U.S. Income Portfolios: Other Pass-through Entities 
  Portfolio 736-1st: Hedge Funds 
  Portfolio Description

Andrew W. Needham
 Cravath, Swaine &  Moore LLP
 New York, NY
 
 and
 
 Christian Brause
 Cravath, Swaine & Moore LLP
 New York, NY

 Special Consultants to Tax Management

Andrew W. Needham, J.D., Georgetown University Law Center; LL.M. (Taxation), Georgetown University Law Center; M.B.A., The Wharton School; B.A., University of Arizona; Member, Executive Committee, Tax Section of New York State Bar Association, American Bar Association, United States Tax Court.

Christian Brause, First and Second State Examinations in Rhineland-Palantinate, Germany; doctorate in law (Dr. jur.), Johannes Gutenberg University at Mainz; LL.M. (Int. Taxation), New York University School of Law; former Member of the Bar of Frankfurt a. M., Germany;Member of the Tax Section of the New York Bar Association.

U.S. Income Portfolios: Other Pass-through Entities 
  Portfolio 736-1st: Hedge Funds 
  Portfolio Description

Leonard L. Silverstein, Esq. 
 Advisory Board Chairman
 Technical Director
 
 Gerald H. Sherman, Esq. 
 Deputy Technical Director
 
 Patrick G. Dooher, Esq. 
 Deputy Technical Director
 for U.S. Income

U.S. Income Portfolios: Other Pass-through Entities 
  Portfolio 736-1st: Hedge Funds 
  Portfolio Description

PORTFOLIO DESCRIPTION 

Tax Management Portfolio, Hedge Funds, No. 736, addresses the full range of U.S. tax issues that typically arise in the representation of hedge funds.  The purpose of this portfolio is to provide a source of guidance to tax practitioners who regularly advise hedge funds, their portfolio managers and their investors. It also includes descriptions of basic fund prototypes, the relevant regulatory environment, alternative fund structures, and common economic terms and variations thereon.

This portfolio may be cited as Needham and Brause, 736 T.M., Hedge Funds.

U.S. Income Portfolios: Other Pass-through Entities 
  Portfolio 736-1st: Hedge Funds 
  Detailed Analysis 
  I. Introduction

This portfolio addresses major recurring U.S. tax issues that arise in the representation of hedge funds.  The purpose of the portfolio is to provide a source of guidance to the tax practitioner who regularly advises hedge funds, their sponsors, and prospective investors.

U.S. Income Portfolios: Other Pass-through Entities 
  Portfolio 736-1st: Hedge Funds 
  Detailed Analysis 
  I. Introduction

A. What Is a Hedge Fund? 

While precise definitions are elusive, a hedge fund is an alternative investment vehicle that trades in stocks, securities and other financial instruments.  It does so, however, free of the many regulatory constraints that apply to mutual funds (i.e., “regulated investment companies”).1 A hedge fund may acquire long and short positions on a range of different investments, including stocks, fixed income, convertible debt, foreign currencies, exchange-traded futures, forwards, swaps, options and other derivatives.  In many cases, the fund will borrow, hedge or take offsetting positions in a portfolio of securities to implement some overarching, often complex investment strategy.  In others, it will acquire these positions simply to exploit what the portfolio manager perceives as a temporary pricing anomaly in the market.
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1 See generally Kennard, “The Hedge Fund Versus the Mutual Fund,” 57 Tax Law. 133 (2004).

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While often confused with a private equity fund, a hedge fund bears little in common with it.  First, investors in hedge funds have more liquidity.  In a private equity fund, the investor invests for the long term, achieving liquidity in stages as and when the fund disposes of its illiquid portfolio investments for cash or marketable securities and distributes the proceeds.  An investor in a hedge fund, on the other hand, achieves liquidity by selling its shares back to the fund.  Unlike a private equity fund, a hedge fund holds marketable securities, issues shares at regular intervals, and has access to multiple credit facilities.  Each is a source of cash, allowing the fund to offer liquidity to its investors by periodic redemption.  Second, while hedge funds have perpetual lives, private equity funds do not.  The average life span of a private equity fund is seven to ten years, which corresponds to the end of the holding period of the last portfolio investment in the fund.  Third, investors in hedge funds acquire and dispose of their investment in single rather than staggered transactions.  Investors in private equity funds commit to fund their investment over several years, which the portfolio manager calls in stages as it identifies each investment candidate. Fourth, a hedge fund is free to buy, sell and reinvest the proceeds of sale in accordance with a broad investment charter.  A private equity fund closes the fund to new investors after achieving a targeted level of commitments, calls capital to fund investments, and then sells them over time in a protracted liquidation.

Although subject to less oversight from regulators, hedge funds do bear two economic traits in common with mutual funds:both invest in marketable securities and both provide short-term liquidity to their investors by redemption.  The principal economic difference between these two vehicles lies in their respective investment philosophies, and here the market defies any attempt to generalize.

As originally conceived, a hedge fund was an investment vehicle that sought positive absolute returns in all investment environments, rather than returns that merely exceeded the returns of a stated benchmark.  A mutual fund, on the other hand, usually seeks only to exceed (or duplicate in the case of an index fund) the market performance of a specific asset class.  A mutual fund will outperform its competitors, therefore, if its returns exceed the relevant benchmark, even when negative.  A hedge fund seeks positive returns under all market conditions, but without exposing investment “principal”to undue risk of loss.

Indeed, it was this last attribute that first distinguished a hedge fund from other funds.  In the beginning, hedge funds earned their name from their propensity to hedge.  To “hedge”is to reduce the market risk on an investment.  A fund that fully hedged, therefore, was immune to volatility.  No hedge fund ever did that.  A traditional hedge fund, however, did expect to profit whether the market moved up or down, usually because the fund held both long and short positions in the same or similar investments.  If the market rose, the hedge fund profited if the increase in the long positions exceeded the decrease in the short positions.  Conversely, if the market fell, the hedge fund profited if the increase in the short positions exceeded the decrease in the long positions.  Gain or loss to the fund therefore depended upon pricing anomalies in the market, not upon whether the market as a whole moved up or down.  Or as one described it, hedge funds “mine[d] inefficiencies in the market.”2
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2 Mahler, “From Simple to Complex, Hedge Funds Gain Ground,” New York Times, (Feb. 2005).

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Today's hedge fund is a different breed.  Most modern hedge funds employ investment strategies that are not market neutral at all.  Indeed, they operate as hedge funds in name only, distinct from mutual funds not on the basis of market risk, but on the basis of investor population, fee structure, portfolio diversification, degree of leverage3 and extent of regulatory oversight.  Some hedge funds do not even short.  For these funds, the term “hedge” is even less apt.  But most hedge funds do take short positions, usually to hedge offsetting long positions. A straddle, for example, is an archetypal hedge fund investment, often a “bet” that the trading ratio between two securities will expand or contract.4 But portfolio managers occasionally lose those bets, and when they do, the hedge fund realizes a real economic loss.
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3 As described in I, B, below, the Investment Company Act of 1940 limits the ability of a mutual fund to borrow.

4 For a discussion of the straddle rules under  § 1092 and their application to hedge funds, see XI, C, below.

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As described in III, C, below, one longstanding difference between a hedge fund and a mutual fund is the fee structure.  The portfolio manager of a hedge fund charges a fixed percentage of the portfolio gains as compensation for its services, usually 20%.  A mutual fund does not.  Because it sells its shares in registered public offerings, a mutual fund cannot charge a “carry” to its shareholders.

U.S. Income Portfolios: Other Pass-through Entities 
  Portfolio 736-1st: Hedge Funds 
  Detailed Analysis 
  I. Introduction

B. The Regulatory Environment — A Brief Overview 

Unlike mutual funds, hedge funds operate in a largely unregulated niche of the investment world.  First, they do not register their shares under the Securities Act of 1933 (the “33 Act”) because they do not sell their shares in “public offerings.” Most hedge funds instead sell shares in private placements, either to “accredited investors” or to a limited number of buyers.  These private placements generally qualify for an exemption from registration under § 4(2) of the 33 Act and the rules thereunder.  Second, hedge funds are not “investment companies” under the Investment Company Act of 1940 (the “40 Act”).  Although virtually all hedge funds meet the statutory definition of an “investment company,”5 most rely on the exemption under § 3(c)(1) of the 40 Act,6 which excludes most funds with 100 or fewer investors, or Section 3(c)(7) of the 40 Act, which excludes most funds with investors who qualify as “qualified purchasers.”Because the universe of “qualified purchasers” is small, most hedge funds prefer to rely upon the “accredited investor”exemption.  By avoiding 40 Act registration, a hedge fund will also avoid the various constraints on leverage that apply to an open-ended mutual fund.  Section 18(f) of the 40 Act, for example, limits the right of a fund to issue senior securities.  In addition, § § 12(a)(i)and (3) of the 40 Act limit the purchase of securities on margin and short selling.  Third, many portfolio managers do not register as “investment advisors” under the Investment Advisors Act of 1940 (the “Advisors Act”).  They instead rely on Section 203(b)(3) of the Advisors Act, which exempts a portfolio manager with fewer than 15 “clients.”For this purpose, a portfolio manager is not required to “look through” the hedge fund to treat each investor in the fund as a separate client — instead, it may treat the hedge fund itself is a single client.  It is possible, therefore, for a portfolio manager to manage 14 separate funds without becoming a registered investment advisor.  Many portfolio managers seek to avoid registration under the Advisors Act because a registered advisor may only charge a carry to a “qualified client,” a status that few investors attain due to the rigorous investment and net worth criteria.
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5 § 3(a)(1)(A) and § 3(a)(1)(C) of the 40 Act.

6 If the fund is incorporated abroad, only U.S. investors count toward the 100 investor limitation.

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Note: On October 26, 2004, the SEC amended these rules to require a portfolio manager to “look through” a hedge fund to count each of the fund's investors as a separate client unless the  fund satisfied certain conditions.7 The practical effect of this amendment would have been to require a portfolio manager to register as an investment advisor unless the fund, including any otherwise-grandfathered fund that accepted new investments, satisfied these conditions.  Although these amendments became effective on February 10, 2005, the SEC allowed portfolio managers until February 1, 2006 to either register as an investment advisor or comply with the new rules. On June 23, 2006, however, the United States Court of Appeals for the District of Columbia Circuit vacated this rule, finding that the term “client” of a hedge fund manager could not be interpreted to include an investor in a hedge fund.8
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7 See “Registration Under the Advisors Act of Certain Hedge Fund Advisors,” SEC Release IA-2333 (Dec. 2, 2004).

8 Goldstein v. Securities and Exchange Commission, 451 F.3d 873 (D.C. Cir. 2006). In response to the Goldstein decision, the SEC proposed new anti-fraud rules on December 27, 2006 that would prohibit the making of false or misleading statements to an investor or prospective investor in a private equity or hedge fund. The rules would apply to all portfolio managers, whether or not registered under the Advisors Act. See Securities Act of 1933 Release No. 33-8766 (“Prohibition of Fraud by Advisors to Certain Investment Vehicles; Accredited Investors in Certain Private Investment Vehicles”), available at http://www.sec.gov/Rules/proposed/2006/33-8766.pdf(Dec. 27, 2006).

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Because hedge funds are exempt from most of the more onerous regulatory and disclosure obligations that govern mutual funds, they tend to attract less public scrutiny, both in the press and from governmental agencies.  Most hedge funds, however, do issue a “private placement memorandum” (“PPM”)to their investors.  A typical PPM describes the investment strategy of the fund, the identity and track record of the portfolio manager, and the economic terms of the investment.  The breadth of disclosure in a PPM, however, is not nearly as fulsome as the disclosure in a typical mutual fund prospectus.  Moreover, the underlying fund agreement vests more discretion in the portfolio manager to deploy assets and/or alter the investment philosophy of the fund.  Many investors in hedge funds tolerate (even encourage) these broad charters because their own decision to invest in the fund reflects an investment in the portfolio manager and its employees rather than an investment in the underlying portfolio.

U.S. Income Portfolios: Other Pass-through Entities 
  Portfolio 736-1st: Hedge Funds 
  Detailed Analysis 
  II. Fund Prototypes

A. Basic Fund Structures 

1. In General 

Most hedge funds assume one of the four following organizational structures:

• a single entity fund;

• a master-feeder fund;

• a parallel fund; or

•a multi-manager fund.

Like any agreement, a fund agreement is merely a contract.  In any particular case, therefore, its economic terms and structural assumptions will stray from established norms to the extent necessary to reconcile the specific and often competing objectives of the particular participants.  The investment philosophy of the fund, the track record of the sponsor and the composition of the investor group will also inform the structure of the fund and its economic terms.  With that caveat in mind, a brief description of each prototype follows:

2. Single Entity Funds 

A single entity fund is the most basic of fund structures.  A fund of this sort tends to solicit most of its capital from taxable U.S. investors.  The tax objectives of these investors do not include the primary tax objective of tax-exempt and foreign investors, which is to avoid U.S. taxing jurisdiction.  The absence of this objective often obviates the need for the more elaborate structures commonly associated with larger funds.  The sponsor usually organizes a single entity fund as a partnership, often a limited partnership under Delaware law.  As an alternative, the sponsor may choose a foreign partnership as the fund vehicle or, less frequently, a domestic limited liability company (“LLC”).

The general partner of a single entity fund receives a “carried interest” in the fund for services. The stated consideration aside, however, the general partner often provides no services at all.  As a shell holding company, it serves instead as a “warehouse” for the carried interest, engaging in no business activity.  In most funds, the general partner, itself a partnership for tax purposes, will make a capital contribution to the fund.  Although a capital contribution will tend to support the desired status of the general partner as a “partner” for tax purposes,9 that is rarely its purpose.  To the investors in the fund, the objective of the capital contribution is to temper the desire of the general partner to exploit the “option value” of the carried interest.
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9 See Luna v. Comr., 42 T.C. 1067, 1077-8 (1964) (extent of capital contributions and obligation to share losses cited as evidence of partner status).

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As an economic matter, the carried interest is like an option: a right to a fixed percentage of the net gains of the fund.  In most funds, the carry percentage is 20%.  As described more fully in III, C, below, however, the effective carry percentage in many funds will exceed 20% because the fund agreement will not “aggregate” all prior losses or “clawback”earlier gains to recoup later losses.10 Most funds grant the carried interest as a partnership interest, not as a fee for services.  As such, the fund-level character of the income will pass-through to the general partner and its members.  A direct allocation of gains to the general partner will also reduce the effective tax rate of the individual investors by eliminating an expense, which the Code may disallow as a deduction if the fund does not qualify as a “trader”in stocks and securities.11
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10 For a discussion of “high water marks” and the absence of clawbacks in hedge fund agreements, see III, C, below.

11 See VIII, C, below, for a discussion of whether an individual may deduct the cost of the carried interest under  § 162 if the sponsor recasts the carried interest as a fee for services.

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As its name implies, the portfolio manager manages the portfolio of the hedge fund on behalf of its investors.  As consideration, the fund pays the portfolio manager a management fee equal to a fixed percentage of the net asset value of the portfolio.  The portfolio manager is also a partnership for tax purposes, typically a separate sibling to the general partner.  Although the sponsor may choose to house the general partner and portfolio manager within a single entity, the two often operate as discrete legal entities even when they have the same members.  In many funds, the sponsor will bifurcate the general partner and the portfolio manager to reduce the state and local tax burden on the carried interest.12 In other funds, the sponsor will bifurcate the entities to create two distinct income streams in the carry and management fees, facilitating future grants to third parties.
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12 As described more fully in VI, C, 5, below, the separation of the two entities may allow portfolio managers with offices in New York City to avoid “unincorporated business tax” with respect to the carried interest.

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Worksheet 1 presents a diagram of a single entity fund, including the legal entities that serve as the general partner and portfolio manager.

3. Master-Feeder Funds 

A master-feeder fund is a hedge fund that solicits capital from taxable investors, tax-exempt investors and foreign investors. Except as necessary to address the specific concerns of each group of investors, the component entities within a master-feeder fund do not differ from single entity funds in either form or basic fund structure.

In a master-feeder fund, the foreign feeder is a holding company, a special purpose vehicle through which the electing tax-exempt and foreign investors make their investment in the fund.  To effect the investment, the feeder first issues stock to these investors for cash.  The master fund then issues equity units to the feeder.  As a back-to-back arrangement, the terms of the equity units in the master fund will mirror the terms of the stock in the feeder.  Finally, the master fund invests the capital of both the feeder and its other investors in the stocks, securities and other financial instruments that comprise the fund portfolio.13
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13 A master-feeder structure may include a domestic feeder as well.  In a “dual-feeder” structure, taxable U.S. investors and tax-exempt/foreign investors will invest through separate feeders.

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The sponsor organizes the foreign feeder in a low-tax jurisdiction (e.g., the Cayman Islands) as a corporation for tax purposes, not a partnership.  By investing in a corporation, therefore, the tax-exempt investor is a shareholder, not a partner.14 Because subchapter C has no statutory analogue to § 752, the status of the investor as a shareholder prevents any fund-level debt from “tiering up” to the shares, which would otherwise convert a portion of the otherwise exempt dividend and capital gain under  § 512(b) into “unrelated business taxable income” (“UBTI”) under § 514.15 The choice of the corporate form, however, also transforms the feeder from a leveraged partnership to a “passive foreign investment company” (“PFIC”)for tax purposes.  Because a PFIC is usually an unattractive vehicle to taxable investors, the shareholder base of most foreign feeders excludes taxable U.S. investors.16
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14 For a discussion of whether either  § 269 or common law “agency” authorities may apply in this context, see VII, C, 2, below.

15 See § 514.  For a discussion of leverage and its potential effect on the character of investment income to a tax-exempt investor, see VII, B, 2, below.

16 For a fuller discussion of the treatment of offshore feeders and parallel entities as PFICs, see VII, C, 3, below.  For a discussion of the conditions under which a taxable U.S. investor may prefer to invest in the feeder, see VII, C, 3, e, below.

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Finally, although the feeder is a separate taxpayer, it will be subject to U.S. tax on a net basis only if it engages in a U.S. trade or business.17 So long as the master fund in which it is a partner confines its activities to “trading” or “investing,”however, it will not be treated as engaged in a U.S. trade or business.18 The resulting exemption from taxation will therefore increase the after-tax returns to the feeder and its shareholders.  For the same reason, however, the exemption will also eliminate the potential tax benefit of the management fee and other expenses.  Because it is exempt from U.S. tax, the feeder has no stake in whether its share of the fund expenses will reduce gross income.19 In many feeder structures, therefore, the sponsor will exploit this indifference to recast the feeder's share of the carry as a fee for services.  If a portfolio manager on the cash method of accounting then opts to defer receipt of the fee for reinvestment in the master fund, it may defer the tax consequences of its participation in the carried interest until actual receipt of the deferred fee. As described more fully in V, B, below, these deferral arrangements often remain in place for years.20
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17 § 882(a).

18 See § 864(b).  For a discussion of the distinction between “trading” and “investing,”see VII, B, 1, below; see also § 875(1), § 702(b); Regs.  § 1.702-1(b) (character of partnership gains allocated to partner under  § 702(a) determined at partnership level);  § 1446 (requiring partnership to withhold “applicable percentage” of ECI allocable to foreign partners).

19 By allocating income to the general partner, the sponsor conveys an effective deduction to the other partners.  See VIII, C, below.

20 For a discussion of the application of the constructive receipt doctrine and  § 409A to fee deferrals by offshore hedge funds, see VI, B, below.

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Worksheet 2 presents a diagram of a typical master-feeder fund, including the legal entities that serve as the general partner and portfolio manager.

4. Parallel Funds 

A parallel entity is one of two members in a hedge fund complex that together solicit capital from the same population of investors as a master-feeder fund.  Accordingly, as in the case of the feeder entity, the sponsor organizes the parallel entity in a low-tax jurisdiction as well, electing status as a corporation for tax purposes.  Like the foreign feeder, the parallel entity serves as the special purpose vehicle by which electing tax-exempt or foreign investors make their investment in the fund.  Unlike the feeder, however, the parallel entity is not a mere holding company.  Instead, it invests in tandem with a sibling fund in the same stocks, securities and other financial instruments that comprise the aggregate fund portfolio, typically in lockstep.  As in the case of a feeder fund, the sponsor may elect to recast the parallel entity's share of the carry as a deferred fee for services.

5. Multi-Manager Funds 

Some investors invest in more than one hedge fund.  Some do so because they prefer hedge funds that concentrate on specific sectors of the market.  Others do so because they prefer economic exposure to multiple portfolio managers.  But many of these investors lack the time, resources and expertise to invest in several funds.  Still others have the time and expertise, but not the net worth to qualify as a direct investor in a hedge fund. A popular alternative for this type of investor is a “multi-manager”fund, also known as a “fund of funds” (“FOF”). An FOF is a fund that invests in other hedge funds.  By investing in an FOF, an investor delegates to another not only the choice of portfolio investments, but the choice of funds as well.  Accordingly, the manager of an FOF acts as a “gatekeeper” on behalf of its investors.

6. Hedge Funds with Private Equity “Side Pockets” 

Some hedge funds allocate a small portion of their total capital to the “private equity” sector.  Those that do segregate the illiquid securities from the marketable securities in the portfolio and then establish “side pocket” capital accounts to track the economic performance of the illiquid securities. By segregating private capital within  separate “silos,”the general partner seeks to ensure that the conventional exit mechanisms apply solely to the liquid portion of the portfolio.  A hedge fund with side pockets will therefore exclude the private equity investments from periodic redemption until the investments are no longer private.

Unlike an actual private equity fund, however, most hedge funds with side pockets do not distribute the proceeds of a side pocket sale to their investors.  Instead, they merge the newly-liquid capital back into the primary capital account of the participating investors in accordance with their relative capital percentages on the date of investment.  Unlike a private equity fund, therefore, a hedge fund may reinvest the proceeds of a side pocket sale, which the investors permit because they retain ultimate liquidity through the right of redemption.

Although modern hedge fund agreements include the right to segregate capital into side pockets, most portfolio managers do not exercise the right.  Those that do tend to invest only a small percentage of it in the private equity sector.

The Worksheets provide an example of a side pocket provision in a typical fund agreement.

U.S. Income Portfolios: Other Pass-through Entities 
  Portfolio 736-1st: Hedge Funds 
  Detailed Analysis 
  II. Fund Prototypes

B. Basic Fund Categories 

Hedge funds differ not only by structure and economic terms, but by investment objective.  Here, the menu of alternatives includes more choices.  The net investment positions of some hedge funds occasionally approach Byzantine levels of complexity.  Suffice it to say that some of their trading strategies do not lend themselves to simple description.  Nevertheless, the following subsections of this portfolio attempt to describe a few of the major categories.

1. Arbitrage Funds 

An “arbitrage” fund is a hedge fund that seeks to profit from errors in the market price of a security, not in absolute terms but relative to the price of a related security. The absolute price of a particular security is therefore irrelevant. What is relevant is that the pricing error is real and ephemeral, and therefore likely to correct itself as buyers and sellers in the market exploit the same opportunity.  An arbitrage fund often acquires long and short positions in two or more securities.  Whether the market rises or falls, the fund profits so long as the aggregate gain on the long or short position exceeds the aggregate loss on the offsetting position.

The portfolio manager of an arbitrage fund will usually concentrate on arbitrage strategies of a specific type.  Common categories include “convertible arbitrage,” “merger arbitrage” and “fixed income arbitrage.”  In a “merger arbitrage” fund, for example, a portfolio manager may purchase the stock of a target and short the stock of an acquirer after the parties have announced a plan to merge.  In doing so, the portfolio manager may expect the trading ratio on the date of investment to adjust to the exchange ratio in the merger agreement, either because the current market price of the target stock is too low or because the current market price of the acquiring company stock is too high. Alternatively, the portfolio manager may expect that a competing bid will prevent the transaction from closing at all.

2. Distressed Securities Funds 

As the name implies, a “distressed securities”fund is a hedge fund that invests in the debt securities of a bankrupt, insolvent or other financially-troubled company.  These funds tend to target overleveraged debtors with high gross asset values.  The ultimate objective of these funds is to acquire the business or an equity interest therein by first acquiring a controlling interest in the outstanding debt securities.  The debt securities of these companies usually trade at steep discounts to their accreted values, reflecting the high risk of default.  By purchasing the securities in large blocks, a distressed securities fund seeks to participate in a future financial recovery of the debtor, often assuming an active role in the restructuring effort.

Investments in distressed debt present special tax issues for hedge funds and their investors.  Among them, whether investing in distressed debt is a “trade or business”distinct from “trading” in debt and whether the “market discount” rules under § § 1276-78 apply to a purchaser of distressed debt.21 The “trade or business”issue is relevant to tax-exempt and foreign investors, who seek to avoid net basis taxation in the United States, and to taxable individual investors, who seek to deduct their allocable share of the fund expenses under § 162.22 The market discount issue is more relevant to individual investors, who bear tax at a 35% rate on interest income.
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21 For a discussion of the “market discount” rules and how they may apply to the purchase of distressed debt, see XI, B, below.

22 For a discussion of whether distressed securities funds are engaged in a U.S. trade or business, see VII, F, 1, b, below.

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3. Event Funds 

An “event” fund is a hedge fund that, like an arbitrage fund, acquires offsetting positions in two or more securities at spreads that the portfolio manager expects will either expand or contract over time.  The trigger for this sort of investment is often a public announcement of an extraordinary corporate transaction.  These transactions may include a spin-off, a stock repurchase, a rating agency downgrade or any other event outside of the ordinary course of business of the target company.

In 2000, for example, 3Comm issued 5% of the stock of Palm, a wholly-owned subsidiary of 3Comm, in an initial public offering.  3Comm then announced its intention to spin-off its remaining 95% stake pending the receipt of a favorable IRS ruling.  Applying the IPO closing price as a proxy for the value of the Palm business as a whole, the retained 95% stake in Palm had an implied value to 3Comm well in excess of its entire market capitalization. That in turn implied that the retained 3Comm liabilities must have exceeded the value of the retained 3Comm assets.  The paradox, of course, was that the “stub value” of 3Comm could not have been negative.  Many investors therefore assumed that the market had either overvalued the stock of Palm or had discounted the likelihood of a favorable IRS ruling.

An event fund under these circumstances would have shorted the Palm stock and purchased the 3Comm stock.

4. Opportunistic Funds 

An “opportunistic” fund is a hedge fund that delegates broad discretion to the portfolio manager to alter the investment strategy of the fund, even in fundamental ways.  The portfolio manager of such a fund is usually free to redeploy capital to exploit almost any investment opportunity.  In the extreme case, therefore, the portfolio of such a fund may resemble the portfolio of an arbitrage fund in one year and a distressed securities fund in the next.

5. Macro Funds 

A “macro” fund is a hedge fund that invests on the basis of global or regional economic indicators rather than on the basis of specific company or industry sectors.  Depending upon interest rates, exchange rates or inflation, a macro fund may acquire long or short positions on entire asset classes.  A macro fund that expects interest rates in the United States to rise relative to interest rates in Europe, for example, may short the dollar and acquire euros, or may borrow domestically and invest the proceeds in European debt securities.

6. Market Timing Funds 

A “market timing” fund is a hedge fund that, in the benign sense of the term,23 seeks to profit from short term, even daily changes in the market price of a stock or security.  The stock of a mutual fund is a favorite target.  The shares of a mutual fund, for example, may trade at a net asset value that exceeds the aggregate trading price of the underlying portfolio.  A market timing fund in this situation may short the shares of the mutual fund at their current price.  Under the opposite conditions, it may buy the shares of the mutual fund.
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23 Market timing is distinct from “late trading.” Late trading is illegal under both federal and state securities laws, and entails the buying of shares in a mutual fund at the closing NAV based upon material information that becomes available thereafter regarding the portfolio. The regulatory scandal that erupted in September 2003 over late trading of this sort prompted a number of market timing funds to suspend operations.  Because even legitimate trading in and out of mutual funds on a daily basis imposes a cost upon all of the shareholders, most U.S.-based mutual funds now prohibit the practice of market timing.

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7. Futures Funds 

A “futures” fund is a hedge fund that invests in the futures market.  A futures contract is an agreement to either buy or sell an asset, usually a commodity or stock index, at a fixed price on a future date.  Unlike a forward contract, however, a futures contract trades on one or more public exchanges, and therefore requires each party to post collateral to insulate the transaction from external credit risk.24
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24 Upon execution of a futures contract, the investor usually deposits cash into a margin account.  The margin account is then marked-to-market at the end of each trading day, with the cash balance adjusted to reflect interim gains and losses.  As an economic matter, therefore, most futures contracts “settle” in cash on a daily basis, and are then re-executed.

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The predecessor to the futures contract is the forward contract.  The forward contract became popular during the Middle Ages as a way for a farmer to hedge the risk that his crops would sell at a lower than expected price at the time of harvest. His customers, fearing the opposite, would agree in advance to buy the crops from the farmer at a fixed price at the time of harvest, regardless of the then-prevailing market price.25  Today, these same parties would strike this agreement on one of the commodities exchanges, with the farmer taking the “short” futures position and the customer taking the “long” futures position. The parties to a futures contract generally settle the contract in cash on or before the delivery date.
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25 Hull, Futures and Options Markets (3d ed. 1998).

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A portfolio manager of a futures fund may acquire a futures contract for any number of reasons.  It may do so to hedge an offsetting position in its portfolio.  Alternatively, it may do so as part of a broader arbitrage strategy.  A futures contract reflects an implicit borrowing: unlike a long option, a futures contract does not lapse unexercised when the market price of the subject property falls below the price due on the delivery date.  Accordingly, the market risk associated with an unhedged futures contract exceeds the risk associated with many other investments.

U.S. Income Portfolios: Other Pass-through Entities 
  Portfolio 736-1st: Hedge Funds 
  Detailed Analysis 
  II. Fund Prototypes

C. The Investor Participants 

Most investors in hedge funds pursue higher but less volatile returns than the returns available to the public at large from direct investment in publicly-traded stocks and securities. Some seek positive absolute returns, without regard to whether the market as a whole rises or falls.  Their common economic objectives aside, investors in hedge funds have distinctly different tax characteristics.

1. Individual Investors 

Although hedge funds buy and sell publicly-traded stock, they do not issue their own stock in public offerings.  Other restrictions under the federal securities laws further limit individual investment in this sector.  For these reasons, individuals represent only a small percentage of the total investor base.  If an individual is accredited, however, he or she may generally invest in a hedge fund.26 Even if a hedge fund has no individual investors, however, the general partner usually issues one or more interests in the underlying carry to individuals members.  Accordingly, the tax issues of concern to individuals require careful attention in virtually every hedge fund.
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26 See I, B, above.

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2. Public Company Investors 

Public companies occasionally invest in hedge funds, in particular insurance companies, mutual funds and other companies with large portfolios of investment assets.

3. Tax-Exempt Investors 

Pension funds and other tax-exempt entities invest in the hedge fund sector.  Although the bulk of their capital resides in less risky, more diversified portfolios, most pension funds allocate a small percentage of their total capital to alternative asset categories, including hedge funds and private equity funds. In absolute terms, these small percentages represent billions of dollars.

Tax-exempt entities bear no tax on interest, dividends or capital gains from stock, but do bear tax on UBTI.  Although the UBTI provisions of the Code generally apply to income from an “unrelated”trade or business under § 513, they also apply to certain categories of passive income from leveraged investments under § 514. To avoid the special limitations on leverage under § 514, a tax-exempt investor will often invest in the offshore “feeder” or other parallel vehicle within the hedge fund complex, which the sponsor forms as a corporation for tax purposes.  Because the tax-exempt investor is a shareholder of a corporation and not a partner of a partnership, the debt encumbering the underlying portfolio does not taint its economic share of the portfolio returns as “debt-financed” income.27
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27 See VII, C, 1, below, for a discussion of the application of  § 514 to the foreign feeder.

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4. Foreign Investors 

Like pension funds, foreign investors also invest in the hedge fund sector on a large scale.  As “traders”or “investors” for U.S. tax purposes,28 they do not bear net basis taxation on interest, dividends, non-FIRPTA capital gains and most other categories of investment income.  Foreign investors generally seek to avoid “effectively connected” income (“ECI”), which is subject to U.S. tax at full rates unless a treaty applies. Although tax-exempt and foreign investors bear tax under separate and distinct provisions of the Code, the practical application of these provisions tends to overlap in practice, often leading to very similar investment restrictions in the fund agreement.
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28 See VII, A, 3, below.

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U.S. Income Portfolios: Other Pass-through Entities 
  Portfolio 736-1st: Hedge Funds 
  Detailed Analysis 
  III. The Basic Economic Deal

A. In General 

Many who do not practice in the area conflate private equity and hedge funds. Both are private vehicles that pool capital for passive investment.  How they deploy their capital differs, however, and this difference alters virtually every aspect of their operations.  To provide meaningful advice to a hedge fund, therefore, the tax practitioner must first understand the fundamental economic agreement among the fund, its investors, the general partner and the portfolio manager.  To an  investor, this agreement commences on the date of investment and ends on the date of redemption.

Private equity funds are “financial buyers.” The market uses this term to distinguish a private equity fund from a “strategic buyer,” for example a public company that merges with a target business to build market share, to eliminate a competitor or to capture a perceived synergy.  A financial buyer may spend months to source, negotiate and close a single transaction. For advice and assistance, it may engage outside counsel, an accounting firm and an investment bank.  Many of its deals never sign.  Some sign, but never close.  Until a particular deal signs and closes, a financial buyer will not deploy cash except as necessary to fund the management fee, the cost of a “broken deal” or some other operating expense.  A private equity fund therefore calls its capital in stages.

A hedge fund is not a financial buyer.29 Like a mutual fund, a hedge fund acquires publicly-traded stocks and securities.  When it deploys capital, it may not retain outside counsel; indeed, if the investment is a legacy security, it may not even engage the issuer.  To match sources and uses of cash, therefore, it is not necessary for a hedge fund to “stagger”its capital calls.
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29 Strictly speaking, this is not entirely correct. For a discussion of certain hedge funds that also invest in the private equity sector, see II, A, 6, above.

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The differences between a private equity fund and a hedge fund on exit are just as stark.  Both vehicles offer liquidity to investors from their own portfolios.  In a hedge fund, however, the investor initiates the sale.  The investor in a private equity fund does not.  After the initial capital commitment, an investor in a private equity fund assumes a passive role during the remaining life of the fund, waiting until the fund calls capital or sells an investment. Moreover, the liquidity event occurs in stages:  the fund disposes of each portfolio company in a privately-negotiated transaction and then distributes the proceeds to its investors, each as a single step in a protracted liquidation.

The investor in a hedge fund has more control over the sales process.  It initiates the process by notifying the portfolio manager that it intends to withdraw from the fund, either in whole or in part.  A hedge fund is able to finance these requests at regular intervals without regard to whether they coincide with a planned sale of marketable securities in the portfolio.  Although any given redemption will deplete capital, a successful hedge fund issues new shares on each redemption date.  The cash proceeds from the newly-issued shares will therefore replenish some or all of the depleted capital from the redemption.  Indeed, if the fund issues more shares than it retires, the net cash position of the fund may actually increase.  If necessary, a hedge fund also has the discretion to fund a redemption from other sources, including cash on the balance sheet, cash from lenders, and cash from the sale of marketable securities.

In a redemption, the fund distributes cash to the withdrawing investor in an amount equal to his or her capital account balance on the date of withdrawal.  In hedge funds, however, the capital account balance differs from the capital account balance in most other partnerships.  It is neither a “book” balance in the traditional sense nor a tax balance; indeed, a much better analogy is “net asset value” in a mutual fund, which ignores realization entirely.  Together with the right of redemption, the capital account balance at any given time captures the fundamental economic agreement between a hedge fund and its investors.

Consider the following excerpt from an actual fund agreement:

At the end of each Accounting Period, the Capital Account of each Partner, including the General Partner, shall initially be credited to reflect the Net Profit or debited to reflect the Net Loss of the Partnership during the Accounting Period, pro rata in proportion to the Partners' respective Capital Account balances at the beginning of the Accounting Period.

“Net Profit” means, with respect to any Accounting Period, the excess of the fair market value of the net assets of the Partnership at the end of the Accounting Period over their fair market value at the beginning of such Accounting Period, plus the amount of any withdrawals during that Accounting Period and minus the amount of any capital contributions to the Partnership during that Accounting Period, adjusted to reflect the deduction of all general, administrative and other operating expenses of the Partnership.

A Limited Partner may request a partial or total withdrawal from its Capital Account as of the last business day of each calendar quarter or at such other times as determined by the General Partner.

Note the peculiar definition of the term “net profit.”  It ignores realization, a basic pillar of our tax system.30 This provision also measures the cash entitlement of each investor at the time of withdrawal by its capital account balance.  The trend in other partnerships is just the opposite, with many partnership agreements severing each and every link between capital accounts and distributions.31 But with hedge funds, capital accounts are (and will likely remain) the paradigm for measuring the economic rights of the investors.  A hedge fund holds marketable securities, redeems shares at regular intervals and may determine its  § 704(b) capital accounts on a mark-to-market basis.32 As such, the book capital account serves as a perfect proxy for the buyout price. At any given time, therefore, an investor's capital account —and therefore the redemption price — is the capital account of the investor at the end of the last period plus or minus the investor's share of any change in the portfolio value, as adjusted for expenses and the incentive allocation.33
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30 As described more fully in V, C, 1, below, the  § 704(b) regulations generally permit hedge funds to calculate profit and loss in this manner for purposes of determining the book capital accounts of its investors.

31 For a detailed discussion of the pervasive use of “forced allocations” by private equity funds, see 735 T.M., Private Equity Funds.

32 See Regs. § 1.704-1(b)(2)(iv)(f)(5)(iv).

33 This assumes that the investor makes no additional contributions or withdrawals during the period in question.

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Example 3-1: Steve, Mike, Bill and Lew each invest $100 in Fusion, a domestic hedge fund, in exchange for a 25% interest.  The general partner charges a 20% carry, bears all expenses, and imposes no management fee.  Fusion invests $200 in Microsoft stock, $100 in Xerox stock and $100 in short term Treasuries. Fusion also writes a call option on shares of Redhat for $200, investing the proceeds in stock of Apple Computer.  Finally, Fusion borrows$250 from a bank, investing the proceeds in convertible debt of American Express.  At the end of the first year, Fusion continues to hold these positions at the following valuations:

Assets	Fair Market Value	
Xerox	125	
Microsoft Stock	100	
Treasuries	105	
Apple Computer Stock	250	
Amex Convertible Debt	300	
Total Assets	$880	
Short Call Option	(175)	
Bank Debt	($250)	
Total Liabilities	($425)	
Net Assets	$455	

At the end of Year 1, Bill tenders his shares for periodic redemption.  Bill's capital account on that date is $111(i.e., $455/4 - ($455-$400) x .20/4). Bill is therefore entitled to $111, which Fusion will raise either by selling a portion of its portfolio or raising alternative sources of cash.

U.S. Income Portfolios: Other Pass-through Entities 
  Portfolio 736-1st: Hedge Funds 
  Detailed Analysis 
  III. The Basic Economic Deal

B. The Management Fee 

As described above, the portfolio manager usually operates as an affiliate of the general partner of the fund.  The role of the portfolio manager is to manage the portfolio of the fund on behalf of its investors.  As consideration, the portfolio manager receives a periodic management fee.  Unlike the carried interest, however, the management fee tracks the net asset value of the portfolio, not the net gains of the portfolio.  The typical fee percentage will usually range from 1.5% to 2% of the net asset value of the portfolio per annum.  Most hedge funds pay the management fee on a monthly or quarterly basis, with a corresponding debit to the capital account of each investor.

The following excerpt from an actual hedge fund PPM is typical:

The Investment Manager receives a management fee(the “Management Fee”) payable monthly in arrears that is 1.5% of the average Net Asset Value of the Partnership attributable to the Capital Accounts of the Limited Partners ... as of the first and last day of each month divided by 12.  The General Partner has in the past and reserves the right to continue to issue Limited Partnership Interests that are not charged the full Management Fee.

In two respects, the economic terms of the management fee in a hedge fund differ from the terms of the management fee in a private equity fund.  First, the fee applies only to capital in the fund.  In dollar terms, therefore, the fee will tend to increase when contributions exceed withdrawals and decrease when withdrawals exceed contributions.  In a private equity fund, the fee base includes not only invested capital, but “uncalled” capital as well.34 Second, the base for the management fee in a hedge fund is net asset value, not cost.  In a rising market, therefore, the portfolio manager will participate in portfolio gains not only through the carried interest, but through the management fee as well.  Other investment funds apply the fee percentage to invested capital at cost, ignoring unrealized gains and losses from one period to the next.
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34 For a detailed discussion of how investors in a private equity fund finance their capital commitments; see 735 T.M., Private Equity Funds.

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In consideration of the management fee, the portfolio manager assumes the operating expenses of the fund.  These expenses will include rent, salary and basic overhead, but not the cost of a portfolio investment or the cost of a “broken deal.” Nor will they include legal and accounting fees, brokerage commissions, custodial fees or margin expenses.  Instead, the investors will bear these costs from invested capital.35 In addition, the fund will usually reimburse the portfolio manager for the organizational and syndication expenses associated with forming the fund and selling its shares to investors.
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35 Because the fund bears these costs from invested capital, however, they will reduce net gains, and therefore the incentive allocation to the general partner.

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In many funds, the general partner reserves the right to waive or reduce the management fee with respect to specific investors.  When it exercises this right, it usually does so on behalf of a large investor, an affiliate of the fund or some loose confederation of “friends &  family.”

U.S. Income Portfolios: Other Pass-through Entities 
  Portfolio 736-1st: Hedge Funds 
  Detailed Analysis 
  III. The Basic Economic Deal

C. The Carried Interest 

The general partner participates in the economic performance of the fund through the “carried interest.” If the fund in question is a partnership, it will issue the carried interest (usually at a 20% rate) as a profits interest, not as a fee. In some funds, the investors will subordinate the carried interest to a “hurdle” return; in others, the carry will bear no hurdle at all.36
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36 For a discussion of the differences between a ‘hurdle’ and ‘preferred’ return in the fund context, see 735 T.M., Private Equity Funds.

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As in the case of the management fee, the terms of the carry in a hedge fund differ from the terms of the carry in a private equity fund.  First, the fund agreement computes the carry on an “investor-by-investor” basis.  This is necessary because investors in hedge funds acquire their shares on different dates and at different valuations.  In a private equity or venture capital fund, each investor usually invests in “lockstep”with the other investors as the general partner calls capital.  The sharing of gains and losses among investors will therefore correspond to relative capital commitments, which will not fluctuate over time.

Example 3-2: Steve, Mike, Bill and Lew each invest $100 in Quark, a domestic hedge fund partnership, in exchange for a 25% interest.  The general partner charges a 20%carry, bears all expenses, and imposes no management fee.  Quark invests the $400 in Microsoft stock.  At the end of Period 1, when the shares of Microsoft have appreciated to $600, Andy invests $140 in Quark in exchange for a 20% interest (i.e., $400 x ($200 x.8) / .8 x .2).  Quark invests the $140 in stock of Xerox. At the end of Period 2, both Lew and Andy withdraw, tendering their shares for redemption.  On that date, the shares of Microsoft and Xerox have a value of $800 and $200, respectively.  Although both Lew and Andy receive $180.60, Lew bears an aggregate carry of $20.40(i.e., (200 x .25 x .2) + ($260 x .2 x.2)) and Andy bears an aggregate carry of $10.40 (i.e.,$260 x .2 x .2).  The reason for the difference is that Andy's share of the carry does not reflect the Period 1 gains.

Second, the carry only participates in portfolio gains above the last “high water mark” for each investor. The high water mark is a colloquial term for “imperfect”loss aggregation.  The purpose of the high water mark is to prevent the general partner from participating in portfolio gains until the value of an investor's shares exceeds their value on the date of investment:

Example 3-3: A hedge fund with a 20%carry holds a portfolio with a beginning value of $100 million.  The portfolio declines to $50 million at the end of Year 1 and rises to$150 million at the end of Year 2.  Although the fund realizes a $100 million gain in Year 2, the fund agreement allocates only $10 million to the general partner, or 20% of the net gain in excess of the prior loss over the two year period.

Unlike the carry in other investment funds, however, the high water mark in a hedge fund may ignore losses of less recent vintage:

Example 3-4: A hedge fund with a 20%carry holds a portfolio of positions with a beginning value of $100 million.  The portfolio declines to $50 million at the end of Year 1, stays “flat” during Year 2, and rises to $150 million at the end of Year 3.  The fund agreement requires that the net portfolio gains in any particular year exceed the net portfolio losses in the immediately preceding year before the carry participates.  Because the fund realized an aggregate gain of $100 million from the end of Year 1 to the end of Year 3, it will allocate $20 million to the general partner at the end of Year 3.

The usual rationale for “truncating”the look back period is that a fund with a full look back may lose its best traders to a competing fund after a particularly bad year if it must earmark 100% of the future gains to first reimburse its investors for the losses.  Traders do not work for free, and those at an “underwater” fund may feel undercompensated, especially if their peers at the hedge fund across the street participate in portfolio gains from first dollar.37 So even though this concession to the general partner may increase its effective carry percentage, many funds grant the concession to minimize the risk of even greater losses.
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37 Many hedge funds are across the street from one another; in some cities, they even occupy the same building.  See Dugan, “Big Hedge Funds Feel Right at Home in Greenwich, Conn.,” Wall St. J. (Aug. 2005) (“more than 100 hedge funds ... have set up shop here in the past few years ... Trains and roads into Greenwich are jammed at rush hour with traders reverse-commuting from their Manhattan homes, along with investors, corporate executives and bankers coming in for meetings”).

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Alternatively, the fund may require full aggregation, but grant a reduced carry percentage to the general partner until the future gains recover the losses.

Example 3-5: A hedge fund with a 20% carry and a portfolio value of $100 million rises to $200 million in Year 1 but declines to $150 million in Year 2.  Although the carried interest earns $20 million in Year 1, it does not participate in any Year 3 gains until those gains exceed $50 million.  To encourage employee retention, therefore, the investors may convey a reduced 10% carry on the first $55.6 million of gains (i.e., $50 million/.9), allowing the investors to recover the $50 million loss at one-half of the regular carry percentage.

Third, most hedge funds do not “clawback”prior incentive allocations.  In a private equity fund, the carry represents the right to a fixed percentage of the net gains over the life of the fund, computed on an aggregate basis.  Even with aggregation, however, most of these funds will still distribute sales proceeds on an “investment-by-investment” basis.  The general partner will therefore receive carry distributions before the fund has returned 100% of invested capital to its investors. The clawback obligation is the typical mechanism by which a general partner is forced to restore any “unearned” distributions, most often at fund liquidation.  In most hedge funds, the later losses will not reduce the earlier allocations of gain to the general partner in the first place. The lack of full economic aggregation therefore obviates the need for a clawback.

Example 3-6: A hedge fund with a 20% carry holds a portfolio with a beginning value of $100 million. The portfolio rises to $200 million at the end of Year 1 and declines to $150 million at the end of Year 2.  The fund allocates $20 million of gain to the general partner at the end of Year 1 but none of the loss to the general partner at the end of Year 2.  The general partner therefore realizes $10 million more than the general partner in Example 3-3 even though both funds produce the same economic performance over the two year period.

U.S. Income Portfolios: Other Pass-through Entities 
  Portfolio 736-1st: Hedge Funds 
  Detailed Analysis 
  IV. Achieving Pass-Through Treatment for the Fund and Its Affiliates

A. In General 

Most hedge funds are partnerships for tax purposes. The sponsor usually forms the fund as a partnership whether the entity in question is a single entity fund, a master fund or domestic feeder in a master-feeder structure, or a domestic fund in a parallel structure.38 The partnership form serves a number of purposes, first and foremost to avoid entity-level tax.  In addition —
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38 As described more fully in VII, C, below, the sponsor usually forms the offshore feeder in a master-feeder structure and the offshore fund in a parallel structure as a corporation for tax purposes.

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• foreign investors who invest directly in the underlying fund will report capital gain and portfolio interest, two categories of income usually exempt from U.S. tax,39 on a flow-through basis;
  
• tax-exempt and foreign investors who invest through the offshore feeder in a master-feeder structure will report higher after-tax returns because the offshore feeder will claim the “trading”safe harbor under  § 864(b) with respect to its share of the master fund returns;40
  
•the foreign feeder will avoid U.S. withholding tax on what would otherwise constitute dividend income from the master fund;

• individual investors will report long-term capital gain and “qualified dividend income” (“QDI”), both of which bear tax at reduced rates,41 on a flow-through basis;
  
• members of the general partner will report the grant of the carried interest as a tax-free transaction;42
  
• individual members of the general partner will report future allocations of long-term capital gain and QDI on a flow-through basis; and

• all classes of participants will avoid immediate tax upon the distribution of marketable securities by the fund.43

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39 See § 871(a)(2); Regs.  § 1.1441-2(b)(2)(i) (gains derived from sale of property not “fixed or determinable,”subject to certain exceptions);  § 1441(c)(9) (no withholding on “portfolio interest” under § 871(h)).

40 If the master fund generates “effectively-connected income,” the foreign feeder will be subject to U.S. tax on its allocable share.  See § § 882, 875.

41 § 1(h)(1)(C) (15% rate on “adjusted net capital gain”);  § 1(h)(3)(B) (treatment of QDI as component of “adjusted net capital gain”).

42 See VI, A, below, for a discussion of the tax consequences of the grant of the carried interest.

43 See X, C, below, for a discussion of the tax consequences of an in-kind distribution of marketable securities.

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U.S. Income Portfolios: Other Pass-through Entities 
  Portfolio 736-1st: Hedge Funds 
  Detailed Analysis 
  IV. Achieving Pass-Through Treatment for the Fund and Its Affiliates

B. Classification as a Pass-Through Entity 

1. Before January 1, 1997: The “Kintner” Regulations 

Years ago, the IRS distinguished a corporation from a partnership on the basis of whether the entity in question possessed at least three of four “corporate” attributes:continuity of life, limited liability, centralized management and free transferability of interest.44 This regime introduced a degree of uncertainty on a threshold issue of fundamental import, at times requiring special provisions in the partnership agreement that served no purpose other than to defeat a “corporate” attribute.  On occasion, the legal effectiveness of these provisions depended upon the vagaries of local or foreign law.
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44 To determine the tax status of an unincorporated entity, the “Kintner” regulations identified six “corporate” characteristics: (1) associates; (2) an objective to carry on business and divide the gains therefrom; (3)continuity of life; (4) centralization of management; (5) limited liability; and (6) free transferability of interests.  See Regs. § 301.7701-2(a)(1) (1996). If the entity in question possessed more corporate than noncorporate characteristics, the regulations classified the entity as a corporation. See also Regs.  § 301.7701-2(a)(3) (1996)(regulations ignored first two characteristics, regarded as common to both corporations and partnerships).

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2. Current Law:The “Check-the-Box” Regime 

In 1996, the IRS abandoned the effort to classify entities by traditional corporate attributes, opting instead for a purely elective regime. The “check-the-box” (“CTB”)regulations simplify the issue of entity classification by eliminating the uncertainty of prior law.  As discussed in detail in 710 T.M., Partnerships:Overview, Conceptual Aspects and Formation, the CTB regulations ensure partnership treatment, either by default or election, for virtually every form of legal entity other than a state law corporation and a handful of “per se” foreign entities.

a. State Law General or Limited Partnership 

The CTB regulations treat any general or limited partnership formed under state law as a partnership by default.45 The partners may override the default classification by election.46
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45 Regs.  § 301.7701-3(b)(i) (domestic “eligible entity” with two or more members treated as partnership).

46 Regs. § 301.7701-3(c) (“eligible entity” may elect to be classified other than as provided under default rules by timely filing of Form 8832).

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b. Domestic LLCs 

The CTB regulations treat a domestic LLC as a partnership by default.47 The members may override the default classification by election.48
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47 Regs. § 301.7701-3(b)(i) (domestic “eligible entity” with two or more members treated as partnership).

48 Regs.  § 301.7701-3(c) (“eligible entity” may elect to be classified other than as provided under default rules by timely filing of Form 8832).

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c. Foreign LLCs 

The CTB regulations treat a foreign entity that offers limited liability to each of its members as a corporation by default.49 The shareholders may override the default classification by election.50
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49 Regs.  § 301.7701-3(b)(2)(i)(B) (foreign “eligible entity” treated as association if all members have limited liability).

50 Regs.  § 301.7701-3(c) (“eligible entity” may elect to be classified other than as provided under default rules by timely filing of Form 8832).

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Note: If the sponsor forms the fund as a corporate entity and neglects to elect out of the default classification, the fund will constitute a PFIC for U.S. tax purposes.  Inadvertent status as a PFIC may trigger catastrophic consequences to U.S. investors, including the general partner and its members.51
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51 For a discussion of the tax consequences of PFIC status to U.S. investors, see VII, C, 3, d, below.

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d. Other Foreign Entities 

The CTB regulations treat a foreign entity that does not provide limited liability to each member as a partnership by default.52 As in the case of a domestic partnership or LLC, the members may override the default classification by election.53 Although the CTB regulations treat certain foreign entities as per se corporations,54 many of these entities reside in high tax domiciles.  That attribute alone will usually disqualify them as viable candidates for the fund vehicle in the first place.
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52 Regs.  § 301.7701-3(b)(2)(i)(A) (foreign “eligible entity” with two or more members treated as partnership if at least one member has personal liability).

53 Regs.  § 301.7701-3(c) (“eligible entity” may elect to be classified other than as provided under default rules by timely filing of Form 8832).

54 Regs. § 301.7701-2(b)(8).

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U.S. Income Portfolios: Other Pass-through Entities 
  Portfolio 736-1st: Hedge Funds 
  Detailed Analysis 
  IV. Achieving Pass-Through Treatment for the Fund and Its Affiliates

C. Publicly-Traded Partnership Limitations 

1. In General 

If an entity is a “publicly-traded partnership”(“PTP”),  § 7704(a) will override the CTB regulations to tax it as a corporation unless the “qualifying income” exception of  § 7704(c) applies.55 Most hedge funds therefore permit the general partner to prohibit any transfer that may imperil the status of the fund as a partnership for tax purposes.
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55 The Revenue Act of 1987, P.L. 100-203, 100th Cong., 1st Sess. (1987), added  § 7704 to the Code.  For general background see Joint Committee on Taxation, Tax Treatment of Master Limited Partnerships, JCS-18-87 (June 29, 1987); see also New York Bar State Bar Association Tax Association, “Report on Issues Concerning the Definition of Publicly Traded Partnerships,” reprinted in 88 TNT 130-8 (June 15, 1988).

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A partnership is a PTP if the interests therein either trade on an “established securities market” (the “Market Rule”) or are “readily tradable on a secondary market ...or the substantial equivalent thereof” (the “Secondary Market Rule”).56 For this purpose, a “partnership interest” includes a capital interest, a profits interest and certain types of derivatives.57 Special rules also apply to “tiered”partnerships.58 For purposes of determining whether a partnership is a PTP, the regulations ignore an interest in another entity (including a RIC or a REIT) that holds an interest in such partnership.59 A hedge fund that violates either of these trading limitations, however, will still maintain its status as a partnership so long as it earns sufficient “qualifying income”during the current and all preceding taxable years.60
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56 § 7704(b).

57 Regs. § 1.7704-1(a)(2).

58 Regs. § 1.7704-1(a)(3).

59 Id.

60 § 7704(c).  For a discussion of the “qualifying income” exception, see IV, C, 4, below.

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A partnership that becomes a PTP under  § 7704 will be deemed to have contributed its assets and liabilities to a newly-formed corporation in exchange for stock and, immediately thereafter, to have distributed such stock to its partners in a liquidation of the partnership.61 Although this “constructive” incorporation transaction will often qualify as a tax-free exchange under § 351, it is possible that one of the exceptions to  § 351 (e.g., liabilities in excess of basis, potential gain recognition under  § 367(a) if the fund is a foreign entity, etc.) will trigger gain to one or more of the partners upon conversion.62
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61 § 7704(f).

62 See, e.g.,  § 357(c) and Regs. § 1.367(a)-1T(c)(3).

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As described in III, A, above, hedge funds provide more liquidity to their investors than private equity funds.  Although the shares of a hedge fund are neither registered under the 33 Act nor transferable to a third party without the consent of the general partner, the investor in a hedge fund may usually tender the shares to the fund for redemption at regular intervals.  Accordingly, although both private equity and hedge funds are private investment partnerships, the sale mechanisms in a hedge fund are far more likely to violate § 7704.63 For this reason, tax practitioners tend to devote more attention to the issue of PTP compliance with hedge funds than with private equity funds.
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63 For a discussion of the application of the PTP rules to private equity funds, see 735 T.M., Private Equity Funds.

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2. The Market Rule 

For purposes of the Market Rule, an “established securities market” includes (a) a national securities exchange registered under Section 6 of the Securities Exchange Act of 1934(the “Exchange Act”); (b) a national securities exchange exempt from registration due to limited trading volume; (c) a foreign securities exchange that satisfies similar regulatory requirements under foreign law; (d) a regional or local exchange; and (e) an interdealer quotation system that regularly disseminates firm buy or sell quotations by identified brokers or dealers by electronic means or otherwise. Under the Market Rule, the actual volume of trading in the hedge fund is irrelevant — any trading will violate the Market Rule.64 For this purpose, “trading” includes redemptions.65 Unless the fund itself participates either in establishing the market or including the fund shares on the market, however, the shares will not be treated as traded on an interdealer quotation system.66
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64 See Scharfstein, “§ 7704 and Publicly (or Non Publicly) Traded Partnerships,” Tax Club (Nov. 17, 2002).

65 Regs. § 1.7704-1(a)(3).

66 Regs. § 1.7704-1(d).

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To the authors' knowledge, no hedge fund has ever inadvertently violated the Market Rule.

3. The Secondary Market Rule 

a. The Problem 

In practice, the real issues under  § 7704 tend to arise under the Secondary Market Rule, not the Market Rule.  Under § 7704, an interest in a hedge fund is “readily tradable on a secondary market or the substantial equivalent thereof” if the investors in the fund are able to buy and sell their shares in a manner that approximates the level of liquidity available to a shareholder on a public stock exchange.67 A sale for this purpose includes a redemption.68 In general, a share is not “readily tradable” unless the issuing fund recognizes the transfer by redeeming the transferor partner or admitting the transferee as a partner.69 The mere right of a general partner to approve such a transfer, however, will not avoid the Secondary Market Rule.70
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67 See Regs. § 1.7704-1(c)(1); see also H.R. Conf. Rep. No. 495, 100th Cong. 1st. Sess. at 948 (1987), 1987-3 C.B. 193 (“The conferees intend that the substance rather than the form determine whether a partnership is treated as publicly traded”).

68 Regs. § 1.7704-1(a)(3).

69 Regs. § 1.7704-1(d).

70 See H.R. Conf. Rep. No. 495, 100th Cong. 1st. Sess. at 949, 1987-3 C.B. 193 (“a provision for the discretion of the general partner or the partnership to refuse consent to the transfer of an interest in the partnership(or of rights to income or other attributes of an interest in the partnership) does not, without more, prevent a partnership from being considered publicly traded.  Similarly, the discretion of the general partner to refuse consent to a transfer if the transfer would cause a termination of the partnership for Federal income tax purposes does not cause the partnership to be treated as not publicly traded”).

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As described in III, A, above, a hedge fund provides liquidity to its investors by redemption.  Accordingly, the PTP issues under  § 7704 tend to arise in the redemption context.  Specifically, if the right of redemption causes the shares to be “readily tradable”under the Secondary Market Rule,  § 7704 will treat an issuing hedge fund that fails to generate sufficient qualifying income as a foreign or domestic corporation, depending upon its domicile.

