A Basic Outlook on Hedge Fund Structure and Taxation Issues

Author:Guillermo Gil Díaz
Position::Certified Public Account; J.D. University of Puerto Rico Law School, 2011 and Associate, Tax Practice Group, Fiddler Gonzalez & Rodriguez, P.S.C.
Pages:265-286
 
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A BASIC OUTLOOK ON HEDGE FUND STRUCTURE AND TAXATION
ISSUES
GUILLERMO GIL DÍAZ*
ARTICLE
I. Introduction ...................................................................................................................... 264
II. Hedge Fund Structure .................................................................................................. 265
A. U.S. Hedge Fund Corporate Structure................................................................ 265
B. Foreign or Offshore Hedge Fund Structure ..................................................... 267
C. Passive Foreign Income Taxation........................................................................ 269
III. US investors in offshore hedge funds ................................................................... 270
IV. Tax Exempt Organizations ........................................................................................ 273
V. Hedge Fund Manager’s Compensation and Carried Interest ........................ 277
VI. Hedge Fund Manager and Puerto Rico ................................................................ 282
VII. Conclusion ..................................................................................................................... 284
I. INTRODUCTION
In today’s worldwide financial arena, investing in the global and state
markets has become a sophisticated and difficult task. Financial instruments have
been created to satisfy the market demands for risk taking and niche investing. One
of the popular financial vehicles, which allow wealthy individuals, prospering
businesses, and charitable organizations to participate in diverse investment
strategies, are called hedge funds. “The term hedge fund is commonly used to
describe a variety of different types of investment vehicles sharing common
characteristics. Although it is not statutorily defined, the term encompasses any
pooled investment vehicle that is privately organized, administered by professional
money managers, and not widely available to the public.”1 Traditionally, these types
of funds are highly leveraged and invest in high-risk financial derivatives. In today’s
global market, hedge funds encompass different types of strategies that may fit
every client’s individual investment need.
* Certified Public Account; J.D. University of Puer to Rico Law School, 2011 and Associate, Tax
Practice Group, Fiddler Gonzalez & Rodriguez, P.S.C.
1 The President’s Financial Working Group of Financial Markets, Hedge Funds, Leverage, and
the Lessons of Long Term Capital Management, (Apr. 1999), at page 1 in Jerald David August
& Lawrence Choen, Hedge Funds--Str ucture, Regulation and Tax Implic ations, 870 PLI/Tax
715 n. 7, (2009)(Emphasis added).
No. 2 Hedge Fund Structure and Taxation Issues 265
Given the nature of this type of investment vehicle, it is important that these
funds are structured in accordance with applicable securities and tax law in order to
avoid complex regulatory hurdles and minimize tax liability. This work will discuss
the basic aspects of a Hedge Fund’s structure and some of the fundamental issues
they face in regards to United States Federal taxation.
II. HEDGE FUND STRUCTURE
A. U.S. Hedge Fund Corporate Structure
The basic hedge fund structure consist of two entities, (1) Hedge Fund,
which possesses exclusively assets for the purpose of investing and (2) the Hedge
Fund Manager, which administers the hedge fund’s daily operation and investment
strategy. The first important step in structuring a hedge fund is deciding under
which type of legal entity the fund should be organized. There are five types of
entities under which a fund may be structured: (1) Subchapter C corporation, (2)
Subchapter S Corporation, (3) SEC Regulated Investment Company, (4) Partnership
and (5) Limited Liability Corporation (LLC)2. Subchapter C corporations are usually
not an appropriate legal entity to structure a hedge fund, mainly due to the high
corporate tax rate and double taxation issues, as the shareholders’ dividend
distributions are also taxed. Although a Subchapter S corporation may elect to be a
pass-through entity, the restriction on the number and type of investors is normally
unsuitable for hedge funds3. Though regulated investment companies, consisting of
mostly mutual funds, are not taxed at the entity level, they are subject to limitations
on investment strategies and complicated regulations.4
Most hedge funds are organized as limited partnerships due to a
partnership’s ability to be considered a pass-through entity for tax purposes. Hence,
partners are not subject to double taxation, and report their shares of the
partnership’s earnings on their individual tax returns. But if the partnership is
2 NAVENDU P. VASAVADA, TAXATION OF U.S. INVESTMENT PARTNERSHIPS AND HEDGE FUNDS ACCOUNTING
POLICIES, TAX ALLOCATIONS, AND PERFORMANCE PR ESENTATION 4 (2010).
3 Subchapter S corporations must be a domestic corporation, only natural personas and
certain trust and estates may be investors an d has a limit of 100 shareholders. See Internal
Revenue Service, S corporations,
http://www.irs.gov/businesses/small/a rticle/0,,id=98263,00.html (last visited Jan. 26,
2011).
4 Anne Granfield, Mutual Fund Tax Traps.
http://www.forbes.com/forbes/1998/0824/6204158a.html (las t visited November, 20,
2011).

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