A ruling last month by the Internal Revenue Service, limiting the ability of investors in funds of hedge funds to deduct management fees from their federal income taxes, could prompt some managers and their investors to either redo their tax forms or challenge the decision.
The question at the core of Revenue Ruling 2008-39 is whether funds-of-funds, because of their investments in underlying hedge funds, can categorize their own management fees as "trader expenses." In deciding that, for tax purposes, funds-of-funds should be considered investors and not traders, the IRS said that the fees must be treated as miscellaneous itemized investment expenses under Section 212 of the Internal Revenue Code.
Investors previously could deduct all or a portion of a fund of funds' management fees as a business expense. Now, for a fund-of-funds investor to deduct the fees, the total amount, when added to other, similar expenses, must make up more than 2% of the individual's adjusted gross income-and overall itemized deductions are subject to a "phase out" based on that income. If the investor is subject to the alternative minimum tax, the fees may not be deductible at all.
The IRS ruling, which marks the first time the agency has addressed the tax status of funds-of-funds, will likely only have an effect on high-net-worth individuals who have until now benefited from the loophole that gave them trader status, according to tax experts. As tax-exempt entities, institutional investors - endowments, pension funds and insurance companies - won't be affected.
Funds-of-hedge funds, which select portfolios of individual funds to reduce investment and market risk, typically charge a flat annual management fee of 1% to 2% of the value of the assets under management. That fee is in addition to those charged by the managers of the underlying funds.