The Secondary Market Rule will ignore a redemption or other transfer that occurs under any of the following safe harbors:

• the “private transfers” safe harbor;

•the “redemption” safe harbor;

• the “private placement” safe harbor;

• the “qualified matching service” (“QMS”)safe harbor; or

• the 2% de minimis safe harbor.71

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71 The IRS chose not to grant a broad exemption for redemptions generally. See T.D. 8629, 95 Fed. Reg. 43980 (11/29/95) (“Several commentators suggested that redemptions by an investment partnership for the net asset value of the redeemed interest should not be treated as a transfer for purposes of  § 7704(b) because these transfers do not involve a third party broker or a commission or mark-up. This comment is not adopted in the final regulations.  The redemption of a partnership interest combined with the issuance of an interest to a new partner can result in the creation of a secondary market or the substantial equivalent thereof within the meaning of § 7704(b), even if no third party or commission is present” (emphasis added)).

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b. The Private Transfers Safe Harbor 

The “private transfers” safe harbor disregards certain transfers.  Of these, four types of exempted transfers are relevant to hedge funds.  First, the regulations disregard a transfer pursuant to a redemption or repurchase agreement that is exercisable only upon the death, disability or mental incompetence of a partner. The regulations define a “redemption or repurchase agreement”as a plan of redemption or repurchase maintained by a partnership whereby a partner may tender his interest for purchase by the partnership or another partner (or a related person of such other partner).72 Second, the regulations disregard “block transfers.”  The regulations define a “block transfer”as a transfer by a partner (or a related person) in one or more transactions during any 30 day period in an aggregate amount that exceeds 2% of the total partnership capital or profits.73 Third, the regulations disregard transfers pursuant to a “closed end redemption plan.”  The regulations define a transfer as occurring pursuant to a “closed end redemption plan” only if the partnership does not issue any interest after the initial offering and no partner (or related person) provides contemporaneous opportunities to acquire interests in similar or related partnerships which represent substantially identical investments.74 Finally, the regulations disregard a transfer by one or more partners of interests representing 50% or more of the total interests in partnership capital and profits in a single or series of related transactions.75
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72 Regs. § 1.7704-1(e)(3).

73 Regs. § 1.7704-1(e)(2).

74 Regs. § 1.7704-1(e)(4).

75 Regs. § 1.7704-1(e)(1).

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c. The Redemption Safe Harbor 

The redemption safe harbor disregards any transfer pursuant to a “redemption or repurchase agreement” so long as the transfer satisfies three conditions.76 First, the agreement must provide that the transfer may not occur until at least 60 days after the withdrawing partner notifies the partnership in writing that it intends to sell.  Second, the agreement must set the transfer price either no earlier than 60 days after receipt of such notice or no more frequently than four times per year.  Third, the sum of the transfers during the year (excluding any “private transfers”) may not exceed 10% of the total interests in partnership capital or profits.
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76 Regs. § 1.7704-1(f).

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Some hedge funds circumscribe the right of redemption to strictly comply with every condition of this safe harbor.  For example, many funds allow quarterly redemptions upon 60 days advance notice except to the extent that the total quarterly redemptions over the course of the year would exceed the 10% volume cap.  Other hedge funds follow the same model, but ignore the volume cap.  Although these funds bear more PTP risk than funds with § 7704-compliant volume caps, they bear less business risk of losing a prospective investor to a competing fund.  Without a volume cap, these funds must rely upon the “facts and circumstances” test to avoid PTP status.77
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77 The preamble to the final regulations clarifies that the general facts and circumstances rule applies to all non-safe harbor transfers, with no presumption in favor of public trading.  See T.D. 8629, 95 Fed. Reg. 43980 (11/29/95); see also Regs. § 1.7704-1(c)(1); Scharfstein, “§ 7704 and Publicly (or Non Publicly) Traded Partnerships,” Tax Club (Nov. 17, 2002).

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Example 4-1: Slag is a domestic hedge fund partnership with 150 investors.  Slag is not registered under the 40 Act. GP serves as the general partner of Slag. Under the fund agreement, each investor may request redemption, in whole or in part, on a quarterly basis with 60 days advance notice.  The fund sets the redemption price at the end of each quarter rather than on the date of notice. During Year 6, six investors, each owning 3%of the capital of Slag, request complete redemption.  During the same year, Slag also redeems the entire interest of various other investors, each of whom owns less than 2% of the capital of Slag.  These redemptions represent 12% of the fund's total capital.  Finally, Slag also admits several new investors during the same year.

The redemption safe harbor ignores each of the six redemptions in this example as “block transfers” under the private transfers safe harbor.  The other redemptions, however, do not qualify either as “block transfers” or transfers pursuant to a “closed end” plan.  The redemption safe harbor does not apply, therefore, because the total redemptions exceed the 10% volume cap.  Nevertheless, a fund that so circumscribes the right of redemption denies the type of liquidity that is available to a shareholder of a publicly-traded company, in particular during periods of volatility.78 In the authors'view, therefore, although none of the transfers in this example fits precisely within the contours of a single safe harbor, the interests of Slag are not “readily tradable” under the Secondary Market Rule.
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78 See H.R. Conf. Rep. No. 495, 100th Cong. 1st. Sess. at 948-949, 1987-3 C.B. 193 (“[T]he substantial equivalent of a secondary market exists where prospective buyers and sellers have the opportunity to buy, sell or exchange interests in a time frame and with the regularity and continuity that the existence of a market maker would provide [...] Nor will the occasional and irregular repurchase or redemption by the partnership, or acquisition by the general partner, of interests in the partnership, cause the partnership to be considered as publicly traded under the provision”(emphasis added)).

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d. The Private Placement Safe Harbor 

Under the private placement safe harbor, an interest in a partnership is not “readily tradable” under the Secondary Market Rule if the issuing partnership satisfies each of two conditions.79 First, the partnership must issue the interests in one or more exempt offerings under the 33 Act.  Second, the partnership must have no more than 100 partners at any time during the taxable year.  Under an anti-abuse rule, a partnership must look through any “flow-through entity” partner (i.e., a partnership, an S-corporation or a grantor trust) to count each of its members as a separate partner if —
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79 Regs. § 1.7704-1(h)(1).

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• substantially all of the value of the investor's interest in the flow-through entity is attributable to the underlying partnership; and

• “a” principal purpose for the arrangement is to permit the partnership to satisfy the 100 partner limitation.80

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80 Regs. § 1.7704-1(h)(3).

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Although some funds seek to comply with this safe harbor, larger hedge funds tend to regard the “100 partner”limitation as too confining.  It should be noted, however, that the look through rule exempts the most common form of hedge fund conduit in the industry:

Example 4-2: Fission is a hedge fund partnership.  GP, a domestic LLC with 10 members, is the general partner of Fission.  Fission has 91 partners, consisting of 90 taxable investors and OFC, an offshore “feeder” corporation.  OFC is a special purpose entity formed for the sole purpose of holding an interest in Fission.  OFC has 50 foreign and tax-exempt investors. Because OFC is a corporation for tax purposes, it is not a “flow-through entity” under the anti-abuse rule.  The safe harbor therefore ignores the 50 shareholders of OFC for purposes of determining whether Fission itself has more than 100 partners.81

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81 Because the GP entity merely facilitates the grant of separate interests in the incentive allocation, the anti-abuse rule should ignore the separate members of the GP as well.

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Accordingly, a hedge fund that employs one or more “corporate” feeders may issue shares to more than 100 investors without violating the private placement safe harbor.

e. The Qualified Matching Service Safe Harbor 

The QMS safe harbor disregards any transfer that occurs through a “qualified matching service.”82
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82 Regs. § 1.7704-1(g)(1);for an explanation of the rationale for this safe harbor, see H.R. Conf. Rep. No. 495, 100th Cong. 1st. Sess. at 948, 1987-3 C.B. 193(“[T]he substantial equivalent of a secondary market exists where prospective buyers and sellers have the opportunity to buy, sell or exchange interests in a time frame and with the regularity and continuity that the existence of a market maker would provide.[...] For example, if interests are quoted and traded on an irregular basis as a result of bid and asked prices listed on a computerized system, and such interests cannot normally be disposed of within the time that they could be disposed of on an over the counter market, then the interests are not considered as readily tradable on the substantial equivalent of a secondary market”).

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A matching service is a QMS if:

• the matching service consists of a computerized or printed listing system that lists customers'bid and/or ask quotes in order to match partners who want to sell their interests in a partnership with persons who want to buy those interests;

• matching occurs either by matching the list of interested buyers with the list of interested sellers or through a bid and ask process that allows interested buyers to bid on the listed interest;

•the selling partner cannot enter into a binding agreement to sell the interest until the 15th calendar day after the date information regarding the offering of the interest for sale is made available to potential buyers and such time period is evidenced by contemporaneous records ordinarily maintained by the operator at a central location;

• the closing of the sale effected by virtue of the matching service does not occur prior to the 45th calendar day after the date information regarding the offering of the interest for sale is made available to potential buyers and such time period is evidenced by contemporaneous records ordinarily maintained by the operator at a central location;

• the matching service displays only quotes that do not commit any person to buy or sell a partnership interest at the quoted price (nonfirm price quotes) or quotes that express interest in a partnership interest without an accompanying price (nonbinding indications of interest)and does not display quotes at which any person is committed to buy or sell a partnership interest at the quoted price (firm quotes);

• the selling partner's information is removed from the matching service within 120 calendar days after the date information regarding the offering of the interest for sale is made available to potential buyers and, following any removal (other than removal by reason of a sale of any part of such interest) of the selling partner's information from the matching service, no offer to sell an interest in the partnership is entered into the matching service by the selling partner for at least 60 calendar days; and
  
• the sum of the percentage interests in partnership capital or profits transferred during the taxable year of the partnership does not exceed 10% of the total interests in partnership capital or profits.83

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83 Regs. § 1.7704-1(g)(2).

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Some hedge funds rely on the QMS safe harbor.84 For purposes of the 10% volume cap, a fund that participates in a QMS must account for all transfers other than exempt transfers under the private transfers safe harbor, including a transfer through a nonqualified matching service.85 Any person may sponsor or operate a QMS, including an investor in the fund, the underwriter to the fund or an unrelated third party.86
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84 See PLR 200507001; see also Market Notes, “Qualified Matching Service for Hedge Funds Avoids Established Securities Market Designation and Corporate Treatment,” J. Tax'n Investments 343 (2005) (describing ruling as “considerable gift to the hedge fund industry”).

85 See T.D. 8629, 95 Fed. Reg. 43980 (11/29/95) (preamble).

86 Regs. § 1.7704-1(g)(4).

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f. The 2% de Minimis Safe Harbor 

A de minimis exception under  § 7704 disregards transfers that do not exceed 2% of the total interests in partnership capital or profits during any taxable year, other than exempt transfers under the private transfers, redemption or QMS safe harbors.87
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87 Regs. § 1.7704-1(j)(1).

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4. Qualifying Income Exception 

a. In General 

A hedge fund that violates the trading limitations of the Market Rule or the Secondary Market Rule will nevertheless maintain its status as a partnership so long as at least 90% of its gross income during the current and all preceding taxable years consists of “qualifying income.”88 Gross income for this purpose includes any amount includible in income under the mark-to-market rules (e.g., pursuant to a valid  § 475(f) election).89 Because  § 7704 determines qualifying income on a gross basis, it ignores losses or other items of expense that do not reduce gross income.90
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88 § 7704(c)(2).

89 Regs. § 1.7704-3(b)(2).

90 Regs. § 1.7704-3(b)(1).

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b. Safe Harbor Not Available to Certain 40 Act Funds 

The qualifying income exception does not apply to a partnership that would be described in  § 851(a) if it were a domestic corporation.91  Section 851(a) defines a regulated investment company to include a domestic corporation that has elected under the 40 Act to be treated as a “business development company” or is registered under the 40 Act as a “management company” or “investment unit trust.”  In general, therefore, a hedge fund that registers under the 40 Act may not rely on this exception.92 40 Act registration will not disqualify a fund, however, if the fund buys and sells commodities as one of its principal activities.93
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91 § 7704(c)(3).

92 See Staff of Joint Committee on Taxation, 105th Cong., 1st Sess., General Explanation of Tax Legislation Enacted in 1997 (Comm. Print 1997) (“a publicly traded partnership that is registered under the Investment Company Act of 1940 generally is treated as a corporation under the provision”); see also Willis, Pennell and Postlewaite, Partnership Taxation at ¶ 3.04[5][a] (6th ed. 1998); McKee, Nelson and Whitmire, Federal Taxation of Partnerships and Partners at ¶ 3.09[7](3d ed. 1997).

93 § 7704(c)(3) (second sentence).

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c. Definition of Qualifying Income 

The term “qualifying income” generally includes —

• interest (other than certain interest contingent on profits94 and interest derived in the conduct of a financial or insurance business95);
  
•dividends;

• real property rents;

• gain from the sale of real property (including gains earned as a dealer);

• gain from the sale of a capital asset held for the production of qualifying income;96
  
•income from securities lending activities;

• gain from the sale or other disposition of stock or securities or foreign currencies;

•other income (including but not limited to gains from options, futures, or forward contracts) derived with respect to its business of investing in such stock, securities or currencies”;97
  
•income from swaps (but only if the property, income or cash flow that determines the amounts to which the partnership is entitled under the swap would itself give rise to qualifying income if held or received directly by the partnership);98
  
•income from certain commodities transactions;99 and
  
• “other substantially similar income from ordinary and routine investments to the extent determined by the Commissioner.”100

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94 § 7704(d)(2)(B); § 856(f).

95 § 7704(d)(2)(A).

96 § 7704(d)(1).

97 § 7704(d)(4); § 851(b)(2)(A).

98 Regs. § 1.7704-3(a)(1).

99 § 7704(d)(1)(G).

100 Regs. § 1.7704-3(a)(1).

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None of these items qualify, however, to the extent that they arise “in the ordinary course of a trade or business” of a partnership, including a business as a broker, market maker, or dealer.101
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101 Regs. § 1.7704-3(a)(2).

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Most hedge funds generate sufficient amounts of qualifying income to avoid  § 7704 without regard to the liquidity of their shares on the market.102 Depending upon the precise nature of the fund-level activities, however, certain questions can and do arise at the margins.  The following four subsections of the portfolio address four of these questions.
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102 The extension of the definition of qualifying income to include income from many swaps is particularly significant to hedge funds. T.D. 8799, I.R.B. 1999-6. By agreeing to the extension, the IRS adopted a number of recommendations from the hedge fund industry; see, e.g., letter by Daniel Shapiro to the Commissioner dated July 28, 1995, commenting on the proposed regulations, reprinted in 95 TNT 161-27; letter by Jeffrey Bortnick to the Commissioner dated July 27, 1995, commenting on the proposed regulations under § 7704, reprinted in 95 TNT 152-26; letter by Leon Metzger to the Commissioner dated July 31, 1995, commenting on the proposed regulations, reprinted in 95 TNT 196-23.

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d. Commodities Income 

First, income from commodities is not qualifying income unless “a principal activity” of the hedge fund is buying and selling commodities or options, futures, or forwards with respect to commodities.103 Although the statute refers only to “a”principal activity, the precise quantum of commodities transactions necessary to transmute nonqualifying income from commodities into qualifying income from commodities is not clear.  Indeed, it is not even clear whether volume is the appropriate benchmark.  Other possible criteria include relative gross income, relative net income, relative net or gross assets, or even relative hours devoted to commodities transactions.  Nor is it clear whether the “principal activity”test applies on an annual basis and, if so, whether and how a change in investment strategy should affect the status of income from commodities as qualifying income in a particular year.104
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103 § 7704(d)(1)(G); § 7704(c)(3) (second sentence); see also H.R. Conf. Rep. No. 495, 100th Cong. 1st. Sess. at 946, 1987-3 C.B. 193 (“In addition, passive-type income includes income and gains from commodities (not described in § 1221(1))or futures, options or forward contracts with respect to such commodities[...] in the case partnerships, a principal activity of which is the buying and selling of such commodities, futures, options or forward contracts (i.e., typical commodity pools)”); letter by Daniel Shapiro to the Commissioner dated July 28, 1995, commenting on the proposed regulations, reprinted in 95 TNT 161-27(“it is not entirely clear whether and to what extent gains realized by a hedge fund from commodities futures, forward and options transactions will be treated as qualifying income”).

104 See also Scharfstein, “§ 7704 and Publicly (or Non Publicly) Traded Partnerships,” Tax Club (Nov. 17, 2002).

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e. QEF Inclusions 

Second, the treatment of PFIC income attributable to a QEF election is not entirely clear.105 The statute provides that “there shall be treated as dividends amounts included in gross income under § 1293(a) for the taxable year to the extent that, under § 1293(c), there is a distribution out of the earnings and profits of the taxable year which are attributable to the amounts so included.”106 Read literally, therefore, income attributable to a QEF inclusion counts toward the 90% threshold only if, in the year of inclusion, the distributions from the PFIC correspond to the QEF inclusion.  Under that construction of the statute, however, many QEF inclusions will generate non-qualifying income.  Like the PFIC mark-to-market election under § 1296, the purpose of the QEF election is to prevent the deferral of tax on passive income.  Income attributable to a QEF inclusion, therefore, should qualify as “other income derived with respect to [the hedge fund's] business of investing in such stock, securities, or currencies.”107
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105 The regulations specifically address PFIC inclusions under the mark-to-market regime of § 1296.  See Regs. § 1.7704-3(b)(2) (reference to § 1296). Accordingly, income recognized under  § 1296 is qualifying income.

106 § 7704(d)(4); § 851(b)(2);  § 851(b) (third sentence).

107 § 851(b)(2)(A); but see also T.D. 8799, I.R.B. 1999-6, 12 (Feb. 8, 1999) (“§ 851(b)(2) [...]provides rules on the extent to which [...] certain inclusions under  § 1293(a) are treated as dividends and, thus, qualifying income [...].  Any expansion of qualifying income with respect to investments in foreign corporations should be addressed under  § 851(b)(2) and the regulations “thereunder”(emphasis added)).

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In PLR 200722007, the IRS supported this analysis. In that ruling, a partnership owned foreign subsidiaries that were CFCs or PFICs. The IRS concluded that subpart F inclusions under § 951(a)(1)(A)(i) and PFIC inclusions under § 1293(a) would be qualifying income, regardless of whether the income is attributable to subpart F or PFIC inclusions and regardless of whether the income is distributed. Several months later, PLR 200743005 reached a similar conclusion in the context of RICs; this ruling is relevant to partnerships because § 7704(c)(3) uses the RIC definition of qualifying income.

f. Interest Income from a “Financial or Insurance” Business 

Third, interest that is “disqualified interest” of a “financial or insurance business”is not qualifying income.108 Here again, the statute offers little guidance.  According to the legislative history:
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108 § 7704(d)(2).

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[I]nterest is not treated as passive-type income if it is derived in the conduct of a financial or insurance business. Thus, for example, interest income from the conduct of a banking business is not treated as passive-type income, as deriving interest is an integral part of the active conduct of the business. Similarly, it is not intended that dividend income derived in the ordinary conduct of a business in which dividend income is an integral part (e.g., a securities broker/dealer)be treated as passive-type income under the provision ...109

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109 H.R. Rep. No. 100-391 at 1068(1987) (emphasis added).  Despite the legislative history, the statute itself only applies to interest income.

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The IRS has addressed the meaning of “disqualified interest” in the context of  § 7704 only twice, in each case by private letter ruling. In one ruling, the IRS considered whether  § 7704(d)(2) applied to certain interest income of a REIT that intended to convert to a partnership.110 The IRS reasoned that “in light of the expressed legislative intent, the key question is whether the lending activity is in the nature of creating investments, or in the nature of an active business enterprise that is normally carried on by a corporation.”  Consistent with the legislative history,111 the IRS did not rely upon any authorities outside of  § 7704 for guidance.  Concluding that  § 7704(d)(2) did not apply, the IRS reasoned that the entity was not engaged in a “financial business” because it had only two employees, engaged in limited loan origination, and did not hold mortgages for sale in the ordinary course of business.
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110 See PLR 9701006.

111 H.R. Rep. No. 100-391 at 1068(1987).

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In the second ruling, a PTP received interest on originated loans to affiliates.112 The taxpayer did not originate any loans to third parties, and represented that the interest was not integral to the business.  The loans also provided for fixed rather than contingent interest. Citing the legislative history, the IRS treated the interest as qualifying income.
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112 See PLR 200411018.

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It is difficult to distill any guiding principles from these rulings.113 Although the Code uses these terms elsewhere,114 the legislative history warns that the definition under  § 7704 is not coextensive “with existing categories of passive income,”but is instead “specific to the purposes of this provision.”115 Nevertheless, one cannot ignore the longstanding distinctions in the case law among “investing,” “trading”and “dealing” in securities.116 “Investing”is not a trade or business.  “Trading” is not a trade or business in the foreign context, but is a trade or business in the domestic context.117 But neither trading nor investing is a “financial business.”118 Indeed, the PTP regulations themselves treat income from both trading and investing as qualifying income.119 Moreover, although a “dealer” does engage in a “financial business,”a dealer earns its profit by selling inventory to customers.  A hedge fund buys and sells stock or securities as a “trader”or “investor.”120
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113 For example, the stated rationale for excluding contingent interest from the definition of qualifying income is that it “involves a greater degree of risk, and also a greater potential for economic gain, than fixed (or even market-indexed) rate of interest [...], and thus is more properly regarded as from an underlying active business activity.” See H.R. Rep. No. 100-391 at 1068 (1987).  Given the contrary treatment of income from equity investments and most swaps under § 7704, this distinction strikes many as rather odd.

114 See, e.g.,  § 953(e) (relating to active insurance business exception to subpart F);  § 954(h) (relating to active banking and financing business exception to subpart F);  § 1297(b)(2) (relating to active banking and insurance exception to PFIC rules).

115 H.R. Rep. No. 100-391 at 1068(1987).

116 See Regs. § 1.7704-3(a)(1), (2); see also Peaslee/Nirenberg, Federal Income Taxation of Securitization Transactions at Ch. 4 F.3.b.(3d ed. 2001) (distinguishing among investors, traders and dealers in other contexts in construing scope of “financial business”exception).

117 See § 864(b).

118 See also Peaslee/Nirenberg, Federal Income Taxation of Securitization Transactions at Ch. 4 F.3.b.(3d ed. 2001) (“Trading is an odd duck.  Although it is ...a business, it is not a financial business”).

119 See Regs. 1.7704-3(a)(2) (“income derived from an asset with respect to which the taxpayer is a trader or investor is not income derived in the ordinary course of a trade or business”); see also T.D. 8799, I.R.B. 1999-6, 12 (Feb. 8, 1999) (“The IRS and Treasury Department believe that  section 851(b)(2) generally encompasses income from the business of trading as well as investing. Thus, income from the securities lending activities of a trader will be qualifying income”); see also Preamble to the proposed regulations, 1998-8 I.R.B. 31 (2/23/98) (“income derived by traders and investors can be qualifying income under the proposed regulations”).

120 See Kemon v. Comr., 16 T.C. 1026, 1032 (1951):

Those who sell “to customers”are comparable to a merchant in that they purchase stock in trade, in this case securities, with the expectation of reselling at a profit, not because of a rise in value during the interval of time between purchase and resale, but merely because they have or hope to find a market of buyers who will purchase from them at a price in excess of their cost.  This excess or mark-up represents remuneration for their labors as a middle man bringing together buyer and seller, and performing the usual services of retailer or wholesaler of goods. Contrasted to “dealers” are those sellers of securities who perform no such merchandising functions and whose status as to the source of supply is not significantly different from that of those to whom they sell.  That is, the securities are as easily accessible to one as the other and the seller performs no services that need be compensated for by a mark-up of the price of the securities he sells.  The sellers depend upon such circumstances as a rise in value or an advantageous purchase to enable them to sell at a price in excess of cost.  Such sellers are known as “traders”.

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Nor is a hedge fund like a bank.  It is not regulated as a bank and does not accept deposits from customers.121 Indeed, a hedge fund has no customers. Because the legislative history refers to a “banking business,”however, the absence of a state charter may not be dispositive.122 Loan origination, for example, is an activity often associated with the banking industry, not only under  § 7704 but under  § 864 as well.123 It is possible, therefore, that Congress intended that the term “banking business”in this context subsume something more than legal status as a bank. If the nature of the underlying activity controls, then the conduct of a “financial business” under  § 7702(d)(2) may include the regular and continuous origination of loans, or at least loans of a certain type.
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121 See § 581; see also Regs. § 301.7701-2(b)(5) (treating state-chartered business entity that conducts “banking activities”as per se corporation if FDIC or similar federal statute insures deposits).

122 Compare  § 881(c)(3)(A) (portfolio interest does not include “interest received by a bank ...”)(emphasis added).

123 For a general discussion of the status of loan origination by hedge funds as a financial lending business under § 864, see VII, F, 2, below; see also Sheppard, “News Analysis — Neither a Dealer Nor a Lender Be, Part 2: Hedge Fund Lending,” reprinted in 2005 TNT 157-3 (Aug. 16, 2005).

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g. Credit Derivatives 

Although the definition of qualifying income includes most categories of investment income, it does not include premium income attributable to the writing of insurance or fee income attributable to debt guarantees. The status of income from certain types of credit derivatives under  § 7704 is therefore uncertain.

As described more fully in XI, A, 7, below, a credit derivative is a contractual arrangement that shifts credit risk associated with one or more specified debt obligations or borrowers from one person to another person. Examples of credit derivatives include credit default swaps, credit options, total return swaps and credit-linked notes.124 Whether a particular credit derivative generates qualifying income under § 7704, however, will depend upon its particular classification for tax purposes. If, for example, a credit default swap qualifies as an option or a notional principal contract, then it should generate qualifying income under § 7704.125
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124 See generally D. Miller, “An Overview of the Taxation of Credit Derivatives,” (Chapter) in F. Fabozzi &  R. Molay, The Use of Derivatives in Tax Planning (1998);Nierenberg &  Kopp, Credit Derivatives: Tax Treatment of Total Return Swaps, Default Swaps, and Credit Linked Notes, 87 J. Tax'n 82 (1997).

125 For a fuller discussion on the proper tax classification of a credit default swap, see XI, A, 7, below.

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U.S. Income Portfolios: Other Pass-through Entities 
  Portfolio 736-1st: Hedge Funds 
  Detailed Analysis 
  IV. Achieving Pass-Through Treatment for the Fund and Its Affiliates

D. Choice of Entity for General Partner 

The general partner of a hedge fund is usually a partnership for tax purposes.  If the sponsor were to form the general partner as a domestic corporation, its individual shareholders would forego the benefit of the reduced rate of tax on capital gain and QDI attributable to the incentive allocation.  Even worse, they would bear two levels of tax on the incentive allocation, once at the entity level and once again upon the distribution of the after-tax proceeds. To avoid this double tax, a general partner with otherwise eligible shareholders could make a subchapter S election.  Under § 1361(b)(1)(D), however, an ‘S’ corporation cannot issue more than one class of stock.  Each outstanding share of an ‘S’ corporation must confer identical rights to distribution and liquidation proceeds, taking into account any differences in rights under the corporate charter, articles, bylaws or other binding agreements.126 With an ‘S’ corporation, therefore, the general partner cannot grant anything beyond a purely fungible undivided interest in the carry to its members.127 None of these constraints apply to a partnership.
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126 Regs. § 1.1361-1(l)(1).

127 For a discussion of the “one class of stock” limitation, see 730 T.M., S Corporations: Formation and Termination.  If the sponsor structures the incentive allocation as a fee for services, however, it may subdivide the fee in any manner it chooses without invalidating the S election. For a discussion of the fee alternative as a possible deferral vehicle for an offshore fund, see VI, B, below.

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U.S. Income Portfolios: Other Pass-through Entities 
  Portfolio 736-1st: Hedge Funds 
  Detailed Analysis 
  IV. Achieving Pass-Through Treatment for the Fund and Its Affiliates

E. Choice of Entity for Portfolio Manager 

For similar reasons, the sponsor will also form the portfolio manager as a partnership for tax purposes, often a domestic LLC but occasionally an offshore entity in a low tax jurisdiction(e.g., the Cayman Islands).

U.S. Income Portfolios: Other Pass-through Entities 
  Portfolio 736-1st: Hedge Funds 
  Detailed Analysis 
  IV. Achieving Pass-Through Treatment for the Fund and Its Affiliates

F. Taking the Portfolio Manager Public? 

Following the decline of the stock market in 2001, a number of  hedge fund managers experienced rapid growth.  With greater assets under management, some hedge funds many hedge funds now hold enormous portfolios of stocks and securities.  As a result, a portfolio manager may employ hundreds of investment professionals to manage these investments.

This phenomenon has exacerbated a longstanding problem for investment professionals in this industry: lack of diversification.  Although many of these professionals would prefer to invest their private wealth across a broader range of asset classes, some must commit a substantial percentage of it to their own funds.  For the same reason, they may lack sufficient liquidity to fund their allocable share of the co-investment obligation of their employer in newly-organized funds of the sponsor. Finally, many portfolio managers now grant participations in the underlying carried interest and incentive fees to a larger groups of employees.

One portfolio manager responded to this phenomenon by going public. On November 8, 2006, Fortress Investment Group Holdings LLC (“Fortress”)filed a registration statement with the SEC for an initial public offering.128 According to the S-1, Fortress will list its shares on the New York Stock Exchange, allowing small investors to participate in the performance results of a sector in the market previously available only to institutional and wealthy investors.
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128 See Form S-1 of Fortress Investment Group Holdings LLC, as filed with the SEC on November 8, 2006, and amended on January 19, 2007, (http://www.sec.gov/Archives/edgar/data/ 1380393/000095013607000244/file1.htm).  According to the Form S-1, Fortress increased its assets under management from approximately $1.2 billion as of December 31, 2001 to approximately $29.7 billion as of September 30, 2006.

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Fortress is not itself a hedge fund, but a portfolio manager of several private equity and hedge funds.  According to the S-1, Fortress will effect the IPO as follows:129
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129 See Worksheet 12.

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• The sponsor will form a Delaware limited liability company as the public vehicle (“Public Holding LLC”).  As described more fully below, Public Holding LLC will qualify as a partnership for tax purposes.

• In the IPO, Public Holding LLC will issue Class A shares to the public.130 Public Holding LLC will contribute the proceeds from the IPO (net of any underwriting commissions) to two wholly-owned domestic subsidiaries, one of which will be a corporation (“BlockerCo”) and the other a disregarded entity for tax purposes (“DRE LLC”).
 
•DRE LLC will then lend a portion of the cash proceeds contributed by the public vehicle to BlockerCo (the “Intercompany Loan”).

• BlockerCo will then contribute its cash on hand (including the proceeds from the Intercompany Loan) to the entities of the Fortress group that serve as the general partners of various private equity and hedge funds of the sponsor (the “GP Entities”) in exchange for the sole general partner interest and limited partnership interests in each of these entities.

• DRE LLC will then contribute its cash on hand to a partnership(“Principals Holdings”), which will hold all the capital investments of the five Fortress founders and key investment professionals(the “Principals”) in exchange for the sole general partner interest and limited partnership interests in Principals Holdings.

• The GP Entities and Principals Holdings (“Operating Group”)will deploy the cash proceeds of the IPO to retire debt and fund future operations.

• The Principals will remain direct partners of each GP Entity and direct partners of Principals Holdings.  Immediately after the IPO, Public Holding LLC will own 22% of the Operating Group and the Principals will own the remaining 78%.

• In a recapitalization of Public Holding LLC, the Principals will receive (i) 100% of the Class B shares for each equity unit in the Operating Group and (ii) the right to exchange each such unit at any time after the IPO into a Class A share. Each Class B share will entitle the holder to one vote per share but will not convey any economic rights.  The Principals will therefore retain voting control over the public vehicle.

•Prior to and in connection with the IPO, Operating Group will distribute cash to the Principals.131

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130 On January 17, 2007, Fortress sold the largest block of Class A shares to a single investor, Nomura Investment Managers U.S.A., Inc.

131 See p. 5 of Form S-1.

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Worksheet 12 presents a simplified diagram of the fund structure in the Fortress IPO.

The Fortress offering includes a number of interesting features:

• Although not an explicit rationale for the offering, the Fortress IPO should allow the Principals to “monetize” a portion of the carry-related returns in the underlying private equity and hedge funds132 prior to actual realization of the gains by the funds and without triggering an immediate tax liability.133 As partners of the GP Entities and Principals Holdings, each Principal would be permitted to withdraw his or her allocable share of the cash proceeds in a “basis first” distribution under § 731, so long as the IRS does not recast the distribution as a “disguised sale” under §  707.134
 
• The partnership form of the public vehicle should avoid significant corporate level tax. More than 50% of the assets managed by Fortress will represent investments in underlying private equity funds,135 which tend to generate long-term capital gain and qualified dividend income.  As a domestic corporation, the public vehicle would have borne corporate-level tax at regular graduated rates on these returns.
 
• Because the Class A shares will be publicly-traded, Public Holding LLC will qualify as a partnership only if it meets the “qualifying income” exception under § 7704.136 Public Holding LLC will generate the following types of gross income, either directly or through subsidiaries: (i)management fees for services, (ii) incentive allocations in respect of profits interests granted in exchange for services, (iii) incentive fees for services and (iv) income from invested capital.  Because “qualifying income” under  § 7704 excludes income from the performance of services,137 this income will be earned by BlockerCo, a separate corporate taxpayer, effectively “blocking”the bad income from the public entity.  Although any such income will bear corporate tax at a 35% rate, BlockerCo will claim an interest deduction on the Intercompany Loan.  The interest on the Intercompany Loan will therefore convert a portion of the “bad” service income in the blocker into “good” interest income to the public vehicle.
 
• As described above, the Principals will retain their equity in the Operating Group, coupled with a right to exchange the equity for shares in Public Holding LLC in the future.  Because BlockerCo (rather than the public vehicle) would be the transferee in any such exchange, the exchange of units in the Operating Group for Class A shares should constitute a taxable exchange.138 Assuming valid  § 754 elections within the constituent entities, the acquiring entity will therefore obtain a basis step-up in the underlying assets of the hedge funds and private equity funds upon exercise of the exchange right at a gain.  BlockerCo and DRE LLC will enter into a “tax receivables agreement” with the Principals pursuant to which BlockerCo and DRE LLC will agree to pay the Principals 85% of the actual future tax savings attributable to the exchange of Operating Group units for Class A shares.139
 
• The post-IPO grant of equity interests to employees is likely to present special issues to Fortress that tend not to arise with purely private funds.140 First, Revenue Procedure 93-27 does not apply to a profits interest in a PTP.141 Second, the Class A shares themselves will not qualify as profits interests for tax purposes.  According to the S-1, Fortress intends to issue Operating Group units coupled with Class B shares (rather than Class A shares) to certain employees and to issue “incentive units” in the lower tier partnerships that qualify as profits interests for tax purposes.142
 
• Since Public Holding LLC will be treated as a partnership for tax purposes, it will issue IRS Schedules K-1 (rather than IRS Forms 1099) to the public investors to report their allocable share of the income attributable to Public Holding LLC.  Historically, public investors prefer to receive IRS Forms 1099 to Schedules K-1.  It appears, however, that the public markets have begun to accept the need for K-1 reporting, at least in this limited context.  As a result, the significance of this reporting issue appears to have diminished.
 
• A foreign holder of Class A shares will be sensitive to the question of whether the investment will trigger the obligation to file a U.S. tax return. In general, a foreign partner in a partnership is deemed to be engaged in any U.S. trade or business conducted by the partnership.143 The provision of investment management services within the U.S. in exchange for a fee is a “U.S. trade or business.”144 As a result, if Public Holding LLC were itself to perform such services or to receive such fees, a foreign shareholder would be required to file a U.S. tax return.  Thus, a secondary purpose of BlockerCo is to “trap” the trade or business activities of the group within a separate corporate taxpayer.

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132 The S-1 refers to “deferred incentive income” in the form of: (i) carried interests in certain private equity funds; and (ii) deferred incentive fees in certain offshore hedge funds.

133 The Form S-1 cites the following reasons for the IPO: (i) to increase Fortress' ability to provide financial incentives to existing and future employees, (ii) to solidify Fortress' institutional presence as an “investor,” (iii) to more efficiently access capital to develop the business and create new investment products, and (iv) to create a publicly-traded security to finance strategic acquisitions.

134 This assumes that each Principal has a sufficient outside basis to absorb the distribution. For a discussion of the “disguised sale” rules under § 707 as applied to hedge funds, see X, A, below.

135 See Form S-1 (of$29.7 billion of total assets, $17.3 billion represent assets in private equity funds, $9.4 billion represent assets in hedge funds, and $3 billion represent assets in real estate funds).

136 For a fuller discussion of the “qualifying income” exception under § 7704, see IV, C, 4, above.

137 §  7704(c); Regs. §  1.7704-3.

138 If the public vehicle were the transferee, the exchange would likely qualify  under § 721, even though the holder would immediately recognize the deferred gain when it sells the shares of the public vehicle on the market.

139 Tax receivables agreements have become a common feature in a number of recent IPOs.  For example, the IPO of DreamWorks Animation Inc. (2004), Lazard Ltd (2005), Evercore Partners (2006)and Hawkeye (2006) each featured a tax receivables agreement for the benefit of the selling shareholders.  The Fortress IPO, however, is unusual in this regard because Fortress conducts business as a fund manager.  With an operating business, a substantial portion of any basis step-up is likely to attach to goodwill, which is amortizable under  § 197 over 15 years.  In the fund context, however, some of the basis step-up will attach to the investment assets of the underlying private equity or hedge funds.  The Principals in the Fortress IPO may therefore obtain cash pursuant to the tax receivables agreement over a much shorter time horizon.

140 See Form S-1, p. 182 (“Equity Incentive Plan”).

141 1993-2 C.B. 343. For a fuller discussion of the tax treatment of the grant of a profits interest in the hedge fund context, see VI, A, below.

142 See  p. 182 et seq. of Form S-1 (“long-term incentive units” to be structured as profits interests for U.S. tax purposes).

143 § 875(1).  For a fuller discussion of the trade or business issue as applied to foreign investors in hedge funds, see VII, A, below.

144 § 864(b) (trade or business includes “performance of personal services within the United States”).

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U.S. Income Portfolios: Other Pass-through Entities 
  Portfolio 736-1st: Hedge Funds 
  Detailed Analysis 
  V. Profit &  Loss Allocations

A. In General 

As partnership agreements, most fund agreements provide for the allocation of profit and loss.  The IRS will not challenge an allocation if it has “substantial economic effect”under § 704(b).145 Under the  § 704(b) regulations, an allocation has substantial economic effect if it satisfies each of two conditions.  First, the allocation must have “economic effect.”146 An allocation has “economic effect”so long as the allocation conforms to the underlying economic agreement among the partners,147 as tested under various regulatory regimes.  Second, the economic effect of the allocation must be “substantial.”148 The economic effect of an allocation is “substantial”if a reasonable possibility exists that the allocation will affect substantially the amount distributable to a partner on a pre-tax basis.149 Even then, an allocation will not qualify as substantial if the effect of the allocation is to increase the after-tax return to one or more partners and a “strong likelihood”exists that the after-tax return to no other partner will be “substantially diminished,” as determined on a present value basis.150 In making this assessment, the partnership must consider the relationship between the allocation and the tax attributes (e.g., net operating losses) of its partners.151 Under the “present value”aspect of the “substantiality” test, therefore, the effect of an allocation on the expected after-tax return of a partner during a particular year is not dispositive.
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145 § § 704(a), 704(b)(1); see also Regs. § 1.704-1(b)(1)(i).

146 Regs. § 1.704-1(b)(2)(i).

147 Regs. § 1.704-1(b)(2)(ii).

148 Regs. § 1.704-1(b)(2)(i).

149 Regs. § 1.704-1(b)(2)(iii).

150 Id.

151 Id. A partnership must also consider the tax attributes of any owner of a partner that is itself a pass-through entity. See Regs. § 1.704-1(b)(2)(iii)(d).

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This portfolio does not address the difficult question of how to draft § 704(b)-compliant allocations in a partnership agreement. The practitioner should appreciate, however, that most hedge funds, along with their general partners and portfolio managers, are partnerships for tax purposes.  Like any partnership, therefore, they must comply with the  § 704(b) regulations.152 The following subsections of the portfolio instead identify the special issues that the  § 704(b) regulations present to hedge funds and how many hedge funds address them.
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152 For an excellent discussion of the  § 704(b) regulations, see 712 T.M., Partnerships: Taxable Income; Allocation of Distributive Shares; Capital Accounts.

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U.S. Income Portfolios: Other Pass-through Entities 
  Portfolio 736-1st: Hedge Funds 
  Detailed Analysis 
  V. Profit &  Loss Allocations

B. Allocations of “Book” Income 

As described in III, A, above, most hedge funds admit new investors at periodic intervals, for example on a quarterly or semi-annual basis.  Upon admission, the new investors will contribute cash to the fund for newly-issued shares.  Unlike other investment funds, however, hedge funds also redeem shares from their withdrawing investors, typically on the same dates.153 At any given time, therefore, an investor's “capital percentage”in the fund will reflect its variable share of the aggregate capital in the fund.  It is this percentage that will establish the investor's share of the book income or loss of the fund during the period in question (as adjusted for the incentive allocation), which the fund determines on a mark-to-market basis.
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153 The manner and timing of investments and withdrawals may raise “disguised sale” and other tax issues.  See X, A, below.

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Because hedge funds issue and redeem shares at regular intervals, the capital percentages of their investors will vary from period to period, even in the case of an investor who does not buy or sell any shares in the interim.  The changes in these percentages will in turn alter the relative allocation of unrealized gains and losses among the book capital accounts of the investors from one period to the next.  But for tax purposes, most hedge funds will report gains and losses on a realized basis.154 As a result, the tax capital accounts of the investors will not reflect the unrealized gains or losses, regardless of relative capital percentages.
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154 For a discussion of whether a hedge fund may elect to report taxable income on a mark-to-market basis by making a  § 475(f) election, see IX, B, 3, below.

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So the problem under  § 704(b) is this: the current capital percentage of an investor when a hedge fund realizes a gain or loss may not correspond to the capital percentage of the investor when the fund marked the gain or loss to market and debited or credited its book capital account.  As described in III, A, above, the book capital account balance sets the economic deal between the fund and each of its investors because it sets the redemption price of the shares. To qualify as “substantial,” therefore, the correlative tax allocation of realized gains or losses must produce the equivalent tax capital account over time.

To address this problem, most hedge funds divide each fiscal year into separate “break periods.”  A fund that admits and redeems investors on a quarterly basis, for example, will have four break periods during the year.  An investor's share of the book income or loss of the fund during each break period will reflect its capital percentage of the underlying appreciation or depreciation with respect to such period:

Example 5-1: On 1/1/06, Investor A and B each contribute $100 to X, a newly-formed hedge fund organized as a partnership for tax purposes.  X invests the proceeds as follows:

Assets	Adjusted Basis	Fair Market Value	
Lucent Shares	$150	$150	
Puts on Time Warner Shares	 $50	 $50	

On 6/30/06, these positions have the following values:

Assets	Adjusted Basis	Fair Market Value	Gain/Loss	
Lucent Shares	$150	$200	$50	
Puts on Time Warner Shares	 $50	$100	$50	

On 7/1/06, C invests $100 in X for 25% of the shares.  X invests the proceeds in shares of Intuit.  On 12/31/06, these positions have the following values:

Assets	Adjusted Basis	Fair Market Value	Gain/Loss	
Lucent Shares	$150	$250	$50	
Puts on Time Warner Shares	 $50	$150	$50	
Intuit Shares	$100	$100	 $0	

If X admits and redeems investors on a semi-annual basis, it will have two “break periods,” one running from 1/1/06 to 6/30/06 and the other from 7/1/06 to 12/31/06.  The relative interests of the investors at the end of each break period is as follows:

 	Break Period Capital Percentages	
Investor	1/1/06-6/30/06	7/1/06-12/31/06	
A	50.00%	37.50%	
B	50.00%	37.50%	
C	0.00%	25.00%	
Total	100.00%	100.00%	

The book and taxable income during each break period is $100 and $0, respectively.  X therefore allocates the book income as follows:

 	Break Period Book Income/Loss	
Investor	1/1/06-6/30/06	7/1/06-12/31/06	
A	$50.00	$37.50	
B	$50.00	$37.50	
C	$0.00	$25.00	
Total	$100.00	$100.00	

Finally, assuming a 20% carry, the general partner would “reallocate” 20% of the book income from A, B & C to itself in accordance with the prior allocations of book income:

 	 	 	Break Period	 	 	
 	1/1/06-6/30/06	 	7/1/06-12/31/06	
Investor	Before 
 GP Carry	GP Carry	After 
 GP Carry	Before 
 GP Carry	GP Carry	After 
 GP Carry	
A	$50.00	$10.00	$40.00	$37.50	$7.50	$30.00	
B	$50.00	$10.00	$40.00	$37.50	$7.50	$30.00	
C	$0.00	$0.00	$0.00	$25.00	$5.00	$20.00	
Total	$100.00	$20.00	$80.00	$100.00	$20.00	$80.00	

U.S. Income Portfolios: Other Pass-through Entities 
  Portfolio 736-1st: Hedge Funds 
  Detailed Analysis 
  V. Profit &  Loss Allocations

C. Allocations of Taxable Income 

1. Nature of the Problem 

Given these allocations of book income, how should X allocate  taxable income?155 Any partnership that “books up”capital accounts under the  § 704(b) regulations must address this issue.  But the book-up problem is a recurring one with hedge funds.  Marking-to-market is the norm in this industry, not the exception.  Investors in hedge funds will enter and exit the fund at different valuations over multiple break periods.  During these periods, the fund will realize some gains and losses and “book up” or “book down” other gains and losses.  The likelihood that the capital percentages of its investors on the various dates of realization will coincide with the capital percentages of its investors on the date (or dates) of the relevant “book up” is remote.  To achieve substantial economic effect, therefore, the fund must allocate the realized gain or loss among its investors in accordance with the relative capital percentages of its investors during the relevant “break periods,”regardless of relative capital percentages on the date of realization.
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155 This assumes that the hedge fund has not made a  § 475 election. For a discussion of whether a hedge fund is eligible to make a  § 475 election, see IX, B, 3, below.

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Part of this problem is the province of § 706.156 For the most part, however, the reconciliation of book/tax differences is the province of § 704(c), or more precisely, the province of the “reverse” § 704(c) principles of the regulations.  As described above, a hedge fund that allocates taxable gains and losses in accordance with capital percentages on the date of realization will fail to reconcile book and tax capital accounts.  Accordingly, a tax allocation that follows capital percentages on the realization date cannot have economic effect:
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156 See X, B, 2, below, for a discussion of the application of  § 706 to hedge funds.

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Example 5-2: Assume the same facts as in Example 5-1, except that on 1/1/07, X sells its entire portfolio for $500, realizing a taxable gain of $200.  If X were to allocate the $200 of taxable gain in accordance with the capital percentages of A, B and C on that date, the tax and book capital accounts (ignoring the incentive allocation) immediately after the sale would differ:

 	Capital Accounts	
Investor	Book 
 Capital 
 Account	Tax 
 Capital 
 Account	
A	$187.50	$175.00	
B	$187.50	$175.00	
C	$125.00	$150.00	
Total	$500.00	$500.00	

In this example, X has allocated too much of the taxable gain to C and too little of the taxable gain to A and B.  The reason is that the prior book allocation of gain occurred during a break period in which A and B had a higher capital percentage in the fund.  To be faithful to the economic deal, therefore, X must allocate the realized gains in accordance with the old ratios.

The  § 704(b) regulations permit a partnership to “restate”its assets to reflect fair market value immediately before certain specified events.  When a partnership does so, it must treat any unrealized gains or losses from the restatement as net profit or loss for book purposes and allocate the profit or loss among the book capital accounts of its partners as if the partnership had actually realized the profit or loss.157 When a restatement event occurs, therefore, the book up (or down) will create a difference between book and tax capital accounts.  To reconcile the resulting disparity over time, the  § 704(b) regulations therefore require a partnership to allocate the ultimately-realized gain or loss in accordance with the principles of § 704(c).158
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157 See Regs. § 1.704-1(b)(2)(iv)(f).

158 See Regs. § § 1.704-1(b)(2)(iv)(f)(4),-1(b)(2)(iv)(g).

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What are the “principles” of § 704(c)?  Section 704(c) itself applies to unrealized gain or loss on property contributed to a partnership by a partner under § 721.  The gain or loss on the property will therefore have accrued before the partner contributed the property to the partnership.  In this context, the “principles”of  § 704(c) require the contributing partner to bear incremental tax on future allocations of taxable income equal to the gain inherent in the contributed property.159
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159 See Regs. § 1.704-3(a).

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In a restatement, however, the principles of § 704(c) do not apply to the contributing partner.  They apply to the non-contributing partner.  Moreover, the relevant unrealized gain or loss in the “reverse”  § 704(c) context is the gain or loss arising after the partnership acquires the property, not before.  Just as a partner who contributes property with unrealized gain or loss to a partnership will have a difference in its opening book and tax capital account, a  § 704(b) “book up” event will create a disparity in the book and tax capital account of the non-contributing partner.

Hedge funds effect “reverse”  § 704(c) allocations during every fiscal year.  In fact, they are among the few partnerships to mark book capital accounts to market on a recurring basis.  Most other partnerships mark book capital accounts to market much less frequently, for example immediately before the admission of a new partner, the non-pro rata distribution of property to an existing partner or the liquidation of the partnership.160 The  § 704(b) regulations,161 however, permit a “securities partnership”to revalue its assets at any time so long as the revaluation conforms to “generally accepted industry accounting practices.” Under this special provision, a hedge fund will mark book capital accounts to market at the end of every break period.  To further complicate matters, each book-up will occur during a period in which a fund may hold hundreds, perhaps even thousands of investment positions, the values of which will have fluctuated from one break period to the next just as the capital percentages of its investors will have fluctuated. To comply with the strict principles of § 704(c), therefore, such a fund would be required to allocate the realized gain or loss on each investment in accordance with the prior book allocation that created the disparity in the first place.
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160 See Regs.  § 1.704-1(b)(2)(iv)(f)(5) (permitting “book ups” in each of these situations).

161 See Regs. § 1.704-1(b)(2)(iv)(f)(5)(iv).  A book up under these circumstances also requires that “substantially all of the partnership's property (excluding money) consists of stock, securities, commodities, options, warrants, futures, or similar instruments that are readily tradable on an established securities market.”  Id.

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2. Reverse § 704(c)by “Layering” 

A partnership may comply with  § 704(c) on an asset-by-asset basis, even a partnership with a diverse portfolio of investments. With recurring book-ups, however, the compliance obligation becomes more burdensome.  But it is not difficult as a conceptual matter. Although once described as “nearly impossible to track,”162 asset-by-asset compliance is a rudimentary spreadsheet exercise: the fund need only establish a separate “memorandum account” for each investment to track the variable share of each investor in the unrealized gain or loss from break period to break period.  When the fund sells or otherwise realizes income on the investment, it simply allocates the realized gain or loss among its investors in accordance with each investor's positive or negative balance in the memorandum account.
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162 See, e.g., Letter by Christopher McConnell to IRS dated April 12, 1993, commenting on the proposed regulations under § 704(c), reprinted in 93 TNT 84-33 (“many investment partnerships are either not doing the reverse 704(c) allocation or are applying it in only limited circumstances. This non-compliance ...is ... due to a lack of understanding of how an allocation should be performed with multiple revaluations ... even if an investment partnership understood how the allocation provisions should be applied, ...the administrative burden of a manual asset-by-asset allocation would be nearly impossible to track and extremely costly ... many investment partnerships are unable to calculate this allocation due to its complexity”).

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A more legitimate criticism of pure “layering”is that it leads to recurring violations of the “ceiling”rule, particularly with hedge funds.  Regulations  § 1.704-3(b)(1) describe the “traditional method” for effecting tax allocations under § 704(c). Under the traditional method, the amount of taxable gain or loss on a property that a fund may allocate among its partners may not exceed the taxable gain or loss actually realized on the property. Consider the following example:

Example 5-3: Investor A in hedge fund partnership X invests at the beginning of a break period.  At the end of the last break period, X had unrealized gain of $30 in shares of Microsoft.  Although the shares decline in value by $10 after A invests, X sells the Microsoft shares at a gain of $20.  To conform to the prior book allocation of $30 at the beginning of the break period, X should allocate a taxable loss to A and a taxable gain to the other investors in an aggregate amount of $20.  But that allocation would violate the ceiling rule because the gain allocated to the other investors would then exceed the total gain actually recognized by X on the sale of the Microsoft shares.

This problem is especially acute for hedge funds because the ceiling rule applies even to partnerships with sufficient taxable gains and losses elsewhere in the portfolio on an aggregate basis.  In fact, hedge funds that follow a pure “layering”methodology will usually employ “curative” allocations to address this problem.  Under Regulations § 1.704-3(c)(1), a partnership that employs the “traditional method” may make “reasonable curative allocations to reduce or eliminate disparities between book and tax items of noncontributing partners.” The effect of a curative allocation is to allow the fund to allocate gains or losses from “another item of partnership property”to prevent the distortion that would otherwise result between book and tax capital accounts by strict adherence to the ceiling rule, even though the allocation of a specific taxable gain on an asset will differ from the prior book allocation.  Alternatively, other funds apply  § 704(c) on an asset-by-asset basis over the course of the year without regard to the ceiling rule and then, as of the end of the taxable year, confirm the presence of sufficient gross items of gain and loss elsewhere in the portfolio to avoid a reallocation.  Although this approach does not strictly conform to the ceiling rule, it tends to produce the same result in the majority of cases.

3. Reverse § 704(c)by “Aggregation” 

The regulations nevertheless exempt a “securities partnership” from the requirement to effect reverse  § 704(c) allocations on an asset-by-asset basis.163 The regulations define a “securities partnership” to include an “investment partnership”that, ignoring the incentive allocation, “makes all of its book allocations in proportion to ... relative book capital accounts”.164 An “investment partnership”is a partnership that holds “qualified financial assets”that represent at least 90% of its non-cash assets and that revalues its assets at least annually.165 A “qualified financial asset” is “any personal property (including stock) that is actively traded” within the meaning of Regulations § 1.1092(d)-1.166 Most hedge funds qualify as securities partnerships.
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163 See T.D. 8585, 59 Fed. Reg. 66724 (12/28/94).

164 See Regs. § 1.704-3(e)(3)(iii)(A).

165 See Regs. § 1.704-3(e)(3)(iii)(B)(2).

166 See Regs. § 1.704-3(e)(3)(ii)(A).

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Under this alternative allocation regime, a hedge fund may aggregate gains and losses under any reasonable method, so long as it is consistent with the purposes of § 704(c).167 The regulations describe two presumptively reasonable methodologies: “partial netting” and “full netting.”168 With “partial netting,” a hedge fund separately aggregates taxable gains and losses during each break period within separate baskets and then allocates the aggregated gains and losses among its partners to reduce the differences between their book and tax capital accounts.169 With “full netting,”a hedge fund collapses the multiple baskets into one and allocates the aggregated net gain or loss in the same manner.170 Because full netting entails less “disaggregation”than partial netting, most otherwise-eligible hedge funds follow the full netting methodology.171
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167 Regs. § 1.704-3(e)(3).

168 Regs.  § 1.704-3(e)(3)(iv) (partial netting); Regs.  § 1.704-3(e)(3)(v) (full netting).

169 Regs. § 1.704-3(e)(3)(iv).

170 Regs. § 1.704-3(e)(3)(v).

171 Although a partnership interest is not a “qualified financial asset,”a partnership that holds an interest in a securities partnership will be deemed to hold a proportionate share of the assets of the securities partnership.  See Regs. § 1.704-3(e)(3)(ii)(C). If the master fund in a master-feeder structure is a securities partnership, therefore, the feeder should qualify as a securities partnership as well.

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Under either methodology, the hedge fund will establish a “revaluation account” to track each partner's share of the unrealized gains and losses from one break period to the next.  When the fund realizes gain or loss from any asset, it allocates the gain or loss to reduce or increase (respectively)the revaluation account of each partner; conversely, the unrealized gains or losses from a “book up” or “book down”during a break period will increase or reduce (respectively) the revaluation account of each partner.172
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172 See Regs.  § 1.704-3(e)(3)(ix) (Ex. 1).

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Example 5-4: On 1/1/06, A and B each contribute $75 to the Zod fund, a partnership with no carry that computes book income and loss on a mark-to-market basis.  Zod invests the full $150 in Stocks 1, 2 and 3, each at a cost of $50.  On 7/1/06, Zod admits C as a new investor for $100.  On that date, Stocks 1, 2 and 3 have a value of $75, $100 and $25, respectively.  C therefore acquires a 1/3 interest in Zod.  Zod invests the $100 in Stock 4. Before the end of the year, Zod sells Stocks 1 and 2 for $100 each, resulting in a total realized gain of $100.  On 12/31/06, Zod holds Stocks 3 and 4, now worth $50 and $200, respectively.

Based upon the foregoing, A, B and C have the following book capital, tax capital, and “revaluation”accounts:

Investor	Book 
 Capital 
 Account	Tax 
 Capital 
 Account	Revaluation 
 Account	
1/1/2006	 	 	 	
A	$75.00	$75.00	$0.00	
B	$75.00	$75.00	$0.00	
C	$0.00	$0.00	$0.00	
7/1/2006	 	 	 	
A	$100.00	$75.00	$25.00	
B	$100.00	$75.00	$25.00	
C	$100.00	$100.00	$0.00	
12/31/2006	 	 	 	
A	$150.00	$116.67	$33.33	
B	$150.00	$116.67	$33.33	
C	$150.00	$116.67	$33.33	

Note that C in this example has a book capital account in the Zod fund at the end of 2006 of $150 (i.e., $450/3), which exceeds his book capital account at mid-year by $50.  At mid-year, however, each of A and B had book capital accounts in excess of tax capital accounts of $25 (i.e., $100-$75), which represent the $50 of unrealized gain in the portfolio at the time. To track the $50 of unrealized gain after C invests, therefore, Zod sets up a “revaluation account” of $25 for each of A and B.  Under the aggregation methodology, Zod then allocates the first$50 of realized gains after mid-year (arising in this case from the sale of Stock 1) entirely to A and B in order to increase their tax capital accounts and reduce their revaluation accounts. Note that Zod will effect this tax allocation even though it recognized only $25 of book gain before the date of C's investment.  Zod then allocates the remaining $50 of realized gains (arising in this case from the sale of Stock 2) to A, B and C on a pro rata basis, even though Zod realized none of that gain for book purposes after the date of C's investment.  At the end of the year, therefore, A, B and C will have revaluation accounts of $33.33 each, which reflects the $100 of remaining unrealized gain in Stock 4.  When Zod sells Stock 4, it will allocate the $100 gain pro rata to each of A, B and C, reducing their revaluation accounts to zero and bringing the book and tax capital accounts back into conformity.  Under this “netting”methodology, therefore, the allocations of specific items of taxable gain do not correspond to the allocations of specific items of book gain during the earlier break periods.  In fact, which asset the fund sells is irrelevant.  What is relevant is the existing book/tax disparity in total capital accounts on an aggregate basis at the time of realization.

As this example demonstrates, both full and partial netting may at times shift the character and timing of income from one partner to another, often without violating § 704(b).  Under the  § 704(b) regulations, however, if a partnership aggregates gains and losses under any such regime, it must (i) preserve the tax attributes of each item of gain or loss;(ii) aggregate under a consistently applied approach; and (iii) not aggregate “with a view to reducing substantially the present value of the partners' aggregate tax liability.”173 Accordingly, a hedge fund that employs either a partial of full netting methodology will usually divide the aggregated gains and losses among at least four baskets:
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173 See Regs. § 1.704-3(e)(3)(vi).

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• net long-term capital gains and losses;

• net short-term capital gains and losses;

•net ordinary gains and losses (e.g., foreign currency);and
  
• net  § 1256 gains or losses.

