is treated as owning the underlying financial assets, the income from the transaction may be ordinary income taxed at a marginal rate of 35 percent instead of long-term capital gain taxed at a favorable rate of 15 percent. Payments on the underlying assets may also incur U.S. withholding tax. For example, in AM 2010-005, the IRS took the position that an option that referenced a managed portfolio of securities was not an “option” for tax purposes and that the hedge fund was the true owner of the underlying securities.
Wash Sales and Straddles
Under the wash sale rules, if a taxpayer disposes of stock or securities at a loss and acquires “substantially identical” stock or securities within 30 days before or after the loss transaction, the loss is disallowed. Under the straddle rules, if a taxpayer holds offsetting positions, the taxpayer is generally treated as holding a “straddle” and any losses are allowed only to the extent they exceed unrecognized gain on the offsetting positions. For funds engaged in active securities trading, tracking wash sales and straddles can be difficult. Generally, the IRS will ask the fund to explain its process for tracking wash sales and straddles and then audit the fund’s process.
Management Fee Conversions
Fund managers may agree to convert their management fees into additional carried interest. Whereas management fees are taxed as ordinary income, the income from a carried interest is often long-term capital gain. The IRS may argue that the income from the additional carried interest is taxable as ordinary income because the management fee conversion should be treated as a disguised nonpartner transaction under section 707(a)(2)(A) or a guaranteed payment under section 707(c).
Nonqualified Deferred Compensation
Under section 409A, fund managers may defer the recognition of compensation under a nonqualified deferred compensation plan if the amount is subject to a substantial risk of forfeiture. However, section 409A(b)(1) requires current income inclusion in the case of certain offshore funding of nonqualified deferred compensation. In addition, section 457A accelerates the recognition of compensation under a nonqualified deferred compensation plan of a “nonqualified entity” such as a foreign entity that is not subject to a comprehensive income tax.
In summary, the IRS has expanded its audits of hedge funds. IRS hedge fund audits can be very burdensome, involving large audit teams with multiple entities under simultaneous examination. Therefore, hedge funds should assess whether they are prepared for an IRS audit.