Acting under the authority of Regs. § 1.704-3(e)(4) to allow partnerships other than securities partnerships to aggregate gain and loss, the IRS published Rev. Proc. 2007-59.173.1Rev. Proc. 2007-59, which is generally effective for taxable years beginning after September 30, 2007 (although taxpayers may apply it to taxable years beginning after 2005), grants permission to any “qualified partnership”to aggregate built-in gains and losses from “qualified financial assets” for purposes of making reverse §  704(c) allocations under Regs. § 1.704-3(e)(3). For a complete discussion of Rev. Proc. 2007-59, see 712 T.M., Partnerships — Taxable Income; Allocation of Distributive Shares;Capital Accounts.
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173.1 2007-40 I.R.B. 745.

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U.S. Income Portfolios: Other Pass-through Entities 
  Portfolio 736-1st: Hedge Funds 
  Detailed Analysis 
  V. Profit &  Loss Allocations

D. The “Stuffing” Allocation 

1. Nature of the Problem 

As described in III, A, above, an investor in a hedge fund achieves liquidity by redemption.  A hedge fund is able to redeem the shares of its investors at regular intervals because it holds marketable securities.  It also receives cash from newly-issued shares and has broad latitude to borrow.  Absent sufficient cash on hand, however, a hedge fund may choose to sell a marketable security to fund a redemption request.

When a partner withdraws from a partnership by redemption, the withdrawing partner will recognize gain in an amount equal to the difference between the cash distributed by the partnership and its tax basis in the partnership.174 Because a complete redemption will terminate the interest of the withdrawing partner, the partner's tax basis in the partnership will include an allocable share of the income or loss during the intervening “stub period.”175 This pre-redemption basis adjustment will therefore reduce or increase the partner's gain or loss attributable to the redemption itself.
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174 § 731.  Both the amount of the distribution and the investor's tax basis will also reflect an allocable share of any fund-level debt. See § 752.

175 See  § 706(c)(2)(A) (closing the tax year as to such partner); § 705(a)(1)(A), (B) (basis in partnership interest adjusted to reflect income or loss “for the taxable year”).

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So assume that a hedge fund sells a marketable security at a gain to finance a redemption request.  Under § 704(b), the fund must allocate the gain on a pro rata basis among all of its investors, even though it intends to distribute 100% of the proceeds to the withdrawing investor.  The other investors will therefore incur an immediate tax liability:

Example 5-5: At end of a calendar quarter, A, a holder of 5% of the shares of the Nebula hedge fund, a partnership for tax purposes, tenders those shares for redemption. The shares have a fair market value of $200 and a tax basis of $160. To fund the redemption, Nebula sells a security in its portfolio with a tax basis of $150 for $200, recognizing $50 of gain.  Assuming that $10 of that gain is allocable to the general partner (i.e., 20%), Nebula would allocate $2 of the remaining $40 of gain to A (5% x$40).  A would therefore recognize an additional $38 of gain under § 731 upon receipt of the $200 distribution.  Although the remaining members retain their shares in Nebula, they will bear tax on the remaining$38 of gain.

As a partnership, Nebula in this example may increase the tax basis of its remaining assets by the $38 of gain to A, so long as it has a  § 754 election in effect.176 This “step-up”will reduce the gain (or increase the loss) allocable to the other members when Nebula sells its remaining assets.  But many hedge funds do not make the  § 754 election.177 Without a basis step-up, therefore, the remaining members may not recover the incremental tax associated with the earlier sale of assets until they tender their shares for redemption at a higher tax basis.
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176 § 734.

177 See IX, A, below, for a discussion of the  § 754 election as applied to hedge funds.

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2. The “Stuffing”Solution 

Many hedge funds purport to solve this timing problem by “stuffing” the withdrawing member with a disproportionate share of the realized gains.

Example 5-6: Assume the same facts as in Example 5-5.  Rather than prorating the $40 of residual taxable gain among all of its members,  however, Nebula allocates the entire amount to A.  A therefore recognizes no additional taxable gain under § 731 when Nebula redeems its shares.

Note that the fund in this example allocates more gain to the withdrawing member.  The additional gain will increase A's basis and therefore reduce A's gain in the redemption. Indeed, absent a character difference between the allocated income and the reduced gain under § 731, A may not even notice the “excess” allocation.  Even if a difference in character between the excess allocation and the  § 731 gain would in fact increase A's net tax liability upon withdrawal, the fund may attempt to justify the allocation on the basis that A precipitated the sale of the underlying security by choosing to tender its shares for redemption.

The Worksheets provide an example of a “stuffing”provision in a typical fund agreement.

3. Does Stuffing Have Substantial Economic Effect? 

A “stuffing” allocation does not affect the amount of cash or other property distributed to the withdrawing member.  Therefore, it has no economic effect, substantial or otherwise.178
——————————————————————————————

178 See also Brannan, “Ruminations on Section 704(b),” Tax Club (May 15, 2001) (“While at first blush stuffing allocations may seem equitable as an intuitive matter, stuffing allocations do not technically comply with  Section 704(b) of the Code, since they do not affect the amount of cash and property received by the partner being redeemed, nor do they otherwise affect the economic interests of the partners in the partnership in any way. Rather, they are made solely to divert taxable income away from the continuing partners without any corresponding economic consequence”).

——————————————————————————————

4. Stuffing to Avoid Mandatory § 754 Election on Redemptions 

As described in IX, A, 5, below, § 734 now requires a partnership, including a hedge fund, to reduce the inside basis of its assets after an investor withdraws if the fund would have been required to reduce basis by more than $250,000 had it made the  § 754 election(i.e., a “substantial basis reduction”). Due to the administrative complexities associated with computing and tracking basis adjustments on an asset-by-asset basis, many hedge funds do not make the  § 754 election.179 Nevertheless, § 734 compels the hedge fund to do so after a “substantial basis reduction.”
——————————————————————————————

179 See IX, A, below, for a discussion of the  § 754 election as applied to hedge funds.

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Some hedge funds may attempt to avoid an otherwise mandatory basis step down by “stuffing” the withdrawing member with losses instead of gains:

Example 5-7: At the end of a calendar quarter, A, a holder of 5% of the shares of the Cepheid hedge fund, tenders those shares for redemption.  The shares have a tax basis of $1 million and a fair market value of $0.5 million.  During that quarter, Cepheid incurred a $0.5 million loss on the sale of securities. Ignoring the incentive allocation to the general partner, $0.025 million of that loss would be allocable to A.  After the allocation, therefore, A would recognize a loss of $0.475 million upon receipt of the $0.5 million distribution.

If a  § 754 election had been in effect, Cepheid in this example would have reduced the inside basis of its assets under  § 734 by the $0.475 million loss to A.  With no  § 754 election, however, the remaining members will “duplicate” this loss when Cepheid sells its assets at their current tax basis.  To eliminate the “double deduction,”  § 734 will require Cepheid to reduce the inside basis of its assets by $0.475 million.  Cepheid would have avoided this mandatory adjustment, however, if the loss to A upon withdrawal had not exceeded $0.25 million.

So what if Cepheid had “stuffed”A with a disproportionate share of the loss on the prior securities sale? For example, if Cepheid were to allocate $0.225 million of that loss to A, A's basis in Cepheid would decrease by the same amount, reducing A's loss on withdrawal from $0.475 million to $0.25 million. If the IRS were to respect this stuffing allocation as valid under § 704(b),  § 734 would not require the downward basis adjustment because no “substantial basis reduction”will have occurred.

As described above, however, a stuffing allocation has no economic effect.  It does not affect  distributions and is therefore invalid.  Depending upon the character of the allocated loss, a stuffing allocation may also alter the net tax liability of the withdrawing investor.

U.S. Income Portfolios: Other Pass-through Entities 
  Portfolio 736-1st: Hedge Funds 
  Detailed Analysis 
  VI. Special Tax Issues for the General Partner and Its Members

A. Carry as a Profits Interest 

As described more fully in III, C, above, the general partner usually receives the right to a percentage (usually 20%) of the aggregate net gains of the fund on its portfolio investments. The general partner receives the interest for services. In this sense, a portion of the capital of the other investors “carries”the general partner.  The grant and subsequent allocation of the carried interest presents a number of tax issues, beginning with the consequences of the grant itself.180
——————————————————————————————

180 Some funds, in particular offshore “feeders” with tax-exempt and foreign investors, structure the carry as a fee, the payment of which may be deferred to future periods.  For a discussion of the tax issues associated with fee deferrals, see VI, B, below.

——————————————————————————————

1. Receipt of a Profits Interest as a Tax-Free Transaction 

Until Treasury issued proposed regulations on May 24, 2005, the treatment of the grant of a profits interest in a partnership for services was settled law.181 This was not always so.  Before 1993, the proper tax treatment of the grant of a profits interest for services was unclear, a subject of frequent litigation and much debate among practitioners.
——————————————————————————————

181 For a discussion of these regulations and their application to hedge funds, see VI, A, 4, below.

——————————————————————————————

2. The Historical Treatment of a Profits Interests Issued for Services 

Before 1971, many regarded the tax-free character of the grant of a profits interest as a foregone conclusion.  Although neither the IRS nor the courts had squarely addressed the issue, some relied on common law principles.182 Others relied upon the apparent negative inference from Regulations § 1.721-1(b)(1), which provides that the nonrecognition rule of  § 721 does not apply “[t]o the extent that any of the partners gives up any part of his right to be repaid his contributions (as distinguished from a share in partnership profits) in favor of another partner as compensation for services.”183 The italicized language, they contended, evidenced an intent to extend  § 721 to the grant of a profits interest for services.  In Diamond v. Comr.,184 however, the IRS disavowed any such intent and both the Tax Court and Seventh Circuit agreed.
——————————————————————————————

182 In an early edition of a prominent treatise, for example, Arthur Willis wrote the following:

However obliquely the proposition is stated in the regulations, it is clear that a partner who receives only an interest in future profits of the partnership as compensation for services is not required to report the receipt of his partnership interest as taxable income. The rationale is two-fold. In the first place, the present value of a right to participate in future profits is usually too conjectural to be subject to valuation. In the second place, the service partner is taxable on his distributive share of partnership income as it is realized by the partnership. If he were taxed on the present value of the right to receive his share of future partnership income, either he would be taxed twice, or the value of the right to participate in partnership income must be amortized over some period of time.

Arthur B. Willis et al., Partnership Taxation, 84-85 (1971).

183 Emphasis added.

184 56 T.C. 530 (1971), aff'd, 492 F.2d 286 (7th Cir. 1974).

——————————————————————————————

In Diamond, the taxpayer entered into a joint venture with Kargman for the purchase of an office building. Under the terms of the venture, Diamond agreed to arrange for debt financing on the property and Kargman agreed to fund the equity contribution. For that service, Diamond received a 60% share of any profit or loss after Kargman had recovered his capital contributions.  The purchase closed on February 18, 1962, and three weeks later Diamond sold his entire interest in the property to a third party for $40,000.  Diamond did not report the receipt of the profits interest as taxable compensation. The IRS disagreed, contending that the $40,000 represented service income.  Diamond argued that the receipt of the profits interest was exempt from tax under Regulations  § 1.721-1(b)(1) and that the subsequent sale of the interest generated a short-term capital gain.

The Tax Court held that the receipt of the profits interest was taxable to Diamond, reasoning that had Diamond received an interest in capital rather than an interest in profits, he would have included the value of the interest in income under § 61.  The Tax Court also held that “a contribution of services is not a contribution of ‘property.’”185 Characterizing the parenthetical language in the regulation cited above as, at best, “obscure,”it found nothing in the regulation to suggest that  § 721 applied to a partner who received an interest in exchange for services:
——————————————————————————————

185 Diamond, 56 T.C. at 545.

——————————————————————————————

[W]e cannot believe that the Regulations were ever intended to bring  § 721 into play in a situation like the one before us.  The Commissioner disavows such intention, and we agree with him.186

——————————————————————————————

186 Id. at 545-546.

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The Seventh Circuit affirmed, finding that the profits interest in question, having been sold for $40,000 three weeks after the grant date, had a readily ascertainable fair market value. The court acknowledged, however, that a profits interest may have only speculative value in other circumstances.187
——————————————————————————————

187 492 F.2d 286 (7th Cir. 1974).

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After Diamond, the IRS did not challenge every receipt of a profits interest for services as a taxable transaction.  It even considered the release of a formal announcement that it would not follow the Diamond decision when a partner, rather than an employee, received a profits interest for services.188 Although the IRS never issued the ruling, it litigated only four cases in the twenty years since Diamond.189
——————————————————————————————

188 See GCM 36346 (7/25/77).

189 For a detailed discussion of GCM 36346 and the IRS's position in the two decades following Diamond, see McKee, Nelson &  Whitmire, Federal Taxation of Partnerships and Partners at ¶  5.02[3] (3rd ed. 1997).

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Then, in 1990, the Tax Court followed Diamond  in Campbell v. Comr.190 In Campbell, the taxpayer had received limited partnership interests in exchange for services performed in connection with the formation and syndication of three limited partnerships.  As a special limited partner, Campbell was entitled to a portion of the residual profits after payment of a priority return to the other partners.  As in Diamond, the IRS argued that Campbell should have included the fair market value of the interest in income.  The Tax Court agreed, holding that no provision of the Code exempted the receipt of a profits interest for services from tax.191 In contrast to Diamond, however, the profits interest in Campbell had no readily ascertainable value.
——————————————————————————————

190 59 T.C.M. (CCH) 236 (1990), rev'd on this issue, 943 F.2d 815 (8th Cir. 1991).

191 Id.

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The Eighth Circuit reversed on appeal,192 finding that the interest in question was “without fair market value at the time [of receipt] ...and should not have been included in ... income for the years in issue.”193 The court also found that Regulations § 1.721-1(b)(1) afforded “[s]ome justification ... for treating service partners who receive profits interests differently than those who receive capital interests.”194 Ultimately, however, the court declined to settle the issue as a matter of law, confining its holding to a profits interest with speculative value.195 Following this decision, the IRS issued Revenue Procedure 93-27.
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192 943 F.2d 815 (8th Cir. 1991).

193 Id. at 823.

194 Id. at 822.

195 See also St. John v. U.S., 53 A.F.T.R.2d 83-718 (C.D. Ill. 1983) (applying “liquidation analysis” to conclude that profits interest had no value on receipt); Kenroy, Inc. v. Comr., T.C. Memo 1984-232 (same); Hale v. Comr., T.C. Memo 1965-274 (stating in dicta that profits interest did not constitute taxable income on receipt).

——————————————————————————————

3. Revenue Procedure 93-27 

In Revenue Procedure 93-27,196 the IRS announced that it would no longer challenge the receipt of a profits interest for services as a tax-free transaction. While dismissed by one commentator as a “masterpiece of cowardice,”197 most praised the announcement for lending much-needed clarity to a vexing issue of fundamental importance to subchapter K.
——————————————————————————————

196 1993-2 C.B. 343.

197 See Sheppard, “Massive Giveaway in Partnership Compensatory Options Regs,” 107 Tax Notes 1487, 1488 (June 20, 2005).

——————————————————————————————

Revenue Procedure 93-27 applies to a partnership interest issued to or for the benefit of a partnership in a partner capacity or in anticipation of becoming a partner.  It defines a “profits interest” in the negative as any interest in a partnership other than a “capital interest.”  A “capital interest”is “an interest that would give the holder a share of the proceeds if the partnership's assets were sold at fair market value and then the proceeds were distributed in a complete liquidation of the partnership,”as determined on the date of grant.

The self-imposed injunction of the revenue procedure does not apply, however, to any profits interest related to a substantially certain and predictable stream of income from partnership assets, such as income from a high-quality debt security or net lease, to a profits interest that the holder sells within two years, or to a profits interest in a “publicly-traded partnership” under § 7704(b).198 Although the revenue procedure fails to address a number of issues, among them the effect of vesting restrictions on the grant of a profits interest, it has largely achieved its intended purpose of eliminating longstanding uncertainty in the law.
——————————————————————————————

198 The tax-free treatment of a profits interest granted under Rev. Proc. 93-27 was later expanded to include receipt of a profits interest in a partnership even if the interest was subject to a substantial risk of forfeiture and the recipient made no election under  § 83(b) of the Code.  See Rev. Proc. 2001-43, 2001-34 I.R.B. 191, discussed in VI, C, 1, c, below.

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4. The Proposed Regulations 

On May 24, 2005, Treasury issued proposed regulations addressing the taxation of a partnership interest issued for services. The proposed regulations would apply to all compensatory partnership interests issued on or after the date of final regulations.199 Until then, Revenue Procedure 93-27 will remain in effect.  As described in VI, A, 3, above, Revenue Procedure 93-27 generally provides for the tax-free grant of a profits interest for services “to or for the benefit of” the issuing partnership. Together with the proposed regulations, Treasury also issued a proposed revenue procedure that would obsolete Revenue Procedures 93-27 and 2001-43 upon the effectiveness of final regulations.200
——————————————————————————————

199 See REG-105346-03, 70 Fed. Reg. 29675 (5/24/05).

200 Notice 2005-43, 2005-24 I.R.B. 1221.

——————————————————————————————

It would be difficult to overstate the significance of the proposed regulations to hedge funds and other investment partnerships. First, the proposed regulations formally extend  § 83 to the grant of the incentive allocation, resurrecting the issue that the IRS seemed to have interred in 1993: whether the grant of a profits interests for services is a taxable event.  Second, the proposed regulations attempt to resolve fundamental and longstanding discontinuities between  § 83 and subchapter K.

The proposed regulations confirm for the first time by regulation that  § 83 indeed applies to the grant of a profits interest for services.201 In doing so, they make no distinction between a capital interest and a profits interests.202 Accordingly, absent a timely  § 83(b) election, a holder of an unvested partnership interest issued for services is not a “partner”until the interest vests.  If the holder does make an  § 83(b) election, he or she will qualify as a partner on the date of grant.203 As discussed in VI, C, 1, c, below, therefore, the proposed regulations reach the opposite conclusion of Revenue Procedure 2001-43.  In Revenue Procedure 2001-43, the IRS announced that it would treat the recipient of an unvested partnership interest as a partner on the date of grant even without an  § 83(b) election so long as the grant satisfied certain conditions.
——————————————————————————————

201 Although proposed regulations issued in 1971 would have applied  § 83 to the grant of a capital interest for services, the regulations were never finalized.  See Prop. Regs. § 1.721-1(b)(1), 36 Fed. Reg. 10787 (6/3/71).

202 See Regs.  § 1.83-3(e) (defining ‘property’as “real and personal property other than either money or an unfunded and unsecured promise to pay money or property in the future”);Prop. Regs. § 1.83-3(e) (adding following gloss: “accordingly, property includes a partnership interest”); see also Preamble to the proposed regulations, REG-105346-03, 70 Fed. Reg. 29675 (5/24/05).

203 Id.

——————————————————————————————

a. The Basic Conflict between § 83 and Subchapter K 

Subchapter K measures each partner's interest in a partnership by capital accounts, reflecting the basic principle that an allocation of profit and loss has “substantial economic effect” only if each partner is entitled to receive its positive capital account balance no later than upon a sale by the partnership of its assets followed by a liquidating distribution. Section 83, on the other hand, taxes the service provider upon receipt of property at its then-fair market value.  If the property in question is a profits interest, therefore, traditional  § 83 principles would tax the service provider upon receipt of a profits interest even though the service provider receives an opening capital account balance in the partnership of zero. It is here, therefore, that the principles  § 83 and subchapter K first diverge: while one regime embraces “option value,” the other seems to recoil from it.204 A profits interest is nothing if not option value.  Unless subchapter K ignores it, therefore, a capital account balance cannot be said to truly reflect each partner's “correct”economic interest in the net assets of the business.
——————————————————————————————

204 Subchapter K has been aptly described as a “sealed system.” See New York State Bar Association Tax Section, “Report on the Proposed Regulations and Revenue Procedures relating to Partnership Equity Transferred in Connection with the Performance of Services,” 109 Tax Notes 1311(Oct. 26, 2005) (“As a general matter, subchapter K is an intricate, sealed system in which a seemingly simple transaction can trigger numerous ancillary tax consequences. For example, provisions in § § 704(b), 704(c), 737, and elsewhere are designed to ensure that the taxable income, gain, deduction, and loss will be allocated to the partner who received the economic benefit or burden of the item, and provisions in § § 705, 707, 722, 723, 731, 732, 733, 734, 743, 754, and elsewhere are designed to ensure that income, gains, deductions, and losses will be taken into account only once by the partners”).  As such, it does not easily digest principles like present value or option value.  Subchapter K prefers to “keep score” by capital account balances, requiring a partnership to measure each partner's equity interest in the business at liquidation value.

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A second, even more deeply-embedded conflict between the two regimes concerns the treatment of unvested equity. By virtue of an  § 83(b) election, a service provider becomes a “partner” for tax purposes upon receipt of an unvested partnership interest.  As such, the issuing partnership must allocate profit and loss to the service provider between the date of grant and the date of vesting.  Under the  § 704(b) regulations, however, an allocation is not valid unless it has substantial economic effect.205 So here is the paradox: an allocation of profit to a holder of an unvested partnership interest has no economic effect.206 In fact, the “correct”allocation remains unknown throughout the pre-vesting period: if the interest vests, the intervening “build-up”in the partner's capital account will inure to the service partner;if it does not vest, the very same build-up will revert  to the other partners.  The proposed regulations nevertheless validate the “pre-vesting”allocation of income to a service partner if the partnership agreement requires the partnership to make future “forfeiture allocations” and the other material allocations under the partnership agreement have substantial economic effect.207
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205 § § 704(a), 704(b)(1);  see also Regs. § 1.704-1(b)(1)(i).

206 The proposed regulations acknowledge this conflict, providing that “if a  section 83(b) election has been made with respect to a substantially nonvested interest, the holder of the nonvested interest may be allocated partnership income, gain, loss, deduction, or credit (or items thereof) that will later be forfeited,”even though “allocations of partnership items while the interest is substantially nonvested cannot have economic effect.” See Prop. Regs. § 1.704-1(b)(4)(xii)(a).

207 Prop. Regs. § 1.704-1(b)(4)(xii)(b). For a fuller discussion of “forfeiture allocations” under the proposed regulations, see VI, C, 4, below.

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As described below, the proposed regulations sanction alternative reporting, conceding the intrinsic conflict between the two regimes.  Under the general reporting rule,  § 83 principles would govern the grant of a compensatory partnership interest, requiring the use of full fair market value to measure compensation income.  Under a safe harbor alternative, however, the parties may instead use “liquidation value” to measure compensation income, provided that the partnership complies with a number of conditions.208 For all intents and purposes, therefore, the safe harbor reinstates Revenue Procedure 93-27, but under a more rigorous set of ground rules.209
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208 Prop. Regs. § 1.83-3(l).

209 Much of this complexity is intended to foreclose “whipsaw.” Unlike the corporate employee, however, the grantee of a profits interest has nothing to gain from inconsistent reporting.  It will make the  § 83(b) election upon receipt of an unvested profits interest because the cost associated with the election in the corporate context, current income, is zero in the partnership context.  Rather, the inconsistent reporting will tend to occur when both the service provider and the issuing partnership report the receipt of a profits interest at a zero liquidation value, but a partner other than the service provider then invokes traditional  § 83 principles to claim a compensation deduction.  The safe harbor regime therefore amounts to an effective waiver of the right to argue  § 83 on the merits by requiring advance consent to the use of liquidation value by all partners.

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The proposed regulations define “liquidation value” as the amount that the service provider would receive if, immediately after the transfer, the partnership were to sell all of its assets (including goodwill, going concern value, and any other intangibles associated with the partnership's operations) at fair market value and then liquidate.  A true profits interest, therefore, has a liquidation value of zero.  If the liquidation value exceeds zero, the interest in question is a capital interest and the parties must therefore report the excess value as compensation.  In such as case, the service provider would report compensation income under § 83 and receive capital account credit for the amount so included.210 The historic partners, on the other hand, would incur compensation expense, resulting in a corresponding debit to their capital accounts.211 Finally, the timing rules under  § 83 override the timing rules of § 707(c).
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210 Prop. Regs. § 1.704-1(b)(2)(iv)(b)(1).

211 § 83(h).

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b. The Safe Harbor for SHPIs 

Under the proposed regulations, a partnership may invoke the safe harbor only under the following conditions:

First, the partnership must prepare and file a document with its tax return stating that the partnership is electing, on behalf of itself and each of its partners, to apply the safe harbor to all partnership interests transferred in connection with the performance of services while the election remains in effect.212
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212 Prop. Regs. § 1.83-3(l).

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Second, either the partnership agreement or a separate document executed by each partner must include “legally binding” provisions authorizing the partnership to effect the safe harbor election and requiring the partnership and each of its partners to comply with all of the requirements of the safe harbor.213
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213 Prop. Regs. § 1.83-3(l).

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Third, even if a partnership satisfies these conditions, the safe harbor itself will apply only to a “safe harbor partnership interest” (“SHPI”).214
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214 Notice 2005-43, 2005-24 I.R.B. 1221 (§ 3.02 of proposed revenue procedure).

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A SHPI is a partnership interest transferred for services provided to the partnership either before or after its formation, provided that (i) the interest is not related to a substantially certain and predictable stream of income from partnership assets, such as income from high-quality debt securities or a high-quality net lease; (ii) is not transferred in anticipation of a subsequent disposition; and (iii) is not an interest in a “publicly traded partnership” under § 7704(b).215 Absent “clear and convincing”evidence to the contrary, a partnership interest is presumed to be transferred “in anticipation of a subsequent disposition”if the interest is sold or disposed of within two years of the date of grant or is subject to a right to buy or sell regardless of when such right is exercised (other than any such right arising by reason of death or disability).
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215 Notice 2005-43, 2005-24 I.R.B. 1221 (§ 3.02 of proposed revenue procedure.).  For a fuller discussion of the application of the PTP regime to hedge funds, see IV, C, above.

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Finally, the safe harbor election will terminate if the partnership fails to satisfy each of these requirements or if any party reports the grant in a manner that is inconsistent with the proposed revenue procedure.216 Once the election is terminated, a partnership may not “reelect” under the safe harbor without the consent of the Commissioner for five years.217
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216 Notice 2005-43, 2005-24 I.R.B. 1221 (§ 3.04 of proposed revenue procedure).

217 Notice 2005-43, 2005-24 I.R.B. 1221 (§ 3.05 of proposed revenue procedure).  The five-year rule also applies to any “successor partnership,” defined as “any partnership that (1) on the date of termination, is related (within the meaning of  § 267(b) or  § 707(b))to the partnership whose Safe Harbor Election has terminated (or, if the partnership whose Safe Harbor Election has terminated does not exist on the date of termination would be related if it existed on such date), and (2) acquires (either directly or indirectly) a substantial portion of the assets of the partnership whose Safe Harbor Election has terminated.” Id.

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c. Application to Hedge Funds 

The scope of the proposed regulations and related revenue procedures raises a number of issues for hedge fund portfolio managers and their members.  First, although the proposed regulations apply only to the transfer of an interest for services after the date that they become final, the general partner of an existing fund is likely to grant sub-interests in the incentive allocation to future members.  As a practical matter, therefore, the “grandfathering”of existing partnerships will extend only to service grants from the entity before the effective date, not to the entity itself.  Second, many sponsors form the portfolio manager as an offshore entity.  Because the safe harbor election must be “legally binding” on all parties, the validity of certain elections may therefore depend upon the vagaries of foreign law.  Third, as described in VI, C, 2, below, the hedge fund sponsor may have decided to split the general partner and the portfolio manager into two entities, one to hold the carried interest and the other to manage the fund.  In such a case, the general partner will have granted an interest in the underlying carry in consideration of services to an affiliate of the general partner, not to the general partner itself.  Revenue Procedure 93-27 arguably applies even in a “bifurcated” fund structure because it refers to the grant of a profits interest in exchange for services “to or for the benefit of” the issuing entity.  The proposed regulations, however, apply only to a partnership interest issued for services “to”the issuing partnership.218
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218 In the preamble to the proposed regulations, the IRS requested comments on the proper tax consequences of transactions involving affiliated entities, including the transfer of an interest in a lower-tier partnership in exchange for services provided to the upper-tier partnership.  REG-105346-03, 70 Fed. Reg. 29675 (5/24/05).

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5. Should the General Partner and Its Members Contribute Capital? 

To achieve pass-through treatment, the general partner and its members must qualify as “partners” of their respective entities for tax purposes.219 If they qualify as partners, they will report their allocable share of the income of the fund in accordance with its underlying character.
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219 See  § 702(a)(1) and (2); see generally 710 T.M., Partnerships;Overview, Conceptual Aspects and Formation.

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Generally, a person should not fail to qualify as a partner for want of a capital contribution.  Indeed, Revenue Procedure 93-27 presupposes that a person who receives an interest solely for services may qualify as a partner for tax purposes.220 Many practitioners nevertheless advise that the general partner and its members contribute capital for two reasons.  First, the contribution tends to clarify the status of a person as a “partner” for tax purposes.  The basis for the concern is that, without capital at risk, the putative partner may bear no risk of loss in the venture.221 A capital contribution therefore eliminates ambiguity in special cases, in particular when the tax status of the person is amenable to alternative characterizations(e.g., employee, independent contractor) or is not consistent with the legal form.222 Nevertheless, if a person is legally a member of an entity treated as a partnership under state law, shares in the future profits of that entity and participates in management, he should be respected as a partner for tax purposes whether or not he makes a capital contribution.  Second, the service element of the consideration is arguably less apparent when the partner acquires its interest for property.  Without the service element, the status of the interest as a profits interest rather than a capital interest is less significant because the recipient need not depend upon the vagaries of Revenue Procedure 93-27 to avoid a taxable event — § 721 applies by its terms to the issuance of a partnership interest for property.
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220 See also Diamond v. Comr., 56 T.C. 530 (1971), aff'd, 492 F.2d 286 (7th Cir. 1974) (taxpayer who contributed no capital respected as a partner for tax purposes).

221 See Luna v. Comr., 42 T.C. 1067, 1077-8 (1964) (extent of capital contributions and obligation to share losses cited as evidence of partner status).

222 See Luna v. Comr., 42 T.C. at 1078 (taxpayer sought to characterize employment contract as constructive partnership);Weigel, “Private Investment Fund Interests Held by Employees —Campbell,  Section 83(b) and Other Considerations,” Tax Forum No. 543 (June 5, 2000) (capital contribution tends to establish that member is acting in partner capacity).

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6. Self-Employment Taxes 

The general partner will usually contribute capital to the fund as partial consideration for the carried interest.223 Certain members of the general partner, however, may receive their interest in the underlying carry without funding any portion of this contribution.  So long as such member qualifies as a “partner”for tax purposes, however, he should also avoid self-employment tax, which does not apply to carry allocations of interest, dividends or capital gains.224
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223 A carried interest is similar to a long call option: although it participates in future appreciation, it bears no risk of loss.  Without risk of loss, a holder of an option will tend to prefer riskier investments than would a holder of stock. To temper this preference, investors typically demand that the general partner contribute capital to the fund.

224 See  § § 1402(a)(2) (dividends and interest), 1402(a)(3)(A) (gain from sale of capital asset).  As described more fully in VIII, C, below, structuring the carry as a partnership allocation also conveys an effective deduction to U.S. individual investors who might otherwise bear tax on a portion of the general partner's compensation.

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U.S. Income Portfolios: Other Pass-through Entities 
  Portfolio 736-1st: Hedge Funds 
  Detailed Analysis 
  VI. Special Tax Issues for the General Partner and Its Members

B. Carry as a Fee 

1. Why a Fee?/Why Defer? 

The portfolio manager may choose to structure the incentive allocation as a fee.  The fee alternative  produces very different tax consequences, not only to the portfolio manager and its members but to the taxable investors in the underlying fund as well.  Although portfolio managers of private equity funds rarely pursue this alternative, the portfolio manager of a hedge fund may.

A portfolio manager on the accrual method of accounting must report service income when the right to the income becomes fixed and determinable.225 A portfolio manager on the cash method of accounting must report service income upon receipt, including “constructive” receipt.  If the right to participate in portfolio gains is a partnership allocation, however, the portfolio manager will report the income in accordance with the timing and character of the income at the fund level, regardless of its own method of accounting.226
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225 This discussion assumes that the portfolio manager and general partner operate as single entity, receiving both the incentive allocation/fee and the periodic management fee.  As discussed in VI, C, 5, below, the portfolio manager and general partner often operate as separate entities.

226 § 702(a).

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As described in VIII, A, below, many hedge funds do not generate substantial amounts of long-term capital gain.  They instead tend to pursue investment strategies that involve short-term or “tolled” holding periods.227 As a result, the portfolio manager and its members will often bear effective tax rates on the carry that roughly approximate their effective tax rate on service income.228 If the portfolio manager and its members report service income on the cash method of accounting, however, they will defer tax on this species of income until receipt, without regard to when the fund realizes the underlying gains.
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227 For a discussion of common investment strategies among hedge funds, see I, B, above.

228 Because hedge funds generate investment income, the portfolio manager and its members will avoid self-employment taxes if they receive their share of the portfolio gains as a partnership allocation.  See  § § 1402(a)(2) (“net earnings from self-employment” excludes dividends and interest), 1402(a)(3)(A) (“net earnings from self-employment” excludes gain from sale of capital asset).  In addition, fee income may attract incremental tax at the state and local level.  As described in VI, C, 5, below, for example, a portfolio manager operating in New York City is subject to Unincorporated Business Tax.

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To the investors in the fund, the carry is just another expense.  A taxable U.S. investor, whether individual or corporate, will prefer to bear this expense as a partnership allocation, even if the fund generates nothing but short-term gains.  If structured as a fee, the carry will instead produce “investment expense”under  § 212 unless the fund is a “trader” rather than an “investor.”As described in VIII, A, below, the Code limits the deduction of these expenses to individual investors.  If the fund also defers payment of the fee, both individual and corporate investors in the fund will bear tax on 100% of the portfolio gains during the deferral period, including the portion earmarked for future payment to the portfolio manager.  A direct allocation of 20% of the portfolio gains to the portfolio manager, on the other hand, will effectively convey a current deduction to these investors regardless of when the portfolio manager receives the correlative distribution.

As discussed in VII, A, below, tax-exempt and foreign investors are generally exempt from net basis taxation in the United States on their hedge fund returns.  As such, they will not derive a tax benefit from their allocable share of the fund expenses.  For this subset of investors, therefore, the decision to structure the incentive allocation as a fee should not increase their effective U.S. tax rate.  This is one reason that a portfolio manager may choose to form the offshore feeder as a separate vehicle for its tax-exempt and foreign investors.  By segregating the “tax indifferent” capital within a separate entity, it will have greater flexibility to structure the incentive allocation as a partnership interest to one group of investors and as a deferrable fee for services to the other.229 If the portfolio manager and its members then opt to defer and reinvest the fee in the master fund, they will avoid immediate tax on their participation in the carried interest until actual receipt of the fee and the earnings thereon, which may not occur for many years.
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229 As described more fully in VII, C, 1, below, a corporate feeder may also allow tax-exempt investors to avoid UBTI on the debt-financed returns of the feeder.

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In a master-feeder fund, therefore, the portfolio manager often structures the portion of the incentive arrangement attributable to the “feeder” capital as a fee for services, deferring receipt of all or a portion of the fee until a future period. Any amount so deferred will usually remain invested in the fund (or in a segregated account) and will therefore continue to participate on a pre-tax basis in future gains.

Example 6-1: GP is the portfolio manager of ABC, an offshore hedge fund organized as a corporation with assets under management of $100 million.  ABC regularly turns over its portfolio, generating short-term gains and other income that would bear tax at the investor level at a 35% rate.  Under a management contract, GP is entitled to 20% of the net gains from the portfolio as a fee for services.  GP timely elects to defer its right to the first year fee for ten years. At the end of the first year, the assets of the hedge fund have appreciated to $200 million, generating an accrued fee of $20 million. At the end of Year 11, ABC pays the deferred fee (in addition to the earnings thereon) to GP.  The members of GP incur an aggregate tax liability on the deferred fee at that time of $7 million.  Assuming a discount rate of 7%, the present value of this tax as of the end of Year 1 is $3.5 million.  Ignoring employment taxes, therefore, GP bears an effective tax rate on the deferred fee of 17.8%.

Tax deferral over a protracted period conveys a substantial benefit to the portfolio manager.  Tax-exempt and foreign investors not only accept but encourage these arrangements because the incentive of the portfolio manager to defer tax by deferring receipt happens to coincide with the desire of the investors that the portfolio manager leave its capital in the fund.  With more capital at risk, the portfolio manager is less prone to exploit the option value inherent in the carried interest.

2. Requirements for Deferral 

a. Cash Method of Accounting 

An accrual basis taxpayer must report gross income when all events that establish the taxpayer's right to the income and the amount thereof become determinable with reasonable accuracy.230 Under the “all events”test, the taxpayer has income when performance is complete, when payment is due, or when payment is made, whichever occurs first.231 Accordingly, an accrual method portfolio manager may not defer recognition of the incentive fee merely by postponing its receipt.232
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230 § 451(a); Regs. § 1.446-1(c)(1)(ii).

231 Rev. Rul. 84-31, 1984-1 C.B. 127.

232 See, e.g., FSA 200102008 (service provider must accrue management fees at year end where services were performed and amount payable can be reasonably estimated).

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A cash basis taxpayer reports gross income upon actual or constructive receipt.233 Unlike the accrual method, the cash method does not depend upon when the right to income becomes fixed and determinable. As described below, therefore, a portfolio manager on the cash method of accounting may defer an incentive fee beyond the taxable year of service if the deferral meets certain conditions.
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233 Regs. § 1.446-1(c)(1)(i).

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A threshold inquiry in any fee deferral is whether the portfolio manager is eligible to report on the cash method of accounting.  A taxpayer may choose any method of accounting prescribed by the Code or regulations so long as that method clearly reflects income.234 Section 448, however, prohibits reporting on the cash method by most C corporations, by most partnerships with a C corporation partner, and by any “tax shelter.”235
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234 § 446(a) (exclusions);  § 446(b) (exceptions to exclusions).

235 The IRS also has authority to require the accrual method when the taxpayer's chosen method of accounting does not clearly reflect income.  Regs. § 1.448-1T(c).  The clear reflection standard requires that income “be reflected with as much accuracy as standard methods of accounting practice permit.” Caldwell v. Comr., 202 F.2d 112 (2d Cir. 1953).

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As described in IV, A, above, the sponsor will usually form the portfolio manager as a partnership for tax purposes.  A portfolio manager organized as a partnership may report income on the cash method of accounting if it does not have a C corporation as a partner at any time during its taxable year, provided that it is not a “tax shelter.”236 For this purpose,  § 448 treats both a trust that generates UBTI under  § 511(b) and a partnership that has a C corporation partner as a C corporation.237 A portfolio manager on the cash method of accounting, therefore, is likely to prohibit transfers to these entities.238 Subject to the “clear reflection” requirement, a partnership may use the cash method of accounting even if one or more of its non-corporate partners reports on the accrual method of accounting.239
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236 Regs. § 1.448-1T(a)(2). Under § 448(b)(2), a C corporation does not include a “qualified personal service corporation.”  Moreover, a partnership with a C corporation as a partner may use the cash method of accounting if the partnership, for every prior taxable year beginning after December 31, 1985, generates no more than $5 million in average annual gross receipts for the three-year period ending with each such prior taxable year. See § 448(b)(3), (c); Regs. § 1.448-1T(f)(1), (f)(3) (Ex. 3);  see also Temp. Regs.  § 1.448-1T(f)(2)(ii) (gross receipts aggregated under  § 448(c)(2) for all persons treated as single employer under § 52(a) or (b) or  § 414(m) or (o)).

237 § 448(d)(6); Regs. § 1.448-1T(a)(3).

238 See Bowers &  Albaral, “Planning to Avoid the Cash Basis Limitations Under the New Temp. Regs.,”67 J. Tax'n 204 (Oct. 1987). A tax-exempt or foreign investor will occasionally acquire an interest both in the underlying fund and in the portfolio manager. By acquiring an interest in the portfolio manager, the investor usually seeks to reduce its effective carry percentage vis-à-vis the other investors. If the portfolio manager has structured the carry as a fee, however, the grant of an interest therein to such an investor will often preclude the reporting of income on the cash method of accounting.

239 § 703(b) (election affecting computation of taxable income derived from partnership must be made by partnership); Fong v. Comr., T.C. Memo 1984-402 (holding that, prior to enactment of § 448, cash method of accounting clearly reflected income of service partnership even though corporate partners reported on accrual method).

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A portfolio manager may not use the cash method of accounting if it is a “tax shelter.”240 A “tax shelter”includes the following:241
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240 See  § 448(a)(3) (excluding “tax shelters”).

241 § 448(d)(3).

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• any “enterprise”(other than a C corporation) if at any time interests in such enterprise have been offered for sale in any offering required to be registered with any Federal or State agency;242
  
• any “syndicate,”which includes any partnership or other entity if more than 35% of the losses of such entity during the taxable year are allocable to limited partners;243 and
  
•any “tax shelter” within the meaning of § 6662(d)(2)(C)(ii).244

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242 § 461(i)(3)(A).  An offering is required to be registered if, under applicable federal or state law, failure to register the offering would result in a violation of the applicable federal or state law.

243 § 461(i)(3)(B); § 1256(e)(3)(B).

244 § 461(i)(3)(C).

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A portfolio manager is not an “enterprise”because it does not offer its interests in registered offerings.

A profitable portfolio manager is not a “syndicate,”even if it allocates more than 35% of its profits and losses to limited partners.245 The regulations define “losses” as the excess of allowable deductions over recognized income, excluding any gain or loss from the sale of capital assets or assets described in § 1221(2).246 The regulations clarify that a partnership is a “syndicate” if more than 35% of the losses recognized in a taxable year are allocated to limited partners.247 If the portfolio manager generates a loss under its method of accounting, therefore, it may avoid status as a syndicate by allocating no more than 35% of the loss to its limited partners.248
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245 PLR 9321047 (“classification as a syndicate and [the] prohibition from using the cash method of accounting depends on how [a partnership's] members are classified and how its losses are allocated”).

246 Regs. § 1.448-1T(b)(3).

247 Id.

248 See Bowers &  Albaral, “Planning to Avoid the Cash Basis Limitations Under the New Temp. Regs.,”67 J. Tax'n 204, 205 (Oct. 1987).  A limited partner includes any person that does not actively participate in management. Regs. § 1.448-1T(b)(3); § 1256(e)(3)(C).

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Section 6662(d)(2)(C)(ii) defines a “tax shelter”to include any partnership or other entity, any investment plan or arrangement, or any other plan or arrangement, if a significant purpose of such partnership, entity, plan or arrangement is the avoidance or evasion of federal income tax.  The sponsor forms the portfolio manager to manage the underlying fund, not to serve a tax avoidance purpose.  Accordingly, the portfolio manager is not a “tax shelter.”249
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249 In 2001, however, the IRS issued a “30 day letter” to III Offshore Advisors, a portfolio manager of a $2.5 billion bond hedge fund.  In the 30 day letter, the IRS asserted that the portfolio manager was a “tax shelter”under  § 448(a)(3) and was therefore ineligible to report the incentive fee on the cash method. The portfolio manager had deferred and reinvested approximately $192 million of incentive fees from 1994 through 1997, electing to reinvest them in the fund on a pre-tax basis.  In support of its characterization of the portfolio manager as a tax shelter, the IRS stated that a new entity had assumed all of the rights and obligations of an affiliate to provide the same investment management services only because the affiliate had elected to report income on the accrual method of accounting, and not for any “economic reason.”  The IRS also asserted that the new entity lacked a business purpose and was created solely for the “improper deferral of income.” The authors understand that the IRS settled the case before trial in 2004 on undisclosed terms.

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b. Constructive Receipt Issues 

To achieve deferral, a portfolio manager on the cash method of accounting must avoid both actual and “constructive”receipt of the accrued incentive fee.  The regulations define the doctrine of constructive receipt as follows:

Income although not actually reduced to a taxpayer's possession is constructively received by him in the taxable year during which it is credited to his account, set apart for him, or otherwise made available so that he may draw upon it at any time, or so that he could have drawn upon it at any time during the taxable year if notice of intention to withdraw had been given.  However, income is not constructively received if the taxpayer's control of its receipt is subject to substantial limitation or restrictions.250

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250 See Regs. § 1.451-2(a).  For a more complete discussion of the doctrine of constructive receipt, see 385 T.M., Deferred Compensation Arrangements.

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The IRS has published guidance on the application of the constructive receipt doctrine to various types of deferral arrangements.251 Although constructive receipt is a factual determination, “[a] mere promise to pay, not represented by notes or secured in any way, is not regarded as a receipt of income within the intendment of the cash receipts and disbursements method.”252 An agreement between a cash basis author and a publisher to defer the payment of unearned royalties on future book sales was therefore sufficient to defer tax on the royalties until receipt.253 A cash basis taxpayer is deemed to receive property that is unconditionally and irrevocably paid to a fund or trust for the taxpayer's sole benefit.254
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251 See, e.g., Rev. Rul. 60-31, 1960-1 C.B. 174 (“a determination of whether the doctrine of constructive receipt is applicable must be made upon the basis of the specific factual situation involved”).

252 Id.; PLR 199906008.

253 See Rev. Rul. 60-31, 1960-1 C.B. 174 (Ex. 3).

254 Sproull v. Comr., 16 T.C. 244 (1951) (employer's transfer in trust for benefit of taxpayer employee conferred economic or financial benefit on taxpayer taxable upon establishment of trust).

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The IRS will not rule on the issue of constructive receipt for any unfunded deferral arrangement unless the service provider elects to defer receipt before the beginning of the taxable year of service.255 In most cases, the relevant period of service is the taxable year of the service provider, usually the calendar year.256 The plan must also define the time and method of payment for each event that would entitle the service provider to payment.257 Finally, the plan must provide that (i)the service provider is a general unsecured creditor; (ii) the plan is a mere unfunded promise to pay in the future;258 and (iii) the rights of the service provider are non-transferable and may not be encumbered by creditors of the service provider.259 Any amounts deferred by the service provider after the beginning of the period of service must be subject to substantial forfeiture provisions.260
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255 Rev. Proc. 92-65, 1992-2 C.B. 428, modifying Rev. Proc. 71-19, 1971-1 C.B. 698; see also Rev. Proc. 2009-3, 2009-1 I.R.B. 107 (“no rule” policy extends to the tax consequences of unfunded deferred compensation arrangements that do not satisfy requirements of Rev. Proc. 92-65 and Rev. Proc. 71-19). Rev. Proc. 92-65 provides two exceptions to this rule relating to new plans and new participants in existing plans.  It should be noted, however, that these are merely ruling guidelines.  Accordingly, the failure of a plan to satisfy these requirements does not necessarily establish constructive receipt. In practice, the revenue procedures often serve as guideposts even though the case law affords more latitude.

256 Rev. Proc. 92-65, 1992-2 C.B. 428.

257 Id.

258 If the arrangement is funded, § 83 may trigger immediate compensation income.  For purposes of applying § 83, property excludes money or an unfunded and unsecured promise to pay money or property in the future.  See Regs. § 1.83-3(e).

259 Rev. Proc. 92-65, 1992-2 C.B. 428.  If amounts payable under a plan are held in trust to assist the employer in meeting its obligations under the plan, the terms of the trust must conform with the model trust provisions contained in Rev. Proc. 92-64, 1992-2 C.B. 422.

260 Rev. Proc. 71-19, 1971-1 C.B. 698.

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3. Fee Deferrals by Hedge Funds before Enactment of § 409A 

Most hedge fund fee deferrals assume the following basic form:

First, the offshore fund and portfolio manager enter into a contract to provide investment management services. The management contract will entitle the portfolio manager to the incentive allocation as a fee for services.

Second, the management contract permits the portfolio manager to defer all or a portion of the fee beyond the taxable year of service (a “Fee Deferral”).261 In accordance with IRS ruling policy, the portfolio manager will make the election before the beginning of the taxable year to which the services relate. Any amounts so deferred will remain invested in the underlying fund, typically in the same manner as the fund's other assets.  As such, the assets that secure ultimate payment of the incentive fee will remain subject to the claims of fund creditors during the deferral period.  In addition, both the actual payment and the amount thereof will depend upon the economic performance of the fund.  In this regard, therefore, fee deferrals tend to align the interests of the portfolio manager with those of the investors.
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261 The deferral arrangement may be the subject of a separate deferral agreement between the offshore fund and the manager.

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Third, the portfolio manager grants a separate participation in the fee to its employees.  As part of this grant, the portfolio manager allows its employees to defer payment of all or a portion of their share of the fee to a future period (an “Employee Deferral”).  If an employee elects to do so, the portfolio manager will make a corresponding deferral election for a like amount of the incentive fee from the fund.  The terms of the Fee Deferral will therefore mirror the terms of the Employee Deferral.262
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262 See New York State Bar Association Tax Section, “Report on  Section 409A of the Internal Revenue Code and Internal Revenue Service Notice 2005-1,”108 Tax Notes 198 (July 11, 2005) (general discussion of back-to-back arrangements); Managed Funds Association, “Comments on Proposed Deferred Compensation Regs,” 2006 TNT 18-35(Jan. 27, 2006) (same).

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Fourth, the fund establishes an account on its books and records for each taxable year in which a valid Fee Deferral is in effect.  The fund then subdivides the account into separate “subaccounts”for each employee.  In any given year, therefore, the sum of the fee deferrals in the subaccounts will equal the aggregate Fee Deferral.

Finally, a subaccount payment event with respect to an employee will trigger a corresponding payment event with respect to the portfolio manager.

Example 6-2: X, the portfolio manager of ABC hedge fund, is a partnership eligible to report income on the cash method of accounting.  X has established a deferred compensation plan (the “Manager Plan”) with its employees, including Dan, who serves as COO.  On December 31, 2005, Dan elects to defer 50% of his 2006 annual bonus.  ABC projects that Dan's 2006 annual bonus will reflect 2% of the aggregate incentive fees from the fund during 2006.  Immediately after Dan's deferral election, X elects to defer 2% of the aggregate management and incentive fees attributable to 2006 pursuant to a separate deferred compensation plan with ABC(the “Fund Plan”).  ABC therefore establishes a subaccount on its books to reflect X's deferral.  The combination of Dan and X's deferral elections constitute a “back-to-back” deferral. The Manager Plan, and therefore the Fund Plan, provide for the payment of any amounts deferred thereunder upon the earlier to occur of (a)December 31, 2010; or (b) (i) Dan's death or disability, (ii) Dan's departure from X; or (iii) an unforeseeable emergency.  On January 31, 2007, Dan quits.  Under the terms of the Fund Plan, X is entitled to the balance credited to Dan's subaccount within ten days after Dan quits.  X has no source of income to satisfy its payment obligation to Dan other than from the corresponding amounts deferred under the Fund Plan.  X therefore pays Dan his deferred compensation under the Manager Plan upon receipt of payment from ABC under the Fund Plan.

The purpose of these arrangements is to defer tax on the future fee.  If effective, therefore, none of the portfolio manager, its partners or its employees will realize compensation income until the fund pays the deferred fee to the portfolio manager at the end of the deferral period.  When the portfolio manager receives the fee and then effects a back-to-back payment to the relevant employee, it will report matching items of compensation income and expense. Accordingly, the payment of the fee first to the portfolio manager and then to the employee should have no net tax consequence to the partners of the portfolio manager.  If the ultimate recipient of the fee is a partner, it will likely report the deferred fee as a “guaranteed payment” under § 707(c).

4. Fee Deferrals by Hedge Funds after Enactment of § 409A 

a. Section 409A —In General 

Section 409A was added to the Code by the American Jobs Creation Act of 2004.263 With this legislation, the Code for the first time imposes specific statutory requirements on nonqualified deferred compensation plans.  To the extent a plan subject to § 409A does not comply with that section's requirements, there are three adverse tax consequences to the service provider: First, the service provider must include all of the deferred compensation under the plan in gross income except to the extent it was previously included in income or is subject to a substantial risk of forfeiture. To the extent it is subject to a substantial risk of forfeiture, it must be included in gross income when it is no longer subject to a substantial risk of forfeiture.264 Second, the service provider is subject to an additional, non-deductible “interest”tax equal to the interest that would have been assessed had the income been included in income when initially deferred using the underpayment interest rate plus one percent.265 Third, the service provider is subject to an additional tax equal to 20% of the amount included in income.266 A nonqualified deferred compensation plan generally includes any plan that provides for the deferral of compensation other than certain tax-favored plans, like qualified retirement plans and § 403(b) plans.267
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263 American Jobs Creation Act of 2004, P.L. 108-357.

264 H.R. Rep. No. 548, 108th Cong., 2d Sess. (2004).

265 § 409A(a)(1)(B)(i)(I).

266 § 409A(a)(1)(B)(i)(II).

267 § 409A(d)(1).

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On December 20, 2004, Treasury issued Notice 2005-1268 to provide interim guidance regarding certain aspects of  § 409A in Q& A format.  On October 4, 2005, Treasury issued proposed regulations under § 409A,269 which were originally proposed to apply to taxable years beginning on or after January 1, 2007.270 On October 4, 2006, Treasury issued Notice 2006-79 to announce that final regulations will not become effective until January 1, 2008.271 Until such time, however, the notice provided that Notice 2005-1 would remain in effect and taxpayers could rely upon the proposed regulations until the effective date of final regulations.
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268 2005-2 I.R.B. 274.

269 See REG-158080-04, 70 Fed. Reg. 57930 (10/4/05).

270 See Preamble to the proposed regulations, REG-158080-04, 70 Fed. Reg. 57930 (10/4/05).

271 I.R.B. 2006-43.

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The IRS finalized the  regulations under § 409A in 2007.271.1 The final regulations were to be effective for taxable years beginning on or after January 1, 2008.271.2 However, in Notice 2007-86,271.3 the IRS provided that taxpayers are not required to comply with the final regulations until January 1, 2009. Instead, during the transition period through the end of 2008, taxpayers must operate their plans under a reasonable, good faith compliance standard, taking into account the interim guidance issued by the IRS before the final regulations become effective.. Where Notice 2005-1 is inconsistent with the final regulations, a taxpayer may rely on either. Taxpayers may not rely on the proposed regulations for periods after December 31, 2007, but may rely on specified sections of the preamble to the proposed regulations.271.4 For a complete discussion of § 409A and the regulations thereunder, see 385 T.M., Deferred Compensation Arrangements.
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271.1 T.D. 9321, 72 Fed. Reg. 19234 (4/17/07).

271.2 Regs. § 1.409A-6(b).

271.3 2007-46 I.R.B. 990.

271.4 See Notice 2007-86, § 3.01(A).

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b. Does § 409A Apply to Fee Deferrals by Hedge Funds? 

Although  § 409A usually applies to the individual employee of an operating business who enters into a deferral arrangement with his employer, the reach of the statute is much broader.   Section 409A also applies to other types of service providers, including a personal service corporation or similar entity organized in noncorporate form.272 Under Notice 2005-1, however, the IRS announced that a service provider with multiple unrelated clients (e.g, an independent contractor) would not be subject to  § 409A in the typical case.273 Because many portfolio managers manage more than a single hedge fund, the notice appeared to have excluded many hedge fund management contracts from the reach of § 409A.  In the proposed and final regulations, however, Treasury eliminated this ambiguity by clarifying both the definition of “service provider” and the circumstances under which a client of the portfolio manager would be deemed “unrelated.”273.1  It is now clear, therefore, that  § 409A applies to most “back-to-back” deferrals by hedge funds.
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272 Notice 2005-1, 2005-2 I.R.B. 274 (stating at Q& A-8 that “until additional guidance is issued, a service provider ... includes ... a personal service corporation ... or a noncorporate entity that would be a personal service corporation if it were a corporation”).

273 Id. (excluding service provider who “provides such services to two or more service recipients to which the service provider is not related and that are not related to one another”).

273.1 Regs. § 1.409A-1(f)(1), (2)(iv);former Prop. Regs. § 1.409A-1(f)(1),(3)(iv).

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Under the final regulations, a “service provider” does not include an independent contractor who “provides significant services to two or more service recipients to which the service provider is not related and are not related to one another.”274 In the case of “management services,”however, the independent contractor exception does not apply.275 The regulations define “management services” to include “investment advisory services provided to a service recipient whose primary trade or business includes the management of financial assets ... for its own account, such as a hedge fund ...”276
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274 Regs. § 1.409A-1(f)(2)(i).

275 Regs. § 1.409A-1(f)(2)(iv).

276 Id.  (emphasis added).

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Accordingly, a portfolio manager on the cash method of accounting who earns deferrable compensation from a hedge fund may have to comply with  § 409A regardless of how many hedge fund “clients”it manages.

The impact of  § 409A upon back-to-back fee deferrals by hedge funds is significant.  In many respects, it is also uncertain.  First, the new requirements imposed by § 409A are in addition to the tax rules that applied prior to its enactment (i.e., they are an overlay).277 Thus, the doctrines of constructive receipt and economic benefit continue to apply.  If an amount is included in income earlier than would be required under § 409A, the inclusion may not be subject to the adverse tax consequences imposed by § 409A.  Second, § 409A generally applies only to taxpayers who report income under the cash method of accounting.278 Thus, if a portfolio manager is either on the accrual method of accounting or in constructive receipt of the incentive fee, it must report the incentive fee as current ordinary income generally without regard to § 409A. In effect, therefore,  § 409A will only tax an otherwise valid deferral of compensation that fails to meet additional statutory requirements.  The following subsections of the portfolio address what the authors consider to be the more significant of these requirements.
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277 See  § 409A(c) (“nothing in this section shall be construed to prevent the inclusion of amounts in gross income under any other provision of this chapter or any other rule of law earlier than the time provided in this section”).

278 Regs. § 1.409A-1(f)(1) (which defines a service provider to include only service providers using the cash method of accounting).

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c. Timing of Deferral Election 

In general,  § 409A requires the service provider to make the initial deferral election no later than the close of the taxable year immediately preceding the taxable year of service.279 This rule does not apply, however, to “performance-based compensation.”  If compensation is performance-based, the service provider may postpone the deferral election until no later than six months before the end of the service period.280 A threshold issue, therefore, is whether the incentive allocation, if structured as a fee for services, qualifies as performance-based compensation. If it does, then the portfolio manager and its members have more time to effect a valid deferral election.
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279 § 409A(a)(4)(B)(i) (general rule).

280 § 409(a)(4)(B)(iii). The services in question must also relate to a period of at least 12 months.  Id.

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In Notice 2005-1,281 the IRS excluded compensation “based solely on the value of, or appreciation in value of, the service recipient”from the definition of performance-based compensation. Other than perhaps goodwill, the management contract between the portfolio manager and the underlying fund will represent the principal asset of the portfolio manager.  Accordingly, the value of the portfolio manager will tend to rise and fall with the value of the hedge fund portfolio. Under Notice 2005-1, therefore, the incentive fee probably did not qualify as performance-based compensation.
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281 2005-2 I.R.B. 274, Q& A-22.

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In the final regulations, however, the IRS appears to have reversed course, concluding that performance-based compensation includes compensation “based solely on an increase in the value of the service recipient ... after the date of a grant or award.”282 It would appear, therefore, that the incentive allocation now satisfies that definition.  Nevertheless, the regulations provide no explicit guidance on the application of this definition in the hedge fund context.  Accordingly, absent further guidance, most portfolio managers and their employees should probably make their deferral elections at the end of the preceding year, at least when feasible.283
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282 Regs. § 1.409A-1(e)(3).

283 If the deferral arrangement in place for a particular portfolio manager subsumes other forms of compensation as well (i.e., the fixed management fee), it would be prudent to comply with the general rule even if the incentive allocation is itself “performance-based” because the aggregate compensation may not be “based solely on” an increase in value of the service recipient.

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d. What if the Employees of the Portfolio Managers Are also “Partners”? 

The back-to-back deferral rules under the regulations apply to deferrals that either are “subject to” § 409A or satisfy the requirements of § 409A (e.g., where the deferral arrangement between the portfolio manager and hedge fund is not subject to § 409A because the portfolio manager is an accrual basis taxpayer, but the deferral arrangement between the portfolio manager and one of its employees is subject to § 409A;in such case, if the deferral arrangement between the portfolio manager and hedge fund otherwise satisfies the § 409A requirements, even though the arrangement is not subject to § 409A, the back-to-back rules under the final regulations may be used for the deferral arrangement between the portfolio manager and its employees).284 The regulations reserve for future regulations the treatment of deferral arrangements between a partner and a partnership.285 So what should a portfolio manager do when its employees are also partners?
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284 Regs. § 1.409A-3(i)(6).

285 Regs. § 1.409A-1(b)(7).

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The preamble to the regulations provides that, pending further guidance, taxpayers may continue to rely on the interim guidance in Notice 2005-1 and Section II, E of the preamble to the proposed regulations regarding deferral arrangements between partnerships and partners.286 Notice 2005-1 provides that  § 409A will not apply to the grant of a partnership interest for services.287 It provides no such guidance, however, regarding the treatment of the same arrangement when the parties structure it as a fee, stating only that “§ 409A may apply to payments covered by  § 707(a)(1) ...if such payments otherwise would constitute a deferral of compensation.”288 The preamble does clarify, however, that “§ 409A will apply to guaranteed payments described in  § 707(c) ...where the guaranteed payment is for services and the partner providing the services does not include the payment in income” within 2.5 months of the end of the relevant taxable year.289
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286 See Preamble to T.D. 9321, 72 Fed. Reg. 19234 (4/17/07), Section III, G.

287 Notice 2005-1, 2005-2 I.R.B. 274 (Q& A-7).

288 Id.

289 See  Preamble to the proposed regulations, REG-158080-04, 70 Fed. Reg. 57930 (10/4/05) (Section II, E).

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An interesting question, therefore, is whether a portfolio manager and an employee may qualify for deferral under the back-to-back rule if the employee is also a partner.  If the amount subject to deferral is a “guaranteed payment,” it should qualify because the deferral arrangement would then be “subject to” § 409A. Under § 707(a), if a partner engages in a transaction with a partnership other than in its capacity as a partner, the transaction will be treated as occurring between the partnership and one who is not a partner.  The incentive fee cannot qualify under  § 707(a) because the recipient partner cannot be said to be acting independently of the partnership in this context.290 Under § 707(c), however, a payment determined without regard to “income” of the partnership may also qualify as a guaranteed payment, even if the recipient of the payment receives it in its capacity as a partner.
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290 See, e.g., Pratt v. Comr., 64 T.C. 203 (1975), aff'd in part, rev'd in part, 550 F.2d 1023 (5th Cir. 1977) (management fees based on a percentage of gross rentals not treated as  § 707(a) payments because terms of partnership agreement and actions of parties indicated that taxpayers provided management services in capacities as general partners).

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So is a typical incentive fee determined without regard to the “income” of the portfolio manager? The answer is yes.  Although the incentive fee is without question the primary source of income to a successful portfolio manager, the fee is an item of gross income, not net.  The portfolio manager must fund its deductible expenses from the incentive fee, including rent, overhead and salaries.  In Revenue Ruling 81-300, the IRS ruled that —

Although a fixed amount is the most obvious form of guaranteed payment, there are situations in which compensation for services is determined by reference to an item of gross income. For example, it is not unusual to compensate a manager of real property by reference to the gross rental income that the property produces. Such compensation arrangements do not give the provider of the service a share in the profits of the enterprise, but are designed to accurately measure the value of the services that are provided.  Thus, in view of the legislative history and the purpose underlying  section 707 of the Code, the term “guaranteed payment” should not be limited to fixed amounts. A payment for services determined by reference to an item of gross income will be a guaranteed payment if, on the basis of all of the facts and circumstances, the payment is compensation rather than a share of partnership profits.291

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291 Rev. Rul. 81-300, 1981-2 C.B. 143 (item of gross income may qualify as guaranteed payment).

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Based upon the language in the preamble to the proposed regulations, a deferral arrangement between a partnership and a partner is “subject to”  § 409A in spite of the broad reservation on the tax treatment of payments between these parties so long as the incentive fee qualifies as a guaranteed payment under § 707(c).  As a policy matter, an employee's status as a “partner” in this context should have no bearing on the timing of deferred service income.  The authors therefore anticipate that final regulations or other guidance will confirm the application of  § 409A to an otherwise compliant deferral arrangement between a partnership and its partner-employees.

e. Other Timing Issues 

Another unresolved issue concerning back-to-back deferrals292 is whether the portfolio manager must know the percentage participation of each partner at the time of the fee deferral.  The regulations require the portfolio manager to make the initial deferral election either no later than the close of the taxable year immediately preceding the taxable year of service or six months thereafter, depending upon whether the incentive fee qualifies as “performance-based.”293 Under its partnership agreement, however, the portfolio manager often defers setting each partner's percentage share of the fee until well after the date of the election.294 Under the back-to-back rule, will such a contract still “expressly provide ...for the time and form of payment” to its partners at the time of the election? If not, the election is invalid.  In the authors'view, however, the IRS should respect the deferral election if, at the time of the initial fee deferral, the portfolio manager has at least identified the participants and if the sum of the employee deferrals reflects the total fee deferral.295 First, delayed allocations are the industry norm and are imbued with non-tax significance.  Second, they do not affect the aggregate fee deferral, which the portfolio manager will have made in advance.
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292 For a discussion of whether the deferred fee is a “guaranteed payment” under  § 707(c) and therefore otherwise eligible for relief under the regulations, see VI, B, 4, d, above.

293 See VI, B, 4, c, above, for a discussion of this issue.

294 See Managed Funds Association, “Comments on Proposed Deferred Compensation Regs,” 2006 TNT 18-35 (Jan. 27, 2006).

295 The practical effect of a delayed allocation is that it may limit individual deferrals by a partner who does not know his or her percentage interest in the portfolio manager at the time of the election.  If, for example, Partner A wants to defer 50% of his share of the incentive fee and Partner B only 25% of her share, and A and B are equal partners, the portfolio manager would elect an aggregate fee deferral of 37.5% (i.e.,  (.5 x.5) + (.5 x .25)).  But if the portfolio manager has not yet determined A and B's relative share of the aggregate fee as of the date of the fee deferral, a fee deferral of 37.5% may not reflect the correct amount because it is a weighted-average calculation. To eliminate any chance of an excess fee deferral, therefore, the portfolio manager would have to limit the total fee deferral in this example to 25%.

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f. Certain Accelerations May Disqualify Entire Plan 

Section 409A limits the right to accelerate the payment of deferred compensation.296 The statute, however, does allow for accelerated payment of deferred compensation under very limited conditions, among them the death or disability of the service provider297 and a separation from service.298 It also permits acceleration upon a “change of control” of the service recipient299 or an “unforeseeable emergency.”300 Finally, in the case of a back-to-back deferral, the regulations further permit the management contract between the portfolio manager and the hedge fund to accelerate payment if an otherwise permitted payment event occurs under the back-to-back plan between the portfolio manager and its employees.  Specifically, under Regs. § 1.409A-1(i)(6), a plan between “a service recipient and a service provider that is also a service recipient” may accelerate payment upon the occurrence of a permissible payment event under the service provider's back-to-back plan with its employees so long as the plan “provides” for the accelerated payment.
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296 See § 409A(a)(3).

297 § 409A(a)(2)(A)(iii) (death); § 409A(a)(2)(A)(ii) (disability).

298 § 409A(a)(2)(A)(i).

299 § 409A(a)(2)(A)(v).

300 § 409A(a)(2)(A)(vi).

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Example 6-3: GP is the portfolio manager of ABC, an offshore hedge fund with assets under management of $100 million.  Under a management contract, GP receives 20% of the net gains from the portfolio as a fee for services.  GP has also established a deferred compensation plan with its employees, including Eric, who serves as CFO.  On December 31, 2007, Eric elects to defer his share of the incentive allocation until 2011, subject to acceleration upon his death or separation from service.  The management contract between ABC and GP may therefore provide that if Eric dies or quits, ABC may accelerate the portion of the deferred fee allocable to Eric even though Eric does not provide services to ABC.

Unfortunately, however, the regulations do not operate in the opposite direction.

Example 6-4: Same facts as in the previous example, except that the management contract between ABC and GP provides that upon liquidation of ABC, ABC may accelerate payment of the aggregate deferred fee to GP.  The back-to-back plan between GP and its employees therefore provides for the accelerated payment of amounts deferred by its own employees upon a liquidation of ABC.301

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301 See also Managed Funds Association, “Comments on Proposed Deferred Compensation Regs,” 2006 TNT 18-35 (Jan. 27, 2006) (providing similar example).

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Section 409A would permit ABC to accelerate payment to GP under these circumstances. GP may therefore receive the entire deferred fee upon liquidation of ABC without triggering a taxable event under  § 409A before that time. Nevertheless, the regulations do not permit the corresponding payment by GP to its employees, even though GP would otherwise intend to distribute all or substantially all of the deferred fee to its employees upon receipt.  Under the regulations, only the plan between the portfolio manager and the fund may incorporate a “payment trigger” from the other plan.302 As a result, therefore, GP cannot distribute the amount it receives from ABC to its employees even though they may be the very parties who bear immediate tax as its partners.
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302 See Regs. § 1.409A-1(i)(6) (cross trigger permitted in plan ultimate service recipient plan, but not in back-to-back plan between intermediate service recipient and its service providers).

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The authors had anticipated that final regulations would broaden the “cross trigger” rule for back-to-back deferrals to allow GP to make a corresponding distribution to its employees on these facts, and remain of the belief that this rule would be desirable.

g. Effect of Vesting Failures 

Regardless of its form as a fee or allocation, the derivative right of the portfolio manager members to participate in the net gains of the fund will usually include some form of vesting condition.  The vesting condition attaches to this right even though the underlying grant of the fee or carried interest from the fund to the portfolio manager has no vesting condition.  The absence of back-to-back vesting is relevant because in many back-to-back deferrals, an employee may quit after he or she elects to defer a percentage of the unvested fee but before his or her right to the deferred fee has vested:

Example 6-5: GP is the portfolio manager of ABC, an offshore hedge fund with assets under management of $100 million.  Under a management contract, GP is entitled to 20%of the net gains from the portfolio as a fee for services.  GP also has a deferred compensation plan with its employees, consisting of Eric, Jennifer and Lauren, each of whom is entitled to one-third of the total incentive allocation, subject to vesting.  On December 31, 2007, Eric, Jennifer and Lauren each elect to defer 33% of his or her share of the incentive allocation until 2009, subject to acceleration upon separation from service.  GP therefore makes a back-to-back deferral election with ABC.  On December 31, 2008, ABC earns $300 in incentive fees, of which $100 is deferred and remains invested in ABC.  On January 1, 2009, Eric quits, forfeiting his entire interest in the deferred fee.

When Eric quits, therefore, ABC will have a “residual deferral” in this example of $33.303 GP may choose to leave the $33 residual amount in place for future allocation to a new employee or may elect to accelerate the residual deferral for distribution to its members or reinvestment in the business.
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303 See Managed Funds Association, “Comments on Proposed Deferred Compensation Regs,”2006 TNT 18-35 (Jan. 27, 2006) (similar example).

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The consequences of these choices under  § 409A are unclear.  Because the forfeiting employee will never receive the forfeited fee, the failure of the portfolio manager in this circumstance to accelerate the payment is probably not a “redeferral” subject to § 409A(a)(4)(C). Less clear, however, is whether either of the two choices by the portfolio manager would violate the back-to-back deferral rule.  For example, had Eric separated from service after rather than before vesting, ABC would have accelerated the $33 in deferred fees and paid it to Eric in a perfectly valid acceleration.  May ABC therefore accelerate an unvested fee and either retain it or distribute it to someone else? If not, would leaving the deferred fee in the fund violate  § 409A because Eric's departure remained a designated payment event in spite of the intervening forfeiture?

h. Impact of § 409A and § 457A When Fund Is Offshore 

(1) Section 409A 

Section 409A prohibits the funding of deferral arrangements through a trust “or other arrangement determined by the Secretary” that is located outside of the United States.304 The offshore “rabbi trust”is the principal target of this prohibition, due to the many legal, procedural and practical difficulties a creditor is likely to confront when it pursues a claim against such an entity.305 In a typical “back-to-back” hedge fund deferral, the underlying assets do not reside in an offshore trust but in an offshore entity operating as the fund vehicle, and are subject to the claims of fund creditors.  Neither Notice 2005-1 nor the regulations define or establish special rules for “other arrangements” that, although foreign, do not involve a trust.306 The authorizing language of the statute, however, appears broad enough to reach an offshore hedge fund.  Moreover, an offshore trust no longer achieves deferral even though the trust assets remain “subject to”claims of creditors because Congress determined that the assets may be difficult to reach as a practical matter.307 The same is likely to be true if the assets reside not in an offshore trust, but in a Cayman Islands entity treated as a corporation for U.S. tax purposes.308  Section 409A(e)(3) also authorizes regulations that would exempt deferral arrangements that “will not result in assets being effectively beyond the reach of creditors.” Nevertheless, it is widely known that offshore hedge funds are among the principal participants in arrangements of this sort.  Given the intended beneficiaries of these arrangements, it is unlikely that the IRS sought to ban deferrals through offshore hedge funds even though many such funds probably enjoy de facto immunity from creditors' claims.
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304 § 409A(b)(1) (treating such arrangements under  § 83 “as property transferred in connection with the performance of services whether or not such assets are available to satisfy claims of general creditors”).

305 H.R. Rep. No. 755, 108th Cong., 2d Sess. (2004) (noting that “arrangements have developed which attempt to protect the assets from creditors despite the terms of the trust”).

306 In Notice 2005-1, the IRS requested comments on deferral arrangements “that involve foreign trusts or similar arrangements, and identification of arrangements that will not result in an improper deferral of United States tax and will not result in assets being effectively beyond the reach of creditors for purposes of the potential exemption from the provisions of  § 409A(b) that the Treasury Department and the Service are authorized to provide under § 409A(e)(3).” 2005-2 I.R.B. 274.

307 See Rev. Proc. 92-64, 1992-2 C.B. 422 (safe harbor model “rabbi trust” agreement).

308 See also Sheppard, “Moving Deferred Compensation Offshore,” 92 Tax Notes 1140(Aug. 27, 2001) —

the hassles that an American creditor might face trying to pry assets out of a foreign jurisdiction include trying to get jurisdiction to sue a foreign entity, having to hire a local lawyer, having to enforce a judgment in foreign courts, and generally having to contend with quirky and creditor-hostile laws of bank secrecy jurisdictions ...The fact that the hedge funds are offshore might give the tax administrator pause when an American service provider asserts that funds set aside for him offshore somewhere really are reachable by the service recipient's creditors.

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(2) Section 457A 

(a) In General 

Effective for amounts deferred that are attributable to services performed after December 31, 2008, compensation deferred under a nonqualified deferred compensation plan of a “nonqualified entity” is includible in gross income under § 457A(a) when there is no substantial risk of forfeiture of the rights to such compensation.309 In many cases, § 457A eliminates deferral of fee income due to fund managers from offshore funds.
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309 § 457A(a), added by the Emergency Economic Stabilization Act of 2008, P.L. 110-343, Div. C, §  801. Generally, the amount includible in income under § 457A is determined under the rules applicable to the determination of amounts includible in income under § 409A(a). Notice 2009-8, 2009-4 I.R.B. 347, Q&  A-16.  See Notice 2008-115, 2008-52 I.R.B. 1367. Notice 2009-8 provides interim guidance on the application of § 457A. Until further guidance is issued, taxpayers may rely on Notice 2009-8 beginning from the date of enactment of § 457A (Oct. 3, 2008). According to Notice 2009-8, any further guidance will be prospective.

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(b) Substantial Risk of Forfeiture 

Section 457A applies principles similar to § § 457 and 409A. Generally, compensation is considered subject to a substantial risk of forfeiture under this provision only if a person's rights to such compensation are conditioned upon the future performance of substantial services by any individual.309.1 If compensation is determined solely by reference to the amount of gain recognized on the disposition of an “investment asset,” the compensation must be treated as subject to a substantial risk of forfeiture until the date of that disposition. An investment asset is defined as any single asset (other than an investment fund or similar entity) (1) that is acquired directly by an investment fund or similar entity, (2) if the entity or any related person does not participate in active management of that asset, and (3) if substantially all of any gain on the disposition of the asset (other than the nonqualified deferred compensation) is allocated to investors in such entity.309.2
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309.1 § 457A(d)(1)(A); Notice 2009-8, Q&  A-3(a).

309.2 § 457A(d)(1)(B).

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If the amount of any compensation is not determinable at the time it is otherwise includible in gross income under the above rule, then: (1) that amount is includible in gross income when it is determinable; and (2) the income tax for the taxable year in which the compensation is includible in gross income is increased by the sum of: (a) interest at the underpayment rate under § 6621 plus one percentage point on the underpayments that would have occurred had the deferred compensation been includible in gross income for the taxable year in which first deferred (or, if later, the first taxable year in which the deferred compensation is not subject to a substantial risk of forfeiture), and (b) 20% of the amount of compensation.309.3
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309.3 § 457A(c); see Notice 2009-8, Q&  As-19 through -21.

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(c) Nonqualified Entity Defined 

A nonqualified entity is: (1) any foreign corporation, unless substantially all of its income is (a) effectively connected with the conduct of a trade or business in the United States, or (b)subject to a comprehensive foreign income tax; and (2) any partnership, unless substantially all of its income is allocated to persons other than (a) foreign persons for whom the income is not subject to a comprehensive foreign income tax, and (b) organizations which are exempt from tax under the Code.309.4
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309.4 § 457A(b); Notice 2009-8, Q&  A-6.

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The determination of whether an entity is a nonqualified entity is made as of the last day of each of the service provider's taxable years in which the nonqualified deferred compensation is no longer subject to a substantial risk of forfeiture and remains deferred.309.5
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309.5 Notice 2009-8, Q&  A-13(a).

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Whether a partnership is a nonqualified entity as of the last day of the service provider's taxable year is determined based on the allocations (or deemed allocations) of gross income by the partnership for the partnership's taxable year ending with or within the service provider's taxable year. If a partnership does not yet have a taxable year that has ended or ends on the last day of the service provider's taxable year, a reasonable, good faith estimate of such allocation (or deemed allocation) of the partnership for its current taxable year must be used to determine whether it is a nonqualified entity.309.6
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309.6 Notice 2009-8, Q&  A-13(b).

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(d) Nonqualified Deferred Compensation Plan Defined 

A nonqualified deferred compensation plan is defined the same as under § 409A(d), but also includes any plan that provides a right to compensation based on the appreciation in value of a specified number of equity units of the service recipient.309.7 However, compensation is not treated as deferred if the service provider receives it within 12 months after the end of the service recipient's taxable year during which the right to the payment of such compensation is no longer subject to a substantial risk of forfeiture.309.8
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309.7 § 457A(d)(3)(A).

309.8 § 457A(d)(3)(B); Notice 2009-8, Q&  As-2 and -4. In addition, deferred compensation includes income (whether actual or notional) attributable to that compensation or income, and rules similar to the controlled group and common control rules under § 414(b) and § (c) apply. § 457A(d)(5); Notice 2009-8, Q&  A-15.

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An independent contractor is not a service provider subject to § 457A if an arrangement with respect to the independent contractor would be excluded from coverage under Regs. § 1.409A-1(f)(2), which generally excludes arrangements with independent contractors having multiple unrelated clients, but not arrangements with such independent contractors that provide management services.309.9 Since fund managers are not excluded from § 409A under this rule, they are not excluded from § 457A.
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309.9 Notice 2009-8, Q&  A-5.

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Whereas § 409A applies only to cash method service providers, § 457A applies whether the service provider uses the cash method or an accrual method.309.10
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309.10 Id.

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(e) Coordination with §  409A 

Section 409A applies in addition to § 457A.309.11 In applying § 409A to arrangements covered by § 457A, rules similar to those addressing arrangements subject to § 457(f) apply. Thus, an inclusion in income under § 457A is treated as a payment for purposes of the short-term deferral rule under Regs. § 1.409A-1(b)(4). In addition, until further guidance is issued, the inclusion in income under § 457A of earnings on amounts subject to § 457A is treated as a payment in accordance with a fixed schedule of payments if the earnings are reasonable, are credited at least annually, and are included in income under § 457A for the later of the taxable year in which such earnings are credited or when such amounts would otherwise be includible in income under § 457A. However, the right to an amount that is not subject to § 457A because it is a short-term deferral under Q& A-4 of Notice 2009-8 is subject to § 409A unless the arrangement also qualifies as a short-term deferral under Regs. § 1.409A-1(b)(4).309.12
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309.11 Notice 2009-8, Q&  A-24. Note also that there are inconsistencies between the two sections. For example, § 457A contains a definition of “substantial risk of forfeiture” (as discussed above) that is more restrictive than that under § 409A.

309.12 Notice 2009-8, Q&  A-24.

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(f) Effective Date and Transition Relief 

As noted above, § 457A is effective with respect to amounts deferred which are attributable to services performed after December 31, 2008. If a deferred amount is attributable to services performed on or before December 31, 2008, and to the extent it is not includible in gross income in a taxable year beginning before 2018, that amount is includible in gross income in the later of: (1)the last taxable year beginning before 2018, or (2) the taxable year in which there is no substantial risk of forfeiture of the rights to such compensation.309.13
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309.13 P.L. 110-343, Div. C, §  801(d)(1) and (2); Notice 2009-8, Q&  A-22.

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Notice 2009-8 contains detailed rules for determining the periods of service to which compensation is attributable for purposes of applying the effective date,309.14 as well as transition rules for coordinating § 457A with § 409A.309.15
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309.14 Notice 2009-8, Q&  A-23.

309.15 Notice 2009-8, Q& As 25 through -27.

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U.S. Income Portfolios: Other Pass-through Entities 
  Portfolio 736-1st: Hedge Funds 
  Detailed Analysis 
  VI. Special Tax Issues for the General Partner and Its Members

C. Other Tax Issues for Members of the General Partner 

Unlike the grant of the carried interest by the fund to the general partner, the grant of a participation in the carried interest by the general partner to its current or future members raises several tax issues.

1. Vesting 

The general partner structures the grant of a participation in the carried interest as a profits interest to its members for the same reason that the fund structures the grant of the carried interest as a profits interest to the general partner:to upstream the character of the underlying income.  Unlike the carried interest in the underlying fund, however, the interest in the general partner will usually bear some form of vesting restriction.  For reasons that practitioners debated for years, Revenue Procedure 93-27 failed to address the treatment of vesting restrictions on a profits interest. As described below, the treatment of an “unvested” profits interest remained unclear until the IRS issued Revenue Procedure 2001-43.

a. Pre-Revenue Procedure 2001-43: The Minority View 

Under what was probably the minority view among practitioners, the IRS chose not to address the effect of vesting restrictions because it assigned no significance to them.  Under this interpretation, the recipient of an unvested profits interest would incur no tax liability upon vesting even if the value of the profits interest had substantially appreciated.

This view was not without merit.  First, until May 24, 2005,310 the issue of whether  § 83 even applied to the grant of a profits interest remained unsettled.  In a leading treatise on partnership taxation, for example, one commentator asserts that the principles of  § § 61 and 83 should not extend to the receipt of a profits interest for services because those provisions conflict with longstanding principles of partnership taxation, which he characterizes as “premised on nonrealization concepts.”311 Second, until May 24, 2005, the  § 83 regulations were silent on the issue.  Although final regulations provide explicit rules for unvested stock in both ‘C’ corporations and ‘S’corporations, they provide no guidance on the treatment of an unvested partnership interest.312 Finally, most practitioners agree that the IRS issued Revenue Procedure 93-27 to provide clarity on an issue that had plagued the tax bar for decades. As the vast majority of profits interests issued for services bear some form of vesting limitation, a narrow construction of the revenue procedure would provide such clarity in only a minority of the cases.
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310 On May 24, 2005, Treasury issued proposed regulations under  § § 83 and 704(b) to address the taxation of a partnership interest issued for services. As described more fully in VI, A, 4, above, the proposed regulations apply  § 83 to the grant of a profits interest.  The proposed regulations will apply to all compensatory partnership interests issued on or after the date of final regulations.  See REG-105346-03, 70 Fed. Reg. 29675 (5/24/05).

311 See McKee, Nelson and Whitmire, Federal Taxation of Partnerships and Partners at ¶  5.02[6](3d ed. 1997).  See also GCM 36346 (7/23/75) (profits interests not taxable under  § 83 because analogous to unsecured promise to pay); Weigel, “Private Investment Fund Interests Held by Employees — Campbell,  Section 83(b)and Other Considerations,” Tax Forum No. 543 (June 5, 2000) (citing various theories for and against application of § 83); but see Campbell v. Comr., T.C. Memo 1990-162, rev'd, 943 F.2d 815 (8th Cir. 1991) (rejecting notion that profits interest is not “property” under § 83).

312 See Regs.  § 1.1361-1(b)(3) (holder of restricted stock in S corporation not treated as shareholder absent a  § 83(b) election); Regs. § 1.83-1(a); Regs.  § 1.83-1(f) (Ex. 1) (employer treated as owner of restricted stock issued to employee until property becomes substantially vested; interim dividends and gains characterized as compensation income).

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b. Pre-Revenue Procedure 2001-43: The Majority View 

Nevertheless, the majority view was that vesting restrictions suspended application of Revenue Procedure 93-27 until the restrictions lapsed, at least absent an  § 83(b) election.  The determination of whether the recipient received a profits or capital interest would therefore depend upon the value of the fund portfolio on the lapse date rather than on the date of grant.  Those subscribing to this view often advised the recipient to make a “protective” § 83(b) election on the date of grant, reporting the interest at a value of zero.313 Although the interest undoubtedly had positive value on such date, in particular as the statute requires the recipient to disregard any discount attributable to the vesting restrictions, the recipient relied upon Revenue Procedure 93-27 and other theories of nonrealization to claim exemption from tax.314 In fact, it would be difficult to reconcile Revenue Procedure 93-27 with § 83 were the election to trigger a contrary result, given the purpose of  § 83(b) to impose the  § 83(a) regime on electing taxpayers.315 Having concluded that  § 83(a) does not tax the grant of a fully-vested profits interest, the IRS could hardly impose less favorable consequences upon the recipient of an identical interest of lesser value due to the vesting restrictions.
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313 See, e.g.,, McKee, Nelson and Whitmire, Federal Taxation of Partnerships and Partners at ¶  5.09(3d ed. 1997); Baneman, “Selected Tax Issues in Equity-Based Compensation for Partnerships and LLCs,” Tax Club (Jan. 2001).

314 See McKee, Nelson and Whitmire, Federal Taxation of Partnerships and Partners at ¶  5.02[6](3d ed. 1997).  See also GCM 36346 (7/23/75) (profits interests not taxable under  § 83 because analogous to unsecured promise to pay); Weigel, “Private Investment Fund Interests Held by Employees — Campbell,  Section 83(b)and Other Considerations,” Tax Forum No. 543 (June 5, 2000) (citing various theories for and against application of § 83); but see Campbell v. Comr., T.C. Memo 1990-162, rev'd, 943 F.2d 815 (8th Cir. 1991) (rejecting notion that profits interest is not “property” under § 83).

315 See, e.g., Rev. Rul. 83-22, 1983-1 C.B. 17 (property deemed “substantially vested” at time of  § 83(b) election, and therefore no longer subject to substantial risk of forfeiture).

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c. The Current View: Revenue Procedure 2001-43 

In Revenue Procedure 2001-43,316 the IRS seemingly settled the debate, announcing its intention not to discriminate between the grant of a vested profits interest and the grant of an unvested profits interest. Provided that the partnership and the grantee otherwise meet the conditions of Revenue Procedure 93-27, treat the grantee as a current member of the partnership and do not claim a compensation or other deduction on the grant or vesting date, the IRS will not challenge either the grant or vesting of the profits interest as a tax-free transaction to the parties.  The revenue procedure also clarifies that the recipient of an unvested profits interest need not file a  § 83(b) election to achieve this result.
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316 2001-43 I.R.B. 2001-34.

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Comment: If a profits interest is indeed “property” under § 83, then the legal basis of Revenue Procedure 2001-43 is not at all clear.317 The IRS did not even attempt to articulate one, suggesting a perhaps more pragmatic agenda — the IRS has been besieged with  § 83(b) election forms in recent years, due in large part to the surge in popularity of LLCs. Moreover, unlike a recipient of stock in a corporation, a recipient of a true profits interest has no reason not to make the  § 83(b) election. In view of this difference, the IRS may have concluded that the election imposed a trap for the unwary to the service provider and an administrative burden on the government without advancing any affirmative policy. But if stemming the tide of  § 83(b) elections was its purpose, the IRS has not achieved it.  Most within the tax bar now advise a “protective” § 83(b) election in the wake of this pronouncement, arguing that the interest in question may not satisfy each condition of Revenue Procedure 93-27.318
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317 The IRS has requested comments on the application of  § 83 generally to partnership options and interests in partnership capital.  See 2003 TNT 14-13.

318 For a discussion of “protective”elections under § 83(b), see Kalinka, “Rev. Proc. 2001-43 and the Transfer of a Nonvested Partnership Profits Interest,” 79 Taxes 11 (Dec. 2001); see also Mincey et al., “Rev. Proc. 2001-43, Section 83(b), and Unvested Profits Interests — The Final Facet of Diamond?,” 95 J. Tax'n 205 (Oct. 2001).

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Note: On May 24, 2005, the IRS issued proposed regulations under  § § 704(b) and 83 to address the tax consequences of the grant and forfeiture of a partnership interest for services.319 As described more fully in VI, A, 4, above, the proposed regulations would require the recipient of an unvested profits interest to make an  § 83(b) election to treat the profits interest as “property”on the date of grant.
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319 See REG-105346-03, 70 Fed. Reg. 29675 (5/24/05).

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2. Bifurcation 

As described more fully in VI, C, 5, below, if the investment management activities of the general partner would otherwise attract state or local taxes, the sponsor may choose to split the general partner and the portfolio manager into two entities, one to receive the carried interest and the other to manage the fund. In such cases, the general partner will have effectively granted an interest in the carry in consideration of services to an affiliate of the general partner, not to the general partner itself. Because Revenue Procedure 93-27 applies to the grant of a profits interest in exchange for services “to or for the benefit of” the issuing entity, the issue this raises is whether the grant of the carried interest in a bifurcated fund structure still qualifies as a tax-free transaction under the revenue procedure.

The services performed for the portfolio manager affiliate by the members of the general partner certainly benefit the general partner because the services increase the value of portfolio company investments; indeed, they are the quid pro quo for the carried interest.  The portfolio manager employees therefore receive their interest in the general partner in consideration of services performed “for the benefit of” the general partner, complying with the literal language of the revenue procedure.  Some practitioners, however, have construed the “for the benefit of” language as an attempt by the IRS to extend the benefit of the revenue procedure only to persons who, like the taxpayer in Diamond, performed the services before formation of the issuing partnership.320 Even if Revenue Procedure 93-27 does not apply, however, the recipient may be able to avoid a taxable event on other grounds.  If, for example, the interest has speculative value on the grant date or if the grant itself is simply not a realization event, the recipient will avoid tax even if the revenue procedure does not apply.321
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320 See McKee, Nelson and Whitmire, Federal Taxation of Partnerships and Partners at ¶  5.02[7][a](3d ed. 1997) (“[T]he revenue procedure clearly leaves open the question whether the receipt of a profits interest for services on behalf of someone other than the partnership is a taxable event”); see also Campbell v. Comr., T.C. Memo 1990-162, rev'd, 943 F.2d 815 (8th Cir. 1991) (IRS argued, inter alia, that taxpayer rendered services not to partnership, but to his employer).

321 See, e.g., McKee, Nelson and Whitmire, Federal Taxation of Partnerships and Partners at ¶  5.02[7][b] (3d ed. 1997).  McKee cites the Campbell, Diamond and Pacheco cases as support for the proposition that the issuance of a “garden variety” profits interest lacks a readily determinable fair market value and therefore is not includible in income.  Campbell v. Comr., T.C. Memo 1990-162, rev'd, 943 F.2d 815 (8th Cir. 1991); Diamond v. Comr., 56 T.C. 530 (1971), aff'd, 492 F.2d 286 (7th Cir. 1974); U.S. v. Pacheco, 912 F.2d 297 (9th Cir. 1990).  The argument in support of non-realization is that a partner did not realize income upon the receipt of a profits interest prior to passage of the 1954 Code, which merely restated the law then in effect under the provisions of the 1939 Code governing the taxation of compensation for services. See McKee, Nelson and Whitmire, Federal Taxation of Partnerships and Partners at ¶  5.02[6][a] and [b] (3d ed. 1997).

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Note: On May 24, 2005, the IRS issued proposed regulations under  § § 704(b) and 83 to address the tax consequences of the grant and forfeiture of a partnership interest for services.322 As described more fully in VI, A, 4, above, the right to use “liquidation value” to value a compensatory profits interest applies only if the service provider provides services “to”the issuing partnership.
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322 See REG-105346-03, 70 Fed. Reg. 29675 (5/24/05).

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3. Late Hire/“Catch Up” Solution 

The general partner will often grant a participation in the underlying carried interest in the fund to employees who join the general partner after the fund has made substantial investments. If the capital account of the general partner reflects any net realized or unrealized gains on the date of grant, the carried interest will no longer qualify as a profits interest. By extension, therefore, a direct grant of a pro rata interest therein will not qualify as a profits interest to the employee.  Indeed, because the new hire had no role in generating any of those gains, the portfolio manager may not intend that the new hire participate in them.  To ensure this result, the general partner will usually “book up”the capital account balances of the existing members to reflect any unrealized appreciation in the incentive allocation, granting to the new hire an interest only in future profits or appreciation.  Although the upward adjustment to the capital accounts will generate a book profit, it should not give rise to any actual tax liability.

Note: In 2004, Treasury amended the regulations to extend the list of permissible “book up”events to include a book up immediately before a partnership admits a new partner for services.323 Before that time, a “book up” of capital account balances following the grant of a profits interest for services violated the capital account maintenance requirements.  Given the purpose of these book-ups, which was merely to ensure that the newly-admitted partner participated only in the future profits of the business, it is unlikely that the IRS ever intended to prohibit a book up in this situation.324
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323 See Regs.  § 1.704-1(b)(2)(iv)(f)(5)(iii) (referring to revaluations “in connection with the grant of an interest in the partnership (other than a de minimis interest) on or after May 6, 2004, as consideration for the provision of services to or for the benefit of the partnership by an existing partner acting in a partner capacity, or by a new partner acting in a partner capacity or in anticipation of being a partner”);T.D. 9126, 69 Fed. Reg. 25315 (5/5/04) (final regulations).  See also Preamble to the proposed regulations, REG-139796-02, 68 Fed. Reg. 39498 (7/2/03) (“The proposed regulations expand the circumstances under which a partnership is specifically permitted to increase or decrease the capital accounts of the partners to reflect a revaluation of partnership property on the partnership's books [to include] revaluations in connection with the grant of an interest in the partnership (other than a de minimis interest) on or after the date final regulations are published in the Federal Register as consideration for the provision of services to or for the benefit of the partnership by an existing partner acting in a partner capacity, or by a new partner acting in a partner capacity or in anticipation of being a partner”).

324 The proposed regulations issued on May 24, 2005, however, would limit this type of book up to the transfer or vesting of a “compensatory partnership interest.” Even then, a book-up would be available “only if the transfer or vesting results in the service provider recognizing income under section 83 (or would result in such recognition if the interest had a fair market value other than zero).”  See Prop. Regs. § 1.704-1(b)(2)(iv)(f)(5)(iii).  Prop. Regs. § 1.721-1(b)(3) defines a “compensatory partnership interest” as “an interest in the transferring partnership that is transferred in connection with the performance of services for that partnership.” (emphasis added).  The current regulations, however, allow a book-up upon the grant of a partnership interest for services “to or for the benefit of”the issuing partnership.  See Regs. § 1.704-1(b)(2)(iv)(f)(5)(iii) (emphasis added).  For a fuller description of the proposed regulations, see VI, A, 4, above.

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In certain cases, however, the general partner may prefer to grant a fungible interest in the carry to the new hire. If the underlying portfolio has not appreciated, the general partner can do so without tax consequence to the recipient.  Whether it can do so in any particular case will obviously depend on the specific facts and circumstances on the date of grant.  Assuming any meaningful appreciation, however, the interest issued on the grant date will constitute a capital interest in the general partner, triggering a taxable event to the recipient.325
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325 See Regs. § 1.721-1(b)(1).

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Comment: Some practitioners may be tempted to “neutralize” the effect of the grant by allocating the resulting compensation deduction to the newly-admitted partner.  Such an allocation will not have “substantial economic effect” under  § 704(b) absent an equivalent book allocation, which would deprive the new member of his capital interest.  Moreover, if the “capital shift”generates gain at the partnership level, the other partners may realize income with no offsetting compensation deduction.

The general partner should be able to avoid triggering a taxable event by recasting the interest as a profits interest with a “catch up” allocation.

Example 6-6: Assume the general partner holds a 20% carried interest in the underlying fund.  Further assume that the portfolio has appreciated by $100 and that the carry has a liquidation value of $20.  The general partner wishes to grant a 25% interest in the carry to A, a new member.  If the general partner did so directly, A would receive a capital interest of $5, triggering an immediate tax liability.  If the general partner instead “books up” the capital account balances of the existing members to$20 and then issues a profits interest to A, A would avoid a taxable event.  By recasting the grant as a profits interest, however, the general partner will deprive A of a 25% interest in the first $20 of unrealized appreciation.  To achieve participation from the “ground floor,” the general partner could issue the same profits interest to A, but with a special allocation of first profits until A's capital account balance accretes to 25% of the aggregate capital account balances. Assuming no interim distributions during the “catch up”period, the general partner would therefore allocate the first $6.67 of profits to A.326 The effect of this special allocation is that A will receive the equivalent of a 25%capital interest so long as the underlying carried interest appreciates by at least $6.67.

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326 5/(1-.25) = $6.67; $6.67/($20+ $6.67) = 25%.

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4. Capital Shift on Forfeiture of Appreciated Profits Interest 

As described above, unlike the incentive allocation in the fund, the separate grants by the general partner of interests therein may be subject to vesting.  At least before Revenue Procedure 2001-43, therefore, the grantee usually made an  § 83(b) election within 30 days of receipt to avoid a taxable event on the vesting date.327 But what if the grantee forfeits the interest in the interim? These types of forfeitures will benefit the remaining members in the form of a “capital shift,” assuming at least that the fund generated gains (realized or unrealized) after the date of grant.  Many of these forfeitures occur well into the life of the fund.  A capital shift of this sort is therefore quite common.  Whether this type of capital shift has any immediate tax consequence to the forfeiting or other members, however, is unclear.
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327 See VI, C, 1, above.

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In a corporation, a forfeiture of appreciated stock by a shareholder with a  § 83(b) election in effect is not a taxable event to the other shareholders.  This is so even though the other shareholders will increase their effective claim to the remaining net assets of the corporation at the time of forfeiture because the forfeiture by the service provider is not a “realization” event to the shareholders under § 61. Although the economic consequences of a forfeiture in a partnership are no different, subchapter K may compel a different result.  The fundamental legal basis for the concern is Regs. § 1.721-1(b)(1), which states that  § 721 does not apply if “any of the partners gives up any part of his right to be repaid his contributions (as distinguished from a share of partnership profits) in favor of another partner as compensation for services ....”  Read literally, the regulation does not apply in this context because the forfeiting member has neither surrendered his “contribution”to the partnership nor acted to compensate the other parties for services. To the contrary, the member has forfeited his interest for failing to provide the agreed services during the period of appreciation. Nevertheless, it is this regulation that is the genesis of the “capital shift” theory of subchapter K.328
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328 See generally Schneider, O'Connor, “LLC Capital Shifts: Avoiding Problems When Applying Corporate Principles,” 92 J. Tax'n 13 (Jan. 2000);New York State Bar Association Tax Section, “Report on Taxation of Partnership Options and Convertible Securities,” reprinted in 2002 TNT 21-24 (Jan. 29, 2002); Alster, “Shifts of Partnership Capital in the New Service Economy,” Tax Club (Nov. 27, 2000).

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The “capital shift” theory of subchapter K basically postulates that a shift of capital from one partner to another is the functional equivalent of a taxable transfer of assets by the partnership to the transferee partner, followed by a re-contribution of assets by the transferee partner to the partnership in exchange for a capital interest.329 Had the partnership actually effected such a transfer, it would have recognized a taxable gain under  § 1001 in a deemed sale of assets for services.  Moreover, the transferee partner would have recognized compensation income under § 61.330
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329 See, e.g., McKee, Nelson and Whitmire, Federal Taxation of Partnerships and Partners at ¶  5.08(3d ed. 1997); Schneider, O'Connor, “LLC Capital Shifts: Avoiding Problems When Applying Corporate Principles,” 92 J. Tax'n 13, 16-18 (Jan. 2000).

330 Regs. § 1.721-1(b)(1).

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Whether a capital shift is taxable solely in this context or instead reflects an isolated application of a broader tax principle is a source of much debate within the tax bar.  On January 22, 2003, the IRS issued proposed regulations under § § 704, 721 and 761 addressing the consequences of the grant and subsequent exercise of a noncompensatory option to acquire a partnership interest.331 In general, the regulations treat the exercise of an option as a tax-free transaction under § 721, even though the exercise has the effect of shifting capital from the existing partners to the option holder.332 Although not strictly relevant in the context of a forfeiture of an unvested profits interest, the proposed regulations clearly reject the broadest interpretation of Regs. § 1.721-1(b)(1), which would disqualify any capital shift from nonrecognition treatment.  Even before the issuance of these regulations, however, most portfolio managers probably relied upon one or more countervailing theories of subchapter K333 to narrowly construe the regulation and did not report a forfeiture-driven capital shift as a taxable event.334
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331 2003 TNT 14-13.

332 Id.

333 See, e.g., St. John v. U.S., 53 AFTR2d 84-718 (C.D. Ill. 1983)(court treated profits interest as without value because taxpayer would not have been entitled to any proceeds upon immediate liquidation); Campbell v. Comr., T.C. Memo 1990-162, rev'd, 943 F.2d 815 (8th Cir. 1991) (interests at issue were too speculative to value); GCM 36346 (7/23/75) (profits interests not taxable under  § 83 because analogous to unsecured promise to pay).

334 Although it clarifies the treatment of an unvested profits interest upon grant and vesting, Rev. Proc. 2001-43 does not address the consequences of a forfeiture of that interest to the other members.  2001-43 I.R.B. 2001-34.

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On May 24, 2005, however, the IRS issued proposed regulations under  § § 704(b) and 83 to address the tax consequences of the compensatory grant and forfeiture of a partnership interest.335 Under the proposed regulations, a forfeiture of an unvested partnership interest will give rise to immediate tax in many cases.336 The tax will arise, however, not by any recast of the forfeiture as a constructive “capital shift,”but from “forfeiture allocations” of gross income to the historic partners.  The apparent purpose of forfeiture allocations is to conform the “substantiality” requirement of  § 704(b) to the future vesting failure.  The proposed regulations had allowed prior allocations of profit to the forfeiting partner even though those allocations had no “economic effect,”337 based upon the assumption that the interest would ultimately vest.  Indeed, had the interest in fact vested, the intervening “build-up” in the partner's capital account would have remained with the service partner; because it did not, it must “migrate” to the other partners in some fashion.338
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335 See REG-105346-03, 70 Fed. Reg. 29675 (5/24/05).

336 For a fuller discussion of the proposed regulations, see VI, A, 4, above.

337 See Prop. Regs. § 1.704-1(b)(4)(xii)(a).

338 See Prop. Regs. § 1.704-1(b)(4)(xii)(b). The proposed regulations permit “pre-vesting” allocations in spite of their lack of substantiality so long as the remaining material allocations are substantial and the partnership agreement requires the partnership to make future “forfeiture allocations.”

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Under the proposed regulations, the partnership must allocate to the service partner during the year of forfeiture an amount equal to (a) the excess, if any, of any prior distributions to the service partner (to the extent not taxable under § 731); over the amounts paid for the interest; minus (b) the cumulative net income (or loss) allocated to the service partner.339 The purpose of the forfeiture allocation is twofold: First, to reverse prior allocations of income to the service provider that never vested.  Second, to preserve the prohibition under § 83(b)(1) on deductions to the service partner with respect to amounts includible in income under § 83(b).
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339 Prop. Regs. § 1.704-1(b)(4)(xii)(c).

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A typical forfeiture allocation involving a profits interest should produce losses to the service provider, not profits.  First, it is unlikely that a partnership will have allocated net losses to the service partner before the date of forfeiture because such an allocation would only create a negative capital account balance that the service partner has no obligation to restore.  Second, few partnerships distribute significant amounts of cash to an unvested service partner.  In the overwhelming majority of cases involving a successful hedge fund, therefore, the service provider will have a positive (albeit unvested) capital account balance at the time of forfeiture.  Accordingly, the forfeiture allocation in such a case will “unwind” the prior allocations of income that caused the positive balance, imputing income to the remaining partners in the year of forfeiture.  In effect, the partnership corrects the prior misallocation, not by requiring the filing of an amended return, but by reversing the earlier allocation of income in the year of forfeiture and reallocating it to the other partners.340
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340 Note that a forfeiture allocation to the service partner may be positive if the service partner previously received distributions that were not themselves forfeited and therefore reduced basis.

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Example 6-7: A and B form XYZ, a partnership for tax purposes, as equal partners.  At the beginning of Year 1, XYZ issues an unvested 10% profits interest to C for services. C makes a timely  § 83(b) election. In Year 1, XYZ earns $100 of taxable income; in Year 2, XYZ generates a $50 taxable loss.  In Year 3, C forfeits his profits interest without having received any prior distributions.  During Year 3, XYZ breaks even, generating $100 of gross income and incurring $100 of deductible expenses.  Because XYZ allocated $10 of income to C in Year 1 and$5 of loss to C in Year 2, it will make a $5 “forfeiture allocation”of expenses to C.  After allocating $5 of expense to C, therefore, XYZ allocates a corresponding $5 of incremental income to A and B even though it generated no taxable income in Year 3.

Note that the proposed regulations do not describe the gross income allocation as a taxable “capital shift”by name.  The net effect, however, is precisely that — the forfeiture allocation shifts capital account balances from the service partner to the remaining partners by specially allocating items of deduction and income among them.  The service partner, however, may not claim a loss from the forfeiture itself.341 In the case of a profits interest, therefore, the loss to the service partner is more likely to arise from the allocation, which will reverse prior allocations of profit.342
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341 § 83(b)(1).

342 The preamble to the proposed regulations notes that if a partnership does not have sufficient items of deduction and loss in the year of the forfeiture to “reverse”the prior allocations of income, the service provider may be denied all or a portion of the loss inherent in his/her forfeited tax basis under § 83(b)(1). See REG-105346-03, 70 Fed. Reg. 29675 (5/24/05).  The IRS has requested comments on whether final regulations should permit allocations of “notional”items of deduction or loss in this circumstance.  Id.

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Note: Many forfeiture allocations in the hedge fund context will involve capital losses  to the departing member.  Accordingly, if the allocations of income to the departing member occurred in an earlier taxable year, the departing member may derive no immediate tax benefit.343
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343 § 1212 (individuals cannot carry back capital losses).

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5. Avoiding Local Taxes on Carry 

Structuring the incentive allocation as a partnership interest may also reduce the state and local tax burden on the general partner and its owners.  In many domestic funds, the general partner has offices in New York City (“NYC”).  As an unincorporated entity, a general partner engaged in business in NYC is subject to the unincorporated business tax (“UBT”).  The tax applies to any unincorporated business carried on in whole or in part within the city344 at a rate of 4% of allocable net income after certain adjustments, including a mandatory addback of otherwise deductible payments to partners in exchange for services or the use of capital.345 An unincorporated entity will not be deemed to be engaged in business, however, “solely by reason of the purchase, holding and sale for his, her or its own account of property.”346 For this purpose, “property”includes stock, securities, options, forward contracts, swaps and other “derivative financial instruments.”347 Before 1994, NYC had construed the term “solely” in a strict ‘B’ reorganization sense of the word, prohibiting any other activities not within the trading exception.  That construction produced a cliff effect because any nonexempt income subjected all income to UBT. Effective July 1, 1994, however, the city tempered the severity of this rule with a $25,000 safe harbor.  So long as an unincorporated business received no more than $25,000 in gross receipts from a nonexempt business, NYC would not impose UBT on its trading income.348
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344 N.Y. City Admin. Code § § 11-502(a), 11-503.

345 N.Y. City Admin. Code § § 11-503(a), 11-505, 11-507(3).

346 N.Y. City Admin. Code § § 11-502(c)(2).

347 N.Y. City Admin. Code § § 11-502(c)(1)(A).

348 N.Y. City Admin. Code § § 11-502(c)(3).

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Until 1996, however, the issue of whether carried interest distributions to a general partner even qualified for the trading exception was not clear.  In Swid-Pearlman Management v. Tully,349 the New York State Supreme Court held that the general partner of two limited partnerships that derived its sole source of income from capital gain allocations did not qualify under the trading exception because the general partner received the carried interest for services.  This interpretation effectively rejected the “look through” treatment of the carried interest at the federal level, not to mention long-standing industry practice. The city later amended the UBT to extend the trading exception to capital gains derived from an incentive allocation, determined without regard to whether the general partner acquired its interest for services and without regard to whether the interest was proportionate to contributed capital.350
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349 413 N.Y.S.2d 239 (3d Dep't 1979).

350 See N.Y.S. Bill No. 3424, 218th Gen. Ass., 1st Reg. Sess. (June 11, 1996); N.Y. City Admin. Code § § 11-506(a)(2).  The trading safe harbor is not available, however, to payments treated as occurring between an unincorporated entity and one who is not a partner under § 707 of the Code.  Id.

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Nevertheless, UBT continues to apply to carried interest distributions if the general partner also receives the customary management fee from the underlying fund, which will exceed the $25,000 de minimis exception in all but the smallest of funds.  To protect the carry from UBT, therefore, the sponsor of a NYC fund will usually split the general partner and portfolio manager into two entities, one to hold the carried interest as a passive conduit and the other to operate the fund, receive the management fee, and incur any associated expenses.  Although NYC may attempt to collapse the two entities into a single venture for UBT purposes, the risk of a successful challenge is probably small absent substantial overlapping ownership.351
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351 Even if a single entity were to receive both carry distributions and nonexempt income (e.g., the management fee), thereby disqualifying it from the trading exception, the entity may be able to allocate a substantial portion of the capital gain and other investment income attributable to the carry outside of NYC based upon its “investment allocation percentage,”which generally determines business activity within NYC by reference to the underlying portfolio company.  See N.Y. City Admin. Code § § 11-508(a), 11-508(f).

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6. Pass-Through Structure for General Partner 

Much of the preceding discussion presupposes that the sponsor has structured the general partner as a partnership for tax purposes.  If the sponsor instead were to structure the general partner as a ‘C’ corporation, its individual owners would forego the benefit of the reduced rate of tax on long-term capital gain and QDI on the underlying carry allocations.  Perhaps worse, its shareholders would bear two levels of tax on the carry-related profits, once at the corporate level and once again at the shareholder level upon the distribution of the after-tax proceeds as a dividend. To avoid this result, the sponsor may elect to treat a domestic general partner as an ‘S’ corporation.  Section 1361(b)(1)(D), however, will prohibit the general partner from issuing more than one class of stock.  Under the regulations,352 all outstanding shares of an ‘S’corporation must confer identical rights to distribution and liquidation proceeds, taking into account any differences in rights under the corporate charter, articles, bylaws or under binding agreements. Subchapter S therefore prohibits any form of equity-based non-linear subdivision of the incentive allocation.353 If the sponsor intends to grant anything more than a purely fungible undivided interest in the incentive allocation to its members, it should not use a corporate entity as the vehicle.354
——————————————————————————————

352 Regs. § 1.1361-1(l)(1).

353 For a discussion of the “one class of stock” limitation, see 730 T.M., S Corporations: Formation and Termination.

354 Although the sponsor could structure participations in the carry as deferred compensation without invalidating the S election, the participants would lose the capital gains preference.

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U.S. Income Portfolios: Other Pass-through Entities 
  Portfolio 736-1st: Hedge Funds 
  Detailed Analysis 
  VII. Special Tax Issues for Foreign and Tax-Exempt Investors

A. In General 

1. ECI 

Foreign persons bear full net basis taxation in the United States on income that is “effectively connected”with the conduct of a U.S. trade or business.355 For a foreign person with treaty protection, the imposition of U.S. taxing jurisdiction further requires that the income in question be “attributable to” a U.S. permanent establishment of the foreign person.356 Finally, a foreign corporation is subject to branch profits tax on the deemed repatriation of ECI from the United States to the foreign jurisdiction at a 30% rate.357 Thus, a foreign corporation may incur an effective tax rate on ECI of 54.5%, computed without regard to state and local taxes.358
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355 § § 872(a)(2), 882(a)(1).

356 See, e.g., U.S. Model Income Tax Convention, Articles 5(1), 5(2) (Sept. 20, 1996).

357 § 884.

358 Section 11 of the Code provides for a maximum federal tax rate of 35% on ECI of foreign corporations and  § 884 provides for a branch profits tax on ECI net of such taxes of 30%.  Assuming full application of the branch profits tax, therefore, the effective tax rate on ECI is 54.5% (i.e., (35% + (1 – 35%) x30%)).

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Foreign persons are subject to tax on ECI even if they engage in no direct business activities in the United States. The mere investment by a partner in a partnership that is itself engaged in a U.S. trade or business is sufficient to establish taxing nexus.359 Indeed, this “look-through”rule applies without regard to the number of partnership tiers that may separate the foreign person from the operating partnership.360 A foreign investor in an FOF, for example, is engaged in a U.S. trade or business if it invests in a fund that holds a partnership interest in a single portfolio company that is so engaged.361 If a foreign person or a partnership in which the foreign person is a partner sells an interest in a partnership that is engaged in a U.S. trade or business, the foreign person must treat all or a portion of the gain as ECI.362 Finally, a partnership that generates ECI must withhold each foreign partner's “applicable percentage” of tax on such partner's “allocable share” under  § 704 of the Code.363
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359 § 875(1); see also § 702(b); Regs.  § 1.702-1(b) (character of partnership gains allocated to partner under  § 702(a) determined at partnership level); see also  § 1446 (requiring partnership to withhold “applicable percentage” of ECI allocable to foreign partners).

360 See, e.g., Johnston v. Comr., 24 T.C. 920 (1955) (individual partner in Canadian partnership that invested in partnership engaged in U.S. business treated as engaged in trade or business).

361 In general, treaties do not protect foreign persons from “partnership-to-partner” attribution if the partnership has a U.S. permanent establishment.  See Donroy, Ltd. v. U.S., 301 F.2d 200 (9th Cir. 1962) (office or permanent establishment of U.S. partnership treated as office of each partner for purposes of Canadian treaty); Unger v. Comr., 936 F.2d 1316 (DC Cir. 1991)(limited partnership's permanent establishment attributed to limited partner based upon “aggregate” theory of partnerships); Rev. Rul. 91-32, 1991-1 C.B. 107 (gain attributable to permanent establishment in U.S. under applicable income tax treaty, treating partnership as “aggregate”of partners); Rev. Rul. 90-80, 1990-2 C.B. 170.

362 See Rev. Rul. 91-32, 1991-1 C.B. 107.  Some argue that this ruling is invalid.  See Blanchard, “Rev. Rul. 91-32: Extrastatutory Attribution of Partnership Activities to Partners,”1776 Tax Notes 1331 (Sept. 8, 1997).

363 § 1446(a).  Regs.  § § 1.1446-2 and 1.1446-3.

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2. UBTI 

Tax-exempt entities, including U.S. pension funds, enjoy a broad statutory exemption from U.S. federal income tax on all income other than income attributable to an “unrelated”trade or business.364  Section 511 imposes tax on the “unrelated business taxable income” (“UBTI”) of a tax-exempt entity at regular graduated rates, computed under the same rules that apply to domestic corporations.365 As in the case of a foreign person, the Code will impute the unrelated trade or business activities of a partnership to any tax-exempt partner of the partnership.366 Accordingly, a tax-exempt partner must report its allocable share of any income and deductions attributable to such unrelated trade or business as UBTI.
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364 § § 511, 512, 513.

365 § 511(a)(1). Under § 115, “gross income does not include” income derived from the exercise of any essential governmental function and accruing to a State or any political subdivision thereof, or the District of Columbia or income accruing to the government of any possession of the U.S., or any political subdivision thereof. Except for state colleges and universities, therefore, the income of an entity operated by a state, such as an employee pension plan, should not be subject to tax as UBTI.

366 § 512(c)(1).

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Unlike the rules that apply to a foreign person, however, the UBTI provisions of the Code also apply to leveraged investments. Specifically,  § 514 may recast otherwise exempt interest, dividends or capital gain as UBTI if the underlying property is “debt-financed,” whether the tax-exempt entity borrows directly or through a partnership.367 In contrast, a foreign person is generally free to borrow to fund an otherwise passive investment without fear that the borrowing will “taint” the investment return as ECI.
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367 See § 512(b)(5); see also Regs.  § 1.514(c)-1(a) (Ex. 4).

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3. Common Exception for Investment Income 

Neither a foreign nor tax-exempt entity bears net U.S. tax on interest, dividends or most categories of capital gains, which together comprise the principal return of a typical hedge fund.  A foreign person avoids such taxation as either an “investor”or a “trader,”  neither of which represent the conduct of a U.S. trade or business.368 A tax-exempt entity avoids such taxation by statute.  If a hedge fund limits its investment returns to these categories of income, therefore, a foreign investor in such a fund will bear no net basis U.S. tax and a tax-exempt investor in the fund will bear no U.S. tax at all.369 Unless a foreign investor may claim a lower treaty rate, however, it will bear U.S. withholding tax at a 30% rate on U.S. source dividends and certain limited categories of U.S. source interest.370
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368 The case law defines “investing” as the act of buying, holding and selling stocks or securities for current income and long-term capital appreciation and “trading” as the buying and selling of securities with sufficient frequency to profit from short-term market fluctuations. See Higgins v. Comr., 312 U.S. 212 (1941); Liang v. Comr., 23 T.C. 1040 (1955).   Section 864(b) grants special statutory protection to foreign persons with respect to most trading activities.  See also Regs.  § 1.864-2(c) (“the volume of stock or security transactions effected during the taxable year shall not be taken into account in determining under this subparagraph whether the taxpayer is engaged in trade or business within the United States”).

369 § 512(b).  If the fund investment is “debt-financed,” however,  § 514 may override the statutory exemption.

370 Most categories of interest are exempt from U.S. withholding tax under the “portfolio interest”exception of  § 871(h) and § 881(c) of the Code.  If a foreign lender owns 10% of the voting stock of the U.S. borrower, however, the portfolio interest exemption will not apply.  See § § 871(h)(3)(A); 881(c)(3)(B). If the foreign lender is a partnership, however, proposed regulations would “look through” the partnership to determine whether any of its partners own 10% of the voting stock of the borrower.  See  Prop. Regs. § 1.871-14(g)(3); see also Preamble to the proposed regulations, REG-118775-06, 71 Fed. Reg. 34047 (6/13/06). If the portfolio interest exemption does not apply, the foreign investors will bear withholding tax at a 30% or reduced treaty rate.

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U.S. Income Portfolios: Other Pass-through Entities 
  Portfolio 736-1st: Hedge Funds 
  Detailed Analysis 
  VII. Special Tax Issues for Foreign and Tax-Exempt Investors

B. Application to Hedge Funds 

1. Activities of the Fund as a U.S. Trade or Business 

A typical tax-exempt or foreign investor in a hedge fund seeks to avoid net basis taxation in the United States. Whether it succeeds in doing so will depend upon whether the fund is engaged in a trade or business.  For a foreign investor, neither “trading”nor “investing” is a trade or business.371 For a tax-exempt investor, neither activity is an “unrelated” trade or business under § 513,372 provided that the investor does not borrow to fund the activity.373 The distinction between trading and investing is really more pertinent in the domestic tax context because it often establishes whether an individual investor may deduct the management fee and other costs as a business expense under § 162.374 Most hedge funds therefore seek to confine their activities to those described under the  § 864(b) trading safe harbor.
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371 The case law defines “investing”as buying, holding and selling stocks or securities for current income and long-term capital appreciation and “trading” as buying and selling stocks or securities with sufficient frequency to profit from short-term market fluctuations. See Higgins v. Comr., 312 U.S. 212 (1941); Liang v. Comr., 23 T.C. 1040 (1955).  Section 864(b), however, grants special statutory protection to the trading activities of a foreign person.  See also Regs.  § 1.864-2(c) (“the volume of stock or security transactions effected during the taxable year shall not be taken into account in determining under this subparagraph whether the taxpayer is engaged in trade or business within the United States”).

372 Technically,  § 513 does not exclude trading or investing from the definition of an “unrelated” trade or business.  Rather,  § 512(b) excludes most of the income from these activities (e.g., interest, dividends, capital gains, swap income, etc.) from the definition of UBTI.  See also Regs. § 1.512(b)-1.

373  See § 514.

374 For a fuller discussion of the distinction between “trading” and “investing” and why the distinction is relevant to a U.S. individual investor, see VIII, A, below.

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As described in VII, F, below, however, whether the continuous “origination” of certain types of loans is a trade or business is unclear.

2. Tax Effect of Leverage on Investment Returns 

As described in VII, A, 2, above, the practical difference in the fund context between the separate and distinct rules of net basis taxation that govern foreign investors on the one hand and tax-exempt investors on the other is the impact of debt financing.  If a tax-exempt investor borrows to fund an investment, either directly or through a partnership,375 it may bear tax under  § 514 on income that would otherwise have been exempt under § 512(b). Hedge funds finance the purchase of many of their investments with debt.  Indeed, leverage is an inherent and recurring attribute of many hedge fund investment strategies.  If a tax-exempt entity invests in a hedge fund, therefore,  § 514 is likely to recast a portion of its distributive share of the fund income as UBTI if the fund is a partnership.  To avoid § 514, most tax-exempt investors will fund their investment in the hedge fund through the offshore feeder or parallel vehicle.  As described more fully below, the imposition of a corporate entity between the tax-exempt investor and the leveraged investment of the fund has the effect of “blocking” the debt within a separate and distinct taxpayer, preventing the borrowing from tainting the return to its tax-exempt shareholders as debt-financed income.
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375 See Regs. § 1.514(c)-1(a)(2), (Ex. 4);  Rul. 74-197, 1974-1 C.B. 143.

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U.S. Income Portfolios: Other Pass-through Entities 
  Portfolio 736-1st: Hedge Funds 
  Detailed Analysis 
  VII. Special Tax Issues for Foreign and Tax-Exempt Investors

C. Structuring the Offshore Feeder or Parallel Fund as a Corporation 

1. Purpose 

As described, in VII, B, 2, above, many tax-exempt investors invest in hedge funds through the offshore vehicle.  With few exceptions, the offshore vehicle resides in a low tax jurisdiction, often the Cayman Islands or Bermuda.  It may be the feeder entity in a master-feeder fund or a parallel entity that coinvests with a sibling fund.  The status of the offshore vehicle as a foreign corporation should prevent  § 514 from recasting the leveraged investments of the fund as a direct investment in debt-financed property by the tax-exempt shareholder.

If a tax-exempt entity were to instead invest directly in the fund,  § 514 would recast a portion of its allocable share of the gains as UBTI, assuming that the hedge fund borrows to fund or carry its investments.  If the tax-exempt entity instead invests in the hedge fund through a foreign corporation, the corporation rather than the tax-exempt entity will report the leveraged returns.  As a foreign rather than a domestic corporation, however, the foreign corporation will not bear entity-level tax on these returns except to the extent that they represent ECI. Accordingly, because the trading safe harbor under  § 864(b) exempts income from trading and does not prohibit borrowing,376 the corporate vehicle will generally avoid net basis taxation in the U.S. even though the very same returns would have generated UBTI to a tax-exempt entity. Moreover, when the tax-exempt shareholder tenders its shares for redemption, it will report the proceeds as exempt income under § 512(b).  If the particular withdrawal constitutes a partial redemption that fails to qualify as a “sale” under § 302(a), the tax-exempt shareholder will report the gain as exempt dividend income.  If the withdrawal qualifies as a “sale”(e.g., a complete termination), the tax-exempt shareholder will report the gain as exempt capital gain.
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376 See Regs.  § 1.864-2(c)(2) (buying securities on margin and obtaining credit both subsumed under trading safe harbor).

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In summary, therefore, the use of the corporate feeder is pervasive in the hedge fund sector because it allows the tax-exempt investor to avoid UBTI on its hedge fund returns, but without the implicit cost of corporate-level tax ordinarily associated with the use of a blocker entity.

2. Section 269 

Could the IRS invoke  § 269 to disregard the feeder and apply  § 514 to the tax-exempt shareholder? In the authors' view, the theoretical basis for doing so is weak.   Section 269 authorizes the IRS to disallow any “deduction, credit or other allowance” if any person or persons acquire control of a corporation and “the principal purpose” of that acquisition is the evasion or avoidance of U.S. tax by securing the benefit of such deduction, credit or other allowance.377 For this purpose,  § 269 defines “control”as the ownership of 50% of the vote or value of the stock of a corporation.378
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377 § 269(a).

378 § 269(a)(2).

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In a typical master-feeder structure, one or more of the standard defenses under  § 269 will apply.  First, the feeder may serve a sufficient non-tax objective to negate the required finding of “principal purpose.”   A corporate vehicle, for example, may permit the domestic fund to avoid status as an “investment company”under the Investment Company Act, which excludes certain funds with fewer than 100 investors.379 Unless a special “look through”exception applies, the offshore corporate vehicle may qualify as a single investor for purposes of the ‘100 investor’ cap even though the vehicle has multiple shareholders.380 Second, the shareholder base in the feeder may be sufficiently dispersed to avoid the threshold requirement that one or more persons acquire “control” of the feeder.
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379 15 U.S.C. § 80a-3(c)(1).

380 15 U.S.C. § 80a-48(a).  See generally Schell, Private Equity Funds: Business Structure and Operations at § 8.03.

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Even absent one of the typical defenses, however, § 269 will not apply unless the remedial language of the statute authorizes the IRS to disregard the fund.  In Siegel v. Comr.,381 the taxpayer, a resident of Florida, acquired a 20% interest in a Cuban joint venture to sell vegetable produce to third parties.  The taxpayer held its interest in the joint venture through a Panamanian corporation (“PanamaCo”).  During the years in question, PanamaCo derived substantial profits from the joint venture, which it did not repatriate to the taxpayer.  Following termination of the joint venture, however, the taxpayer liquidated PanamaCo and reported the proceeds in excess of basis as long-term capital gain.382
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381 45 T.C. 566 (1966).

382 The years in question preceded the enactment of Subpart F and PFIC legislation, which would probably have precluded any significant deferral by the taxpayer.

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The IRS assessed deficiencies in tax for the years preceding the liquidation, contending that PanamaCo was a sham and, in the alternative, that  § 269 applied to the taxpayer's acquisition of the Panamanian corporation.  In rejecting the  § 269 argument, the court observed that the IRS had not disallowed any “deduction, credit or other allowance”claimed by the taxpayer, which the statute empowers it to do, but had instead “added to petitioner's reported income.”383 By its terms, therefore,  § 269 did not apply.  Based upon Siegel,  § 269 provides no independent basis for imputing debt-financed income of the feeder to its shareholders.
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383 45 T.C. 566, 578 (1966).

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3. But Offshore Entity Is a PFIC 

Because the offshore vehicle is a corporate entity, it is also a PFIC.384 The PFIC provisions of the Code may subject a taxable U.S. shareholder to a number of undesirable consequences, among them loss of the lower tax rate on long-term capital gain and QDI385 and loss of tax deferral.  Although a detailed discussion of the PFIC rules is beyond the scope of this portfolio,386 a practitioner who advises hedge funds must be familiar with their basic impact in the hedge fund context.  As described more fully below, hedge funds usually prohibit (or at least discourage)taxable U.S. investors from investing in the offshore feeder or parallel fund.
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384 See § § 1291-1298.

385 § 1(h)(1)(C) (15% rate on “adjusted net capital gain”);  § 1(h)(3)(B) (treatment of QDI as component of “adjusted net capital gain”).

386 See generally 923 T.M., PFICs  for a detailed discussion of the PFIC rules.

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Generally, a foreign corporation is a PFIC if(i) 75% or more of its gross income for a taxable year is passive within the meaning of  § 954(c) (the “income test”) or (ii) 50% or more of the average value of its assets produce, or are held for the production of, passive income (the “asset test”).387 Unlike the rules that apply to CFCs, the PFIC rules do not require any minimum threshold of U.S. stock ownership.
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387 § 1297(a).

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a. The Income Test 

A foreign corporation satisfies the income test of  § 1297(a)(1) if 75% or more of its gross income for the taxable year is “passive.”  Income is “passive” for this purpose if it is of a kind that would qualify as foreign personal holding company under  § 954(c) of the Code.  Passive income therefore includes most categories of interest, dividends, and capital gain.388
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388 § § 1297(b)(1); 954(c).

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b. The Asset Test 

A foreign corporation satisfies the asset test if 50% or more of its assets during the taxable year produce passive income or are held for the production of passive income.389 According to Notice 88-22,390 the asset test “applies on a gross basis,” and therefore includes assets funded with debt, “whether secured by particular assets or otherwise traceable to particular assets.”   In applying the asset test, a foreign corporation must determine the average fair market value of its assets as of the end of each quarter.  If an asset generates both passive and nonpassive income, it is bifurcated into an “active” and a “passive”asset based upon the relative percentages of each category of income it produces.391 Notice 88-22 provides special rules for certain types of assets, including intangible assets and working capital.
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389 § 1297(a)(2).

390 1988-1 C.B. 489.

391 Id.

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c. The “Look-Through”Rules 

For purposes of determining whether a foreign corporation is a PFIC,  § 1297(c) establishes an important “look-through”exception to the PFIC rules.  Under the look-through rule, if a foreign corporation owns, directly or indirectly, at least 25% by value of the stock of another corporation, it will be treated as owning its proportionate share of the assets and earning its proportionate share of the income of the corporation.392 As such, the PFIC rules will disregard any actual dividends from such subsidiaries, crediting the parent instead with its pro rata share of the subsidiary's passive and active gross income.393  Moreover, since this look-through rule treats a foreign corporation as owning its proportionate share of the subsidiary's gross assets and earning its proportionate share of the subsidiary's gross income, it is often possible for a relatively small equity investment in an active subsidiary with significant debt on its balance sheet to “swamp” the directly-held passive assets and income of the foreign corporation.
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392 § 1297(c)(1), (2).

393 Most hedge funds do not acquire sufficient stock in a portfolio company to qualify for look-through treatment under § 1297(c).

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d. Investment Usually Not Open to Taxable U.S. 
  Investors 

The typical corporate feeder or parallel vehicle in a hedge fund complex is a PFIC of the classic variety.  Given the nature of its business, the vehicle will fail both the asset and income tests by wide margins.  If a taxable U.S. investor invests in the offshore vehicle and fails to make a valid QEF election,394 therefore, it will bear tax under the “excess distribution” regime of § 1291.
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394 A valid QEF election requires, among other things, that a PFIC make certain information available to the IRS.  See § 1295(a)(2).

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Section 1291 imposes a special tax and interest charge on “excess distributions,”which include gain realized from the disposition of stock in a PFIC.395  Section 1291 applies not only to sales, but  to certain tax-free dispositions as well,396 imposing a rate of tax equal to the “[h]ighest rate ...in effect for such taxable year.”397 To compute the special interest charge, the PFIC rules prorate the excess distribution over the investor's entire holding period.398 Moreover, a U.S. investor subject to this regime may not apply any otherwise available net operating losses or other deductions to shelter the portion of the “excess distribution”gain allocated under  § 1291 to earlier periods.399
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395 § 1291(a)(2).

396 § 1291(f); see also Prop. Regs. § § 1.1291-3, -6.

397 § 1291(c)(2).

398 § 1291(a)(1)(A).

399 § 1291(c)(2).

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Example 7-1: X is a taxable U.S. investor.  On January 1, 2008, X acquires stock in the offshore corporate feeder of a hedge fund for $100.  On December 31, 2017, X tenders the stock to the feeder for $600.  Assume that the feeder is a PFIC and made no distributions during the intervening ten-year period. Assume further that the highest marginal rate applicable to X is 40% and that the tax rate on capital gain and QDI in 2017 is 15%. Finally, assume that  § 6621 provides for an 8% underpayment rate.  Under § 1291, X must treat the $500 of gain as an “excess distribution” and allocate $50 of the gain to each of the years between 2008 and 2016.  In addition to the $20 of tax allocable to the 2017 taxable year ($50 x 40%), X will incur $180 of “aggregate increases in taxes” under  § 1291(c)(2) (i.e., $450 x 40%) and an interest charge of $90.  In this example, therefore, X will bear an effective tax rate on the gain of 58% in the year of redemption (i.e., $290/$500).

e. What If the Taxable U.S. Investor Makes a QEF Election? 

Under limited conditions, a feeder may be the more efficient vehicle to a taxable U.S. investor, even though the feeder is a PFIC.400 Assume, for example, that the investment activities of the fund fail to qualify as “trading”for tax purposes and that a U.S. individual acquires shares in the feeder and makes a timely QEF election.  First, although the QEF election will require the shareholder to report its share of the fund income on a current basis, it will not require the shareholder to forego the capital gains preference on entity-level capital gain.401 Second, because the feeder is a corporation, it will not report the management fee as “investment expense”under  § 212 or the interest expense as “investment interest” under § 163(d).  These expenses will instead reduce “ordinary earnings” at the feeder level, and therefore the amount includible in income at the shareholder level.402 The net effect of the QEF election in this case, therefore, is to convert expenses that would not have been deductible to an individual investor in the underlying fund partnership into a reduction in the amount includible in income of a feeder shareholder. To effect a valid QEF election, however, the feeder must make certain information available to the IRS.403
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400 For a fuller discussion of this point, see VIII, A, 2, below.

401 See § 1293(a)(1)(B). If the underlying fund generates otherwise eligible QDI, however, the offshore feeder will instead bear a 30% withholding tax on its allocable share of the dividend.  See § 881(a).  Moreover, when the feeder distributes its share of the dividend to its individual shareholders, the distribution will not qualify as QDI. See § 1(h)(11)(C)(iii) (excluding PFIC from definition of “qualified foreign corporation”).

402 See  § 1293(e)(1) (defining “ordinary earnings” as excess of earnings and profits over net capital gain).  If the offshore entity has a fee deferral arrangement in place with the portfolio manager, however, the individual shareholders will include the accrued but unpaid portion of the fee in “ordinary earnings” as well.  For a discussion of fee deferral arrangements in the hedge fund context, see VI, B, above.

403 See § 1295(a)(2). If the feeder itself holds stock in a PFIC, however, it cannot make the QEF election because it is not a U.S. person. See § 1295. The individual investor in the feeder, however, would be treated as owning a pro rata share of the PFIC stock. See § 1298(a)(2)(B). When the feeder disposes of the PFIC stock, the statute treats the individual investor  as having sold his or her pro rata share of such stock, which may result in an “excess distribution” under § 1291(b). See § 1298(b)(5).

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U.S. Income Portfolios: Other Pass-through Entities 
  Portfolio 736-1st: Hedge Funds 
  Detailed Analysis 
  VII. Special Tax Issues for Foreign and Tax-Exempt Investors

D. The Outer Boundaries of the ‘Trading’Safe Harbor 

1. The Trading Safe Harbor Generally 

The term “engaged in trade or business within the United States” does not include trading in stocks, securities or commodities for one's own account.404 The broad purpose of this safe harbor is to “facilitate foreign investment in U.S. markets.”405 Foreign investors who invest in hedge fund partnerships, together with the “corporate” offshore feeder or parallel entity, rely on the trading safe harbor to avoid net basis taxation in the United States on their distributive share of the hedge fund earnings.406
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404 See § § 864(b)(2)(A)(ii), (B)(ii); Regs. § 1.864-2(c)(2)(i)-2(d)(2)(i).  Before 1997, the trading safe harbor did not apply to partnerships or foreign corporations with a “principal office” in the United States.  Although the Taxpayer Relief Act of 1997 repealed the “principal office” limitation, Treasury has yet to amend the regulations under  § 864(b) to conform them to the statutory amendments.

405 S. Rep. No. 105-33 at 216 (1997).

406 The securities trading safe harbor does not apply to any member of a partnership that is a “dealer” in stocks or securities, either in the U.S. or abroad.  Regs. § § 1.864-2(c)(2)(ii), -2(c)(2)(iv)(a). Likewise, the commodities trading safe harbor does not apply to any member of a partnership that is a “dealer” in commodities. Regs. § 1.864-2(d)(2)(ii).

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2. Transactions in Derivatives under the Proposed Regulations 

The current  § 864(b) regulations construe the statutory safe harbors broadly.  Under these regulations, the trading safe harbor subsumes a range of transactions involving stock and securities,407 including the buying, selling (including by short sales) or trading in stocks, securities, or contracts or options to buy or sell stocks or securities, either on margin or otherwise, for the account and risk of the taxpayer, and any other activity “closely related thereto.”408 In spite of their breadth, however, the regulations do not expressly sanction the use of derivatives, now a pervasive investment strategy in the market. In an attempt to “modernize”the  § 864(b) regulations,409 therefore, Treasury issued proposed regulations in 1998.  The proposed regulations expand the scope of the safe harbor to permit transactions in derivatives for the taxpayer's own account, including hedging transactions, provided that the taxpayer qualifies as an “eligible nondealer.”410
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407 The regulations define a “security”as any note, bond, debenture, or other evidence of indebtedness, or any evidence of an interest in or right to subscribe to or purchase any of the foregoing.  See Regs. § 1.864-2(c)(2)(i).

408 Id.

409 Treasury promulgated the original  § 864(b) regulations in 1968.  See T.D. 6948 (Mar. 27, 1968).

410 Prop. Regs. § 1.864(b)-1(a).

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The proposed regulations define an “eligible nondealer” as a nonresident who is neither (i) a dealer in stocks, securities or commodities; nor (ii) a person “that regularly offers to enter into, assume, offset, assign or otherwise terminate positions in derivatives with customers in the ordinary course of a trade or business, including regularly holding oneself out, in the ordinary course of one's trade or business, as being willing and able to enter into either side of a derivatives transaction.”411 A dealer in commodities, therefore, cannot effect transactions in an equity or credit derivative under the trading safe harbor even if it is not a dealer in stocks or securities.  Likewise, a dealer in stocks or securities cannot effect transactions in a commodity derivative under the trading safe harbor even if it is not a dealer in commodities.  This particular limitation would appear to conflict with the statute, which permits a dealer in commodities to rely upon the securities trading safe harbor and vice versa.
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411 Prop. Regs. § 1.864(b)-1(b)(1).

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The exclusion also highlights a problem intrinsic to many derivatives, which is their lack of any obvious association to a specific stock, security or commodity under § 864(b)(2).  Indeed, the proposed regulations do not even classify a derivative as a stock, security or commodity.  As a result, the status of a nonresident as a dealer in one category will likely “taint” its status in the other for purposes of applying the safe harbors.412
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412 The preamble to the proposed regulations states that Treasury is considering the appropriate application of both safe harbors to a dealer in a derivative.  See Preamble to the proposed regulations, REG-106031-98, 63 Fed. Reg. 32164 (6/12/98).

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The proposed regulations define a “derivative”to include —

• an interest rate, currency, equity, or commodity notional principal contract; and

• an evidence of an interest, or a derivative financial instrument (including any option, forward contract, short position and any similar financial instrument), in any commodity, currency, share of stock, partnership or beneficial ownership interest in a widely held or publicly traded partnership or trust, note, bond, debenture, or other evidence of indebtedness, or notional principal contract as described above.413

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413 Prop. Regs. § 1.864(b)-1(b)(2).  It is unlikely that Treasury intended to exclude “credit-linked”swaps from the definition of a derivative, even though it omitted any direct reference to them.  Indeed, the definition of derivatives, which includes “an evidence of an interest, or a derivative financial instrument ... in any ... note, bond, debenture, or other evidence of indebtedness,” should extend to most credit derivatives.  Id.; see also Sheppard, “News Analysis —Neither a Dealer Nor a Lender Be, Part 2: Hedge Fund Lending,”reprinted in 2005 TNT 157-3 (Aug. 16, 2005) (“The proposed regulation tries to shoehorn derivatives into the trading safe harbor by analogizing them to the underlying securities and commodities. Credit derivatives, under this approach, would logically be analogous to loans.  Prop. Regs.  § 1.864(b)-1(b)(2)(ii)(E) would define derivatives to include an evidence of an interest or derivative contract in any note, bond, debenture, or other evidence of indebtedness”).

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A taxpayer who enters into a derivative transaction before the effective date of the proposed regulations may report the transaction in accordance with any reasonable position under current law.414 It may also adopt any of the positions reflected in the proposed regulations themselves.415 A foreign investor in a hedge fund may therefore treat the  § 864(b) trading safe harbor as if it applied to derivatives under current law.
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414 Preamble to the proposed regulations, REG-106031-98, 63 Fed. Reg. 32164 (6/12/98).

415  Id.

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3. Transactions in Derivatives under Current Law 

Even before Treasury extended the  § 864(b) trading safe harbor to derivatives, a derivative that hedged a position in a stock, security or commodity still qualified for relief.  The IRS has ruled, for example, that an interest rate swap employed by a taxpayer as part of an integrated investment strategy to hedge interest rate risk fell within the statutory safe harbor because, although the swap itself was not a transaction in stocks or securities, it was “closely related thereto” within the meaning of Regulations § 1.864-2(c)(2)(i):

A principal rationale for including contracts or options to buy or sell securities within the ambit of Regs.  § 1.864-2(c)(2) is that such contracts frequently hedge portfolios of securities.  Since an interest rate swap serves the same function, it qualifies as an ‘activity closely related (to)’ a contract or option to buy or sell securities.416

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416 PLR 9204015; see also New York State Bar Association Tax Section, “Report on Securitization Reform Measures,” 98 Tax Notes 795 (Special Supplement Feb. 10, 2003) (entering into interest rate swaps or other hedges is covered by regulations under § 864(b)); Reich, “Taxing Foreign Investors' Portfolio Investments: Developments and Discontinuities,” reprinted in 98 TNT 114-71 (June 15, 1998) (derivatives entered into to hedge a position in stock, securities or commodities are protected under the trading safe harbors).  The IRS has also ruled that a § 1058-compliant securities lending transaction falls within the  § 864(b) trading safe harbor.  PLR 9041011.

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The same analysis should extend to many other derivatives.  In 2005, the New York State Bar Association observed that “[h]edge funds ... use credit derivatives as part of arbitrage transactions to short risk synthetically, and/or to unbundle the risks of financial instruments they have acquired in order to isolate the risks they wish to take.”417 A credit derivative that transfers the credit or other risks associated with a security that the fund actually holds in its portfolio should therefore fall within the trading safe harbor because, like the swap in the private ruling, the credit derivative is “closely related” to trading in the underlying security.
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417 New York State Bar Association Tax Section, “Report on Credit Default Swaps,”  reprinted in 2005 TNT 176-21 (Sept. 9, 2005).

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Less clear, however, is whether an equity or credit derivative that creates rather than hedges an exposure associated with a stock or security will qualify as “trading in securities” rather than trading in a derivative financial instrument.418 If the derivative itself were construed as an interest in stock or securities (e.g., a cash-settled, single-name credit default swap or a total return equity swap), the trading safe harbor should apply even without resort to the proposed regulations.  If the derivative is instead construed as a distinct investment, a taxpayer would need to rely on the proposed regulations.
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418 The regulations define a security to include any note, bond, debenture, or other evidence of indebtedness, or any evidence of an interest in or right to subscribe to or purchase any of the foregoing.  Regs.  § 1.864-2(c)(2)(i) (emphasis added).

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U.S. Income Portfolios: Other Pass-through Entities 
  Portfolio 736-1st: Hedge Funds 
  Detailed Analysis 
  VII. Special Tax Issues for Foreign and Tax-Exempt Investors

E. Withholding Taxes on FDAP Income 

The Code imposes U.S. withholding tax on several categories of non-effectively connected fixed and determinable income(“FDAP”) derived from U.S. sources.419 Foreign persons bear these taxes whether they derive the income directly or through a partnership.420 The tax rate on FDAP income is 30% unless the foreign person is eligible to claim a reduced rate of withholding under a treaty.421 If organized as a U.S. entity, the fund will bear the primary obligation to withhold from its foreign members.422 If organized as a foreign entity, the nature of the withholding obligation will initially depend on whether the fund is a partnership or a corporation for tax purposes.423 As described in VII, C, above, the sponsor often forms the foreign parallel or feeder entity in a hedge fund as a corporation for tax purposes.  If the entity is a foreign corporation, the Code will impose the withholding obligation on the issuer of the security or other U.S. withholding agent.424 If the entity is a foreign partnership, the Code will probably impose the withholding obligation on either the domestic master fund or other U.S. withholding agent, depending upon whether the entity is a feeder or parallel fund.
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419 § § 871(a), 881(a).

420 § 702(b).

421 § § 871(a), 881(a), 1441(a), 1442(a).

422 See  § 1441(b) (last sentence).

423 A domestic partnership that is a “withholding agent” must withhold tax at source under Regs.  § 1.1441-1 on items of income described in paragraphs (a) and (b) of Regs.  § 1.1441-2 and includible in the distributive share of a member who is a nonresident alien individual, nonresident alien or foreign fiduciary of a trust or estate, foreign partnership, or foreign corporation.  See  § 1441(b) (last sentence); see also Regs.  § 1.1441-1(b)(7) (definition of “withholding agent”).  Special withholding procedures apply to “foreign withholding partnerships.”   See Regs. § 1.1441-5(c)(2).

424 § 1442.

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The withholding obligation is derivative, a collection mechanism for funding the substantive tax liability of the foreign investor.  If a fund withholds with respect to an investor, therefore, it should treat any amounts so withheld as if the fund had distributed such amounts to the investor.  On occasion, however, the amount withheld will exceed the amount otherwise distributable to an investor during the period in question.  The general partner will usually debit the book capital account of the investor by the amount of the “excess” withholding, which will reduce what the investor will receive in a later redemption.  In some funds, however, the fund agreement will characterize the excess portion as a demand loan.  Finally, if a general partner fails to pay the withholding tax, a typical fund agreement will require the investor to indemnify the general partner for any resulting tax, interest or penalties.

The Worksheets provide an example of a typical withholding provision in a fund agreement.

1. FDAP Withholding when Fund Is a Foreign Corporation 

As described in VII, C, above, the offshore vehicle through which the tax-exempt or foreign investor will often hold its investment in the fund is a corporate entity for tax purposes.  The corporate form serves a number of purposes, among them to “block” the entity-level debt that would otherwise tier up to a tax-exempt investor under § 514,425 as well as to facilitate the structure of the incentive allocation as a deferrable fee.426 In addition, should the underlying fund earn any incidental amount of “bad income” (i.e., income that would otherwise constitute ECI or UBTI to a foreign or tax-exempt investor), the corporate form of the intervening vehicle will “trap” the tax return filing requirement within a separate entity.
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425 See § 512(b)(5); see also Regs.  § 1.514(c)-1(a) (Ex. 4).

426 For a discussion of fee deferrals, see VI, B, above.

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With most U.S.-based hedge funds, however, the foreign parallel or feeder entity will operate in a jurisdiction with no income tax treaty with the United States (e.g., Cayman Islands).  A foreign or tax-exempt investor who invests in this vehicle will therefore bear the full economic cost of U.S. withholding tax on U.S. source FDAP income at a 30% rate, even though the same investor may have avoided that cost by investing through a partnership.427 A tax-exempt investor in a partnership, for example, will avoid U.S. withholding tax on FDAP as a U.S. person.  Similarly, a foreign investor in a partnership may qualify for a reduced rate of withholding under a treaty.428 The tax advisor should be mindful, therefore, that the incremental U.S. withholding tax will tend to reduce the net tax or other benefit that the tax-exempt or foreign investor would otherwise derive from investing in the fund through the offshore entity.  Indeed, in an effort to minimize these costs, many hedge funds avoid investments that generate U.S.-source FDAP income.
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427 § 1442.

428 See Regs.  § 1.1441-6(b)(2) (payment of FDAP to “fiscally transparent entity”); Regs.  § 1.1441-1(c)(2) (definition of “flow through entity”).

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2. Pervasive Use of Swaps 

One way that a hedge fund may avoid U.S. withholding tax is to avoid  investments that  attract them.  An offshore hedge fund that invests only in growth stocks and portfolio debt, for example, will avoid U.S. withholding tax entirely.429 A less restrictive alternative is to invest in a derivative.  A typical swap, for example, will capture part or all of the economic return of an asset without a transfer of tax ownership.  Although the return on the underlying asset may generate U.S.-source FDAP income to its foreign owner, the equivalent swap payment will often avoid U.S. withholding tax as foreign source income.430
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429  See § 871(a)(2); Regs.  § 1.1441-2(b)(2)(i) (gains derived from sale of property not “fixed or determinable,” subject to certain exceptions);  § 1441(c)(9) (no withholding on “portfolio interest” under § 871(h)).

430 See, e.g., Regs. § 1.863-7(b)(1) (swap income generally sourced in accordance with residence of recipient); see also § 1441(a) (withholding applies only to FDAP “from sources within the United States”).

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Example 7-2: ParallelCo is a foreign fund that coinvests with MasterCo, a domestic fund. The sponsor organizes ParallelCo as a Cayman Islands corporation through which electing foreign and tax-exempt shareholders invest in MasterCo.  ParallelCo would like to acquire 10 shares of publicly-traded stock in XYZ for$100.  It is expected, however, that XYZ will pay periodic dividends. If ParallelCo acquires the stock, therefore, it will bear U.S. withholding tax at a 30% rate431 even though its shareholders would  have been exempt from tax or eligible to claim a reduced rate under a treaty had they invested directly in MasterCo.  So ParallelCo instead enters into an “equity swap” with ABC bank.  Under the terms of the swap, ABC agrees to pay to ParallelCo an amount equal to any dividends paid on 10 shares of XYZ over a three year term, together with an amount equal to any appreciation in the value of the shares above $100.  ParallelCo in turn agrees to pay to ABC a floating rate of interest on a “notional”amount of $100 over three years, together with an amount equal to any decline in value of the shares of XYZ over the same period.  Although not required to do so, ABC intends to hold at least 10 shares of XYZ over the term of the swap to hedge the underlying risk.

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431 § § 881(a), 1442(a).

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As an economic matter, ParallelCo has borrowed $100 and acquired the XYZ shares from ABC with the proceeds. As a mere counterparty to a swap,432 however, ParallelCo will nevertheless avoid U.S. withholding tax on the periodic payments from ABC because the payments will represent foreign source income.433 Moreover, because the trading safe harbor under  § 864(b) now subsumes this type of derivative,434 neither ParallelCo nor its shareholders will bear net basis taxation on the swap payments.
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432 The preamble to T.D. 8491 states that “the IRS is considering whether notional principal contracts involving certain specified indexes (e.g., one issuer's stock)should be excluded from the general sourcing rules of  Sections 861 through 865...” See Fed. Reg. 53,125, 53,126 (10/8/93).  See also Sheppard, “To Withhold or Not To Withhold on Equity Swaps,”  reprinted in 92 TNT 133-12 (June 29, 1992) (“some tax lawyers have warned that an equity swap involving the shares of a single issuer could be considered a leveraged purchase of these shares by the foreign investor so that tax would have to be withheld...”).

433  See Regs. § 1.863-7(b)(1). But see Notice 2004-52, 2004-32 I.R.B. 168 (requesting information on credit default swaps for purposes of determining their tax treatment including potential application of withholding tax).

434 See Prop. Regs. § 1.864(b)-1(a) (trading in “derivatives” not a trade or business); see also Prop. Regs.  § 1.864(b)-1(b)(2) (defining “derivative” to include “notional principal contract” under § 475(c)(2)).

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U.S. Income Portfolios: Other Pass-through Entities 
  Portfolio 736-1st: Hedge Funds 
  Detailed Analysis 
  VII. Special Tax Issues for Foreign and Tax-Exempt Investors

F. Investments in Debt Securities 

1. Lending as a “Financing” Trade or Business 

Under § 864(b), the act of trading in “securities”is not a U.S. trade or business.  A foreign person who limits his activities in the United States to trading, therefore, will avoid net basis taxation in the United States on the trading income.  A “security”for this purpose includes a “note, bond, debenture, or other evidence of indebtedness.”435 A similar exclusion does not extend to the active conduct of a banking, financing, or similar business in the United States.  These activities will constitute the conduct of a U.S. trade or business, provided that they include, among other things, “making personal, mortgage, industrial, or other loans to the public.”436 A foreign person who engages in this activity, therefore, will bear net basis taxation in the United States on the attributable income.
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435 Regs. § 1.864-2(c)(2)(i)(c).

436 Regs. § 1.864-4(c)(5)(i)(b).

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What does it mean to “trade” in a debt security? Is it limited to the purchase and sale of debt originated by another party? If the  § 864(b) trading safe harbor applies only to the act of buying and selling debt on the secondary market, a foreign investor who funds a loan at original issue cannot rely on the  § 864(b) trading safe harbor to avoid net basis taxation.  By advancing the borrowed funds and, depending on the nature of the loan, negotiating terms and receiving fees, the foreign investor must be acting in some other capacity.

To be sure, a hedge fund that invests in newly-issued debt advances funds and therefore “originates” the debt. Even a fund that acquires outstanding debt will succeed to the rights of the original lender, and therefore will become a lender even though it has not advanced any funds to the borrower.  One cannot equate the mere acquisition of outstanding debt, however, with the trade or business of “making loans to the public.”   Otherwise, both the  § 864(b) trading safe harbor for debt and the  § 871(a) withholding tax on U.S. source interest, each of which presuppose a foreign person not engaged in a U.S. trade or business, would apply only in isolated cases.  The act of “origination”appears to be a necessary (albeit not sufficient) condition to the trade or business of “financial lending.”   A typical hedge fund, therefore, is not engaged in a U.S. lending business merely because it acquires publicly-traded debt on the market.

Note: Under the “portfolio interest” exception, a typical offshore hedge fund that invests in debt of a U.S. borrower (including syndicated loans) will avoid U.S. withholding tax on the interest.437 Although the portfolio interest exception does not apply to a “bank,”438 a hedge fund is not a “bank”within the meaning of the statute because it is not regulated as such under § 581.439
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437 See § 881(c)(1).

438 See § 881(c)(3)(A).

439 See PLR 9822007 (concluding that the term “bank” in  § 881(c)(3)(A) should be defined by reference to  § 581 because “[i]n the absence of . . . regulations . . . the term “bank”must be construed narrowly and must be given a meaning that distinguishes it from all other entities that make commercial loans”).

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a. Loan Origination Generally 

But what if a hedge fund does originate a loan? At what point will the act of loan origination rise from the level of “trading” in debt securities to a full-blown “lending”trade or business?

Although not the subject of this portfolio, many issuers of collateralized debt obligations (“CDOs”)scrupulously avoid the act of origination for fear that the activity would constitute a “financing” business for U.S. tax purposes, subjecting them to net basis taxation in the United States.  In a typical CDO transaction, an offshore vehicle (the “CDO issuer”)will raise cash from investors and acquire a portfolio of debt securities from one or more companies.  The sellers of the portfolio, however, are not the original borrowers, even when the debt in question is of recent vintage.  For newly-issued debt, the CDO issuer usually acquires the securities after the funding event from the original lenders.  Indeed, the lending syndicate will often enter into a “forward sale” of participations in the loans to the CDO issuer and other buyers before it advances the funds to the borrower.  By not acting as the original lender, the CDO issuer does not technically “originate”any of the acquired loans.  The CDO issuer therefore contends that it is not engaged in the trade or business of making “loans to the public.”   Although its relationship with the original lender may bear many of the hallmarks of agency, the CDO issuer does not negotiate directly with the borrower and does not acquire the securities from the original syndicate of lenders for a period of time (e.g., 48 hours).  Moreover, the parties to a typical CDO transaction endeavor to structure the loan participation as a sale by the original syndicate to the CDO issuers, rather than as a joint venture or direct issuance by the borrower.

Whether these types of activities constitute “origination”and, if so, a lending trade or business of the CDO issuer is not clear, and the subject of debate among practitioners.440 Even when the CDO issuer does participate in the syndication group, its role is often no more active than that of an initial purchaser of debt securities in a registered public offering, with much of the actual negotiations confined to the issuer and the lead lender.441
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440 See, e.g., Humphries, “The Way (Securitization) Things Ought To Be,” Tax Forum No. 561 at 16, 37 (Nov. 4, 2002) (noting that line between two activities is “sometimes murky” and that practitioners “tend to be conservative” in establishing permissible scope of activities by CDO issuers due to high stakes of being wrong); Mullin, “The Impact of the ‘97 Tax Act on Private Investment Funds,”15 J. Tax'n Investments 91 (trading safe harbor under § 864 not intended to protect funds that enter into loan syndications); Sicular, “Selected Current Effectively Connected Income Issues for Investment Funds,”56 Tax Law. 719, 761 (Summer 2003) (extensive origination and negotiation by CDO issuers creates “risk” of net basis taxation; but distinction between lending trade or business and trading/investing activities is “far from clear”).

441 See Humphries, “The Way (Securitization) Things Ought To Be,” Tax Forum No. 561 at 16 (Nov. 4, 2002).

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In the domestic context, the issue of whether lending is a trade or business arises not in the context of U.S. jurisdiction to tax, but in the context of whether a U.S. lender may deduct its expenses.  For example, an individual lender may not deduct a “bad debt” as an ordinary loss under  § 166 unless the debt was “created or acquired in connection with a trade or business of the taxpayer.”442 The regulations provide that the status of debt as a nonbusiness debt is a question of fact.443 As a general proposition, however, merely sporadic lending activity is not a trade or business.444
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442 § 166(d)(2)(A) (definition of “nonbusiness debt”).

443 Regs. § 1.166-5(b).

444 See Sicular, “Selected Current Effectively Connected Income Issues for Investment Funds,”56 Tax Law. 719, 750-51 (Summer 2003) —

The Tax Court and the IRS consistently have held that a trade or business of money lending is limited to those ‘exceptional situations' where the taxpayer's lending activities are so extensive and continuous as to rise to the level of a separate trade or business. Specific relevant factors include the number and frequency of loans made by the taxpayer over the years, the amount of time and effort spent on lending activities, the maintenance of an office for purposes of engaging in a money lending business, the employment of employees or other dependent agents, and the maintenance of books and records detailing the taxpayer's money lending activity.

(citations omitted).  For a general discussion of the trade or business requirement under § 166, see 538 T.M., Bad Debts.

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Certain types of origination raise fewer issues than others.  For example, a hedge fund lender may have a shareholder relationship with the borrower as well.  It may acquire newly-issued debt and equity securities of a single issuer.  Or it may choose to advance funds to a particular issuer as debt during a period of declining valuations, seeking to protect a prior equity investment and/or to limit its risk should the financial condition of the issuer deteriorate even further.  It may even acquire newly-issued convertible debt, a form of investment that conveys an equity-like return but creditor remedies upon default.

In none of these cases should a hedge fund be deemed to be engaged in a financial lending business. First, the issuers are neither “customers” of the hedge fund nor part of the “public” at large, but rather companies with whom the hedge fund lender enjoys a shareholder relationship.  Hedge funds that lend on this basis do not hold themselves out as lending institutions. Second, unlike banks and other financial institutions, they generally do not earn commitment fees or other service income in connection with this type of lending, any more than they would derive fees for advancing the funds as equity.445 Third, the fund's primary motivation in advancing the funds is not to secure a fixed return, but to protect a prior or contemporaneous equity investment.  In Whipple v. Comr., for example, the Supreme Court declined to treat loans from a substantial shareholder as incurred in a trade or business of the shareholder when the purpose of the purported lending “services”was to procure investment income —
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445 The receipt of fee income is occasionally cited as evidence that the recipient is engaged in the trade or business of “promoting” corporations.  See, e.g., Milsap v. Comr., 46 T.C. 751 (1966); Whipple v. Comr., 373 U.S. 193, 202-03 (1963) (“the promotion of more than one corporation might lend support to the finding that the taxpayer was engaged in ... promoting corporations for a fee ... but in such cases there is compensation other than the investor's return, income received directly for his own services rather than indirectly through the corporate enterprise”).

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When the only return is that of an investor, the taxpayer has not satisfied his burden of demonstrating that he is engaged in a trade or business since investing is not a trade or business and the return to the taxpayer, though substantially the product of his services, legally arises not from his own trade or business but from that of the corporation.446

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446 373 U.S. 193 (1963).

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In the domestic context, a controlling shareholder who claims an ordinary bad debt deduction under  § 166 for prior advances to a corporate borrower will usually fail to establish a shareholder-level trade or business that is distinct from the trade or business of the corporate borrower.447 Finally, investments in the form of convertible debt or debt with warrants bear many of the basic hallmarks of stock, including the expectation of capital appreciation. It is difficult to imagine how the act of purchasing a convertible instrument or similar investment unit, an investment activity for U.S. tax purposes if structured as equity, could become part of a financial lending business if recast as debt merely because the investor “originated”the investment.448
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447 See, e.g., Kelly v. Patterson, 331 F.2d 753 (5th Cir. 1964)(loan by controlling shareholder and president treated as nonbusiness debt because shareholder not engaged in separate trade or business); Milsap v. Comr., 46 T.C. 751 (1966) (shareholder loans to protect equity investment in controlled corporation constitute nonbusiness debts).

448 See Sicular, “Selected Current Effectively Connected Income Issues for Investment Funds,”56 Tax Law. 719, 773 (Summer 2003) (“nothing ...[about convertible debt financing] suggests a distinction that should be relevant to the tax treatment of the fund for ECI purposes”). See also Leblang &  Rosenberg, “Toward an Active Finance Standard for Inbound Lenders,” 31 Tax Mgmt Int'l J. 131(2002) (“there is essentially no risk under current law that a foreign person that enters into private equity transactions will be treated as engaged in a trade or business by virtue of such activities.  Accordingly, foreign persons who engage in equity finance activities in the United States ... generally will not be engaged in a trade or business by virtue of their equity investment activities, even if the investments take the form of preferred stock ...It is difficult to reconcile this difference in tax treatment between debt financing and equity financing activities”).

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b. Acquisitions of Outstanding Debt by Distressed Securities Funds 

As described in II, B, 2, above, a “distressed securities” fund targets public companies that are bankrupt, insolvent or otherwise financially troubled.  The debt securities of these companies tend to trade at steep discounts to their accreted values, reflecting the increased risk of default attributable to events that have occurred after the date of origination. By purchasing these securities in blocks, a distressed securities fund usually seeks to participate in the bankruptcy or other reorganization of the issuer.

These funds do not originate loans; nor do they acquire the loans to earn a lender's return.  Indeed, a distressed debt investment bears tremendous risk, not unlike an investment in illiquid stock.  What arguably distinguishes the activities of a distressed securities fund from “trading” or “investing,”however, is the process by which the fund achieves these returns. After a distressed securities fund acquires a substantial block of securities, it will usually exploit its controlling position on the balance sheet to extract more favorable terms from the borrower, whether by active participation on the creditors' committees or by exercising other rights under the governing indenture or credit agreement.  These negotiations may lead to a cash payment, a change in payment terms or, in certain cases, an actual exchange of the securities for stock in the reorganized company.  Although the return to the fund will still consist of interest and capital gain, the fund will not have earned it by “trading” in the common law sense.  Should that matter?

In the authors' view, it should not.  First, the very form of the return as interest and capital gain should establish the investment character of the activity unless the activity is a financial lending business.  The trading safe harbor defines “trading”to subsume virtually all non-dealer transactions in stocks and securities, including activities “closely related thereto.”449 Second, the ability to influence the restructuring process is purely derivative, flowing from the rights conveyed through ownership of the securities.  It is the securities themselves, therefore, that convey influence and control to their owner, which in turn produces the financial gain.
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449 Regs. § 1.864-2(c)(1), (2).

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In a technical sense, however, the activities of a distressed securities fund may trigger an “origination.”  One commentator, for example, has observed that the restructuring process itself often results in a “reissuance” of the distressed debt under § 1001.450 If the holder of the distressed debt is deemed to have exchanged old debt for new debt because the new borrowing terms represent a “significant modification” of the old debt, it will have originated the new debt.  Will this sort of “constructive”origination transmute the activities of the fund from trading to a financial lending business?
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450 See Sicular, “Selected Current Effectively Connected Income Issues for Investment Funds,” 56 Tax Law. 719, 771 (Summer 2003); Regs.  § 1.1001-3(b) (definition of “significant modification”).

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It should not.  Although a fund that exchanges old debt for new debt will “originate” the new debt, it will not have advanced funds to the borrower — the issuer borrowed the cash when it issued the old debt.  The financial lending authorities involve the lending of money.451 Indeed, the IRS has accepted this distinction in other contexts.  Prior to the repeal of  § 860L under the Jobs Act, a FASIT was subject to a “prohibited transactions” tax if it originated loans.  The proposed FASIT regulations defined “origination,” however, to exclude the exchange of an old loan for a new loan of the same obligor.452 Because a distressed securities fund does not originate funded debt, it should not be viewed as engaged in a lending business.
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451 See, e.g., Eberhart v. Comr., T.C. Memo 1977-155 (record did not justify finding that taxpayer was in “business of lending money”); Imel v. Comr., 61 T.C. 318 (1973) (rejecting taxpayer's assertion that he was in trade or business of “lending money”); Baker v. Comr., TC Memo 1995-385 (taxpayer must establish that he was in “trade or business of lending money”).

452 Prop. Regs. § 1.860L-1(a)(4). The proposed regulations also defined “origination” to include “making any offer to lend funds to any person.”   Prop. Regs.  § 1.860L-1(a)(3) (emphasis added).

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2. Bank Loan Syndication 

a. “Virtual”Origination 

With increasing frequency, hedge funds participate in bank loan syndications.  In a typical syndication, a group of lenders will jointly fund a single, very large loan, allowing each lender in the syndicate to diversify its credit exposure.  The lead bank serves as the “administrative agent” on behalf of the other syndicate members.  Indeed, for all intents and purposes, the lead bank underwrites the bank loan.453 As such, it earns its primary return not in the form of interest, but in the form of fees for arranging the loan, negotiating the terms and completing the syndication effort. The other syndicate members then advance funds directly to the borrower at closing.  As syndicate members, they often share in the underwriting and arrangement fees as well, even though they had little or no involvement in the syndication effort.
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453 Under Section 3(a) of the 33 Act, however, the lead bank avoids legal status as an underwriter because the bank loan is an exempted “security”.

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The non-syndicate members, often non-bank entities such as prime rate funds, insurance companies, CDO issuers and hedge funds, do not originate any portion of the bank loan, but instead acquire a “participation” in the loan shortly after funding, often within 48 hours of closing.  In a participation, therefore, the lead bank or other syndicate members will fund the entire commitment and “warehouse” a portion of it for later sale to the participants.  Unlike a typical underwriter, however, the syndicate members will assume a degree of credit risk on the “excess”portion of the loan until they sell it to the participants.

Although beyond the scope of this portfolio, the threshold issue of whether a loan participation is a direct loan to the borrower or a “back-to-back” loan to the lead bank is relevant to the issue of origination.  In a syndication, the syndicate members will often consist entirely of regulated banks.  As such, they will sign the credit agreement as parties and have direct contractual “privity”with the borrower.  In a participation, on the other hand, the non-bank purchaser of the previously-funded loan will not sign the credit agreement. Although it may be aware of the ongoing syndication effort before closing, and may even notify the lead bank of the specific terms it will accept in a participation, the non-bank purchaser will not advance funds to the borrower and will therefore not originate any portion of the loan.

For tax purposes, most loan participations constitute sales by the syndicate member of a fractional interest in the underlying loan to the participant.454 If the participant is not a regulated bank, and if the underlying loan is in registered form, the participant buyer will likely report the future payments of interest on the loan as “portfolio interest” under  § § 871(h) and 881(c)(2).455 Although not entirely free from doubt, a foreign investor in a bank loan may report the interest as portfolio interest so long as it is not itself regulated as a bank, even if all of the original members of the loan syndicate were banks.456
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454 Compare Rev. Rul. 78-118, 1978-1 C.B. 219 (loan participation by Export-Import bank to U.S. commercial bank recast as separate loan from U.S. commercial bank to Export-Import bank) with Rev. Rul. 81-251, 1981-2 C.B. 156 (loan participation treated as sale of underlying loan).

455 Portfolio interest does not include “interest received by a bank on an extension of credit made pursuant to a loan agreement entered into in the ordinary course of its trade or business.”   See § 881(c)(3)(A).

456 Compare § 881(c)(3)(A) (referring specifically to “banks”) with Regs.  § 1.864-4(c)(5) (referring to foreign entities engaged in the “active conduct of a banking, financing, or similar business”).

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Assume that a hedge fund operates solely from a U.S. office and regularly acquires participations in bank loans, even “originating” an occasional loan as part of the syndicate. As described in VII, F, 1, above, the conduct of a financial lending business in the United States by a foreign person will subject any income “effectively connected” to that business to net basis taxation.  If a hedge fund participates in a bank loan syndication, is it “trading” in debt securities or is it behaving more like a “banking, financing, or similar business”? 457 The authority on the proper tax characterization of cross-border origination of debt by non-banks is surprisingly limited. The regulations, however, do identify the following six “attributes”of a financing business:
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457 See Regs. § 1.864-4(c)(5).

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• receiving deposits from the public;

• making loans to the public;

• purchasing, selling, discounting, or negotiating for the public on a regular basis, notes, drafts, checks, bills of exchange, acceptances, or other evidences of indebtedness;

• issuing letters of credit to the public;

•providing trust services to the public; and

• financing foreign exchange transactions for the public.

If a foreign person is “engaged in business in the United States” and the business involves “any one or more” of these activities, it is subject to net basis taxation in the U.S. on its “effectively connected”income.458 In Inverworld, the Tax Court cited these regulations as establishing the criteria for determining when the financing activities of a foreign corporation constitute the conduct of a U.S. trade or business.459 If a hedge fund meets these criteria, then either it or its foreign investors will be subject to U.S. tax on the attributable income, including “effectively connected” interest, dividends and capital gains from U.S. sources.
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458 Id. (emphasis added).

459 InverWorld Inc. v. Comr., T.C. Memo 1996-301. Technically, however, the regulation presumes that the foreign person is engaged in a U.S. trade or business and then identifies whether that U.S. trade or business is a “banking, financing or similar business.”   See Sicular, “Selected Current Effectively Connected Income Issues for Investment Funds,” 56 Tax Law. 719, 749 (Summer 2003).

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Of the six attributes enumerated in the regulations, only the second arguably describes a hedge fund member of a bank loan syndication.  But one attribute is sufficient.  If participating in a bank loan syndication and “making ... loans to the public”are one and the same,460 and a hedge fund does so on a regular and continuous basis in the United States, then it will be treated as engaged in a U.S. trade or business.  In most bank loan syndications, therefore, hedge funds that rely on the  § 864(b) trading safe harbor do not participate as members of the original syndicate.  As such, they do not become direct contractual parties to the original credit agreement and do not, at least as a legal matter, “originate”any portion of the bank loan.  They instead acquire a participation in the loan after initial funding based upon fully-negotiated terms, and do not participate in the origination or commitment fees.
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460 Bank loan syndications involve unusually large loans, loans far too large for a single bank.  The reason that the size of these loans is so large is that the borrower may intend to fund an acquisition or some other extraordinary corporate transaction with the proceeds.  If a hedge fund lends only to this rarified class of borrower, therefore, it may not be dealing with the “public.”   But see Sheppard, “News Analysis — Neither a Dealer Nor a Lender Be, Part 2: Hedge Fund Lending,” reprinted in 2005 TNT 157-3 (Aug. 16, 2005) (“Hedge funds sniff that they would never sully themselves by dealing with the great unwashed public ... The necessity and the narrowness of that latter exception [for certain foreign finance subsidiaries] implies a broad notion of what constitutes the public, that is, any unrelated borrower”) (emphasis added); see also Regs.  § 1.864-4(c)(5) (exempting foreign subsidiary that lends solely to its parent).

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b. Impact of Origination on § 864(b) Trading Safe Harbor 

Although at least one commentator disagrees,461 the conduct of a U.S. financial lending business does not disqualify a foreign person from the  § 864(b) trading safe harbor. The statute does not limit the safe harbor to foreign persons who limit their activities in the United States to trading.462 In the syndication context, however, the analysis is a bit more nuanced.  If bank loan syndication is a U.S. trade or business, whether it will expose the trading income to net basis taxation as well will depend not upon whether “trading”is a separate trade or business —  § 864(b) excludes trading —but rather whether the income from such trading is “effectively connected” to the syndication activities.  Although  § 864(b) excludes trading in stocks and securities from the definition of “trade or business,”  § 864(b) has no bearing on the issue of whether the trading income is “effectively connected” to some other trade or business.463
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461 Sheppard, “News Analysis —Neither a Dealer Nor a Lender Be, Part 2: Hedge Fund Lending,”reprinted in 2005 TNT 157-3 (Aug. 16, 2005) (“Well, why can't a taxpayer have a lending business on one side and a securities trading safe harbor on the other? Because the safe harbor assumes that trading is the taxpayer's only contact with the United States. Once the taxpayer is in some other business in the United States, like lending, the securities trading safe harbor goes out the window because the trading would be effectively connected with some other business.  And that other business may well be securities trading —only securities trading standing alone is eligible for the safe harbor”).

462 See § 864(b)(2)(A)(ii).

463 See also Blanchard, “Cross-Border Tax Problems of Investment Funds,” Tax Review (Oct. 16, 2006) (”there are circumstances in which a foreign person can carry on two distinct activities and have income from one of those activities be treated as effectively connected to the other activity. But that is not the same thing as saying that two activities are aggregated and treated as one, or that one taints the other.”).

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In general, investment income is not “effectively connected” to a U.S. trade or business of a foreign person unless it meets either the “asset use” or “business activities”test of the regulations.464 But if the particular activity is a “banking, financing or similar business,” different rules apply.465 Here, investment income from U.S. sources is “effectively connected” only if the income is “attributable to” the U.S. office that conducts the financing business and, even then, only if either the foreign person acquired the stock or security —
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464 § 864(c)(2); Regs.  § 1.864-4(c)(2) (“asset use” test); Regs.  § 1.864-4(c)(3) (“business activities” test).

465 Regs. § 1.864-4(c)(5).

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• as a result of making loans to the public;

• in the course of distributing stocks and securities to the public; or

• in order to satisfy reserve or reserve-like requirements established by a U.S. banking authority.466
  
or the income arises from —
  
•debt either payable upon demand or having a fixed maturity of one year or less from the date of acquisition;

• Treasury securities; or

• any other debt instrument, but limited to the income from the debt instrument multiplied by a regulatory ratio.467

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466 See Regs. § 1.864-4(c)(5)(ii)(a)

467 See Regs. § 1.864-4(c)(5)(ii)(b).

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Accordingly, even if a hedge fund is engaged in financial lending as its sole trade or business activity in the United States, the  § 864(b) trading safe harbor will still exempt that portion of its investment income that is not “effectively connected”with financial lending under these rules.468 In the case of stock and other non-debt investments, therefore, the participation of a hedge fund in a bank loan syndication should not expose trading income to net basis taxation except in unusual circumstances.469 For example, although the special rule will probably taint income from stock or warrants that the fund acquires as partial consideration for the syndicated bank loan (i.e., as part of an “investment unit”),470 or income from stock acquired in a later foreclosure of the bank loan,471 it should not apply to income from a stock or warrant position that a hedge fund acquires on the open market.472
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468 See Regs.  § 1.864-4(c)(5)(vi) (general “asset use” and “business activities” test applies).

469 See Regs.  § 1.864-4(c)(5)(iii) (requires U.S. office to “actively and materially participate”).

470 Regs. § 1.864-4(c)(5)(iv)(a).

471 Regs. § 1.864-4(c)(5)(iv)(b).

472 Regs. § 1.864-4(c)(5)(iv)(c).

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c. Actual Origination:How Much Is Too Much? 

On occasion, a hedge fund will participate in a bank loan syndication.  If it does, and if the regular and continuous participation in bank loan origination is indeed a “banking, financing, or similar business,” how many originations during the year would a court regard as “regular and continuous”?

There is, unfortunately, no clear answer to this question.  First, as a general matter, the precise quantum of business activity in the United States necessary to establish U.S. taxing jurisdiction over a foreign person is unclear.  But it does not require much.  The IRS has ruled, for example, that the entry of a race horse into a single race is a trade or business.473 For a tax-exempt investor, the bar is considerably higher.  To generate UBTI, the unrelated activity of the tax-exempt must not only constitute a trade or business, but the trade or business must be “regularly carried on.”474 In determining whether a tax-exempt “regularly carries on” a trade or business, the UBTI regulations consider both the frequency and continuity of these activities and the manner in which they are conducted.475 They therefore exempt activities that occur over “only a few weeks,” even though the same activities of a foreign person would probably establish the conduct of a U.S. trade in business.476
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473 See, e.g., Rev. Rul. 58-63, 1958-1 C.B. 624; Rev. Rul. 60-249, 1960-2 C.B. 264.  See also GCM 18835, 1937-2 C.B. 141 (“any activities beyond the mere receipt of income from property, and the payment of organization and administration expenses incidental to the receipt and distribution thereof’are sufficient to give rise to a “trade or business”).

474 § 512(a)(1); see also Regs. § 1.513-1(a)(1).

475 Regs. §  1.513-1(c)(1).

476 Regs. § 1.513-1(c)(2).

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For foreign investors, it is not necessary that a trade or business be “regularly carried on.” The mere conduct of a trade or business will suffice, provided that it is regular and continuous.477 In Pasquel v. Comr.,478 a Mexican citizen who was never present in the United States financed the purchase of a ship by a U.S. taxpayer. Without determining whether the financing qualified as debt or a joint venture for tax purposes, the Tax Court declined to treat a single isolated financing in the United States as a trade or business. Accordingly, based upon Pasquel, it is unlikely that a single bank loan origination during the year would establish a financial lending business.479 Well, what about five originations? Under § 7704, a PTP will be taxed as a corporation unless 90% or more if its gross income is “qualifying income.”480 For this purpose, interest on debt is qualifying income unless it is “derived in the conduct of a financial or insurance business.”481 In PLR 9701006, the IRS ruled that a PTP was not engaged in such a business for purposes of § 7704(d) if it “originate[d] on average no more than five new mortgages per year over any five year period.”482
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477 See, e.g., Pinchot v. Comr., 113 F.2d 718 (2d Cir. 1940) (“regular and continuous activity of the kind of which is commonly concerned with the employment of labor; the purchase of materials; the making of contracts; and many other things that come within the definition of business”).

478 12 T.C.M. 1431 (1953).

479 See also Leblang &  Rosenberg, “Toward an Active Finance Standard for Inbound Lenders,” 31 Tax Mgmt. Int'l J. 131(2002) (“the Pasquel opinion seems to stand only for the principle that the number of loans a foreign person makes in the United States and the extent of its U.S. financing activities ...are important factors in the trade or business determination”).

480 For a more general discussion of the PTP rules, see IV, C, above.

481 § § 7704(d)(1)(A) (interest); 7704(d)(2) (excluding interest “derived in the conduct of a financial or insurance business”).

482 The taxpayer also represented that it did not originate loans to unrelated third parties, that the interest income was not integral to its business, and that the interest income represented only a small portion of its total income.

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As described more fully in VII, F, 1, a, above, whether lending is a trade or business also arises in the domestic context.  Here, U.S. taxing nexus is not an issue.  Instead, the status of lending as a separate trade or business establishes whether and how a domestic lender may deduct its associated expenses.  Under § 166, for example, an individual lender may deduct a “bad debt” as an ordinary loss so long as the loan arose “in connection with a trade or business of the taxpayer.”483 As a general proposition, sporadic lending is not a trade or business.484 In Imel v. Comr., for example, the Tax Court stated that the right to claim an ordinary loss on a bad debt applies “only to the exceptional situations in which the taxpayer's activities in making loans have been regarded as so extensive and continuous as to elevate that activity to the status of a separate business.”485
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483 § 166(d)(2)(A).

484 See Sicular, “Selected Current Effectively Connected Income Issues for Investment Funds,” 56 Tax Law. 719, 750-51(Summer 2003).  For a general discussion of the trade or business requirement under § 166, see 538 T.M., Bad Debts.

485 61 T.C. 318, 323 (1973) (emphasis added).

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Whether it is appropriate to even cite these authorities in the cross-border lending context is not entirely clear.486 In the view of one commentator, however, they are “highly relevant,”487 and the authors agree.  The domestic lending authorities would appear to require more frequent origination activity by a debt holder before “trading” in debt rises to the level of a separate lending business.  Even within the domestic context, however, the number of originations in a particular year is but one factor in the analysis, and the authorities are difficult to reconcile.488 It should also be noted that the IRS and the taxpayer tend to assume the opposite litigating postures in the domestic setting, with the IRS asserting that a taxpayer is not a financial lender in order to deny a putative deduction.  The foreign lender coopts this very argument in the cross-border context to claim exemption from U.S. tax.
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486 See, e.g., Comr. v. Groetzinger, 480 U.S. 23 (1987) (declining to formulate uniform definition of trade or business as “counterproductive”);Leblang &  Rosenberg, “Toward an Active Finance Standard for Inbound Lenders,” 31 Tax Mgmt. Int'l J. 131(2002) (noting that “bad debt” authorities addressing status of financial lending as U.S. trade or business may not apply in cross-border context).

487 See Sicular, “Selected Current Effectively Connected Income Issues for Investment Funds,” 56 Tax Law. 719, 749 (Summer 2003).

488 For a fuller discussion of the relevance of the domestic lending authorities in the cross-border context, see Sicular, “Selected Current Effectively Connected Income Issues for Investment Funds,” 56 Tax Law. 719, 749-54 (Summer 2003); see also Leblang &  Rosenberg, “Toward an Active Finance Standard for Inbound Lenders,” 31 Tax Mgmt. Int'l J. 131, note xxxv (2002).

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A more substantive distinction between the two lines of authority is that the lender in many domestic lending cases enjoys a special relationship with the borrower that both predates and precipitates the loan.  A controlling shareholder, for example, may decide to lend funds to a corporation not to generate a lender's return, but to protect a prior equity investment, to establish a senior claim vis-à-vis another shareholder or creditor, or to benefit the business that employs him.  In each of these cases, the domestic taxpayer will usually fail to establish a trade or business that is separate and distinct from the trade or business of the borrower.489 In a bank loan syndication, ulterior motives of this sort are not present.
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489 See, e.g., Kelly v. Patterson, 331 F.2d 753 (5th Cir. 1964) (loan by controlling shareholder and president treated as nonbusiness debt because shareholder not engaged in separate trade or business); Milsap v. Comr., 46 T.C. 751 (1966) (shareholder loans to protect equity investment in controlled corporation constitute nonbusiness debts).

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d. The “Season & Sell” Solution 

Some hedge funds are less sensitive to the tax consequences of loan origination than others.  A hedge fund comprised solely of taxable U.S. investors, for example, should not be concerned that its activities may be construed as a “banking, financing, or similar business” because that status alone will not establish taxing jurisdiction that did not exist before.  As U.S. persons, the investors in the fund will bear net basis taxation in the U.S. on their worldwide income regardless of the character or location of the fund-level activities.  Indeed, they may even prefer status as a “financial lender” if it would otherwise avoid the application of  § 212 to their related expenses.490 Such a fund may therefore originate loans as a direct member of a bank loan syndication without any concern that the activity will not qualify as “trading”or “investing” in debt securities.
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490 For a discussion of the treatment of the management fee as a non-deductible “investment expense” under § 212, see VIII, A, below.

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But in many of these cases, the very same fund will have a related parallel entity that does seek to avoid U.S. taxing nexus.  If the related entity is a foreign corporation that coinvests with the domestic fund in the same positions, it cannot participate in bank loan syndications without risk of net basis taxation in the United States.  On occasion, therefore, the primary fund will acquire a larger fractional interest in the bank loan as a syndicate member, intending to “warehouse” the excess amount for future resale to the affiliate.  If the offshore affiliate acquires a portion of the loan on a later date, is it merely acquiring a bank loan participation from a syndicate member, and therefore “trading”in debt under § 864(b)? 491 Many tax advisors fear that common law agency principles will recast the sale as origination, citing the common control of both funds by a single portfolio manager and, in many cases, disclosure in the PPM that the two funds intend to invest in “lockstep.”
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491 See VII, F, 2, a, above.

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In any event, many hedge funds respond to the rather opaque distinction in the tax law between cross-border trading and financial lending by “seasoning” the bank loan before selling it to the affiliate.  The premise of “season and sell”is that origination of a bank loan is the badge of financial lending business, and may occur either directly or through an agent. Because the same portfolio manager controls both the putative “syndicate”seller and “participant” buyer, the agency risk in this particular context is more acute.  To minimize agency risk, therefore, many hedge funds pursue the following general choreography:

• Aging: the “originating”fund does not sell to its “participating” affiliate until after it has held the loan for a fixed period, often a few months.
  
• Independent Board: the “participating”affiliate has the right, vested in one or more persons not under the control of the portfolio manager, to accept or reject a bank loan participation in any particular case.
  
• Pricing: the “participating” affiliate pays a price that reflects prevailing market conditions at the time of the participation, not at the time of origination.  If interest rates fall in the interim, therefore, the “participating” fund should pay a higher price than the “originating” fund, assuming no intervening change in credit risk.
  
• Empirical Evidence Is Consistent: the occasional rejection of a participation and/or the payment of a different price for a fractional interest in the bank loan should tend to rebut the agency characterization.

U.S. Income Portfolios: Other Pass-through Entities 
  Portfolio 736-1st: Hedge Funds 
  Detailed Analysis 
  VIII. Special Tax Issues for U.S. Individuals

Most hedge funds are partnerships for tax purposes. As described in IV, above, the status of the fund as a partnership serves a number of objectives, among them the avoidance of entity-level tax and the flow-through of character.  For hedge funds that generate QDI or long-term capital gain,492 the second of these objectives is particularly important to the individual investor.493 As described more fully below, however, the partnership form will often limit the deductibility of the fund expenses to these investors.
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492 See § 1(h)(1)(C) (15% rate on “adjusted net capital gain”);  § 1(h)(3)(B) (treatment of QDI as component of “adjusted net capital gain”).

493 QDI passes through under § 702(a)(5); long-term capital gain passes through under § 702(a)(2).

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U.S. Income Portfolios: Other Pass-through Entities 
  Portfolio 736-1st: Hedge Funds 
  Detailed Analysis 
  VIII. Special Tax Issues for U.S. Individuals

A. Deductibility of the Management Fee 

1. Nature of the Problem 

A vital issue for an individual investor in a hedge fund is whether he or she may deduct the periodic management fee.  Unlike a tax-exempt or foreign investor, a U.S. individual investor bears full net basis taxation on his or her allocable share of the fund profits.  The effective tax rate of the individual on these profits, therefore, will depend in part upon whether the management fee is a fully deductible expense.  This in turn will depend upon whether the fund is engaged in a U.S. trade or business.

As partnerships, hedge funds “pass through”items of expense to their investors.494 Their investors may deduct these expenses as business expenses under  § 162 provided that they incur them in “carrying on” a trade or business.  If they do not incur them in carrying on a trade or business, the investors may deduct the expenses under § 212, but subject to very severe limitations.  Whether a fund is engaged in a “trade or business” is a factual question that generally depends upon whether the fund qualifies as a “trader”or an “investor.”495 If it qualifies as a trader,  § 162 will apply; if it does not qualify as a trader,  § 212 will apply.496
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494 § 702.

495 Although “dealing”in securities is also a trade or business, a hedge fund is not a dealer in securities.  See Kemon v. Comr., 16 T.C. 1026, 1032 (1951); see also Marrin v. Comr., 147 F.3d 147 (2d Cir. 1998); (investment partnership treated as trader, not dealer); Regs.  § 1.864-2(c)(2)(iv) (defining dealer as “a merchant of stocks or securities, with an established place of business, regularly engaged as a merchant in purchasing stocks or securities and selling them to customers with a view to the gains and profits that may be derived therefrom”).

496 If a hedge fund partnership incurs these costs as “investment” expenses, the expenses will pass through to the individual partners under Regs. § 1.702-1(a)(8)(i). Investment expenses include “fees for services of investment counsel, custodial fees, clerical help, office rent, and similar expenses.” These expenses are deductible only if “paid or incurred by the taxpayer for the production or collection of income or for the management, conservation, or maintenance of investments held by him for the production of income.”  See Regs. § 1.212-1(g).

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The distinction between “investing”and “trading” is significant because, in the domestic context, the limitations of  § § 67 and 68 apply only to expenses incurred in connection with the former.   Section 162(a) allows a taxpayer to fully deduct most of its ordinary and necessary business expenses.  An expense under § 212, however, is one of many “miscellaneous itemized deductions.”497 An individual may deduct a  § 212 expense only to the extent that its miscellaneous itemized deductions exceed 2% of “adjusted gross income.”  Moreover, the excess amount so deductible is subject to a second “haircut” under § 68, which caps the deduction at the lesser of (i) the excess of a taxpayer's itemized deductions over 3% of his or her adjusted gross income above a specified base or (ii) 80% of the total itemized deductions.  Third, the alternative minimum tax (“AMT”) denies any tax benefit from the miscellaneous itemized deduction.498 Accordingly, an individual subject to AMT may deduct the management fee only if the investee fund qualifies as a “trader”in stocks or securities.
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497 See Regs.  § 1.67-2T (application of  § 67 and § 212 in the partnership context).

498 § 56(b)(1)(A)(i). See generally Gordon, “Concerned Whether a Hedge Fund Will Fail to Qualify For Trader Status? Investors Can Protect Themselves From the Negative Tax Effects,” Journal of Taxation and Regulation of Financial Institutions (Nov./Dec. 2005); see also Gross, “Tax Planning for Offshore Hedge Funds — the Potential Benefits of Investing in a PFIC,” J. Tax'n Investments 187 (2005).

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Although “trading” in stocks or securities is a “trade or business” under § 162, “investing”in the same stocks or securities is not.499 Whether a person is a “trader”is a question of fact.500 In the case of a partnership, the IRS will make the trading determination at the entity level.501 Nevertheless, most of the domestic authorities to have addressed the distinction between “trading” and “investing”have involved individuals, not partnerships.  In the domestic context, the individual in question will either directly manage a portfolio of stocks or securities or will retain a professional money manager to do so on his or her behalf.  Accordingly, although a hedge fund may employ a full-time staff of professional money managers, pursue a range of complex investment strategies, and engage in no other business activities, its status as a “trader” will still depend upon the very same criteria that apply to an individual.
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499 See Higgins v. Comr., 312 U.S. 212 (1941) (wealthy U.S. citizen residing permanently in Paris with office in New York that participated in certain real estate, stock and bond investments based on directions from Paris characterized as investor); see also Liang v. Comr., 23 T.C. 1040 (1955) (treating capital gains derived by foreign taxpayer from stocks and bonds as exempt from U.S. tax because activities of U.S. agent did not constitute trade or business); Cont'l Trading, Inc. v. Comr., 265 F.2d 40 (9th Cir. 1959)(“... since [Higgins] it is fair to say that it is settled law that the mere management of investments and the collection of rents, interests, and dividends is insufficient to constitute the carrying on of a trade or business ...”).

500 See Higgins v. Comr., 312 U.S. 212 (1941) (determination “requires an examination of the facts of each case”); see also Comr. v. Groetzinger, 480 U.S. 23 (1987) (“We therefore adhere to the general position of the Higgins Court, taken 45 years ago, that resolution of this issue requires an examination of the facts in each case”).

501 § 702; see Brannen v. Comr., 78 T.C. 471, aff'd. 722 F.2d 695 (11th Cir. 1984) (because partnership is separate entity, character of deductions under  § 162 resolved at partnership level); see also IRS Coordinated Issue Paper All Industries, Notional Principal Contracts, UIL NO: 9300.20-00 (Jan. 6, 2005); CCA 200238002 (Apr. 25, 2002) (where non-dealer partnership engaged in transactions in securities and various derivatives, trade or business determination made at partnership level); FSA 200111001 (citing Higgins, Groetzinger, Moller and Liang in assessing whether partnership qualified as trader or investor). See also Rev. Rul. 2008-39, 2008-31 I.R.B. 252 (where upper tier partnership's (UTP) activities consist solely of owning other partnerships whose trading constitutes a trade or business, management fees paid by UTP are not deductible under § 162; such fees are passed through to UTP's partners as separately stated § 212 expenses).

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In evaluating whether the activities of a hedge fund, taken as a whole, qualify as “trading” or “investing,”a court will consider the investment strategy of the fund, the nature of the underlying income, and the frequency, extent and regularity of its transactions in stock or securities.502 Nevertheless, the distinction between the two activities remains obscure to this day.  The courts repeatedly inform us that an “investor” seeks a return in the form of interest, dividends and capital appreciation and a “trader” seeks “to catch the swings in the daily market movements and profit thereby on a short term basis.”503 Yet the nature of the income that each derives in these distinct pursuits is identical in all respects save one: holding period.
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502 See Yaeger Est. v. Comr., T.C. Memo 1988-264 (individual treated as investor for purposes of  § 163(d) rather than trader despite exclusive professional investing activities relating to portfolio in excess of $100 million, more than 1,000 trades per year, and margin loans in excess of $70 million), aff'd, 889 F.2d 29 (2d Cir. 1989); see also Moller v. Comr., 721 F.2d 810 (Fed. Cir. 1983), cert. denied, 467 U.S. 1251 (1984); Purvis v. Comr., 530 F.2d 1332 (9th Cir. 1976) (court must examine “the frequency, extent, and regularity of petitioner's securities transactions as well as his intent to derive profit from relatively short-term turnovers”); Boatner v. Comr., T.C. Memo 1997-379 (taxpayer cannot qualify as “trader” unless both actual trading activity was substantial and taxpayer sought to catch swings in daily market movements rather than to profit from long-term holdings”);IRS Partnership Technical Audit Guide 2002, Chapter 12 (Syndicated Investment Partnerships) (discussing “trader” vs. “investor”status for purposes of expense deductions); IRS Publication 550 (Investment Income And Expenses), Chapter 4, Sales and Trades of Investment Property:Special Rules for Traders in Securities.

503 Id.; see also Liang v. Comr., 23 T.C. 1040 (1955)(capital gains of foreign taxpayer from stocks and bonds not subject to U.S. tax under  § 871 because activities of U.S. agent did not constitute trade or business); Paoli v. Comr., T.C. Memo 1991-351 (activities of trader “must seek profit from short-term market swings, unlike those of an investor who seeks capital appreciation and income and who is usually not concerned with short-term developments that would influence prices on the daily market”).

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Although little in the case law is clear, certain aspects of the distinction between a “trader” and an “investor”are clearer than others.  It is well-settled, for example, that the regularity of the taxpayer's activities,504 the size of the portfolio,505 the use of leverage,506 the time devoted to the choosing an investment507 and the financial acumen of the taxpayer are not dispositive.  Indeed, they may not even be relevant.  One should not assume, therefore, that a hedge fund is engaged in a “trade or business” merely because it scores well in each of these categories and engages in no other business activity during the year. Indeed, courts routinely dismiss the quality, nature and volume of the work involved to research, structure and implement a particular investment strategy as evidence of a trade or business.508
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504 See Higgins v. Comr., 312 U.S. 212 (1941) (“no matter how large the estate or how continuous or extended the work required may be, such facts are not sufficient”); see also Groetzinger v. Comr., 771 F.2d 269 (7th Cir. 1985) (“the fact that one person has accumulated more wealth than another (...)so that passive investment may command substantially more of the wealthier person's time and attention than that of a poorer counterpart, would not justify allowing the wealthier taxpayer the benefit of trade or business treatment”); Yaeger Est. v. Comr., 889 F.2d 29 (2d Cir. 1989)(taxpayer not engaged in trade or business even though he devoted full time to investments); Paoli v. Comr., T.C. Memo 1991-351 (“the management of one's own investments is not considered a trade or business no matter how extensive or substantial the investments might be”).

505 Id.

506 Yaeger Est. v. Comr., 889 F.2d 29 (2d Cir. 1989) (taxpayer treated as investor even though he maintained “a margin of debt which would have caused a more faint-hearted investor to quail”).

507 See Abegg v. Comr., 50 T.C. 145 (1968), aff'd, 429 F.2d 1209 (2d Cir. 1970) (activities of investor may include search for new investment opportunities).

508 See, e.g., Moller v. Comr., 721 F.2d 810 (Fed. Cir. 1983), cert. denied, 467 U.S. 1251 (1984); see also Steffler v. Comr., T.C. Memo 1995-271 (taxpayer a mere investor in commodities despite “painstaking study and ...arduous decision making process” allegedly consuming between 40-60 hours per week); Mayer v. Comr., T.C. Memo 1994-209 (fact that taxpayer handled securities investments in businesslike manner is not relevant to trade or business question); Higgins v. Comr., 312 U.S. 212 (1941) (taxpayer treated as mere investor despite businesslike management of securities portfolio, use of two offices, and staff consisting of office manager, assistant, accountant and clerk); but see Shapiro, “Private Securities Partnership – The Trade or Business Issue Examined,” 56 Tax Notes 85 (July 6, 1992) (arguing that hedge funds should perhaps be treated as engaged in a trade or business as a matter of law based upon day-to-day involvement in markets and high level of professionalism).

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More than any other factor, however, rapid portfolio turnover is the clearest path to trader status.  But even here, precisely what sort of buying and selling establishes “trading”is not clear.  In Yaeger, the Tax Court actually admits that it has “never articulated the specific duration of holding period that divides short-swing gain from long-term appreciation.”509 Although the statutory holding period under  § 1222 is not relevant, a long-term holding period is not the badge of a trader.510 But not all short-term gain is “short-swing”gain.  Indeed, the Tax Court has denied “trader” status to a day trader who traded on a daily basis during one quarter but maintained a full-time job as a computer chip engineer.511 Short-swing gains that are merely “sporadic,” therefore, will not establish a “trading” trade or business.512 Once again, it is difficult to distill any guiding principles from these authorities.  That said, a hedge fund that churns its portfolio is more likely to qualify as a “trader”than one that does not.513
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509 55 T.C.M. at 1106.

510 See Mayer v. Comr., T.C. Memo 1994-209.

511 See Chen v. Comr., T.C. Memo 2004-132 (“daily trading in securities for only a quarter of a single taxable year is reasonably characterized as sporadic rather than frequent, regular, and continuous”).

512 See Chen v. Comr., T.C. Memo 2004-132 (“daily trading in securities for only a quarter of a single taxable year is reasonably characterized as sporadic rather than frequent, regular, and continuous”); see also Paoli v. Comr., T.C. Memo 1991-351 (individual not securities trader under  § 163(d) because, although trading activity during single month qualified as trading, “such pattern did not continue throughout the year”). See also Cameron v. Comr., T.C. Memo 2007-260 (trading activity of 46 purchases and 14 sales in one year and 109 purchases and 103 sales the following year did not constitute a trade or business where taxpayer did not trade five days a week and traded on more than 10 days in a given month only twice during the two-year period); Holsinger v. Comr., T.C. Memo 2008-191 (289 trades on 63 days of one year and 372 trades on 110 days of following year did not demonstrate the frequency, continuity, and regularity indicative of a business; taxpayer held to be investor, not trader).

513 See Liang v. Comr., 23 T.C. 1040 (1955) (“The absence of frequent short-term turnover in petitioner's portfolio negatives the conclusion that these securities were sold as part of a trading operation rather than as investment activity”); see also Shapiro, “Private Securities Partnership – The Trade or Business Issue Examined,”56 Tax Notes 85 (July 6, 1992).

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Other interpretive issues arise as well.514 First, the precise meaning of “trade or business,” a phrase that appears in more than 600 subsections of the Code, will depend upon the context, at least at the margins.  In the foreign context, for example, the distinction between a trader and an investor is irrelevant because neither activity is a trade or business, so long as the asset to which the activity relates is a stock, security, commodity, or derivative thereof.515 In the domestic context, the taxpayer may seek to claim a bad debt loss under § 166, to deduct interest expense free of limitation under § 163(d), to deduct a portfolio management fee under § 162, or even to make a  § 475(f) election.516 In the authors'view, however, any authority that construes the phrase “trade or business” in the context of a securities transaction is relevant, whether the issue before the court is the deductibility of an expense or the taxing jurisdiction of the IRS over a foreign person.517
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514 See Groetzinger v. Comr., 771 F.2d 269 (7th Cir. 1985) (“the distinction courts have made between long-term investors and short-term traders trading solely for their own account in securities is an extremely fine one”); see also Schwartz, “How Many Trades Must a Trader Make to Be in the Trading Business?,” 22 Va. Tax Rev. 395 (2003).

515 § 864(b); Regs.  § 1.864-2(c) (“the volume of stock or security transactions effected during the taxable year shall not be taken into account in determining under this subparagraph whether the taxpayer is engaged in trade or business within the United States”).

516 See Groetzinger v. Comr., 771 F.2d 269 (7th Cir. 1985) (stating that “the precise meaning or connotation of the term appears to vary depending upon the provision in which it is used”); see also Groetzinger v. Comr., 82 T.C. 793 (1984) (stating that term “by necessity must obtain a functional definition according to the context in which the question arises”); Rev. Rul. 88-3, 1988-1 C.B. 268 (definition of trade or business under  § 864(b) may differ “in some respects”).

517 Accord Sicular, “Selected Current Effectively Connected Income Issues for Investment Funds,”56 Tax Law. 719, 749 (Summer 2003).

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Second, some courts equate trading with gambling. As the Tax Court in Groetzinger put it, “one gambles on stocks, the other on dogs.”518 Gambling is a trade or business, so long as the taxpayer gambles all the time (i.e., is a chronic gambler).519 The problem with the gambling analogy, however, is that it lends nothing to the analysis — the element of chance influences all investment returns, whether the taxpayer is a trader, an investor or a gambler.
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518 See Groetzinger v. Comr., 82 T.C. 793 (1984).

519 See Comr. v. Groetzinger, 480 U.S. 23 (1987) (holding that full-time gambler who makes wagers for his own account is engaged in trade or business under § 162).

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Third, a taxpayer must satisfy the “trade or business” test during the year in which it claims the alleged business expense.  A hedge fund, however, may change its investment strategy from time to time,520 acting as an “investor” in one year and a “trader”in the next.521 Even without a change in investment strategy, however, a court may consider and draw reasonable inferences from the activities of the taxpayer in a taxable year other than the taxable year under audit.522
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520 For a case involving a change of strategy, see Fuld v. Comr., 139 F.2d 465 (2d. Cir. 1943) (where taxpayer held shares initially as long-term investment but subsequently changed strategy to short-term trading, taxpayer treated as “trader”for period after change).

521 See also Shapiro, “Private Securities Partnership – The Trade or Business Issue Examined,”56 Tax Notes 85 (July 6, 1992) (“if the pattern of the partnership's securities activities changes, then it would seem that its characterization as a trader or investor should change”).

522 See, e.g., Liang v. Comr., 23 T.C. 1040 (1955) (court considered average holding period of securities over six year period in assessing nature of activities in single year under audit).

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Fourth, how a court would apply these criteria to a fund that employs several investment strategies, some pursuing long-term capital appreciation and others more speculative gains, is not at all clear.  Take the example of a hedge fund with a private equity “side pocket.”523 Private equity investing is intrinsically passive.  The income derived from it is not “trading” income.  Does the “side pocket” activity of the fund taint the other activities of the fund? Presumably not, but if not, how does the investor in such a fund allocate the management fee between the two activities? 524 On the one hand, the regulations under § 67 do envision the right of a taxpayer to bifurcate expenses between business and investment activities.525 Moreover, as a policy matter, an individual who invests in two discrete funds, one engaged in “trading”and the other in “investing,” should bear the same effective tax rate as an individual who invests in a hybrid fund that holds the same portfolio and pursues the same two investment strategies. As described above, however, most of the authorities in this area involve individual taxpayers as direct owners of the portfolio in question.  In this context, it is the individual who must “trade,”not someone else.  An individual, in particular one with an actual job, will have great difficulty establishing that he or she also “invests”and “trades” on a regular and continuous basis.  It is quite possible, however, for an individual to engage in both activities as a partner because in the partnership context, it is the nature and frequency of the activity at the entity level that controls.  Moreover, the Code now provides a clear statutory basis for bifurcation.526 Under the mark-to-market election of § 475(f), a securities trader may mark some of its securities to market and hold other securities for investment.527
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523 For a discussion of private equity “side pockets,” see II, A, 6, above.

524 See King v. Comr., 89 T.C. 445 (1987), acq. 1988-2 C.B. 1 (in rejecting IRS attempt to bifurcate, Tax Court stated that it was “not aware of any case which has held that a taxpayer may hold property both as a trader of commodities futures and as an investor in commodities”).

525 Regs. § 1.67-IT(c).

526 § 475(f).

527 See also H.R. Rep. No. 148, 105th Cong., 1st Sess at 690 (1997); Staff of Joint Committee on Taxation, 105th Cong., 1st Sess., General Explanation of Tax Legislation Enacted in 1997 at 180 (Comm. Print 1997); Shapiro, “Private Securities Partnership – The Trade or Business Issue Examined,”56 Tax Notes 85 (July 6, 1992) (detailed discussion of bifurcation issue).

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Fifth, although the number of trades is important, the number that separates the “trader” from the “investor”is unknown.528 In one context, the IRS dismissed 300 trades during a single year as inadequate.529 Indeed, any test that would consider only the sheer number of trades is prone to abuse because the volume of trades may bear no relationship either to the relative capital committed to those trades or to the relative gains and losses from those trades.  A more appropriate test, it would seem, would consider the income attributable to “short-swing” trading relative to the aggregate income of the fund.  Alternatively, because both “trading” and “investing”may generate losses, the relative capital committed to each activity is perhaps a better proxy.
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528 Compare Levin v. U.S., 597 F.2d 760 (Ct. Cl. 1979) (individual was securities trader where he conducted 332 transactions in one taxable year and devoted virtually all of his time to trading) with Estate of Yaeger v. Comr., 889 F.2d 29 (2d Cir. 1989) (individual not a trader despite operating “one man” hedge fund conducting 1262 transactions in a single year).  See also Mayer v. Comr., T.C. Memo 1994-209 (1994) (suggesting that 1100 transactions per year should suffice for trader status). For a more detailed discussion of this factor, see Schwartz, “How Many Trades Must a Trader Make to Be in the Trading Business?,”22 Va. Tax Rev. 395 (2003) (arguing that “case-by-case”approach does not afford adequate guidance).

529 See FSA 199947006 (arguing that taxpayer who bought and sold foreign currency futures contracts, forward contracts, options and swaps was not engaged in trade or business merely because taxpayer entered into 300 trades).

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2. Use of a PFIC to Solve the Problem? 

Finally, the trade or business question is irrelevant to a corporation because  § 212 applies only to an individual.  A domestic corporation engaged solely in the business of holding investments may therefore deduct its non-capital expenses under  § 162(a) even though the activity would not qualify as a “trade or business”under Higgins and its progeny.530 Assume, therefore, that a portfolio manager forms a fund not as a partnership, but as a corporation in a low tax domicile, limiting the activities of the fund to “investing” in stocks or securities.531 Such a fund would avoid net basis taxation in the United States.532 Accordingly, whether the expenses of the fund qualify as “trade or business” expenses under  § 162 is irrelevant.  Such a fund would also constitute a PFIC.533 Assume, however, that its U.S. shareholders make a valid QEF election to avoid the interest charge and to facilitate the pass-through of the net capital gains.  Section 1293 will “cap”the annual QEF inclusions to a U.S. shareholder at its allocable share of the PFIC's earnings and profits.534 The fund-level expenses would therefore reduce the QEF inclusion of the shareholder even though the same expenses would constitute “miscellaneous itemized deductions” to an individual partner.  Oddly, therefore, the use of a PFIC will allow the effective deduction of the management fee by U.S. investors even though the activities of the fund do not qualify as “trading.”
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530 See GCM 37071 (3/30/77) (concluding that corporation engaged solely in holding investment property may deduct expenses under  § 162(a) notwithstanding Higgins).

531 See Gross, “Tax Planning for Offshore Hedge Funds — the Potential Benefits of Investing in a PFIC,” J. Tax'n Investments 187 (2005) (providing similar example).

532 See § 864(b).  Note, however, that the fund will incur U.S. withholding taxes on FDAP income even with respect to income allocable to its U.S. shareholders.  Moreover, the individual shareholders in this example would forego the reporting of their economic share of any dividends paid to the fund as QDI. See VII, E, above.

533 For a discussion of the application of the PFIC rules to an offshore feeder or parallel fund, see VII, C, 3, above.

534 See  § 1293(e) (defining “ordinary earnings” by reference to “earnings and profits”without regard to certain adjustments under § 312(n)).

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U.S. Income Portfolios: Other Pass-through Entities 
  Portfolio 736-1st: Hedge Funds 
  Detailed Analysis 
  VIII. Special Tax Issues for U.S. Individuals

B. Deductibility of Interest Expense(§ 163(d)) 

Section 163 permits a deduction for interest.535 No deduction is allowed, however, for “personal interest.”536 “Personal interest” does not include interest allocable to a trade or business537 or “investment interest.”538 Although “investment interest”is an “itemized deduction,” it is not a “miscellaneous”itemized deduction.539 Nevertheless, an individual may deduct investment interest only to the extent of his or her “net investment income,”540 which is the excess of “investment income” over “investment expense.”541 “Investment expense” is any expense (other than interest) directly connected to the production of investment income.542 “Investment income”is the total gross income from “property held for investment.” Section 163(d), however, excludes both long-term capital gain and QDI from the definition of “investment income” unless the individual elects to bear tax on these categories of income at ordinary income rates.543 An individual may carry forward any disallowed interest to offset net investment income in a later year.544
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535 § 163(a).

536 § 163(h)(1).

537 § 163(h)(2)(A).

538 § 163(h)(2)(B).

539 § § 62, 67(b)(1).

540 § 163(d).

541 See § 163(d)(4).

542 See § 163(d)(4)(C).

543 See  § § 163(d)(4)(B)(iii) (election), 1(h)(2) (reducing “net capital gain” eligible for 15% rate by amount taxpayer elects to treat as “investment income” under § 163(d)(iv)(B)(iii)); see also Regs.  § 1.163(d)-1T (providing mechanics to effect this election).

544 § 163(d)(2).

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For the reasons described below, interest expense on debt incurred to acquire or hold shares in a hedge fund is subject to § 163(d), regardless of whether the fund qualifies as a “trader”or an “investor” for tax purposes.  This conclusion follows from the definition of “property held for investment,”albeit circuitously.   Section 163(d) defines “property held for investment”to include (a) property that produces non-business portfolio income, and (b) any interest held by the individual in an activity involving the conduct of a trade or business which is not a passive activity and with respect to which the individual does not materially participate.545
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545 See § 163(d)(5)(A).

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Accordingly, if a hedge fund does not qualify as a “trader,” the interest that the individual investor incurs on debt to acquire the shares of the hedge fund will constitute investment interest because it will be allocable to property that produces “portfolio income” under clause (a).  If, on the other hand, the hedge fund does qualify as a “trader,”the same interest will constitute investment interest under clause(b).  Clause (a) will not apply because the hedge fund will have derived income “in the ordinary course of a trade or business,”not “portfolio income.”546 Clause (b) will apply, however, because the act of trading personal property for the account of owners of interests in the activity (i.e., the hedge fund investors)is not a “passive activity,” regardless of whether the activity is a “trade or business,”547 and the investor will not have “materially participated” in the activity.548 In both cases, therefore, the shares in the hedge fund will constitute “property held for investment.”549
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546 See  § § 163(d)(5)(A); 469(e)(1).

547 See Temp. Regs. § 1.469-1T(e)(6)(i).

548 See § 469(h)(2).

549 See Furci, Lee, Beurrier, “Certain U.S. Tax Considerations for Organizing U.S. Hedge Funds,” 658 PLI/Tax 130 (2005) (“an interest in a hedge fund will usually be treated as “property held for investment,” regardless of whether the fund is treated as trading or investing”); see also Shapiro, “Private Securities Partnership – The Trade or Business Issue Examined,”56 Tax Notes 85 (July 6, 1992) (same).

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For the same reason, § 163(d) will also apply to an individual investor's distributive share of any interest expense incurred by the fund.  Although § 163(d) does not apply to interest expense incurred by an individual who is directly engaged in “trading,”550 the IRS has ruled that an individual limited partner in a partnership that is so engaged is subject to § 163(d) because the holding of a partnership interest is an activity involving the conduct of a trade or business that is neither a passive activity nor an activity in which such partner materially participates.550.1 Accordingly, an individual investor's distributive share of any fund-level interest expense will constitute investment interest under § 163(d), even if the activities of the fund qualify as “trading.”
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550 See King v. Comr., 89 T.C. 445 (1987), acq. 1988-2 C.B. 1 (individual trader who incurred debt to carry on trading activities not subject to § 163(d)).  The Tax Court reached its conclusion on the basis of legislative history stating that “interest on funds borrowed in connection with a trade or business would not be affected by the limitation.”  See House Report 413, pt. 1, 91st Cong., 1st Sess. 72 (1969), reprinted in 1969-3 C.B. 200, 245; see also Yaeger Est. v. Comr., 889 F.2d 29 (2d Cir. 1989) (same); Rev. Rul. 93-68, 93-2 C.B. 72 (§ 163(d) applies to interest expense on debt incurred to purchase stock because taxpayer did not qualify as “dealer” or “trader”).

550.1 See Rev. Rul. 2008-12, 2008-10 I.R.B. 520, amplified by Rev. Rul. 2008-38, 2008-31 I.R.B. 249. The result would be different if the individual materially participated in the fund's trading activities, but as a limited partner in the fund, the individual would not materially participate.

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U.S. Income Portfolios: Other Pass-through Entities 
  Portfolio 736-1st: Hedge Funds 
  Detailed Analysis 
  VIII. Special Tax Issues for U.S. Individuals

C. Deductibility of the Carry 

An individual investor in a hedge fund should avoid the same sort of “trade or business” limitation that so often suspends the deduction of the management fee with respect to the carried interest of the general partner, provided that the general partner receives the carry as a partnership interest.  For the individual investor, the direct allocation of gains to the general partner will convert what would otherwise constitute a potentially limited deduction from gross income under  § 212 to an exclusion from gross income.  Having reduced his or her allocable share of the income by the allocation of gains to the general partner, therefore, the individual investor does not require a separate deduction.  Had the general partner instead reported the carry as a “fee”for services,  § 704(b) would have required an “investor” hedge fund to allocate 100%of the gains to its investors, together with the carry as a miscellaneous itemized deduction.551
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551 Expenses incident to a sale generally reduce the seller's amount realized for purposes of computing gain or loss under § 1001.  See, e.g., Wilson v. Comr., 49 T.C. 406 (1968), rev'd on another issue, 412 F.2d 314 (6th Cir. 1969); see also Covington v. Comr., 120 F.2d 768 (5th Cir. 1941), cert. denied, 315 U.S. 822 (1942); Regs. § 1.263(a)-2(e) (commissions paid to broker on sale of securities treated as offset to selling price).  Because the portfolio manager receives the carry not as a selling commission but as consideration for managing the portfolio, the carry would not qualify as a selling expense even if recast as a fee for services.

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U.S. Income Portfolios: Other Pass-through Entities 
  Portfolio 736-1st: Hedge Funds 
  Detailed Analysis 
  VIII. Special Tax Issues for U.S. Individuals

D. Passive Losses 

Under § 469, losses from a “passive activity” may offset income from a “passive activity.”552 They may not offset employment, service or other business income.  As noted in VIII, A, above, however, the activity of a hedge fund is not a “passive activity.”553 Accordingly,  § 469 will not prohibit an individual investor from offsetting “active losses” from a hedge fund investment against unrelated “active income”(e.g., employment income) of the investor from another source.554 In practice, however, the “active losses” from the hedge fund investment will tend to consist of capital losses.  Wholly apart from the limitations of § 469, capital losses cannot offset ordinary income except to a very limited extent.555 The purpose of excluding the investment in a hedge fund from the definition of a “passive activity”is to prevent an investor with unrelated passive losses from another source from sheltering hedge fund “trading” income on the basis that the investor did not “materially participate”in the trading.556
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552 See § 469(a).

553 See Temp. Regs. § 1.469-1T(e)(6)(i), (iii) (example involving partnership that “trades” in securities).

554 This assumes that the individual investor has sufficient outside basis to claim the loss under § 704(d).

555 See § 1211(b).

556 See  § 469(c) (definition of “passive activity”); see also 549 T.M., Passive Loss Rules.

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U.S. Income Portfolios: Other Pass-through Entities 
  Portfolio 736-1st: Hedge Funds 
  Detailed Analysis 
  VIII. Special Tax Issues for U.S. Individuals

E. At Risk Limitations 

Section 465 caps any deduction of losses sustained by an U.S. individual from income-producing activities at his or her “at-risk investment.”557 If the losses of the individual exceed the “at risk” amount,  § 465 will allow the individual to carry forward the excess portion to future years.558 An investment in a hedge fund is an income-producing activity within the meaning of § 465.559 The “at-risk amount” is generally the sum of the cash contributed to the hedge fund in exchange for the shares, together with the cash borrowed to acquire the shares, provided that the investor either has personal liability on the debt or has pledged the shares as security.560
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557 § 465(a)(1).

558 § 465(a)(2).

559 § 465(c)(3).

560 § 465(b)(1)(A); (B); (2)(A).

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U.S. Income Portfolios: Other Pass-through Entities 
  Portfolio 736-1st: Hedge Funds 
  Detailed Analysis 
  IX. Key Hedge Fund Elections

A. The § 754 Election 

1. Redemptions 

A hedge fund investor achieves liquidity by redemption.  To fund a redemption request, the hedge fund will usually distribute cash to the investor.  On occasion, however, a hedge fund will distribute a marketable security.  In a partial in-kind redemption, the investor will receive the distributed asset with a carryover basis equal to the fund's basis in the asset immediately before the redemption.561 In a complete in-kind redemption, the investor will receive the distributed asset with a substituted basis equal to the investor's basis in the fund immediately before the redemption.562 In a partial or complete cash redemption, the investor will recognize gain if the cash exceeds the investor's basis in the fund immediately before the redemption.563
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561 § 732(a)(1).  The investor's basis in the distributed asset is limited to its adjusted tax basis in the fund (i.e., outside basis), reduced by any cash received in the transaction. § 732(a)(2).

562 § 732(b).  The substituted basis of the asset will often differ from the fund's basis in the asset before the redemption.

563 § 731(a).  If the withdrawing investor only receives cash, it will also recognize gain attributable to any deemed reduction in its allocable share of unrealized receivables or other “hot assets” in the fund portfolio.  See § 751(b)(1)(B).  But few hedge funds hold such property.  See  § 751(c) (definition of “unrealized receivables”);  § 751(d) (definition of “inventory”).

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Whether a fund distributes cash in excess of basis in complete or partial redemption or distributes a marketable security in complete redemption, it does not adjust the inside basis of its remaining assets unless the fund has a  § 754 election in effect.564 If the fund does not adjust basis, its remaining investors will recognize the same economic gain or loss when the fund disposes of its remaining assets.  A  § 754 election tends to reduce these types of timing distortions by allowing a partnership to adjust the inside basis of its assets under  § 734(b) at the time of the redemption to reflect either gain or loss to the distributee or a basis adjustment to the distributed property in the hands of the distributee.565 Once a fund makes a  § 754 election, the election will govern all subsequent distributions unless the fund revokes it, which requires IRS consent.566 A fund with a  § 754 election in effect may therefore be required to adjust the inside basis of its assets after every redemption.567 To avoid the administrative complexities associated with calculating and tracking these recurring adjustments, most hedge funds do not make the  § 754 election.568
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564 § 734(a).

565 § § 754; 734(b).

566 § 754; Regs. § 1.754-1(a), (c)(1).

567 Cf. Cuff, “Basis Adjustments after Distributions of Partnership Assets: The Section 734/755 Regs,” 93 J. Tax'n 18(July 2000) (“These computations are just the start, since it is also necessary to set up cost recovery schedules for each of the § 734 adjustments to recovery property or amortizable assets.... It is not unusual for partnerships to have thousands, hundreds of thousands, or even millions of assets.  The computational task can become overwhelming. The  § 734 and § 755 Regulations do not permit aggregation.  The task of making and keeping track of all of the adjustments can be extraordinary”).

568 Compare Regs.  § 1.704-3(e)(3)(i) (“for purposes of making reverse  § 704(c) allocations, a securities partnership may aggregate gains and losses ... using any reasonable approach that is consistent with the purpose of § 704(c)”) with T.D. 8847, 64 Fed. Reg. 69903 (12/15/99) (prohibiting securities partnerships from allocating  § 755 basis adjustments under aggregation methodology as “not consistent with the hypothetical sale of individual assets, which is required by the [743(b)] regulations”).

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Example 9-1: Bill requests a complete redemption from Slag, a domestic hedge fund organized as a partnership for tax purposes.  Slag holds the following positions on the date of redemption:
Assets	Adjusted Basis569	Fair Market Value	
Cash (USD)	700	700	
Microsoft Common Stock	300	700	
Cisco Common Stock	900	700	
Pesos	500	600	
MCI Debt	600	100	
Red Hat Common Stock	400	1,200	
Total Assets	$3,400	$4,000	
Liabilities	$1,900	$1,900	
Equity	 	 	
Bill	500	700	
Pat	500	700	
Mike	500	700	
Total Liabilities and Equity	$3,400	$4,000	

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569 The amounts in this column reflect adjusted tax basis net of the $1,900 in non-recourse liabilities.

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Negative 734(b) Basis Adjustments. (a)Assume that Slag distributes the Microsoft stock to Bill.  Bill will acquire the Microsoft stock at a substituted basis equal to his outside basis in Slag.570 Bill's outside basis in Slag immediately before the redemption, which will include his one-third share of Slag's non-recourse liabilities, is $1,133.571 The reduction in his share of these liabilities attributable to the redemption will reduce his basis in Slag to $500.572 In Bill's hands, therefore, the basis of the Microsoft stock will increase from $300 to $500.  Slag, however, now has only $200 of gain inherent in its remaining assets.  Without a  § 754 election, therefore, the remaining investors in Slag will defer the recognition of their share of the $200 of unrealized gain previously inherent in the Microsoft stock until Slag liquidates or they tender their shares to Slag for redemption.  If a  § 754 election had been in effect, however, Slag would have “stepped-down” the inside basis of its remaining assets by $200 (i.e., the amount of Bill's “step-up”).573 This reduction in basis would have preserved the remaining investors' share of the aggregate unrealized gain in Slag's assets at the time of the redemption.

(b) Assume instead that Slag's investment in the Red Hat stock declines to $1 before Bill tenders his shares to Slag.  At this valuation, Bill would receive only $300 in retirement of his shares and would therefore recognize a $200 capital loss. The $200 loss reflects Bill's proportionate share of the $600 of unrealized losses in Slag's assets as of the date of redemption.  If Slag were to dispose of its remaining assets immediately after the redemption, however, its remaining investors would realize the same loss again. The “duplication” of that loss would then reduce the remaining investors' outside basis in Slag.  If a  § 754 election had been in effect, however, Slag would have “stepped-down” the inside basis of its assets by $200 (i.e., the amount of Bill's loss).574

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570 If  § 731(c) had applied to this distribution, Bill would be treated as having received a distribution of cash.  In such a case, Bill would have recognized gain in an amount equal to the difference between the value of the Microsoft stock and his outside basis in Slag.  So long as Slag qualifies as an “investment partnership” and Bill qualifies as an “eligible partner,”however,  § 731(c) will not override the general rules of subchapter K governing in-kind distributions. See § 731(c)(3)(A)(iii) (exception for distributions by investment partnership to eligible partner) (C)(i) (definition of “investment partnership”), (C)(iii) (definition of “eligible partner”).  For a fuller discussion of the treatment of marketable securities under § 731(c), see X, C, below.

571 § § 722, 752(a).

572 § 752(b).

573 Regs.  § 1.734-1(b)(2) (Ex. 2).

574 Regs.  § 1.734-1(b)(2) (Ex. 1).

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Example 9-2: Positive § 734(b)Basis Adjustments. (a) Assume the same facts as Example 9-1 except that Slag distributes the Cisco stock to Bill.  Bill will acquire the Cisco stock at a substituted basis equal to his outside basis in Slag (i.e., $500), representing a $400 “step-down”over Slag's inside basis in the Cisco stock.  This basis step-down will therefore convert Slag's $200 of unrealized loss in the Cisco stock into a $200 unrealized gain to Bill.  Accordingly, the remaining investors will recognize an $800 gain when Slag later disposes of its assets, rather than their $400 proportionate share of the unrealized gain on the date of redemption.  The “duplication” of this gain would then increase the remaining investors' outside basis in Slag.  If a  § 754 election had been in effect, however, Slag would have “stepped-up”the inside basis of its remaining assets by $400 (i.e., the amount of Bill's “step-down”).575

(b) Assume instead that Bill receives a cash distribution of $700.  Bill would recognize a capital gain of $200, which represents his proportionate share of the $600 of unrealized gain in Slag's assets at the time of the redemption.  If Slag were to dispose of its remaining investments immediately following the redemption, its remaining investors would realize the same gain, increasing their outside basis in Slag.  If a  § 754 election had been in effect, however, Slag would have “stepped-up” the inside basis of these investments by $200 (i.e., the amount of Bill's gain), which would reduce the gain to Slag on the subsequent disposition.576

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575 Regs.  § 1.734-1(b)(1) (Ex. 2).

576 Regs.  § 1.734-1(b)(1) (Ex. 1).

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As Examples 9-1 and 9-2 illustrate, the purpose of the  § 754 election in this context is to preserve the aggregate unrealized gain or loss in the remaining assets of a partnership following a distribution, eliminating the potential for duplication of these gains and losses to the remaining partners.  The effect of the  § 754 election in these examples is —

• to step-up the fund's inside basis in its assets if the distributee either recognizes a gain or takes a substituted basis in the distributed asset below the fund's inside basis in the asset; or

•to step-down the fund's inside basis in its assets if the distributee recognizes a loss or takes a substituted basis in the asset above the fund's inside basis in the asset.

A fund with a  § 754 election in effect must allocate the basis adjustment among its remaining assets.577 For this purpose, the Code recognizes two asset categories: (i) capital assets or  § 1231(b) property(capital gain property); and (ii) ordinary income property.578 If a partnership distributes capital gain property or if a distributee recognizes gain or loss, the partnership must allocate the basis adjustment under  § 734(b) among its remaining capital gain property.579 If a partnership instead distributes ordinary income property, it must allocate the basis adjustment under  § 734(b) among its remaining ordinary income property.580
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577 § 755(a)(1); Regs. § 1.755-1(c)(1). For a more complete discussion of the effect of a 734(b) basis adjustment on inside basis, see 716 T.M., Partnerships — Current and Liquidating Distributions; Death or Retirement of a Partner.

578 § 755(b).

579 Regs. § 1.755-1(c)(1)(i), (ii).

580 Regs. § 1.755-1(c)(1)(i).

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If the basis adjustment is negative, the fund first allocates the basis reduction to each loss property within that category in proportion to its relative share of the unrealized loss.581 The fund then allocates any further basis reduction to each such property in proportion to relative tax basis (but not below zero),582 accounting for the reduction over the remaining depreciable life of such property.583 Finally, with respect to any basis reduction that remains, the fund carries it forward to reduce the basis of subsequently-acquired property within the same category.584
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581 Regs. § 1.755-1(c)(2)(ii).

582 Id.; Regs. § 1.755-1(c)(3).

583 Regs. § 1.734-1(e)(2).

584 Regs. § 1.755-1(c)(4).

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Example 9-3: Assume the same facts as in Example 9-1(a) except that Slag has a  § 754 election in effect. With a  § 754 election in effect, the distribution of the Microsoft stock will trigger a$200 negative  § 734(b) basis adjustment to Slag's depreciated assets.  Slag will therefore reduce its basis in these assets in accordance with their relative share of the total unrealized losses.  Because the Cisco stock and MCI debt have declined in value by $700 and $500, respectively, Slag would reduce the basis of the Cisco stock by $57 ($200 x $200/$700)and the basis of the MCI debt by $143 ($200 x $500/$700).585

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585 Regs.  § 1.755-1(c)(6)(i) (illustrative example).

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If the basis adjustment is positive, the fund first allocates the basis increase to each gain property within that category in proportion to its relative share of the unrealized gain.586 The fund then allocates any further basis increase to each such property in proportion to relative values.587 For purposes of depreciating the basis increase, the fund treats the increase as a newly-acquired asset placed in service at the time of the distribution.588
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586 Regs. § 1.755-1(c)(2)(i).

587 Id.

588 Regs. § 1.734-1(e)(1).

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Example 9-4: Assume the same facts as Example 9-2(a), except that Slag has a  § 754 election in effect. With a  § 754 election in effect, the distribution of Cisco stock will trigger a $400 positive § 734(b) basis adjustment to Slag's appreciated assets.  Slag will therefore increase its basis in these assets in accordance with their relative share of the total unrealized gains. At the time of the distribution, the pesos had appreciated by $100, the Red Hat stock had appreciated by$800 and the Microsoft stock had appreciated by $400.  Slag would therefore increase its basis in the pesos by $31 ($400 x $100/$1,300), its basis in the Red Hat stock by $246 ($400 x $800/$1,300)and its basis in the Microsoft stock by $123 ($400 x $400/$1,300).589

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589 Regs.  § 1.755-1(c)(6)(i) (illustrative example).

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2. Transfers of Fund Interests 

Most hedge funds prohibit the transfer of shares to third parties.  The general partner, however, may permit such transfers on a case-by-case basis.  The unfettered right to transfer shares in a hedge fund tends to implicate one of two concerns: registration under the Securities Act590 and taxation of the fund as a corporation under the PTP rules of § 7704.  As described above, hedge fund investors generally achieve liquidity by redemption rather than by the sale of their shares on the market.
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590 For a discussion of the general regulatory environment governing hedge funds, see I, B, above.  For a discussion of the PTP rules of  § 7704 as applied to hedge funds, see IV, C, above.

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If a fund does allow an investor to sell its shares, it may not adjust the inside basis of its assets by the gain or loss to the seller unless it has a  § 754 election in effect or unless the sale results in a “substantial built-in loss.”591 In the absence of a  § 754 election, therefore, a sale of shares at a gain will produce a disparity between the buyer's outside basis in the shares and its allocable share of the fund's inside basis in its assets.  This disparity in basis will distort the future allocation of profit or loss by the fund to the buyer.  If a  § 754 election had been in effect at the time of the sale, the fund would have adjusted the inside basis of its assets under  § 743(b) to eliminate the difference between the buyer's outside basis in the shares and its proportionate share of the fund's inside basis in its assets.592 Unlike the  § 734(b) basis adjustment described in IX, A, 1, above, a basis adjustment under  § 743(b) affects only the buyer of the interest, not the continuing investors.593
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591 § 743(a).

592 § 743(b).  The allocation of the  § 743(b) basis adjustment generally follows the allocation of gain or loss to the transferee in a hypothetical sale of the fund's assets for their fair market value.  See Regs. § 1.755-1(b)(1)(ii). For a detailed discussion of the computation and allocation of the § 743(b) basis adjustment, see 718 T.M., Partnerships — Disposition of Partnership Interests or Partnership Business; Partnership Termination.

593 § 743(b) (“[S]uch increase or decrease shall constitute an adjustment to the basis of the partnership property with respect to the transferee partner only”);Regs. § 1.743-1(j)(1).

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Example 9-5: (a) Assume the same facts as in Example 9-1, except that Bill sells his shares to Andy rather than to Slag in a redemption.  After the sale, Andy's outside basis in Slag ($1,333) will exceed his proportionate share of Slag's inside basis in its assets ($1,133).594 This disparity in inside and outside basis corresponds to the $200 of gain realized by Bill in the sale.  If Slag were to dispose of its assets immediately after the sale, therefore, it would recognize a gain of $600 and allocate one-third of the gain to Andy.  Although Andy will be entitled to increase his basis in the Slag shares from $1,333 to $1,533, he will derive no tax benefit from this basis increase until he sells his shares or Slag liquidates.  If a  § 754 election had been in effect, however, Slag would have “stepped-up” the inside basis of its assets by an amount equal to the excess of Andy's outside basis in his Slag shares over his proportionate share of Slag's inside basis in its assets. The basis step-up would have eliminated the $200 of gain that Slag would otherwise have allocated to Andy in the later sale of assets.

(b) Alternatively, if the fair market value of Bill's interest in Slag had declined to $300, Bill would have recognized a $200 loss on the sale of his shares to Andy.  Andy's proportionate share of Slag's inside basis in its assets would therefore have exceeded his outside basis in the Slag shares by $200.  If Slag were to dispose of its remaining assets immediately following such transfer, it would recognize a loss of $600 and allocate $200 of the loss to Andy.  The allocation of this incremental $200 of loss will “duplicate”the $200 loss just recognized by Bill.  If a  § 754 election had been in effect, however, Slag would have “stepped-down” the inside basis of its assets by $200 after the sale.

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594 Both outside and inside basis will include Andy's one-third share of the $1,900 in non-recourse liabilities.

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3. Stuffing Allocations 

In an effort to minimize the timing distortions that result from periodic redemptions, many fund agreements that do not provide for a  § 754 election allow the general partner to effect “stuffing” allocations. As described more fully in V, D, above, these provisions purport to specially allocate profit or loss to a withdrawing investor in the year of redemption to reduce (or eliminate) the gain or loss inherent in the shares immediately before the redemption. Because the redeemed investor will recognize less gain or loss in the redemption, a valid “stuffing” allocation will tend to temper the types of timing distortions described in Examples 9-1 and 9-2 above.595
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595 For an explanation of why a “stuffing”allocation has no economic effect, see V, D, 3, above. It should also be noted that a stuffing allocation, even if otherwise valid, does not mitigate the timing distortions that arise from the transfer of an interest in the fund from one investor to another.

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Example 9-6: Assume the same facts as Example 9-2(b), except that Slag sells the Microsoft stock before it redeems Bill's shares, recognizing a $400 capital gain.  If Slag were to specially allocate $200 of that gain to Bill rather than to each of its investors in accordance with their capital percentages, Bill's outside basis in Slag would increase to $700.  Following this allocation, Bill would therefore recognize no further gain or loss upon receipt of the $700 distribution.  As a result, Slag's unrealized gain or loss in its assets at the time of the redemption is unchanged. The stuffing allocation therefore achieves substantially the same effect as a  § 754 election, but without the administrative complexities of recurring basis adjustments.

4. “Pushing Down” the Basis Step-Up — Possible Benefit to GP Members 

As described in II, A, above, most hedge funds operate as tiered partnerships, with the general partner serving as the upper-tier partnership (“UTP”)with respect to the underlying fund (“LTP”).  If a general partner redeems the interest of one of its members for cash or other property, it may adjust the inside basis of its assets, in this case the carried interest in the LTP, under § 734(b), provided that it has a  § 754 election in effect.  But absent a sale of the shares or a distribution of cash in excess of basis, a step-up in the carried interest may not convey a current benefit to the remaining members.  If the general partner were permitted to apply the step-up to its allocable share of the underlying investments in the LTP, however, that additional basis would reduce future allocations of gain to the remaining members of the general partner.  The IRS has issued guidance regarding the application of the basis adjustment rules of  § 734(b) and  § 743(b) to tiered partnerships.596
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596 See Rev. Rul. 92-15, 1992-1 C.B. 215 (addressing distributions of property from a UTP); Rev. Rul. 87-115, 1987-2 C.B. 163 (addressing transfers of interests in a UTP).

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If a UTP distributes property other than its interest in the LTP, it will adjust the inside basis of its assets, including its interest in the LTP, if the distributee partner either recognizes gain or loss or takes a substituted basis in the distributed property that differs from the UTP's inside basis in the property, provided that the UTP has a  § 754 election in effect.  If the UTP adjusts its basis in the LTP interest and the LTP also has a  § 754 election in effect, the LTP will adjust the basis of its assets under § 734(b). Under Revenue Ruling 92-15, however, only the UTP and its members may participate in the basis adjustment, not the other members of the LTP.597 Special basis adjustment rules apply when a UTP distributes its interest in an LTP and both the UTP and LTP have  § 754 elections in effect.598
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597 Rev. Rul. 92-15, 1992-1 C.B. 215 (basis adjustment within LTP does not affect basis of other partners of LTP).

598 Id.

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Example 9-7: ABC is the general partner of the Slag fund, both of which constitute partnerships for tax purposes.  ABC holds the carried interest in Slag as its sole asset.  On December 31, 2007, the carry had a fair market value and book capital account of $8 million.  Because the Slag fund had $4 million of unrealized portfolio gains allocable to ABC at that time, however, ABC's tax capital account in Slag is only $4 million. On the same date, Vinay holds 25% of the shares in ABC with a book capital account of $2 million and an outside tax basis of $1 million.  On January 1, 2008, ABC borrows $2 million and distributes the proceeds to Vinay in complete redemption of his shares, triggering $1 million of gain to Vinay.  Because ABC has a  § 754 election in effect, it “steps up” its basis in the carried interest by $1 million.  If the Slag fund realizes the $4 million of unrealized gain during 2008, the remaining members of ABC will nevertheless report the entire $4 million of gain in spite of the $1 million basis step-up.  If, on the other hand, the Slag fund also has a  § 754 election in effect, the Slag fund would have “stepped-up” the inside basis of its investments by $1 million, allowing ABC to report only$3 million of gain to its remaining members.

In this particular case, therefore, the general partner of the hedge fund will benefit from the fund-level  § 754 election.  It should be noted, however, that the basis for this result is open to doubt.599 As described in IX, A, 1, above, the purpose of the  § 754 election is to reduce the timing distortions in future allocations of profit and loss that would otherwise result from a distribution by allowing a partnership to adjust the basis of its remaining assets under  § 734(b) to account for either gain or loss to the distributee or a basis adjustment to the distributed property in the hands of the distributee.600 In this example, however, the Slag fund did not make a distribution.601 Revenue Ruling 92-15 nevertheless concludes that “it is appropriate” to treat a distribution by a UTP that triggers a basis adjustment to an interest in an LTP as if the LTP had made a similar distribution to the UTP, thereby “pushing down” the basis adjustment to the assets of the LTP.  The authority issue aside, however, by allowing the UTP to “push-down”the basis step-up to the LTP assets, the ruling provides the same tax benefit to the members of the UTP that the members would have derived had they held their respective interests in the LTP directly.
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599 See Pennell & Postlewaite, “Adjusting the Basis of Assets in Tiered Partnerships Under IRS’ Questionable New Ruling,” 77 J. Tax'n 4(1992) (discussing the technical problems of Rev. Rul. 92-15).

600 § § 754; 734(b).

601 Nor did any member of the Slag fund transfer an interest in the fund.

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Finally, if a UTP has a  § 754 election in effect and one of its members sells to a third party, the UTP must adjust the inside basis in its assets (including its interest in a LTP) to reflect any gain or loss to the selling member.  If the UTP adjusts its inside basis in the LTP and the LTP has a  § 754 election in effect as well, the LTP will also adjust the inside basis in its assets allocable to the UTP under § 743(b).602
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602 Rev. Rul. 87-115, 1987-2 C.B. 163.

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5. “Mandatory” § 754 Elections 

Under a Jobs Act amendment to  § § 734 and 743, a partnership must reduce the inside basis of its assets after certain distributions from, or transfers of interests in, the partnership, even if the partnership has no  § 754 election in effect.603 A partnership must reduce the inside basis of its assets after —
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603 American Jobs Creation Act of 2004, P.L. 108-357.

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• any distribution that would trigger a “substantial basis reduction;”604 or
  
• any transfer of an interest in the partnership if the partnership has a “substantial built-in loss” at the time of the transfer.605

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604 § 734(a).

605 § 743(a).

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A distribution is deemed to trigger a “substantial basis reduction” if a negative  § 734(b) adjustment in excess of $250,000 to the inside basis of the partnership's assets would have been required had a  § 754 election been in effect at the time of the distribution.606 If a distributee recognizes a loss on a distribution in excess of $250,000 or takes a substituted basis in the distributed property that exceeds the partnership's inside basis in such property by more than $250,000, the partnership must apply  § 734(b) as if it had a  § 754 election in effect at the time of the distribution.  Similarly, a “substantial built-in loss” is deemed to exist and a partnership is therefore required to adjust the basis of its assets under  § 743(b) if the basis of the assets exceeds their fair market value by more than $250,000 immediately after the sale of a partnership interest.607
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606 § 734(d).

607 § 743(d).

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Under a narrow safe harbor, an “electing investment partnership” will not be deemed to have a “substantial built-in loss,” and will therefore avoid a mandatory basis adjustment under § 743(b), following the sale of a partnership interest at a loss.608 In lieu of the basis adjustment,  § 743(e)(2) allows the partnership to limit the allocation of future losses to the transferee partner.  To effect the  § 743(e) election, a partnership must satisfy a number of conditions, including (i) that it issue all partnership interests pursuant to a private offering within 24 months of the first capital contribution to the partnership; (ii) that the partnership agreement provide “substantive restrictions” on the right of each partner to require redemption; and (iii) that the term of the partnership agreement not exceed 15 years.609
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608 § 743(e)(1).

609 § 743(e)(6).

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Few hedge funds qualify as “electing investment partnerships.” Indeed, most hedge funds fail all three of these conditions.  Even if a hedge fund were to qualify as an electing investment partnership, the  § 743(e) election would only exempt the fund from the mandatory basis adjustment under § 743(b), not the mandatory basis adjustment under § 734(b).  Because hedge fund investors achieve liquidity by redemption, the type of transaction to which the  § 743(e) election affords relief rarely even occurs in the hedge fund context.610
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610 The election is also unavailable to a partnership that “has [ever] been engaged in a trade or business.”  See § 743(e)(6).  Accordingly, a hedge fund that is a partner in another partnership that is itself engaged in a trade or business cannot make the election.  See § 875(1).  In Notice 2005-32, however, the IRS announced that, pending further guidance, it would not treat a UTP as engaged in the trade or business of an LTP “if, at all times during the period in which the [UTP] owns an interest in the [LTP], the adjusted basis of its interest in the [LTP] is less than 25 percent of the total capital that is required to be contributed to the [UTP] by its partners during the entire term of the [UTP].”2005-16 I.R.B. 1.

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Accordingly, a hedge fund can no longer avoid the administrative complexities of recurring basis adjustments if the adjustments would trigger a “substantial basis reduction”or “substantial built-in loss.”  Less clear, however, is how the industry will respond to this new regime.  Some funds will make an affirmative  § 754 election. If a fund is required to “step down” the inside basis of its assets as if it had made a  § 754 election, some portfolio managers may decide to claim the benefit of the  § 754 election as well.  Other funds will not make the  § 754 election. For a non-electing fund, a “stuffing” allocation may circumvent a mandatory basis adjustment under  § 734(b) for certain redemptions, assuming that the allocation had economic effect.611 Accordingly, some funds may attempt to combine periodic stuffing allocations and negative basis adjustments to avoid the specter of recurring basis adjustments on each and every redemption date.612
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611 It does not.  See V, D, 3, above.

612 For an example of a stuffing allocation that, if respected, will avoid a “substantial basis reduction” under § 734, see V, D, 4, above.

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U.S. Income Portfolios: Other Pass-through Entities 
  Portfolio 736-1st: Hedge Funds 
  Detailed Analysis 
  IX. Key Hedge Fund Elections

B. The Mark-to-Market Election 

1. Section 475 

In general,  § 475 requires a dealer in securities to mark its securities to market on the last business day of each taxable year.613 A dealer in securities therefore recognizes its gains and losses as ordinary income or loss, determined as if the dealer had sold each of its securities for fair market value.614 The statute defines a “dealer”in securities as a person who regularly purchases securities from or sells securities to customers in the ordinary course of a trade or business.615
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613 § 475(a).  Congress enacted  § 475 in response to a concern that securities dealers were understating their income under the cost or lower-of-cost-or-market methods of accounting.  H. Rep. No. 111, 103d Cong., 1st Sess. at 661 (1993).

614 § 475(d)(3).

615 § 475(c)(1).

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Prior to 1997,616  § 475 applied only to a dealer in securities.  As amended, however,  § 475 now applies to an electing “trader”in securities as well.617 If a trader in securities makes the  § 475(f) election, the election will apply to all securities held in connection with its business as a trader.618 If a particular security is not connected to the trading business and is clearly identified as such, however, an electing trader may exclude the security from mark-to-market accounting.619 A taxpayer may not revoke the  § 475(f) election without IRS consent.620
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616 Taxpayer Relief Act of 1997, P.L. 105-34.

617 § 475(f).

618 § 475(f)(1)(A).

619 § 475(f)(1)(B); see also H.R. Rep. No. 220, 105th Cong., 1st Sess. at 515 (1997)(“Because the conferees are concerned about issues of taxpayer selectivity, the conferees intend that an electing taxpayer must be able to demonstrate by clear and convincing evidence that a security bears no relation to activities as a trader in order to be identified as not subject to the mark-to-market regime”).

620 § 475(f)(3).

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Section 475 defines a “security” broadly to include (i) stock; (ii) a partnership interest; (iii) a debt instrument; (iv) an interest rate, currency or equity notional principal contract; (v) an interest in or a derivative financial instrument in any of the foregoing (including any option, forward contract, short position, and any similar financial instrument);and (vi) any hedge of the foregoing that the taxpayer identifies as such before the close of the day on which the taxpayer enters into the hedge.621
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621 § 475(c)(2).

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2. Hedge Funds Not Subject to § 475 

As described above,  § 475 requires a dealer in securities to report its gains and losses on a mark-to-market basis. Because a hedge fund is not a dealer in securities, it is not subject to § 475. It does not hold its securities as inventory and does not sell its securities to customers.622 Indeed, a foreign investor in a hedge fund relies on the status of the fund as a “trader”to avoid net basis taxation.623 If a hedge fund were a dealer, its foreign investors could not claim the benefit of the  § 864(b) trading safe harbor on their allocable share of the fund returns.624
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622 See generally H.R. Rep. No. 148, 105th Cong., 1st Sess at 444(1997) (“Traders in securities generally are taxpayers who engage in a trade or business involving active sales or exchanges of securities on the market, rather than to customers”); Bienfeldt v. Comr. 231 F.3d 1035 (7th Cir. 2000) (“The standard distinction between a dealer and a trader is that the dealer's income is based on the service he provides in the chain of distribution of the goods he buys and resells, rather than on fluctuations in the market value of those goods, while the trader's income is based not on any service he provides but rather on, precisely, fluctuations in the market value of the securities or other assets that he transacts in”).

623 A foreign fund that elects to be taxed as a corporation also relies on the  § 864(b) trading safe harbor.  See VII, B, 1, above, for a discussion of the trading safe harbor as applied to foreign investors in both domestic hedge funds and offshore feeder funds.

624 See  § 864(b)(2)(A)(ii) (excluding dealers).

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3. May a Hedge Fund Make the § 475(f)Election? 

The  § 475(f) election is available only to a “trader”in securities.  Is a hedge fund a trader in securities? The issue of whether a taxpayer qualifies as a trader arises in many different contexts, most often in the context of whether  § 162 or  § 212 applies to the associated expenses.  As described more fully in VIII, A, above, whether a taxpayer is a trader is a facts-and-circumstances test under the common law.625 Rapid portfolio turnover is a vital factor in this analysis, perhaps the surest path to trader status.  Yet a court has yet to quantify, either by frequency of trades or average holding period, precisely what sort of buying and selling activity qualifies as “trading”under the common law.  In Yaeger, the Tax Court admits as much, stating that it has “never articulated the specific duration of holding period that divides short-swing gain from long-term appreciation.”626 Although a one year holding period is not the badge of a trader,627 the statutory holding period under § 1222 is not the interval of time that distinguishes “trading”in a security from “investing” in a security.  Even daily trading constitutes investment if it is merely “sporadic”as opposed to regular and continuous.628
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625 See Higgins v. Comr., 312 U.S. 212 (determination “requires an examination of the facts of each case”); see also  Comr. v. Groetzinger, 480 U.S. 23 (1987) (“We therefore adhere to the general position of the Higgins Court, taken 45 years ago, that resolution of this issue “requires an examination of the facts in each case”).

626 55 T.C.M. at 1106.

627 See Mayer v. Comr., T.C. Memo 1994-209.

628 See Chen v. Comr., T.C. Memo 2004-132 (“daily trading in securities for only a quarter of a single taxable year is reasonably characterized as sporadic rather than frequent, regular, and continuous”); see also Paoli v. Comr., T.C. Memo 1991-351 (individual not securities trader under  § 163(d) because, although trading activity during single month qualified as trading, “such pattern did not continue throughout the year”).

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Unlike § 475(f),  § 864(b) ignores the holding period of a stock or security.  The trading safe harbor applies whether a foreign person trades stock or securities every day or once every five years, provided that the foreign person is not a dealer.629  Section 864(b) therefore provides statutory protection from net basis taxation even if the activity of the foreign person constitutes mere “investment” under the common law, which is not a trade or business.  But neither the statute nor the regulations under  § 475 ignore the rate of turnover as a relevant criterion. To effect a valid  § 475(f) election, therefore, a hedge fund must qualify as a “trader” under the common law.630
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629 See Regs.  § 1.864-2(c) (“the volume of stock or security transactions effected during the taxable year shall not be taken into account in determining under this subparagraph whether the taxpayer is engaged in trade or business within the United States”).

630 It should be noted, however, that the IRS has suggested a perhaps broader definition of “trader”in the  § 475 context. In Revenue Ruling 97-39, a ruling that provides guidance on issues unrelated to the  § 475(f) election, the IRS poses the following question:
Issue 3: If a taxpayer's sole business consists of trading in securities (that is, the taxpayer does not purchase from, sell to, or otherwise enter into transactions with customers), is the taxpayer a dealer in securities within the meaning of § 475(c)?

1997-2 C.B. 62 (emphasis added).  Although hardly dispositive, the question implies that a “trader”is anyone who transacts in securities  other than a dealer.  But see Publication 500, Investment Income and Expenses (Including Capital Gains and Losses), reprinted in 2006 TNT 40-30 (Mar. 6, 2006) (citing common law definition of “trader” before describing effect of  § 475(f) election).

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If the common law definition controls, how does a hedge fund with a broad charter know with any degree of certainty that it qualifies as a trader in securities? Is it prudent to make an election regarding tax issues as fundamental as timing and character without a clear statutory basis for doing so? Will a change in a fund's behavior from one year to the next affect the validity of the  § 475(f) election in a later year? Once made, the election may not be revoked without IRS consent.631 Nevertheless, neither the statute nor the regulations address the consequences of failing to qualify as a “trader” during a future period after an otherwise valid § 475(f) election. If a  § 475(f) election becomes invalid, however,  § 481 should apply to the resulting change in accounting method.632
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631 § 475(f)(3).

632 See, e.g., Rev. Proc. 99-17, 1997-7 I.R.B. 52 (describing treatment of initial  § 475(f) election under § 481).

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4. The Benefits of the § 475(f)Election 

If a hedge fund qualifies as a securities trader, it may elect to apply the mark-to-market rules under § 475.  Although the consequences of the election will not appeal to most funds, a  § 475(f) election does offer certain advantages:

• any security that is subject to the mark-to-market regime will not be taken into account for purposes of the “constructive sale” rules of § 1259;633
  
• the capitalization rules under  § 263(g) and  § 263A will not apply to any security subject to the mark-to-market regime;634
  
•the “wash sale” rules under  § 1091 will not apply to any loss recognized under the mark-to-market regime;635
  
•although the straddle rules under  § 1092 will technically apply to any loss recognized under the mark-to-market regime, they will have no substantive effect as long as each offsetting position that comprises the straddle is subject to mark-to-market reporting;636
  
• the loss disallowance rules under  § 267 and  § 707 will not apply to any loss recognized under the mark-to-market regime;637
  
• the “constructive ownership” rules under § 1260 will not apply to any constructive ownership transaction if all of the positions including within the transaction are subject to mark-to-market reporting;638
  
•the capital loss limitations will not apply to losses recognized under the mark-to-market regime; and

• the PFIC rules of § § 1291-1298 will not apply to stock of a foreign issuer in the portfolio without regard to the active or passive nature of the issuer's underlying business.639

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633 H.R. Rep. No. 220, 105th Cong., 1st Sess. at 1010-1011 (1997); § 475(f)(1)(C).

634 § 475(d)(1).

635 § 475(d)(1).

636 H. Conf. Rep. No. 103-213 at 613 (1993).

637 H.R. Rep. No. 111, 103d Cong., 1st. Sess. at 661 n. 37 (1993).

638 § 1260(d)(2).

639 See Regs. § 1.1291-1(c)(4).

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The disadvantages of the election are more obvious.  First and foremost, the election will accelerate the recognition of unrealized gains.  If a fund with a  § 475(f) election in effect has substantial unrealized gains, some of its investors may decide to tender their shares merely to fund the resulting tax liability. Second,  § 475 will recast all gains as ordinary, including long-term capital gain.  An investor in a hedge fund that invests for capital appreciation will therefore forego not only tax deferral, but a lower tax rate.  The character of income is a smaller concern to a hedge fund that holds substantial portions of its portfolio subject to the “tolling”provisions of the straddle rules.640 An “arbitrage” fund with multiple offsetting positions subject to § 1092, for example, may not generate significant long-term capital gain, but will avoid the capital loss limitations that would otherwise have applied in the absence of the election.
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640 See Regs. § 1.1092(b)-2T(a)(1).

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5. May an Electing Hedge Fund Exclude the “Side Pocket” Securities? 

As described more fully in II, A, 6, above, some hedge funds invest capital in the private equity sector.641 By its very nature, a private equity investment produces long-term capital gain or loss.  If a hedge fund makes an otherwise valid  § 475(f) election, however, it must report the gain or loss as ordinary unless it excludes the investment from the election.642
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641 For a discussion of hedge funds with private equity “side pockets,” see II, A, 6, above and IX, B, 5, below.

642 § 475(d)(3), § 475(f)(1)(D), § 475(f)(1)(B); see also H.R. Rep. No. 220, 105th Cong., 1st Sess. at 515 (1997)(“an electing taxpayer must be able to demonstrate by clear and convincing evidence that a security bears no relation to activities as a trader in order to be identified as not subject to the mark-to-market regime”).

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The statute permits an electing hedge fund to exclude a security “held for investment” from mark-to-market accounting.643 If the security a taxpayer seeks to exclude is marketable, the distinction between the two is more elusive because the taxpayer may hold the security either as a trader or as an investor.  A “side pocket” security, however, may only be held for investment.644 Under § 475(f)(1)(B), an electing hedge fund may exclude a security that has “no connection to [its] activities ... as a trader,” provided that the security is “clearly identified” as such.  Under the proposed regulations, a taxpayer must prove the status of the security as an investment security by “clear and convincing evidence.”645 The rationale for the higher burden is that it is “easier to distinguish investment securities from dealer securities than to distinguish investment securities from trading securities.”646 A taxpayer that purports to both trade and invest in the same security must therefore segregate the investment security within “a separate, non-trading account maintained with a third party.”647 If a taxpayer fails to meet this burden, it must mark the investment security to market and report the resulting gain or loss as ordinary.648
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643 § 475(b)(1)(A).

644 The regulations themselves imply that an illiquid security can only be held for investment, albeit indirectly.  See Regs. § 1.475(b)-1(b)(1), (3) (excluding from “per se” treatment as property held for investment a security issued by a related party that is “actively traded” and meets certain other conditions).

645 See Prop. Regs. § 1.475(f)-2.

646 See Preamble to the proposed regulations, REG-104924-98, 64 Fed. Reg. 4374 (1/28/99).

647 Prop. Regs. § 1.475(f)-2(a)(3).

648 See Prop. Regs. § 1.475(f)-2(a)(4).

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The higher burden of proof notwithstanding, a hedge fund with a valid  § 475(f) election in effect should be able to exclude a “side pocket” investment from mark-to-market accounting.  With no established market of buyers and sellers, the illiquidity of the investment will preclude the very type of behavior that distinguishes a trader from an investor.  That fact alone should establish the status of the security as property “held for investment.”

6. Interaction of § 475 and § 864(b)(2) 

As described more fully in VII, B and C, above, both the offshore corporate feeder and the foreign investor in a hedge fund partnership rely on the  § 864(b) trading safe harbor to avoid net basis taxation in the United States on their hedge fund returns.649 For the reasons described in IX, B, 4, above, an otherwise eligible hedge fund may elect to report gains and losses on a mark-to-market basis under § 475.  At least one commentator has suggested that a § 475(f) election may transmute the hedge fund into a “dealer” for all income tax purposes.650 If dealer status were to extend beyond the domain of § 475,(i) the proprietary trading safe harbor of  § 864(b)(2)(A) would no longer apply;651 and (ii) the general securities trading safe harbor would apply only to a fund engaged in securities transactions outside of the United States.652 The  § 475(f) election would therefore disqualify the fund's trading activities under § 864(b)(2)(A).653
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649 For a discussion of the trading safe harbor, see VII, B, 1, above.  For a discussion of the distinction between “trading” and “investing”generally, see VIII, A, above.

650 543 T.M., The Mark-to-Market Rules of § 475 (“a foreign partner of a U.S. partnership that has elected under  § 475(f) to be treated as a dealer in securities cannot rely on the [securities trading safe harbor], with the result that income ‘effectively connected’...with such trading business, will be subject to U.S. taxes”).

651 § 864(b)(2)(A)(ii) (“this clause shall not apply in the case of a dealer in stocks or securities”).

652 § 864(b)(2)(A)(i), (b)(2)(C).

653 Leeds, “When the Exotic Embraces the Mundane: The Total Return Swap Business Expands to Bank Loans,” reprinted in 2005 TNT 69-30 (Apr. 12, 2005) (noting difficulty of sustaining general securities trading safe harbor if hedge fund manager actively manages fund from U.S. office).  If the IRS were to attribute the U.S. office of the fund manager to the offshore fund, therefore, the offshore fund could not rely on the general securities trading safe harbor.

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In the authors' view, a hedge fund that makes a valid  § 475(f) election does not become an ineligible dealer under  § 864(b) by doing so.  Neither the legislative history nor the statute itself purport to alter the underlying character of the electing taxpayer's trade or business activities.654 The purpose of the  § 475(f) election, which is to permit an electing trader in securities to report its gains and losses on a mark-to-market basis, is more limited.
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654 See H. Rep. No 105-148(1997); H.R. Rep. No. 220, 105th Cong., 1st Sess. (1997).

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7. Trap for the Unwary — § 864(c)(3) 

A more serious concern is the effect of a fund-level § 475(f) election upon a foreign investor who invests in the fund and has U.S. source “effectively connected” income from other sources. In such a case, the  § 475(f) election may subject the investor's share of the fund's U.S. source trading gains to full net basis taxation.655 Under § 864(c)(3), all U.S. source income, other than income described in § 864(c)(2), is treated as effectively connected with the conduct of a U.S. trade or business.  Although  § 864(c)(2) generally exempts both U.S. source FDAP income and gains from the sale of a capital asset from this rule,  § 475(d)(3) treats all gains as “ordinary income.”  Sections 64 and 65 further provide that any gain or loss “treated or considered, under other provisions of this subtitle, as ‘ordinary income’ shall be treated as gain from the sale or exchange of property which is [not]a capital asset.”656 It would appear, therefore, that a foreign investor in a fund with a  § 475(f) election in effect will forego any protection from the force of attraction rule of § 864(c)(2).657
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655 Metzger, “Clarifying Tax Issues Will Increase Liquidity of U.S. Capital Markets, Writer Says,”reprinted in 1999 TNT 37-23 (Feb. 25, 1999).

656 Emphasis added.

657 The same concern applies to a foreign feeder fund that elects to be taxed as a corporation and earns incidental amounts of ECI.  In such a case, the otherwise tax-exempt shareholders of the foreign feeder would bear the full economic cost any entity-level tax.

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It should be noted that Congress has recognized the potential for unintended consequences of a  § 475(f) election.  In 1998,658 Congress amended  § 475 to provide that the characterization rules of  § 475(d)(3) will not extend to  § 1402 (self-employment taxes)659 or to  § 7704 (publicly-traded partnerships).660 The legislative history further provides that relief will also extend to “any other Code provision specified by the Treasury Department.”661 To date, however, Treasury has not issued regulations or other guidance to clarify or otherwise establish that the  § 475(f) election does not imperil the  § 864(c)(2) exemption.662 Based upon existing guidance, therefore, a foreign partner's share of the otherwise exempt U.S. source trading gains and losses of an electing fund may attract full net basis taxation under § 864(c)(3).
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658 IRS Restructuring and Reform Act of 1998, P.L. 105-206.

659 § 475(f)(1)(D) (last sentence).  Under § 1402(a)(3)(A), “net earnings from self-employment”excludes gain or loss from the sale or exchange of a capital asset.

660 § 475(f)(1)(D) (last sentence).  Under § 7704(d)(1)(F), “qualifying income” generally includes gain or loss from the sale or exchange of a capital asset.  For a fuller description of the “qualifying income” exception under § 7704, see IV, C, 4, above.

661 Staff of Joint Committee on Taxation, 105th Cong., 2d Sess., General Explanation of Tax Legislation Enacted in 1998 (Comm. Print 1998).

662 The IRS's semiannual regulatory agenda released on April 8, 2005 includes guidance concerning mark-to-market accounting for securities traders, including “the coordination of income character rules of the mark-to-market regime with the capital election under section 988(a)(1)(B).”  2005 TNT 102-39, Corrected Full Text: Treasury Publishes Semiannual Regulatory Agenda, Sequence Numbers 2487, 2587 (May 27, 2005).  The agenda does not mention § 864(c)(2).

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8. Is it Prudent to Make the § 475(f)Election? 

It is a common misconception that the  § 475(f) election is a popular election among hedge funds.  Few hedge funds make it. The likely source of confusion is the “mark-to-market” regime for securities partnerships under the  § 704(b) regulations, which practitioners tend to conflate with mark-to-market reporting under § 475(f). The widespread practice among hedge funds of marking book capital accounts to market for the purpose of determining each investor's “break period” share of unrealized gains or losses in the portfolio under the  § 704(b) regulations is separate and distinct from the actual tax reporting of the unrealized gains or losses under § 475.663
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663 As described more fully in V, C, above, hedge funds are among the few partnerships to adjust book capital accounts under circumstances other than the admission of a new partner, a non-pro rata distribution to a partner, or a liquidation. See Regs.  § 1.704-1(b)(2)(iv)(f)(5) (permitting “book ups” in each of these situations).  Hedge funds also do so at the end of every “break period” under a special provision of the  § 704(b) regulations that applies to securities partnerships. See Regs.  § 1.704-1(b)(2)(iv)(f)(5)(iv) (allowing securities partnership to revalue its assets at any time, so long as revaluation reflects “generally accepted industry accounting practices”).

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For most funds, the reasons not to make the  § 475(f) election are compelling:

• loss of deferral;

• for individual investors, loss of the preferential rates on long-term capital gain;

•legal uncertainty regarding the validity of the election itself; and

• for foreign investors, potential exposure of otherwise exempt interest, dividends and capital gain to net basis U.S. taxation.

9. Section 1256 

Section 1256 generally requires a taxpayer to mark its “§ 1256 contracts” to market on the last business day of each taxable year and to recognize gain or loss as if it had sold the contracts for fair market value.664 A § 1256 contract includes a regulated futures contract, a foreign currency contract, a nonequity option, a dealer equity option and a dealer securities futures contract.665 The taxpayer must report 60% of the gain or loss as short-term capital gain or loss and 40% of the gain or loss as long-term capital gain or loss.666 These rules apply without regard to whether the taxpayer has a  § 475(f) election in effect.667
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664 § 1256(a).

665 § 1256(b)(1)-(5).

666 § 1256(a)(3).

667 See  § 475(c)(2) (§ 1256 contract not a security under  § 475 unless it hedges other securities and is appropriately identified as such); § 1256(e) (§ 1256 contract that is part of hedging transaction not subject to mark-to-market treatment).

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U.S. Income Portfolios: Other Pass-through Entities 
  Portfolio 736-1st: Hedge Funds 
  Detailed Analysis 
  X. Reporting of Transactions between Fund and Investors

A. Disguised Sale of Partnership Interests 

As discussed in III, A, above, hedge funds usually admit new investors for cash. Subject to prior written notice, they also redeem existing investors for cash. The admission of new investors and the redemption of existing investors both occur at regular and periodic intervals, often on the first day of every quarter. The portfolio manager usually reserves the right to limit or delay a redemption depending upon the volume of redemption requests. The purpose of this right is twofold: to ensure adequate liquidity to fund a redemption request without forcing the premature sale of a portfolio investment and to facilitate compliance with the PTP safe harbors under § 7704.668 In form, § § 721 and 731 govern these transactions as separate contributions to and distributions from a partnership.
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668 For a discussion of the PTP rules of § 7704 as applied to hedge funds, see IV, C, above.

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In November 2004, Treasury issued proposed regulations under § 707(a)(2)(B) with respect to “disguised sales” of partnership interests,669 but the proposed regulations were withdrawn in 2009.670 In withdrawing the proposed regulations, the IRS and Treasury stated that they continue to study disguised sales of partnership interests, and that, until new guidance is issued, any determination of whether transfers between a partner(or partners) and a partnership is a transfer of a partnership interest will be based on statutory language, legislative history, and case law.671
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669 REG-149519-03, 69 Fed. Reg. 68838 (11/26/04).

670 REG-149519-03, 74 Fed. Reg. 3508 (1/21/09). See also Announcement 2009-4, 2009-8 I.R.B. 597.

671 REG-149519-03, 74 Fed. Reg. 3508 (1/21/09); Announcement 2009-4, 2009-8 I.R.B. 597.

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The proposed regulations672 would generally would have recast a transfer of money, property, or other consideration, including the assumption of a liability, by a partner to a partnership, coupled with a transfer of consideration by a partnership to another partner, as a full or partial sale between the two partners if, based upon all the facts and circumstances, the transfer by the partnership to the withdrawing partner would not have been made but for the transfer to the partnership by the investing partner. If the two transfers did not occur at the same time, their treatment as a disguised sale would also have depended on whether the later transfer was subject to the “entrepreneurial risks” of the business.673
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672 Which would generally have followed the regulations relating to disguised sales of property under § 707(a)(2). For a general discussion of the disguised-sale-of-property regulations, see 710 T.M., Partnerships — Conceptual Overview.

673 Former Prop. Regs. § 1.707-7(a)(1), (b)(1).

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The proposed regulations would have presumed that transfers to and from a partnership within two years constituted disguised sales, and that transfers beyond the two-year interval did not, in each case, unless the facts and circumstances “clearly established”otherwise.674 Finally, the proposed regulations would have required tax return disclosure if a partner transferred consideration to a partnership and the partnership transferred consideration to another partner within a seven-year period and the two partners did not treat the transfers as a disguised sale for tax purposes.675
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674 Former Prop. Regs. § 1.707-7(c)(within two years), (d) (without two years).

675 Former Prop. Regs. § § 1.707-7(k),-8.

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The proposed regulations contained a list of non-exclusive “disguised sale” factors.676 The factors most relevant to hedge funds would have been—
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676 Former Prop. Regs. § 1.707-7(b)(2).

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• whether there were negotiations between the purchasing and selling partner (or between the partnership and each of the purchasing and selling partners when each partner was aware of the negotiations with the other partner)concerning any transfer of consideration;

• whether the selling and purchasing partner entered into one or more agreements, including an amendment to the partnership agreement (other than for admitting the purchasing partner) relating to the transfers;

• whether the timing and amount of all or any portion of a subsequent transfer were determinable with reasonable certainty at the time of an earlier transfer;

• whether the person receiving the subsequent transfer had a legally enforceable right to the transfer or the right to receive the transfer is secured in any manner;

• whether the transfer of consideration by the partnership to the selling partner was disproportionately large in relationship to the selling partner's general and continuing interest in partnership profits;

•whether the selling partner had an obligation to return or repay the consideration to the partnership, or had an obligation to return or repay the consideration at such a distant point in the future that the present value of that obligation was small in relation to the amount of consideration transferred by the partnership to the selling partner; and

• whether the transfer of consideration by the purchasing partner or the transfer of consideration to the selling partner was pro rata.

The proposed regulations were criticized as overly broad.677  Section 707(a)(2)(B) is a statutory vehicle designed to curb “deferred or avoided tax on sales of property (including partnership interests) by characterizing sales as contributions of property (including money) followed (or preceded) by a related distribution of partnership property (including money).”678
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677 See, e.g., New York State Bar Association Tax Section, “Report on Disguised Sales of Partnership Interests Responding to Reg-149519-03,” 2005 Tax Notes 78-42 (4/22/05) (“[W]e believe the ‘but for’test is simply too susceptible of being read to encompass attenuated chains of causation...when we should be looking for something that approximates a notion of ‘proximate cause.’ For example, in its most literal sense the ‘but for’ test is met any time a partnership would not have had sufficient liquidity to make a distribution ‘but for’ another partner's contribution”).

678 H.R. Conf. Rep. No. 861, 98th Cong., 2d Sess. 860 (1984); S. Rep. No. 369, 98th Cong., 2d Sess. 225 (1984).

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Moreover, Congress cautioned Treasury that future regulations “should be mindful that the committee is concerned with transactions that attempt to disguise the sale of property and not with non-abusive transactions that reflect the various economic contributions of the partners....”679
——————————————————————————————

679 S. Rep. No. 369, 98th Cong., 2d Sess. 225, 230 (1984).

[Footnotes 680 through 691 reserved.]

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Despite these cautions, the withdrawn proposed regulations would have applied to many transfers to and from a partnership that bore no relation to one another other than their proximity in time.

U.S. Income Portfolios: Other Pass-through Entities 
  Portfolio 736-1st: Hedge Funds 
  Detailed Analysis 
  X. Reporting of Transactions between Fund and Investors

B. Varying Interests of Fund Investors during Taxable Year 

1. Periodic Redemptions/Admissions of New Investors 

An investor's distributive share of fund income, gain, loss, deduction, or credit must correspond to its equity interest in the fund. It is common, however, for the equity interest of an investor to vary over the course of the year. As described in III, A and X, B, above, hedge funds both admit and redeem investors on a recurring basis at periodic intervals. These transactions do not end the taxable year of the fund because they do not trigger a § 708 “termination”of the fund. Under § 708(b)(1)(B), a partnership terminates if, within a 12-month period, a “sale or exchange” of 50% or more of the total interests in capital and profits occurs. When a partnership terminates, its taxable year closes.692 Although § 708 applies to both sales between two partners and sales between a partner and a third party, it does not apply to transfers between a partner and a partnership because neither a contribution of property under § 721 nor a distribution of property under § 731 qualifies as a “sale or exchange.”693 Because virtually all transfers in the hedge fund context involve the fund as either buyer or seller, hedge funds rarely experience a  § 708 termination.694
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692 See Regs. § 1.708-1(b)(3).

693 See Regs. § 1.708-1(b)(2). See also McKee, Nelson, &  Whitmire, Federal Taxation of Partnerships and Partners at ¶  13.03[1][b] (4th ed. 2097).

694 For a discussion of when a contribution and distribution of property to and from a hedge fund may be recast as a “disguised sale” between the two partners, see X, A, above. See also Regs. § 1.731-1(c)(3) (§ 731 does not apply to disguised sale between two partners).

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2. Section 706 Rules 

When an investor's interest in a fund varies over the course of a taxable year, its distributive share of the fund's income, gain, loss, deduction, or credit must account for this variation.695  Section 706 limits the authority of a partnership to retroactively allocate income or loss realized by the partnership during the same taxable year but after the change in interest.696 The regulations provide two methods to account for these fluctuations: “interim-closing-of-the-books”and “proration.”697  An allocation of fund income or loss, even if respected under § 704(b), remains vulnerable to reallocation under § 706(d) if it fails to account for the varying interests of its investors during the fund's taxable year.698
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695 § 706(d)(1).  For a detailed discussion of the varying interests rules, see 712 T.M., Partnerships—Taxable Income; Allocation of Distributive Shares; Capital Accounts.

696 Staff of the Jt. Comm. on Tax'n, 98th Cong., 2d. Sess., General Explanation of the Tax Reform Act of 1976, 1976-3 C.B. 1; Rev. Rul. 77-310, 1977-2 C.B. 217.

697 Regs. § 1.706-1(c)(2)(ii). See also Prop. Regs. § 1.706-4(c), (d) (REG-144689-04, 74 Fed. Reg. 17119 (4/14/09)), which would provide more extensive guidance than currently available on the two methods. For a discussion of planning opportunities under these alternatives, see Melone, “Distributive Shares and the Varying Interests Rule: Planning Ideas and Open Issues,” 14 J. P'ship Tax'n No. 4 (Winter 1998) (“The choice between the two methods will depend on (1) the administrative burden of applying the interim closing method and (2) the comparative results, measured at the partner level, yielded by each method”).

698 Regs. § 1.704-1(b)(1)(iii).

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a. Interim Closing-of-the-Books 

Interim closing-of-the-books is the default method under § 706.699 Under the default method, a fund must allocate taxable income or loss as if it had closed its books on the date of the change in interest, even though its taxable year remains open.700 Book closing is more precise than proration because it eliminates the potential for retroactive allocations.  Nevertheless, this precision comes at a price, and may be difficult for a partnership that experiences frequent admissions and withdrawals. For a hedge fund, however, the concern is less acute because, as discussed in III, A, above, the dates of withdrawals and admissions generally coincide with the dates on which the fund marks its portfolio to market for book capital account purposes.701 A hedge fund will therefore allocate any realized gains or losses not under § 706, but under § 704(b), employing either a “layering” or “aggregation”methodology.702 This type of income usually accounts for the bulk of hedge fund taxable income.
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699 Regs. § 1.706-1(c)(2)(ii);Prop. Regs. § 1.706-4(a)(1).

700 Prop. Regs. § 1.706-4(a)(2) would generally require a partnership to maintain “segments”(i.e., specific periods of the partnership's taxable year) to account for variations in a partner's interest during the partnership's taxable year. The partnership would determine items of income, gain, loss, deduction, and credit of the partnership for each segment in accordance with the method of accounting that it uses for its entire taxable year.

701 For a discussion of “book ups” by hedge funds, see V, C, above.

702 For a discussion of “reverse” § 704(c) allocations by hedge funds, see V, C, above.

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b. Proration 

As an alternative to book closing, a fund may instead agree with its investors to determine each investor's distributive share by proration, imputing to each investor its pro rata share of the annual profit or loss as if each investor had remained an investor in the fund through the end of the taxable year.703 The 2009 proposed regulations would require a partnership using the proration method to use the “calendar day convention,” under which the first segment of the partnership's taxable year would commence with the beginning of the partnership's taxable year and end at the close of any day on which the variation occurred (and any additional segment would commence with the beginning of the day following the variation and end on the earlier of the close of the day on which an additional variation occurred or the close of the partnership's taxable year).704 Although less precise, proration avoids the cost and complexity associated with a formal book closing.
——————————————————————————————

703 Regs. § 1.706-1(c)(2)(ii);Prop. Regs. § 1.706-4(a)(1), (d).

704 Prop. Regs. § 1.706-4(d)(2), (e)(1). A partnership using the interim closing method would be able to use either the calendar day convention or the “semi-monthly convention,” under which the first segment would commence with the beginning of the partnership's taxable year and, with respect to a partner's variation occurring up through the 15th day of the calendar month, would close at the end of the last day of the immediately preceding calendar month. Prop. Regs. § 1.706-4(c)(2), (e)(2)

——————————————————————————————

3. Application of § 706 to Tiered Partnerships 

Prior to the enactment of the Deficit Reduction Act of 1984, it was possible to circumvent the principles of  § 706 by investing in one partnership through another partnership.  The upper-tier partnership would employ the interim-closing-of-the-books method for allocating its distributive share of the income or loss of the lower-tier partnership among its partners:

Example 10-3: ABC, a partnership for U.S. tax purposes, is the general partner of the Slag fund, a calendar year partnership.  Slag incurs a loss for the 2005 taxable year. Bill acquires an 80% interest in ABC on June 30, 2005.  For purposes of computing Bill's distributive share of ABC's loss, ABC closes its books on June 30 under § 706(d)(1).  As a partner of Slag, ABC then includes its distributive share of the Slag loss on December 31, 2005.705 As a result, Bill claims 80% of the allocated loss rather than the 40% share that Bill would have been allocated under the proration method (i.e., 80% share of 1/2 of ABC's allocated loss).

——————————————————————————————

705 A partner is required to include its distributive share of partnership income or loss for any partnership taxable year ending within or with the partner's taxable year.  Regs. § 1.706-1(a)(1).

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Section 706(d)(3) now prohibits this type of retroactive allocation by requiring the upper-tier partnership to prorate its allocable share of any income or loss of the lower-tier partnership among its partners to reflect any change in the ownership of the upper-tier partnership over the course of the year.706
——————————————————————————————

706 See also H.R. Rep. No. 432, 98th Cong., 2d. Sess. (1984) (“These rules are intended to prevent the use of tiered partnerships to avoid the retroactive allocation rules”); Rev. Rul. 77-311, 1977-2 C.B. 218.

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U.S. Income Portfolios: Other Pass-through Entities 
  Portfolio 736-1st: Hedge Funds 
  Detailed Analysis 
  X. Reporting of Transactions between Fund and Investors

C. Distributions of Marketable Securities 

As described in IX, A, above, hedge fund investors achieve liquidity by redemption.  In the typical case, they will receive cash from the fund.  On occasion, however, a hedge fund may distribute a marketable security.   Section 732 governs the distribution of property by a partnership to a partner.  In a partial in-kind redemption, the investor will take a carryover basis in the distributed property equal to the fund's basis in the property immediately before the redemption.707 In a complete redemption, the investor will take a substituted basis in the distributed property equal to the investor's basis in the fund, reduced by any cash received in the distribution.708
——————————————————————————————

707 § 732(a)(1).  The investor's basis in the distributed asset will be limited to its basis in the fund, reduced by any cash received in the transaction. § 732(a)(2).

708 § 732(b).

——————————————————————————————

These rules do not apply, however, to the extent that  § 731(c)(1) recasts the distributed property as a distribution of cash.  Under § 731(c)(1), if a partnership distributes a “marketable security,” the partnership will be treated as if it had distributed cash in an amount equal to the value of the distributed security.  In such a case, therefore, the distributee partner will recognize gain to the extent that the value of the security exceeds its basis in the fund.709  Section 731(c)(1) does not apply, however, to a security that was not marketable on the date of acquisition so long as —
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709 § 731(a).

——————————————————————————————

• the issuer of the security had no other marketable securities outstanding at that time;

• the fund held the security for at least six months before it became marketable; and

•the distribution occurs within five years of the date of marketability.710

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710 Regs. § 1.731-2(d)(1)(iii).

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A private equity investor often relies on this exception to avoid the recognition of gain upon the receipt of stock of a portfolio company after an IPO or upon the receipt of stock of a public buyer of a portfolio target711 in a distribution. In the case of a hedge fund, however, this exception is usually unavailable because the distributed security will not have been marketable on the date of acquisition.  Under a second exception, however,  § 731(c)(1) does not apply if —
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711 See Regs.  § 1.731-2(d)(3) (“successor security” qualifies for exception if original security would have qualified).

——————————————————————————————

• the hedge fund is an “investment partnership”; and

• the distributee is an “eligible partner.”712

——————————————————————————————

712 § 731(c)(3)(A)(iii);Regs. § 1.731-2(e).

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Section 731(c)(3)(C)(i) defines an “investment partnership”as a partnership that has never been engaged in a trade or business, substantially all of the assets of which consist of cash, stock, debt instruments, swaps, foreign currency and/or certain derivative investments.  In spite of the “trade or business” limitation, the vast majority of hedge funds qualify as investment partnerships.

Under a statutory exception to the common law, a partnership is not treated as engaged in a trade or business by reason of any activity it undertakes as an “investor,”a “trader,” or a “dealer” with respect to any of the foregoing assets.713 In addition, the regulations ignore other “trade or business” activities under the common law as well, in particular (i) “reasonable and customary management services ... provided to an investment partnership ... in which the partnership holds a partnership interest”714 and (ii) “reasonable and customary services provided by the partnership in assisting the formation, capitalization, expansion, or offering of interests in a corporation(or other entity) in which the partnership holds or acquires a significant equity interest (including the provision of advice or consulting services, bridge loans, guarantees of obligations, or service on a company's board of directors),” so long as the compensation for these services is not a “significant purpose” of the investment, but merely “incidental to” the investment.715
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713 § 731(c)(3)(C)(ii)(I).

714 Regs. § 1.731-2(e)(3)(ii).

715 Regs. § 1.731-2(e)(3)(iii).

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Under § 731(c)(3)(C)(iii)(I), an “eligible partner” includes any investor who purchases an interest in the fund for cash or any other qualifying asset under § 731(c)(3)(C)(i). The regulations extend the definition of eligible partner to include an investor who provides services to the fund in exchange for an interest.716 Accordingly, both the investors in a hedge fund as well as the general partner and its members with respect to the carried interest should qualify as “eligible partners.”
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716 Regs. § 1.731-2(e)(2)(i).

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Although this second exception to  § 731(c)(1) applies only to hedge funds that have “never” engaged in a trade or business, the statute and regulations ignore most of the activities, in particular trading in stocks and securities and the provision of services to portfolio company investees, that would otherwise disqualify them.  Accordingly, most hedge funds will qualify as “investment partnerships” under § 731(c)(3).  As such, a withdrawing investor should not recognize gain upon the receipt of marketable securities even if the value of the securities exceeds the investor's basis in the fund. Instead, the investor will acquire a basis in the distributed securities in accordance with the general rules of § 732.717
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717 § 732(a) (partial redemptions); § 732(b) (complete redemptions).  For a discussion of how an in-kind distribution affects the remaining investors when the fund has either a valid  § 754 election in effect or experiences a “substantial basis reduction,” see IX, A, above.

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U.S. Income Portfolios: Other Pass-through Entities 
  Portfolio 736-1st: Hedge Funds 
  Detailed Analysis 
  XI. Portfolio Investments by the Fund: Recurring U.S. Tax Issues

Except in passing, this portfolio does not address the federal income taxation of mainstream stock or securities transactions. Hedge funds engage in these transactions every day, but so do mutual funds, insurance companies, investment banks and many other investors. What follows instead is a description of the special rules that govern the taxation of certain transactions that fall outside of the mainstream. Unlike a typical “all long” or “buy-and-hold”investment, these transactions usually occur on the outer fringes of the financial continuum and often involve two or more discrete positions that share a direct or inverse economic relationship.  A basic hedge is one, for example.  A hedge fund may be long on a stock in the portfolio, but obligated to pay the stock return to another under a forward contract, short call option or notional principal contract.

At the risk of oversimplifying, an archetypical hedge fund investment is an investment that bears a specific and purposeful relationship to another investment that, by virtue of their association, changes its tax treatment in one or more respects.  The simultaneous acquisition of a long and short position that separately represent component parts of a larger transaction is a hedge fund's stock-in-trade. Another common trait is the tendency of these transactions to occur within the more rarified sectors of the financial markets, in particular the swaps and derivatives markets.  The special tax treatment we afford the foreign counterparty to these transactions is one reason.  A typical swap, for example, allows a hedge fund with non-U.S. investors to invest in U.S. asset categories on a “notional” basis free of U.S. tax on both a gross and net basis.718 The complexity of many of these transactions and the rules that govern them raise special challenges to the practitioner.
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718 See, e.g., Regs. § 1.863-7(b)(1) (swap income generally sourced in accordance with residence of recipient); see also § 1441(a) (withholding applies only to FDAP “from sources within the United States”).

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This subsection of the portfolio endeavors to describe this subset of transactions and their tax consequences. Although the authors make no pretense of addressing the relevant tax issues in any sort of comprehensive way, what follows does attempt to highlight those tax issues that tend to recur in the hedge fund context.

U.S. Income Portfolios: Other Pass-through Entities 
  Portfolio 736-1st: Hedge Funds 
  Detailed Analysis 
  XI. Portfolio Investments by the Fund: Recurring U.S. Tax Issues

A. Swaps 

1. In General 

Hedge funds often participate as counterparties to interest rate swaps, currency swaps, commodity swaps, equity swaps, credit default swaps and other derivatives.  Given the dominant role of hedge funds in this market, no article that sought to address major tax issues with hedge funds may omit a discussion of this particular category of financial instrument.  A general discussion of swaps and their tax treatment, however, is beyond the scope of this portfolio.719
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719 For an excellent and far more comprehensive discussion of tax issues with swaps, see Avi-Yonah, Newman &  Ring, Taxation of Financial Instruments, § 3:01  et. seq., Chapter 3 (Taxation of Notional Principal Contracts)(1999); see also New York State Bar Association Tax Section, “Report on Tax Accounting for Notional Principal Contracts,” reprinted in 89 TNT 211 (Sept. 28, 1989); Kleinbard, “Equity Derivative Products: Financial Innovation's Newest Challenge to the Tax System,” 69 Tex. L. Rev. 1319 (1991).

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Originally developed in the 1980s as an alternative to an actual refinancing or modification of existing debt,720 modern swaps bear little in common with their historic forebears.  In the beginning, however, a swap allowed a taxpayer to modify the effective maturity and duration of debt on its balance sheet.  The oldest and most basic form of swap was an interest rate swap:
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720 See Avi-Yonah, Newman & Ring, Taxation of Financial Instruments, § 3:01, Chapter 3 (Taxation of Notional Principal Contracts) (1999).

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Example 11-1: A taxpayer issues a 10-year bond that pays a floating rate of interest.  The taxpayer fears that short-term interest rates will increase.  Rather than refinance the bond, the taxpayer enters into an interest rate swap.  Under the swap, the taxpayer pays a fixed rate of interest to a bank in exchange for a floating rate of interest, in each case on a “notional”amount equal to the face amount of the bond over the 10-year maturity. Net of the swap payments, therefore, the taxpayer now has a fixed rate liability.

Swaps like this still exist; indeed, they remain a fixture of the modern swap market.721 With the passage of time, however, the market definition of a “swap” now subsumes contractual arrangements that bear no relationship whatsoever to the management of a “fixed income” liability on the balance sheet.  In more rarified corners of the financial markets, modern swaps also facilitate the synthetic transfer of economic exposure to a range of other assets and liabilities.  The  § 446 regulations alone refer to interest rate swaps, currency swaps, basis swaps, interest rate caps, interest rate floors, commodity swaps, equity swaps and equity index swaps.722 Yet the current tax rules still lag an ever-evolving swap market and probably always will.  The market for “credit derivatives” alone now represents trillions of dollars in credit exposure,723 adding credit-linked notes, collateralized debt obligations and credit-default swaps to the mix.  Nevertheless, most swaps still have one basic attribute in common: the transfer of part or all of the economic return on an asset without a corresponding transfer of legal or tax ownership. The International Swaps and Derivatives Association (“ISDA”)publishes standardized forms to reflect every conceivable form of swap, which the overwhelming majority of swap counterparties employ as “templates” to reflect their particular agreement.
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721 See, e.g., “Interest Rate Swap Contracts,” New York Times (Aug. 26, 2006) (interest rate swap contracts totaled $170.2 billion as of Dec. 31, 2005).

722 See Regs. § 1.446-3(c).

723 Fitch Ratings Special Report, Global Credit Derivatives Survey: Single-Name CDS Fuel Growth (Sept. 7, 2004), www.fitchratings.com.

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As an economic matter, a typical swap is just a series of cash-settled options and/or forward contracts bound within a single instrument.  Although the tax treatment of options and forward contracts is well-settled, the IRS opted years ago to establish separate and distinct rules for swaps.724 As of the date hereof, however, no unitary set of rules and regulations addresses the tax treatment of swaps in a comprehensive way.  Instead, the IRS(and occasionally Congress) have issued guidance over the years in bits and pieces in an effort to keep pace with the market.  With the passage of time, the available guidance on the taxation of swaps now appears in fragmented form, scattered throughout the Code and regulations.
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724 See Notice 89-21, 1989-1 C.B. 651.

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One set of rules addresses timing.725 Another set of rules addresses source.726 Yet a third addresses character and timing of contingent and termination payments.727 The regulations under  § 988 provide special rules for currency swaps.728 To further muddy the waters, still other provisions of the Code override or modify these rules in particular cases.  If a hedge fund makes a valid  § 475(f) election, for example, mark-to-market accounting will supersede accrual method accounting for the affected counterparties.729 If a swap hedges a debt instrument, the swap “integration”rules of § 988(d)730 or § 1275731 may apply.  Finally, special rules apply to swaps that reflect component parts of a “straddle.”732
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725 Regs. § 1.446-3; see also T.D. 8491, 58 Fed. Reg. 53125 (Oct. 8, 1993). For a discussion of those regulations, see also NYSBA, “Report on Proposed Regulations on Methods of Accounting for Notional Principal Contracts,” reprinted in 54 Tax Notes 1127(1992).

726 See Regs. § 1.863-7; see also T.D. 8734, 1997-44 I.R.B. 5; see further Notice 98-12, 1998-15 I.R.B. 12.

727 See REG-166012-02, 69 Fed. Reg. 8886 (2/26/04).  For a discussion of those proposed regulations, see Garlock, “The Proposed Notional Principal Contract Regulations: What's Fixed? What's Still Broken?,” 102 Tax Notes 1515 (March 22, 2004).

728 See Regs. § 1.988-2(e).

729 For a discussion of the effect of the  § 475(f) election on a hedge fund, see IX, B, above.

730 For a discussion of the  § 988 “integration”regulations, see XI, G, below.

731 For a discussion of the  § 1275 “integration”regulations, see XI, A, 5, below.

732 For a discussion of the straddle rules under § 1092, see XI, C, below.

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In assessing the tax consequences of a swap to a counterparty, the practitioner usually considers five separate questions:

• is the purported swap a “notional principal contract” (“NPC”)for tax purposes?;

• when should a counterparty report the periodic, non-periodic and termination payments?;
  
• how should a counterparty report the periodic, non-periodic and termination payments?;
  
• what is the “source”of such payments to a foreign counterparty?; and

• will other rules override the foregoing by virtue of the swap's relationship to another investment?

2. Is the Swap a Notional Principal Contract? 

Like the Code and Treasury regulations, tax practitioners usually refer to this instrument not as a “swap,”but as a “notional principal contract” (“NPC”). The two are by no means synonymous.  The market at large defines a swap as anything that appears on ISDA paper as such.  The  § 446 regulations, however, define a swap with greater precision.  Under the  § 446 regulations, an NPC is a contract that provides for payments by one party to another at “specified intervals” calculated by reference to a “specified index”upon a “notional principal amount” in exchange for specified consideration or a promise to pay similar amounts.733 The term “notional” in this context means only that neither party transfers a principal amount to the other.  Rather, the principal amount is just a variable in a formula for calculating the actual payment obligations of each party. The notional amount may vary over the term of a swap, provided that the swap either sets the varying amounts in advance or determines them from objective financial information.
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733 Regs. § 1.446-3(c)(1)(i).

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3. Timing of Swap Payments 

Much of the uncertainty under current law regarding the taxation of swaps concerns the issue of timing and the issue of character.  In the hedge fund context, however, these issues are relevant only to a subset of the participants.  Timing and character are not relevant to the foreign investor, including the “corporate”feeder for the tax-exempt and foreign shareholders,734 unless the swap generates ECI or U.S. source FDAP income.  Timing and character are not relevant to the tax-exempt investor unless the swap generates UBTI.735 What is relevant to these investors is the source of swap income because source tends to establish or negate U.S. taxing jurisdiction.736 Accordingly, the tax practitioner cannot overlook the different and at times divergent interests of the investors concerning the U.S. taxation of a swap — only some of the investors — the taxable participants — will care about the issues of timing and character.  As “partners”for tax purposes, this subset of investors will bear tax on a pass-through basis under  § 702(b) on their allocable share of any swap income or loss generated at the fund level.737
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734 As described more fully in VII, C, above, the sponsor usually forms both the offshore feeder in a master-feeder structure and the offshore fund in a parallel structure as a corporation for tax purposes.

735 In general, swap income is not UBTI.  See Regs.  § 1.512(b)-1(a) (excluding “income from notional principal contracts”).  For a discussion of the taxation of tax-exempt investors in the hedge fund context, see VII, B, 2, above.

736 The status of income as U.S. or foreign source is not strictly relevant to a tax-exempt investor because source does not establish whether income is UBTI.  The tax-exempt investor, however, has an economic stake in the source issue in its capacity as a shareholder of the foreign feeder.

737 See also Regs.  § 1.702-1(b) (character of allocated gains determined at entity level).

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a. Timing under 1993 Regulations 

The timing regulations under  § 446 set forth the general rules of accounting for swaps.  Like the reporting of “original issue discount” (“OID”) on debt, the  § 446 regulations require all taxpayers, even the taxpayer on the cash method of accounting, to report income and loss on a swap on the accrual method.738 In applying the accrual method to swaps, the timing regulations first separate the swap payments into three discrete categories:
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738 See Regs.  § 1.446-3(e)(2) (accrual method applies to periodic payments); Regs.  § 1.446-3(f)(2) (accrual method applies to non-periodic payments).

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• periodic payments;

• non-periodic payments; and

• termination payments.

The regulations then establish the basic principles of accrual for each type of payment.  As described more fully below, these principles generally require each counterparty to report as income or loss on a swap an amount equal to the sum of the “ratable”portion of the swap payments allocable to the year.739
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739 Regs. § 1.446-3(d).

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Periodic Payments.  A “periodic payment” is an amount payable at intervals of one year or less during the entire term of the swap, provided that the amount payable is calculated by reference to a specified index on a notional principal amount.740 In general, each counterparty to a swap reports as income or expense the “ratable daily portion”of the periodic payment for the taxable year to which such portion relates.741
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740 See Regs. § 1.446-3(e)(1).

741 See Regs. § 1.446-3(e)(2)(i).

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Three principles are noteworthy here.  First, the timing regulations aggregate payments on the swap over the course of the year into a single net payment by or to one of the counterparties.  Whether a swap by its terms allows the counterparties to net offsetting payment obligations is therefore irrelevant.  Similarly, whether a swap calls for payments to and from the counterparties on the same date is irrelevant.  Each counterparty instead recognizes the “ratable daily portion” of the net periodic payment attributable to the taxable year.742 Second, the period to which any particular payment relates may vary over the term of the swap without altering its status as a periodic payment, so long as the swap requires payment at least annually.743 Finally, contrary to the “open transaction”treatment we afford an option or forward contract, the timing regulations prohibit the short-term deferral of periodic payments that “straddle”a taxable year:
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742 Regs. § 1.446-3(e)(2)(i).

743 Unlike interest on debt, therefore, the timing regulations ignore the time value of money component embedded in the payment schedule.

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Example 11-2: On January 1, 2007, taxpayer enters into a three year equity swap with ABC investment bank.  Under the swap, ABC agrees to make annual periodic payments to taxpayer equal to the increase in value of an index of stocks above$1000; in exchange, taxpayer agrees to make annual periodic payments at LIBOR on a notional amount of $1000, together with payments equal to any decrease in value of the index below this threshold.  The taxpayer must therefore report as a periodic payment the net difference between any increase in value of the index and the accrued portion of the LIBOR payment as ordinary income during 2007, even though it will neither make nor receive any payment until January 1, 2008.

Had the taxpayer in this example instead entered into a three separate cash-settled forward contracts to acquire the stocks in the index from ABC on January 1 of 2008, 2009 and 2010, each contract would have remained “open” for tax purposes as of the end of the immediately preceding taxable year.744
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744 See Kleinbard, “Equity Derivative Products: Financial Innovation's Newest Challenge to the Tax System,” 69 Tex. L. Rev. 1319 (1991) (economic terms of most financial instruments can be replicated through combinations of other financial instruments).

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Non-Periodic Payments.  A non-periodic payment on a swap is any payment that is neither a periodic payment nor a termination payment.745 For example, a non-periodic payment includes a payment of premium on a cap or a floor, an upfront payment on an off-market swap, and a prepayment of a swap obligation.746 In general, each counterparty to a swap must report the “ratable daily portion” of the net non-periodic payment for the taxable year to which such portion relates.747 In the case of these payments, however, the method of amortization will depend upon whether the non-periodic payment is “significant.”
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745 Regs. § 1.446-3(f).

746 Regs. § 1.446-3(f)(1).

747 Regs. § 1.446-3(f)(2)(i).

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Non-Significant Payments.  The timing regulations allow a swap counterparty to report a non-significant non-periodic payment under one of three amortization methods. Under the “default” method, the counterparties may amortize the payment over the term of the swap “in accordance with the forward rates ... of a series of cash-settled forward contracts that reflect the specified index and the notional principal amount”of the swap in question.748
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748 See Regs. § 1.446-3(f)(2)(ii).

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The following example illustrates the default method as applied to a hypothetical commodity swap:

Example 11-3:749 On January 1, 2006, the Hog fund and Arnold enter into a three year commodity swap involving frozen pork bellies.  Under the swap, Hog agrees to make annual payments to Arnold equal to the product of $4.00 per pound of frozen pork bellies on a notional amount of 400,000 pounds ($1,600,000).  In exchange, Arnold agrees to make annual payments to Hog equal to the product of the spot price for frozen pork bellies and the same notional amount. On January 1, 2006, the price of a one-year, two-year, and three-year forward contract for frozen pork bellies is $4.20, $4.50 and $5.00, respectively.  The parties price the pork belly swap in accordance with these prices, resulting in a net cost to Arnold of $80,000 in 2005, $200,000 in 2006 and $400,000 in 2007.  To compensate Arnold for the “off-market” payments, Hog pays Arnold $589,319 at the inception of the swap.  This prepayment represents the present value of the net cost of the swap to Arnold over the three-year term at a 6% discount rate.

The $589,319 constitutes a “non-periodic payment.”  Under the default method, Hog must amortize the $589,319 over the term of the swap by treating the net cost to Arnold as a self-amortizing loan of $589,319 to be repaid in installments of $80,000,$200,000 and $400,000 over the three-year term of the swap.  The amortization schedule for such a loan is as follows:
Year	Expected
 Forward
 Payment	Time Value
 Component	Principal
 Component	
2006	$80,000	$35,359	$44,641	
2007	$200,000	$32,681	$167,319	
2008	$400,000	$22,642	$377,358	
 	$680,000	$90,682	$589,319	

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749 See Regs. § 1.446-3(f)(4), Ex. 7.

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The final column captures the principal amortization on this hypothetical loan.  Under the default method, the parties report these amounts as “constructive” periodic payments by Hog to Arnold over the term of the swap.

In this example, the use of the forward rates on pork bellies to establish the payment schedule on the hypothetical loan of $589,319 has the effect of “backloading” the amortization of the upfront payment.

As an alternative to the default method, the counterparties may instead elect to amortize the upfront payment under the “level payment” method.750 Under the level payment method, the counterparties continue the “default method”convention of recasting the upfront payment as a hypothetical loan by the payor and then treating the resulting principal amortization as a series of “constructive” periodic payments.  The terms of the hypothetical loan under the level payment method, however, assume debt service in equal annual installments.  Due to the shorter economic duration of a level payment loan, this method of amortization has the effect of “frontloading” the reporting of the upfront payment.751
——————————————————————————————

750 See Regs.  § 1.446-3(f)(2)(iii)(A) (treating prepayment first as a constructive self-amortizing loan that provides for level payments over swap term, then recasting “principal”portion of hypothetical level payments as periodic swap payments). The discount rate used to determine the amortization schedule must correspond to the discount rate used to determine the non-periodic payment.  If this rate is not readily ascertainable, the parties must use a discount rate that is reasonable under the circumstances.  Id.

751 See Avi-Yonah, Newman &  Ring, Taxation of Financial Instruments, § 3:32, Chapter 3 (Taxation of Notional Principal Contracts) (1999).

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Under a second alternative to the default method, the counterparties may amortize a non-periodic payment other than an upfront payment by treating the swap as if it had provided for a single upfront payment equal to the present value of the non-periodic payments, coupled with a hypothetical loan of such amount by the payor. Like the level payment method, the hypothetical loan under this method assumes debt service in equal annual installments.752 Here, however, the timing regulations treat the entire payment stream on the hypothetical loan as a periodic payment (rather than just the “principal”portion).
——————————————————————————————

752 See Regs.  § 1.446-3(f)(2)(iii)(B) (describing similar methodology, but first creating constructive prepayment in amount equal to present value of future non-periodic payments, and then constructing self-amortizing loan that provides for level payments over swap term from such prepayment; unlike treatment of prepaid swap, regulation allows reporting of both “principal” and “interest”portion of hypothetical level payments as periodic swap payments).

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Significant Payments. If a swap provides for “significant” non-periodic payments, the counterparties must bifurcate the swap into two separate instruments:an at-market swap and a separate loan.753 Unlike the loan component in each of the preceding amortization methods, however, the parties account for this loan as an actual loan for all tax purposes:
——————————————————————————————

753 Regs. § 1.446-3(g)(4).

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Example 11-4:754 On January 1, 2006, the Quartz fund enters into a five-year interest rate swap with B.  Under the swap, B agrees to make annual payments to Quartz in an amount equal to the product of LIBOR and $100 million.  In exchange, Quartz agrees to make annual payments to B equal to the product of 6% and$100 million.  Because the market price of a LIBOR swap on this date is 10%, Onyx makes an upfront payment to B of $15,163,147 to compensate B for the “below-market” payments of 6%.  Quartz and B document the entire transaction as a swap.  Because the upfront payment is “significant,” however, Quartz and B must report it as a separate loan for all tax purposes.  The debt service on this loan is deemed to require level payments over the term of the swap at the market rate of 10%.  These assumptions produce the following amortization schedule:
Year	Level Payment	Interest	Principal	
2006	$4,000,000	$1,516,315	$2,483,685	
2007	$4,000,000	$1,267,946	$2,732,054	
2008	$4,000,000	$994,741	$3,005,259	
2009	$4,000,000	$694,215	$3,305,785	
2010	$4,000,000	$363,636	$3,636,364	
 	$20,000,000	$4,836,853	$15,163,147	

The “reconstituted” swap, on the other hand, is deemed to require “periodic payments” of$10 million from Quartz to B, not $6 million.  Quartz will therefore be deemed to have funded the incremental $4 million in periodic payments to B from the debt service it receives from B on the foregoing loan.

——————————————————————————————

754 See Regs. § 1.446-3(g)(6), Ex. 3.

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b. Timing under Proposed Regulations 

The 1993 regulations did not distinguish between contingent and non-contingent payments.  The failure to do so left open the question of whether and under what conditions a contingency should suspend or otherwise alter the obligation to report a non-periodic payment on a “ratable” current basis.  Although the 1993 regulations do not suspend the requirement to accrue such a payment, the preamble to the regulations includes the following statement:

... the final regulations do not include any examples of how to treat nonperiodic payments that are not fixed in amount at the inception of the contract.  The IRS expects to address contingent payments in future regulations ...755

——————————————————————————————

755 See T.D. 8491, 1993-33 I.R.B. 6.

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Many counterparties suspend the accrual of contingent swap payments until future events fix the contingency, relying upon general tax principles rather than the specific accounting rules for swaps.756 On February 26, 2004, however, the IRS issued long-anticipated proposed regulations regarding the accrual of contingent payments.757 Under the proposed regulations, the IRS rejects “wait-and-see” as an appropriate accounting method for contingent payments,758 requiring the counterparties to amortize a contingent payment on a current basis before future events resolve the uncertainty.759 Although a full description of these methodologies is beyond the scope of this portfolio, the proposed regulations describe two alternative approaches.
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756 This type of “wait-and-see”accounting reflects a basic principle of the accrual method of accounting that a taxpayer should not report an item of income or expense until the amount payable may be determined with reasonable accuracy.  See Regs. § 1.451-1(a); see also Avi-Yonah, Newman &  Ring, Taxation of Financial Instruments, § 3:45, Chapter 3 (Taxation of Notional Principal Contracts) (1999) (“the author believes that the most reasonable approach under current law is to defer any inclusion or deduction in respect of such a payment”); see also Steinberg, “Using OTC Equity Derivatives For High-Net-Worth Individuals,” in: F. Fabrozzi/ R.P. Molay (eds), The Use of Derivatives in Tax Planning, p. 211, 228 (1998) (“most practitioners believe, consistent with general tax principles, that such payments should be taken into account only at the time they become fixed”).

757 REG-166012-02, 69 Fed. Reg. 8886 (2/26/04).  Under the proposed regulations, a contingent non-periodic payment is “any non-periodic payment other than a non-contingent non-periodic payment.” See  Prop. Regs. § 1.446-3(g)(6)(i)(B). A non-contingent non-periodic payment is “a non-periodic payment that either is fixed on or before the end of the taxable year in which a contract commences or is equal to the sum of amounts that would be periodic payments if they are paid when they become fixed.” See Prop. Regs. § 1.446-3(g)(6)(i)(A).

758 The IRS appears to regard “wait-and-see”accounting as more vulnerable to abuse in the swap context than in other contexts.  A likely explanation is the difficulty of reconciling suspended accrual of the contingent payments with the tax treatment of the fixed payments.  An accounting method that would allow a swap counterparty under these circumstances to deduct the fixed periodic payments but suspend the accrual of a future (albeit contingent) payment that is the quid pro quo for the deductible payments may fail to “clearly reflect” income.  See Preamble to the proposed regulations, REG-166012-02, 69 Fed. Reg. 8886 (2/26/04) (referring to “back-loaded timing of tax consequences” and “potential for abuse” in wait-and-see accounting).

759 See also Preamble to the proposed regulations, REG-166012-02, 69 Fed. Reg. 8886 (2/26/04) (“adopting this approach for contingent payment NPCs achieves symmetry between fixed payment NPCs and contingent payment NPCs”).

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The first methodology is the “noncontingent swap method.”760 Under the noncontingent swap method, the counterparties project the future contingent payments and then amortize the projected payments under the general rules that apply to noncontingent payments.761 On each “redetermination date,”the counterparties then revise the projections to reflect more current market data, reapplying the original methodology to the new payment schedule.762 The counterparties must account for any adjustments to income or loss that result from the altered projections during the current and subsequent taxable years.763
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760 Prop. Regs. § 1.446-3(g)(6)(ii).

761 Id.

762 See Prop. Regs. § 1.446-3(g)(6)(iv).

763 See Prop. Regs. § 1.446-3(g)(6)(v).

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The second methodology is “mark-to-market”accounting, which is available only for certain types of swaps.764 A counterparty that elects to report swap income or loss on a mark-to-market basis must apply the same accounting method to all of its otherwise eligible swaps.765 Under mark-to-market accounting, therefore, the counterparty does not report the non-periodic payments under the general timing rules of Regs. § 1.446-3(f)(2). Instead, it reports gain or loss on an eligible swap as if it had sold the swap for its fair market value on the last day of the taxable year.766
——————————————————————————————

764 See Prop. Regs. § 1.446-3(i)(2).

765 See Prop. Regs. § 1.446-3(i)(6).

766 Regs. § 1.446-3(i)(1).

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c. Timing of Termination Payments 

The third category of payment under a swap is a “termination payment.”  A termination payment is “a payment made or received to extinguish or assign all or a proportionate part of the remaining rights and obligations of any party.”767 A termination payment includes both a payment between the two counterparties to extinguish the contract, as well as either a payment by a counterparty to a third party or a payment by a third party to a counterparty, in each case to assign the contract to the third party.768 The  § 446 regulations do not require current amortization of a termination payment.  They instead require the counterparties to recognize a termination payment in the year in which the contract is extinguished, assigned or exchanged, along with the remaining unamortized portion of any periodic or non-periodic payments.769
——————————————————————————————

767 See Regs. § 1.446-3(h)(1).

768 Id.

769 See Regs. § 1.446-3(h)(2).

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4. Character of Swap Payments 

a. Periodic and Non-Periodic Payments 

Until the IRS issued the proposed regulations, the proper character of at least certain types of swap payments was unclear.  The proposed regulations dispose of this issue in a simple, albeit rather blunt way.  Rather than consider the economic nature of the payment, they instead draw a bright line between a termination payment, on the one hand, and a periodic or non-periodic payment, on the other.  According to the preamble —

neither periodic nor nonperiodic payments ...involve a sale or exchange within the meaning of § 1222, and no other section of the Code provides otherwise ... even nonperiodic payments made at the maturity of an NPC are not termination payments under § 1234A.770

——————————————————————————————

770 REG-166012-02, 69 Fed. Reg. 8886 (2/26/04).

——————————————————————————————

Under the proposed regulations, therefore, both periodic and non-periodic payments give rise to ordinary income or loss, regardless of their economic character.771
——————————————————————————————

771 See Prop. Regs. § 1.162-30(a) (amounts taken into account pursuant to  § 1.446-3(d)(1) are deductible as ordinary and necessary business expenses); Prop. Regs. § 1.212-1(q)(1) (amounts taken into account by individual pursuant to  § 1.446-3(d)(1) are deductible to extent paid or incurred in connection with production or collection of income); Prop. Regs.  § 1.1234A-1(b) (payments other than termination payments constitute ordinary income or expense).

——————————————————————————————

The principal source of uncertainty under prior law concerned the proper application of § 1234A, in particular as applied to a swap.  Prior to the enactment of § 1234A, the cancellation of a contractual obligation for consideration generally resulted in ordinary income or loss because it did not result from a “sale or exchange” under § 1001. When it applies, however,  § 1234A recasts the gain or loss attributable to the cancellation, lapse, expiration, or other termination of a right or obligation with respect to property which is (or upon acquisition would be) a “capital asset” in the hands of the taxpayer as capital gain or loss, even though the recipient did not receive the payment in a “sale or exchange.”

The IRS first addressed whether  § 1234A applied to a swap in TAM 9730007, concluding that a periodic payment was ordinary in nature.  Even though the  § 446 regulations do not address character, the IRS relied upon the failure of the timing regulations to treat a periodic payment as a termination payment. Nevertheless, the literal language of  § 1234A would appear to subsume a payment that the contract itself requires, for example, a final payment at maturity that reflects a change in value of an underlying asset.

b. Termination Payments 

As described above, a termination payment is a payment to extinguish or assign all or a proportionate part of the remaining rights and obligations of a counterparty.772 Under § 1234A, a termination payment is capital in nature.773 Although the recipient of the payment does not receive the payment in a sale or exchange,  § 1234A “constructs”a sale or exchange under § 1001. Because the swap is a capital asset,774 the payment to terminate the swap is capital in nature.
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772 See Regs.  § 1.446-3(h)(1) (definition of termination payment).

773 See Prop. Regs.  § 1.1234A-1(b) (none of the following constitute termination payments under § 1234A:a periodic payment under Regs. § 1.446-3(e), a non-periodic payment under Regs. § 1.446-3(f), a contingent non-periodic payment under Prop. Regs.  § 1.446-3(g)(6) to which the “non-contingent swap method” applies, or any amount marked-to-market under Prop. Regs. § 1.446-3(i)(1)).

774 See Regs.  § 1.1092(d)-1(c) (“a notional principal contract ... constitutes personal property of a type that is actively traded”).

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In many equity swaps, however, it is difficult to discern any economic distinction between a termination payment and a scheduled payment:

Example 11-5: Onyx is hedge fund organized as a partnership for tax purposes with taxable U.S. partners. Onyx enters into an equity swap with ABC bank.  Under the terms of the swap, ABC agrees to pay to Onyx an amount equal to any dividends paid on 50 shares of Microsoft over a five-year term, together with an amount equal to any appreciation in the value of the shares above$1000x.  Onyx in turn agrees to pay to ABC a floating rate of interest on a “notional” amount of $1000x over five years, together with an amount equal to any decline in value of the shares of Microsoft over the same period.  At the end of each of the five years, ABC makes a payment to Onyx equal to the appreciation in the Microsoft stock.

Onyx must report these payments as ordinary income even though they represent gain attributable to a capital asset.

If enacted in their present form, final regulations will treat each payment to Onyx as ordinary in nature.  The IRS regards all attributes of the payments save one as irrelevant, including the contingency, the timing, the basis of measurement and the character of the underlying asset.775 What matters to the IRS is whether or not the swap “schedules” the payment. If it does, the payment cannot result from a “termination”under § 1234A. Accordingly, even if the parties in this example had deferred 100%of the “change in value” payments on the Microsoft stock until maturity of the swap, the proposed regulations would still have treated the final payment as ordinary in nature and therefore subject to current amortization.
——————————————————————————————

775 See Prop. Regs. § 1.162-30(a) (amounts taken into account pursuant to  § 1.446-3(d)(1) are deductible as ordinary and necessary business expenses); Prop. Regs. § 1.212-1(q)(1) (amounts taken into account by individual pursuant to  § 1.446-3(d)(1) are deductible to extent paid or incurred in connection with production or collection of income); Prop. Regs.  § 1.1234A-1(b) (payments other than termination payments payment constitutes ordinary income or expense).

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c. Assignments 

If a counterparty to a swap assigns its rights and obligations to a third party for consideration, it will realize a gain or loss.776 But what about the non-assigning party? The timing regulations under § 446 provide that the non-assigning party will realize a gain or loss only if the swap assignment results in a “sale or exchange” under § 1001.777 Although the IRS has issued a regulation on the tax treatment of a swap assignment to the non-assigning party, it applies under very narrow circumstances. Under the regulation, the substitution of a swap counterparty is not a sale or exchange to the other counterparty if both the assignor and assignee qualify as “dealers” in swaps and if the terms of the swap allow the assignment without the non-assigning party's consent.778 Because a hedge fund is not a dealer, it cannot rely on this regulation.  The preamble to the predecessor of this regulation, however, provides that “no inference [was]intended with respect to whether an assignment of rights by one party to other types of bilateral contracts results in an exchange ...by the non-assigning party.”779 It would appear, therefore, that the special relief afforded to dealer swaps in this regulation is merely a safe harbor.
——————————————————————————————

776 § 1234A.

777 Regs.  § 1.446-3(h)(1) (last sentence).

778 See Regs.  § 1.1001-4.

779 T.D. 8676, 1996-2 C.B. 9.

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Under § 1001, a taxpayer must recognize gain or loss from the sale or other disposition of property unless a specific provision of the Code allows deferral. In the case of a debt instrument, a transfer by the lender will not trigger gain or loss to the borrower.780 With debt, however, this conclusion is so patently obvious that the explanation is often omitted.  The reason, however, is that the borrower of funded debt is the only remaining party with a payment obligation.  That the borrower now owes the same obligation to someone else is not material.781 An assigned swap, on the other hand, remains at least partially executory on both sides of the contract, even after an assignment.  Unlike funded debt, therefore, a swap imposes a continuing bilateral obligation on both parties to effect future payments.782
——————————————————————————————

780 But see § 108(e)(4).

781 See also New York State Bar Association Tax Section, “Report on Proposed Regulations on Methods of Accounting for Notional Principal Contracts,” reprinted in 54 Tax Notes 1127, 1142-43 (Jan. 15, 1992) (“the change in the payee or debt holder alone is not material to the obligor; it simply owes the same money, property, or other duties to someone else”).

782 New York State Bar Association Tax Section, “Report on Proposed Regulations on Methods of Accounting for Notional Principal Contracts,” reprinted in 54 Tax Notes 1127, 1142 (Jan. 15, 1992) (“contracts that are both assets and liabilities provide better analogies to a notional principal contract than do debt instruments”).

——————————————————————————————

Although swap obligations are indeed bilateral, an assignment of a swap nevertheless results in a change in one of the obligors.  In the case of debt, a change in obligor is usually a taxable event under both Cottage Savings and the  § 1001 regulations.783 For other types of property, however, these authorities are not controlling.784 The non-assigning party in a swap has a stake in the swap assignment only insofar as it affects the underlying credit.  The assignment of a swap, however, usually requires the non-assigning party to consent.  If the non-assigning party consents to the assignment, therefore, it should tend to establish that the change in credit vis-à-vis the assignor was not material.785 Accordingly, the assignment of a swap by a counterparty for no consideration should not trigger gain or loss to the non-assigning counterparty.786
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783 Cottage Savings Ass'n v. Comr., 499 U.S. 554 (1991); Regs.  § 1.1001-3(e)(4) (change in obligor generally a “significant modification”).

784 See T.D. 8675, 1996-2 C.B. 60 (“for contracts that are not debt instruments, the final regulations do not limit or otherwise affect the application of the “fundamental change” concept articulated in Rev. Rul. 90-109”); Rev. Rul. 90-109, 1990-2 C.B. 191 (replacement of insured party on contract of insurance results in deemed exchange of old contract for new contract); see also Avi-Yonah, Newman &  Ring, Taxation of Financial Instruments, § 3:38, Chapter 3 (Taxation of Notional Principal Contracts)(1999); Keyes, Federal Taxation of Financial Instruments and Transactions, Chapter 14 (Notional Principal Contracts) at ¶  14.04[3][c](1997).

785 The non-assigning party may also consent if the assignee has a better credit rating than the assignor.

786 Accord Kramer, Financial Products — Taxation, Regulation and Design at § 78.05[B][4](3d ed. 2000) (“until future regulations are issued, the assignment of an NPC — including assignments by one dealer to another that fall outside the protection of Treas. Reg.  § 1.1001-4 — should not give rise to any federal income tax consequences to the non-assigning party.”)

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5. Source of Swap Payments 

For the hedge fund that participates in a cross-border swap, in particular the corporate feeder vehicle for electing tax-exempt and foreign shareholders, the U.S. tax analysis of a swap often begins and ends with the question of source.787 The reason is that, in the vast majority of cases, the source of the swap income to a foreign counterparty will establish or negate U.S. taxing jurisdiction. Without U.S. taxing nexus, the separate questions of timing and character become academic.
——————————————————————————————

787 As described more fully in VII, C, above, the sponsor usually forms both the offshore feeder in a master-feeder structure and the offshore fund in a parallel structure as a corporation for tax purposes.

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A foreign person that receives U.S. source FDAP is subject to U.S. withholding tax at a 30% or reduced treaty rate.788 Under prior law, however, whether income attributable to a swap qualified as FDAP income was unclear.789 Indeed, until the IRS promulgated regulations under § 863, even the source of swap income was unclear.790 The regulations under § 863, however, now source “notional principal contract income” (“NPCI”) by reference to the residence of the recipient791 unless the income arises from the conduct of a U.S. trade or business.792 For this purpose,793 NPCI should include a periodic payment, a non-periodic payment and a termination payment, whether or not the payment is contingent.  As described above, it will not include a “significant” non-periodic payment under the  § 446 regulations.794 The  § 446 regulations split this type of swap into an “at-market” swap and a separate loan. Accordingly, any interest deemed paid on the loan component of the swap to the foreign counterparty will instead constitute U.S. source income under § 861(a), assuming a domestic payor.795
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788 See  § § 871(a) 881, 1441, 1442.

789 See Notice 87-4, 1987-1 C.B. 416 (IRS has taken no position as to whether swap income constitutes FDAP).

790 See Notice 87-4, 1987-1 C.B. 416.

791 See Regs. § 1.863-7(b)(1). The term “residence” is defined by reference to § 988(a)(3)(B)(i).

792 See Regs. § 1.863-7(b)(3).

793 Although the IRS promulgated the  § 863 regulations two years before it promulgated the  § 446 regulations, the later regulations neither adopt nor employ this term.  But see Keyes, Federal Taxation of Financial Instruments and Transactions, Chapter 14 (Notional Principal Contracts) at ¶  14.04[4][b] (1997) (“it is not clear whether the term ‘notional principal contract income’encompasses gains from the sale or termination of an NPC.  If ...not ... they should also be sourced in the recipient's country of residence under the general sourcing rules [of § 865(a)]”).

794 See XI, A, 3, a, above.

795 See Regs.  § 1.446-3(g)(4) (“[t]he time value component associated with the loan is not included in the net income or net deduction from the swap (...) but is recognized as interest for all purposes of the Internal Revenue Code.”); see also Regs. § 1.1441-4(a)(3) (for withholding tax purposes “[i]ncome on a notional principal contract does not include the amount characterized as interest under the provisions of § 1.446-3(g)(4)”). In most cases, however, the interest will qualify as “portfolio interest” under § 871(h).

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Although a cross-border payment on a swap is FDAP income, the U.S. payor or other withholding agent is not obligated to withhold from the payment even if the foreign payee fails to provide a withholding certificate.796 In such a case, the withholding agent may assume that the payment qualifies as ECI subject to information reporting under § 1461. Even that obligation is excused, however, if either the ISDA agreement or swap confirmation includes a representation that the counterparty is a foreign person operating from a non-U.S. office.797
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796 See Regs. § 1.1441-4(a)(3)(i).

797 See Regs. § 1.1441-4(a)(3)(ii); see also T.D. 8734, 1997-44 I.R.B. 5.

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Based upon the foregoing, a “residence-based”source rule for cross-border swaps will generally allow the foreign feeder798 to participate in the economic return on an asset without bearing the U.S. tax consequences:799
——————————————————————————————

798 As described more fully in VII, C, above, the sponsor usually forms the offshore feeder as a foreign corporation for U.S. tax purposes.

799 See, e.g., Regs. § 1.863-7(b)(1) (swap income generally sourced in accordance with residence of recipient); see also § 1441(a) (withholding applies only to FDAP “from sources within the United States”).

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Example 11-6: ParallelCo is a foreign fund that coinvests with MasterCo, a domestic fund. ParallelCo is a Cayman Islands “feeder” corporation through which electing foreign and tax-exempt shareholders invest in MasterCo.  ParallelCo plans to acquire a portfolio of intellectual property (IP) from a drug company.  The IP in the portfolio is licensed to third parties for use in the United States in exchange for periodic royalties. If ParallelCo were to acquire the IP, it would bear U.S. withholding tax on the royalties at a 30% rate.800 So ParallelCo instead enters into a swap with ABC bank.  Although not required to do so, ABC acquires the portfolio of IP from the drug company to hedge its obligations under the swap.  Under the terms of the swap, ABC agrees to pay to ParallelCo an amount equal to any royalties paid on the IP over a five-year term, plus any appreciation in the value of the portfolio at maturity.  ParallelCo in turn agrees to pay to ABC a floating rate of interest on a “notional” amount equal to the original purchase price of the IP, less any decline in the value of the portfolio at maturity.

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800 § § 881(a), 1442(a).

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As an economic matter, ABC has sold the portfolio of IP to ParallelCo for a note.  If respected as a mere counterparty to a swap, however, ParallelCo will avoid U.S. withholding tax on the periodic payments from ABC because the payments, although based upon U.S. source royalties, represent foreign source income.801 Moreover, although the trading safe harbor under  § 864(b) does not apply to this type of derivative,802 ParallelCo will still avoid net basis taxation on the swap payments so long as its entry into the swap is characterized as an “investment”rather than a U.S. trade or business.803
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801  See Regs. § 1.863-7(b)(1). But see Notice 2004-52, 2004-32 I.R.B. 168 (requesting information on credit default swaps for purposes of determining their tax treatment including potential application of withholding tax).

802 See Prop. Regs. § 1.864(b)-1(a) (trading in “derivatives” not a trade or business); see also Prop. Regs.  § 1.864(b)-1(b)(2) (defining “derivative” to include “notional principal contract” under § 475(c)(2)).

803 For a discussion of the distinction between “trading” and “investing,” see VII, B, 1, above.

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Although not entirely free from doubt, the definition of an NPC under the  § 863 source regulation is coextensive with the definition on an NPC under the § 446 timing regulations.  Accordingly, the source rule under  § 863 should extend to an equity swap even though the source regulation does not cite an equity swap as a type of NPC.804 It does not exclude an equity swap either, and the subsequently-enacted swap timing regulations under  § 446 cite an equity swap as an example of an NPC.805
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804 Less clear is whether an equity swap under the  § 863 source rule also includes a swap involving stock of a single issuer.  It has been observed, for example, that the  § 863 regulations do not define “specified index,” which may require a broader measure than the stock of a single issuer.  See Avi-Yonah, Newman & Ring, Taxation of Financial Instruments, § 3:54, note 5, Chapter 3 (Taxation of Notional Principal Contracts) (1999).  The preamble to T.D. 8491 also provides that the “the IRS is considering whether notional principal contracts involving certain specified indexes (e.g., one issuer's stock) should be excluded from the general sourcing rules of  Sections 861 through 865...” See Fed. Reg. 53,125, 53,126 (10/8/93).  See also Sheppard, “To Withhold or Not To Withhold on Equity Swaps,” reprinted in 92 TNT 133-12 (June 29, 1992) (“some tax lawyers have warned that an equity swap involving the shares of a single issuer could be considered a leveraged purchase of these shares by the foreign investor so that tax would have to be withheld...”).  To date, however, the IRS has made no such determination.

805 See Regs. § 1.446-3(c).

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6. Integration of Swap Payments 

Much of the foregoing discussion assumes that the swap in question does not hedge another position in the portfolio. If it does, it may (or may not) alter how and when the counterparty must report the swap income or loss.  The hedging regulations adopt two sets of rules, one of which addresses character806 and the other of which addresses timing.807 Under the hedging regulations, the character and timing of income or expense on the swap must match the character and timing of income or expense on the hedged asset or liability.
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806 See Regs. § 1.1221-2.

807 See Regs. § 1.446-4.

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Having rejected the IRS's narrow interpretation of Arkansas Best,808 the hedging regulations have had a profound effect on the swap market.  For hedge funds, however, these regulations are largely irrelevant.  They generally apply only to a hedge of “trade or business” risk, for example the currency risk to a U.S. seller of inventory on a foreign market at prices denominated in a foreign currency.  As discussed in VIII, A, above, most hedge funds do not engage in a “trade or business.” They invest in stocks and securities as non-dealers and do not sell inventory to customers.
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808 485 U.S. 212 (1988); see also Federal National Mortgage Association v. Comr., 100 T.C. 541 (1993) (rejecting IRS's narrow construction of Arkansas Best decision).

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Of more relevance to hedge funds are the  § 1275 “integration”regulations.  Under these regulations, the borrower and lender may collapse a debt instrument and related swap into a “synthetic”debt instrument for tax purposes under certain conditions.  The integration regulations apply both to debt issued by the taxpayer as a liability and debt acquired by the taxpayer as an asset.809 In general, a taxpayer may integrate a “qualifying debt obligation” with a “§ 1.1275-6 hedge.” A  § 1.1275-6 hedge is any “financial instrument” that provides for cash payments that, when netted against the payment obligations on the debt, permit a yield-to-maturity calculation.810
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809 See Regs.  § 1.1275-6(a) (“the rules of this section affect only the taxpayer who holds (or issues)the qualifying debt instrument and enters into the hedge”).

810 See Regs. § 1.1275-6(b)(2)(i).

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Example 11-7: A taxpayer issues a five-year bond for $950 that pays semi-annual interest at a 9% rate on a face amount of $1000.  Under § 1273, the bond has $50 of OID, producing a yield-to-maturity of 10.3%.  On the same date, the taxpayer enters into a swap with ABC bank.  Under the terms of the swap, ABC agrees to pay taxpayer$50 at the inception of the swap, together with semi-annual payments of $51.52 for five years, and taxpayer agrees to make semi-annual payments of $45 to ABC over the same period.  If taxpayer elects to integrate the bond and the swap, it will be deemed to have issued a $1,000 bond at par that pays semi-annual interest at a 10.3% rate. This “synthetic” bond would have an “issue price”under  § 1273(b) equal to the sum of the $950 in borrowed proceeds and the $50 received from ABC.811 Although the $1,000 issue price matches the amount due at maturity, none of the coupon interest on the synthetic bond qualifies as “qualified stated interest.”812 The bond will therefore have original issue discount of $515.20 even though it pays interest on a current basis.

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811 See Regs.  § 1.1275-6(f)(4) (upfront payment on swap increases “issue price” of synthetic debt instrument).

812 Regs. § 1.1275-6(f)(6).

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A “financial instrument” does not qualify as a  § 1.1275-6 hedge, however, if the maturity of the “synthetic” debt instrument does not match the maturity of the qualifying debt instrument.813 A financial instrument includes an NPC, as well as a spot, forward, futures or option contract and certain other contractual arrangements.814
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813 Id.

814 Regs. § 1.1275-6(b)(3).

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To elect integration, a taxpayer must satisfy a number of procedural requirements, among them that —

• the parties to the § 1.1275-6 hedge not be related;
  
• the same entity enter into both the qualifying debt instrument and the  § 1.1275-6 hedge;
  
• the  § 1.1275-6 hedge is entered into on or after the date that the taxpayer issues or acquires the qualifying debt instrument; and
  
• neither the  § 1.1275-6 hedge nor the qualifying debt instrument are part of a “straddle” prior to the issue date of the synthetic debt instrument.

As constituent parts of an integrated transaction, neither the  § 1.1275-6 hedge nor the actual debt instrument have any residual tax significance.815 For withholding tax purposes, however, they do:
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815 See Regs. § 1.1275-6(f)(1).  The integration regulations bind only the taxpayer, not the counterparty, to the actual debt instrument or related hedge. See Regs. § 1.1275-6(a).

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Example 11-8: Slag, an offshore feeder treated as a corporation for tax purposes, acquires a bond of a U.S. issuer for $950.  The terms of the bond are identical to the terms of the bond described in Example 11-7.  Slag owns 10% of the voting stock of the U.S. issuer.  On the same date, Slag enters into a swap with XYZ bank.  Under the terms of the swap, Slag agrees to pay $50 to the XYZ bank at the inception of the swap, together with semi-annual payments of $45 for 5 years, and XYZ agrees to make semi-annual payments of $51.52 to Slag over the same period.  As a “trader”in securities under § 864(b), Slag is not engaged in a U.S. trade or business.  Like the taxpayer in Example 11-7, Slag may treat the two transactions as a single $1,000 bond issued at par that pays semi-annual interest at 10.3% rate. Nevertheless, only the $45 payments on the actual bond will be subject to current U.S. withholding tax, not the $51.52 on the “synthetic”bond.816 The periodic payments of $51.52 from XYZ represent foreign source income to Slag, and therefore avoid U.S. withholding tax.817

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816 Because Slag owns 10% of the voting stock of the borrower, the interest will not qualify as “portfolio interest” under § 871(h). See § 871(h)(3)(A).

817 Regs. § 1.863-7; see also Regs. § 1.1275-6(h) (Ex. 7).

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Special rules also permit a taxpayer to “leg in” to the integration regulations by entering into the  § 1.1275-6 hedge after it has acquired or issued a qualifying debt instrument, but not to “leg in” to the integration regulations by acquiring or issuing a debt instrument after it has entered into a  § 1.1275-6 hedge.818
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818 See Regs. § 1.1275-6(d)(1).

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7. Credit Default Swaps 

A credit default swap (“CDS”) is a financial instrument that transfers credit risk on a debt obligation from one counterparty to another counterparty.  In a CDS, one counterparty serves as the “protection buyer” and the other counterparty serves as the “protection seller.” In most CDS, the protection buyer will make a series of fixed payments over the stated term of the CDS to the protection seller.  In return, the protection seller will agree that, upon a default or other credit event, it will either purchase a designated debt obligation of the borrower from the protection buyer at its face value or “cash settle” the liability for a payment equal to the difference between its face value and its current fair market value.819 If the protection buyer owns the reference obligation, the CDS will hedge the risk of default on the obligation.820 If the protection buyer does not own the reference obligation, the CDS will effect an economic “short sale” of the reference obligation.  Banks and insurance companies participate in the CDS market on a regular basis.  In recent years, hedge funds have become dominant players as well.821
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819 For what is perhaps the preeminent piece on the proper federal income tax treatment of a CDS, see New York State Bar Association Tax Section, “Report on Credit Default Swaps,” reprinted in 2005 TNT 176-21(Sept. 9, 2005).

820 In addition, if the reference obligation is actively-traded, the two positions may constitute a “straddle” under § 1092.  In such a case, a sale of the reference obligation while the CDS remains outstanding will require the protection buyer to defer the loss.  See § 1092(a)(1)(A). For a fuller discussion of the straddle rules, see XI, C, below.

821 By one report, hedge funds account for as much as 30% of the global market in credit derivatives.  See FitchRatings Credit Policy Special Report, Hedge Funds:An Emerging Force in the Global Credit Markets (July 18, 2005), www.fitchratings.com (citing survey by Greenwich Associates).

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The most difficult tax issue with a CDS is usually the first of the five described in XI, A, 1, above:whether it is an NPC? For two reasons, this threshold question is far less clear with a CDS than with most other forms of swaps.

First, a CDS does not appear to satisfy the strict definition of an NPC.  The regulations under  § 446 define an NPC as —

a financial instrument that provides for the payment of amounts by one party to another at specified intervals calculated by reference to a specified index upon a notional principal amount in exchange for specified consideration or a promise to pay similar amounts.822

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822 See Regs. § 1.446-3(c)(1)(i).

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In a CDS, the protection seller has no obligation to make a payment unless an event of default occurs. Moreover, if such a credit event occurs, it will terminate the periodic payment obligations of the protection buyer.  In this regard, therefore, the obligations of both counterparties to a CDS are contingent, rather than payable “at specified intervals” or in predetermined amounts.823 Finally, although a CDS calculates the payments from the protection seller by reference to a notional amount (i.e., the anticipated recovery), it does not calculate them in accordance with any “specified index.”
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823 Although the  § 446 regulations provide that a swap may allow early termination, whether this was intended to subsume a termination that serves as the sole trigger for the payment obligations of one of the counterparties is unclear.  See Kayle “The Federal Income Tax Treatment of Credit Derivative Transactions,”658 PLI/Tax 115 (2005).

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Second, a CDS is similar to other financial instruments, including —

• an insurance policy;

• a guarantee of debt; and

• an option contract.

If a CDS is insurance, a foreign feeder that serves as the protection seller may be subject to excise tax on the constructive “premium” payments.824 A hedge fund that engages in the insurance business in the United States may also have ECI subject to net basis taxation.
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824 § § 4371, 4372. If the premiums are subject to excise tax, they should not attract U.S. withholding tax.  See Regs. § 1.1441-2(a)(7). An insurance contract is generally defined as “a contract, whereby, for an adequate consideration, one party undertakes to indemnify another against a loss arising from certain specified contingencies or perils ...” See Epmeier v. U.S., 199 F.2d 508, 509–10 (7th Cir. 1952); see also Helvering v. LeGierse, 312 U.S. 531, 539 (1941) (insurance proceeds defined as amounts “received as a result of a transaction which involved an actual ‘insurance risk’ at the time the transaction was executed”); Allied Fidelity Corp. v. Comr., 572 F.2d 1190, 1193 (7th Cir. 1978) (“one of the essential features of insurance is this assumption of another's risk of economic loss”).  A typical CDS does not require the protection buyer to own the reference obligation.  Unlike the insured party in an insurance contract, therefore, the protection buyer may receive payment whether or not it suffers a loss.

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If a CDS is a guarantee of debt, the fixed payments to a foreign feeder that serves as the protection seller may constitute FDAP income from U.S. sources, which is subject to U.S. withholding tax at a 30% or reduced treaty rate.825 Alternatively, if the business of guaranteeing debt is itself a U.S. trade or business, the feeder may have ECI subject to net basis taxation.826 The protection buyer, on the other hand, will likely treat any payments from the feeder in accordance with the source and character of the underlying debt.827
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825 See, e.g., Bank of America v. U.S., 680 F.2d 142 (Ct. Cl. 1982) (commissions for bankers' acceptances sourced in same manner as interest because predominant feature is substitution of credit); Centel Communications Co. v. Comr., 920 F.2d 1335 (7th Cir. 1990) (citing Bank of America).  A typical debt guarantee runs to the benefit of the debt holder.  A CDS, however, separates the underlying debt from the credit support, even if the protection buyer holds the debt instrument.  Unlike a guarantor, therefore, the protection seller in a CDS has no right of subrogation vis-à-vis the original lender.

826 See, e.g., Notice 2004-52, 2004-32 I.R.B. 168.

827 See Rev. Rul. 76-78, 1976-1 C.B. 25; Rev. Rul. 72-134, 1972-1 C.B. 29 (defaulted interest paid by insurance company on tax-exempt bonds still excludible from gross income); see also Regs.  § 1.861-2(a)(5) (interest paid on U.S. obligation by foreign guarantor of obligation treated as interest from U.S. sources).

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If a CDS is an option contract, the fixed payments to a foreign feeder that serves as the protection seller should qualify as “option premium,” which is exempt from U.S. withholding tax.828 If the feeder is the protection buyer, any gain it may realize after a credit event under the CDS should avoid U.S. withholding tax as gain derived from the sale of property.829 Finally, the CDS should qualify as a “security”under the  § 864(b) trading safe harbor.830 Accordingly, any gain at maturity of the CDS should avoid net basis taxation.
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828 See Regs.  § 1.1441-2(b)(2)(i) (option premium not FDAP income).  A CDS resembles a “put option”written by the protection seller to the protection buyer because it allows the protection buyer to put the reference obligation to the protection seller after a credit event.  Unlike a typical put option, however, the “exercise” of a CDS is contingent rather than elective, triggering no payment obligation from the “writer”of the put until an event of default or other specified credit event occurs.  Compare Rev. Rul. 68-601, 1968-2 C.B. 124 (option exists under  § 318(a)(4) only if holder has right to obtain underlying stock at his election and election is not subject to any contingencies).  The market price of the reference obligation at any particular time is not relevant.  See Garlock, Keinan, Leventhal, Monro, “Proposals Regarding the Taxation of Credit Default Swaps,” 15 J. Tax'n F. Inst. 5(2005).

829 See Regs.  § 1.1441-2(b)(2)(i) (“gains derived from sale of property” not FDAP income); § 1234(a)(1), (c)(2) (gain from sale of cash-settled option treated as gain for sale of underlying property).

830 See  Regs.  § 1.864-2(c) (“securities”include trading in “contracts or options to buy or sell stocks or securities ...”).

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In Notice 2004-52,831 the IRS requested comments on the nature and operation of the CDS market as part of its effort to develop guidance for taxpayers.  In response to this request, many in the tax bar recommended that the IRS extend the definition of an NPC to include a CDS.832 If the IRS chooses to adopt this position, a cross-border payment to a foreign counterparty should qualify as foreign source income exempt from U.S. withholding tax. In addition, the  § 864(b) trading safe harbor should exempt any gain or loss to a foreign protection buyer not otherwise engaged in a U.S. trade or business from net basis taxation.
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831 Notice 2004-52, 2004-32 I.R.B. 168.

832 See, e.g., Kayle, “The Federal Income Tax Treatment of Credit Derivative Transactions,” 658 PLI/Tax 115(2005) (most CDS should qualify as NPCs and should generate foreign source income to non-U.S. counterparties); letter by D. Garlock, et. al. to the Commissioner dated January 7, 2005, responding to IRS request for comments under Notice 2004-52 on CDS, reprinted in 2005 TNT 16-21(same); Garlock, Keinan, Leventhal, Monro, “Proposals Regarding the Taxation of Credit Default Swaps,” 15 J. Tax'n F. Inst. 5 (2005) (same); letter from Managed Funds Association to the Commissioner dated April 26, 2005, responding to IRS request for comments under Notice 2004-52 on CDS, reprinted in 2005 TNT 87-20(same;  § 864(b) trading safe harbor should extend to most CDS); see also Miller, “Distinguishing Risk: The Disparate Tax Treatment of Insurance and Financial Contracts in a Converging Marketplace,” 55 Tax Law. 481 (Winter 2002).

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Nevertheless, the mere treatment of a CDS as an NPC would not resolve every issue regarding the proper accrual and character of payments by the protection seller, at least without further guidance. In particular, whether such guidance will recognize the capital nature of these payments is uncertain.833 If it does not, the capital loss borne by a protection buyer who has hedged the reference obligation will not shelter its gain on the CDS.  The protection buyer may avoid this mismatch by either settling the CDS in-kind or by disposing of the CDS in a  § 1234A termination. The protection buyer would avoid this mismatch under the other CDS analogues described above, including an option contract, a debt guarantee and a forward contract.  As described in XII, A, 4, a, above, however, the proposed regulations treat the final scheduled payment on a swap as a non-periodic payment, not a termination payment, without regard to whether the payment seeks to compensate a counterparty for the change in value of a capital asset.834
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833 See New York State Bar Association Tax Section, “Report on Credit Default Swaps,”reprinted in 2005 TNT 176-21 (Sept. 9, 2005) (“if we were writing on a clean slate, settlement payments would be treated as capital”).

834 See also Prop. Regs. § 1.1234A-1(b); PLR 97330007 (periodic payments on swap treated as ordinary); FSA 0342 (Aug. 6, 1992) (“the economic substance of a termination of a financial instrument such as an interest rate swap is no different than the economic substance of an assignment of such a financial instrument”); FSA 001634(assuming, arguendo, that equity swap was NPC and not forward contract, single payment by taxpayer for appreciation in stock index is ordinary in nature).

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If a CDS qualifies as a swap, it is unlikely that the payments from the protection seller will qualify as a termination payment under § 1234A. Given the definition of a termination payment in the regulations, the only argument at least facially consistent with the treatment of a CDS as a swap is that the payment is not “scheduled,”but instead occurs when the CDS terminates.  In substance, however, this is an argument that a CDS is not a swap at all.  As described above, the protection seller has no obligation to make any payment on a CDS unless and until an event of default occurs, rather than “at specified intervals.”  Yet if the IRS opts to treat a CDS as an NPC, it would elevate form over substance to treat the final payment as ordinary when the payment in fact reflects a decline in value of a capital asset.835 Moreover, the electivity that such a rule would promote conflicts with the very purpose of § 1234A, which is “to remove the effective ability of a taxpayer to elect the character of gains and losses from certain transactions.”836
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835 See New York State Bar Association Tax Section, “Report on Credit Default Swaps,”reprinted in 2005 TNT 176-21 (Sept. 9, 2005) (“we reiterate the position ... that the appropriate solution is for the Service to abandon its narrow reading of the term “termination payment,” and to treat any payment made by reference to the value of a capital asset as attributable to the termination ...”).

836 H.R. Rep. No. 148, 105th Cong., 1st Sess. at 204 (1997).

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8. FIRPTA 

Suppose that the underlying asset on an equity swap is U.S. real estate.  Under § 897(a), a foreign person must report gain or loss on the disposition of a “United States real property interest”as ECI.  Under § 1445(a), if a foreign person disposes of a “United States real property interest,” the transferee must deduct and withhold 10% of the amount realized by the foreign person.

The statute defines a “U.S. real property interest” broadly to include “any interest (other than an interest solely as a creditor) in any domestic corporation”that is a “U.S. real property holding corporation” (“USRPHC”).837 The regulations elaborate further, providing in relevant part that an interest in an entity other than an interest solely as a creditor includes (i) stock of a corporation; and (ii) “an interest which is, in whole or in part, a direct or indirect right to share in the appreciation in value of an interest in” such stock.838 An interest described in clause (ii) includes the right to a payment “from an entity the amount of which is contingent on the appreciation in value of” such stock.839 The right to such a payment is itself a FIRPTA asset, regardless of whether the holder actually holds the stock.  Thus, for example, a stock appreciation right constitutes an interest in a corporation even if the holder of the right does not own the underlying stock.840
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837 § 897(c)(1)(A).

838 Regs. § 1.897-1(d)(3)(i).

839 Regs. § 1.897-1(d)(3)(ii)(B).

840 Id.

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Under these broad definitions, an equity swap between a foreign investor and a USRPHC with respect to its stock would appear to constitute a “U.S. real property interest.” So what if the swap counterparty is not the USRPHC, but an investment bank? Is the equity swap still an “indirect interest”in the stock of the USRPHC? Whether the term “indirect interest”requires direct privity between the foreign person and the USRPHC is not clear.  The consequence of applying FIRPTA to this type of swap, however, is that FIRPTA will apply to the termination payments, but not to the other payments.  This is so even if some (even all)of the other payments also track changes in value of the underlying stock.  The reason for the disparate tax treatment in spite of the similarity of the payments is that  § 897 requires a “disposition.”  Because neither a periodic nor a non-periodic payment arises from a “disposition,” § 1234A and, by extension, § 897, should not apply.841
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841 See Prop. Regs. § 1.1234A-1(a); see also Rubinger, “Can FIRPTA Be Avoided with Financial Instruments?,” 78  Fla. B. J. 44(March 2004).

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Nevertheless, the IRS has publicly stated that the issue of whether FIRPTA applies at all to an equity swap is an open question.842 Extending the FIRPTA regime to an equity swap in which a USRPHC is not a counterparty raises a serious jurisdictional issue as well —if the underlying asset is a FIRPTA asset, should U.S. taxing nexus depend upon whether the swap is cross-border or foreign-to-foreign? In both cases, a foreign person will have realized a FIRPTA-related gain.  In the authors' view, therefore, FIRPTA should not apply to an equity swap on a FIRPTA asset unless the USRPHC is a counterparty.843
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842 See Preamble to final regulations, T.D. 8491, 1993-2 C.B. 215 (IRS “is considering whether notional principal contracts ...involving other specified indices (e.g., U.S. real property) are subject to Section 897”).

843 Accord Avi-Yonah, Newman &  Ring,  Taxation of Financial Instruments, § 3:54, Chapter 3 (Taxation of Notional Principal Contracts) (1999) (“The Regulations ... make clear that an interest other than solely as a creditor is intended to include interests that give rise to a payment by the entity that is the USRPHC”) (emphasis added); Keyes, Federal Taxation of Financial Instruments and Transactions, Chapter 14 (Notional Principal Contracts) at ¶  14.04[4][d](1997) (“the better view under the current regulations is that equity swaps do not constitute a USRPI and do not trigger tax and withholding under  Sections 897 and 1445”).

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U.S. Income Portfolios: Other Pass-through Entities 
  Portfolio 736-1st: Hedge Funds 
  Detailed Analysis 
  XI. Portfolio Investments by the Fund: Recurring U.S. Tax Issues

B. Market Discount on Distressed Debt 

1. In General 

Bond prices depend upon interest rates and credit risk.  Both fluctuate over time.  The trading price of a bond on the market, therefore, will often differ from its issue price.  If interest rates rise, the value of the bond will fall because buyers tend to pay less for bonds that bear below-market coupons.844 More precisely, the price of a bond should drop by the amount necessary to increase the bond's yield-to-maturity to the prevailing market rate.845 The resulting discount, which the borrower pays at maturity along with the remaining principal, compensates the secondary buyer for the below-market coupon.
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844 This assumes no change in the borrower's creditworthiness.

845 If interest rates fall, the price of the bond will increase because a buyer will pay more for a bond that pays an “above-market” coupon.

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In 1984, Congress enacted the “market discount” provisions under § § 1276-1278 of the Code.846 The market discount rules give tax effect to this phenomenon by treating market discount as interest for all purposes of the Code other than withholding.847 Absent an election, however, the holder of a market discount bond does not report market discount as interest until it either sells the bond or the bond matures.  If the holder elects to include market discount on a current basis, it must do so on every market discount bond it holds — it cannot cherry pick. To prevent double tax on the sale or maturity of the bond, the holder may increase its basis in the bond by the accrued portion of the market discount.848
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846 H.R. Rep. No. 432, 98th Cong., 2d. Sess. (1984); S. Rep. No. 369, 98th Cong., 2d Sess. (1984).  For a fuller description of the market discount rules, see generally 535 T.M., Time Value of Money: OID and Imputed Interest; Keyes, Federal Taxation of Financial Instruments and Transactions at ¶  8(1997); Garlock, Federal Income Taxation of Debt Instruments at ¶  11(5th ed. 2005).

847 See § 1276(a)(4).  For purposes of § 1441, therefore, market discount on the bond remains capital gain, which is exempt from U. S. withholding tax to foreign lenders.

848 See § 1278(b).

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The Code defines “market discount”as the excess, if any, of the “stated redemption price at maturity”of the bond over the buyer's tax basis at the time of purchase.849 Under a de minimis exception, however, the Code ignores market discount of less than 1/4 of one percent of the stated redemption price at maturity of the bond multiplied by the number of remaining years to maturity.850
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849 See § 1278(a)(2)(A). In the case of a bond issued with OID, the statute defines market discount by reference to the bond's “adjusted issue price”instead.  The market discount rules do not apply to debt obligations with an original maturity of one year or less, to tax-exempt obligations and to certain installment obligations.  See § 1278(a)(1)(B).

850 See § 1278(a)(2)(C).

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Many bonds pay all principal at maturity.  A secondary buyer that holds a market discount bond until maturity will therefore defer the recognition of market discount until the maturity date.  Some bonds, however, pay principal in installments (e.g., a typical mortgage).  Under § 1276(a)(3), the amortization of principal on such a bond will accelerate the recognition of accrued market discount.  Finally,  § 1277(a) suspends the deduction of interest on debt incurred to fund the purchase of a market discount bond unless the holder elects under  § 1278(b) to report the market discount on a current basis.  The purpose of this limitation is to match the timing of interest expense and interest income, giving effect to the special deferral rules available to the holder of a market discount bond.

2. Application to Distressed Debt 

Suppose a bond trades at a discount not because interest rates have increased, but because credit quality has declined. The market for this sort of bond is more speculative.  At a sufficiently-steep discount, the traditional buyers of fixed income securities will abandon the bond entirely, leaving it to investors who speculate in growth stocks even though the security remains “debt” for tax purposes.851
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851 In general, the IRS will determine the status of an instrument as debt or equity on the date of issue. See, e.g., § 385(c) (borrower's characterization as of “time of issuance” binding on all parties absent notice to IRS); Jack Daniel Distillery v. U.S., 379 F.2d 569, 580 (Ct. Cl. 1967) (issue is whether “at the time of issuance of the instrument ...[the parties intended] to create a debtor-creditor relationship”);Regs. § 1.385-4(b), T.D. 7747, 1981-1 C.B. 141, revised by T.D. 7774, 1981-1 C.B. 168;T.D. 7801, 1982-1 C.B. 60; and T.D. 7822, 1982-2 C.B. 84, withdrawn by T.D. 7920, 1983-2 C.B. 69 (determination of status of instrument as debt made at time of issue and, subject to certain exceptions, such status “can never change”); Regs.  § 1.1001-3(e)(5)(i) (“any deterioration in the financial condition of the obligor between the issue date ... and the date of modification” of debt instrument generally not taken into account in determining whether modification that alters status of instrument as “debt” for tax purposes is “significant modification”); but see Realty Co. v. U.S., 382 F.2d 298, 302 (Ct. Cl. 1967) (holding that character of advance between parent and subsidiary as debt may change if parties fail to act as debtor and creditor during future periods).  A decline in credit quality, therefore, is not an occasion for “retesting” an advance as debt or equity.

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The market has a name for this bond: “distressed debt.”  Many hedge funds invest in distressed debt.  A fund that invests in distressed debt does not  expect the borrower to retire the debt in accordance with its terms.  Indeed, the debt may have defaulted well before the hedge fund acquired the claim.  Hedge funds acquire distressed debt in an effort to participate in a financial recovery of the debtor, often assuming a very active role in the restructuring effort.852 If the ultimate recovery to the fund exceeds the purchase price of the debt, the fund will realize a gain even if the borrower settles the debt at a substantial discount to principal.
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852 See II, B, 2, above, for a discussion of the investment objectives of a distressed securities fund.  Such debt restructurings may result in deemed exchanges under Regs. § 1.1001-3.

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The following excerpt from an actual PPM of a “distressed debt” fund is typical:

Distressed securities are traditionally defined as securities and other obligations of companies that are potentially or actually insolvent ... , causing them to trade at substantial discounts to their issue price.  These securities exhibit high mark-to-market volatility ... The investment advisor screens the world's financial markets for situations in which securities are offered at less than 50% of the issue price, where no real bids exist, and where there is little or no street research.

This issuer described in this PPM is not pursuing a debt-like return.  Should the market discount rules nevertheless apply? Consider the following example:

Example 11-9: On January 1, 2006, SRPM, a domestic hedge fund with taxable U.S. investors, acquires a distressed bond for $400.  The bond has an issue price and principal amount of $1,000, a 10% coupon, and a remaining maturity of two years. The issuer suffered an unexpected judgment in a product liability case that will likely preclude retirement of the bond on its scheduled maturity date.  Accordingly, although interest rates have remained constant, the bond now trades at a 60% discount to face.  Had the borrower originally issued a two-year bond for $400, the bond would have had an original yield of 78.8%, far too high to qualify as “debt” for tax purposes.  Because the bond instead bore a market rate of interest at original issue, however, it was and remains debt for tax purposes in spite of the decline in value.  Under the market discount rules, SRPM has accrued market discount under  § 1276(b)(2) of$215.21 in 2005 and $484.79 in 2006.  Accordingly, any gain that SRPM may realize on the bond at or below these accrued amounts will constitute “interest”for tax purposes.853 If SRPM elects to report market discount on a current basis under § 1278(b), it will report the full accrued amount as interest, together with a capital loss equal to any shortfall.

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853 See § 1276(a)(4).

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The statute measures “market discount” by reference to market price, not issue price.  It makes no distinction between discount attributable to an increase in interest rates and discount attributable to a decline in credit quality.  Read literally, therefore, the market discount rules apply to distressed debt.

Whether Congress intended this result is a separate question.  In the original legislative history, both the Senate and the House characterized market discount as follows:

... from the standpoint of the holder of a bond, market discount is indistinguishable from original issue discount(OID). In each case the discount is a substitute for stated interest ...854

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854 H.R. Rep. No. 432, 98th Cong., 2d. Sess. (1984); S. Rep. No. 369, 98th Cong., 2d Sess. (1984).

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If the drop in price is steep enough, however, the resulting discount is not a substitute for stated interest. It is the expectation that the borrower will not pay the debt in accordance with its terms.  In the previous example, the bond had an adjusted yield of 79% to the secondary purchaser even though the market rate of interest between the date of issue and the date of purchase had not changed.  The difference between 10% and 79% is not interest.  Indeed, it is not even the expected return.  For precisely this reason, the bond would not have qualified as “debt”for tax purposes with a $400 original issue price.

The Joint Committee, albeit indirectly, seems to have recognized this distinction:

Capital gain treatment should not be afforded to a largely predictable return (such as that available on the typical purchase of a market discount bond).855

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855 Staff of the Joint Committee on Taxation, 98th Cong., 2d. Sess., General Explanation of the Deficit Reduction Act of 1984 (Comm. Print 1984) (emphasis added).

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Nevertheless, the IRS applied a rather different analysis to the accrual of OID on a distressed bond.  In TAM 9538007,856 it concluded that the “doubtful collectibility” exception to the accrual method of accounting under Regs.  § 1.451-1(a) did not apply to OID.  Under the “doubtful collectibility”exception, a lender is not required to include the right to future interest in income if it has no reasonable expectation of receipt.857 But according to the IRS, OID is sui generis:
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856 TAM 9538007.

857 See, e.g., Jones Lumber v. Comr., 404 F.2d 764 (6th Cir. 1968); Chicago &  North Western Railway Company v. Comr., 29 T.C. 989, 996 (1958); Corn Exchange Bank v. Comr., 37 F.2d 34, 35 (2d Cir. 1930).

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OID... is not included in income in advance of receipt; it is included in lieu of receipt.

The physicist Wolfgang Pauli once dismissed a physics paper from a student with the remark: “This isn't right.  It's not even wrong.”  Like the student's paper, the IRS is not even wrong.858 A bond has OID because it defers the payment of interest.  The promise to pay interest at maturity is what creates the OID.  Like the reporting of all interest on debt, the obligation to accrue OID presupposes that the debtor will ultimately pay it. Indeed, it was the unconditional obligation to pay the interest that established the bond as debt for tax purposes on the date of issue.859  To argue, therefore, that accrual does not  assume ultimate receipt because it precedes receipt is just sophistry.
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858 See also New York State Bar Association Tax Section, “Report on Proposed Legislation to Amend The Market Discount Rules of Sections 1276-1278,” reprinted in 1999 TNT 124-36 (June 22, 1999) (“We disagree with the position taken by the IRS in TAM 9538007 (June 13, 1995) that the common law “doubtful collectibility” exception for accrual basis taxpayers (...) does not apply to accrual of OID”); Garlock, Federal Income Taxation of Debt Instruments at § 5.15(5th ed. 2005) (“the OID rules generally should be read as placing taxpayers on the accrual method of accounting for interest, ...but not as superseding common law rules regarding the accrual method”).

859 See § 385(b)(1).

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In any event, the IRS misanalyzes the nature of OID in the TAM, not the nature of market discount.860 Market discount on distressed debt is not a proxy for interest.  The buyers of distressed claims seek an equity-like return from the discount, not a debt-like return.861 Moreover, unlike OID, the borrower has no stake in the treatment of market discount by the holder because it cannot claim an interest deduction.  Accordingly, although the IRS cites “whipsaw” as a partial basis for its findings in the TAM,862 this concern is not relevant in the case of market discount.863
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860 See Garlock, Federal Income Taxation of Debt Instruments at § 11.01 (5th ed. 2005); see also American Bar Association, Section of Taxation, “Comments Regarding the Application of Market Discount Rules to Speculative Bonds,” reprinted in 91 TNT 113-28 (May 23, 1991).

861 See also Statement of the Bond Market Association for the Committee on Finance U.S. Senate at the Hearing on Revenue Raising Proposals in the Administration's Fiscal Year 2000 Budget, April 27, 1999, reprinted in 1999 TNT 81-34(“The capital-gain nature of market discount is highlighted in the case of distressed debt.  In this case, when an investor buys a bond at a deeply discounted price due to credit deterioration of the issuer and then realizes a gain due to improvements in the issuer's credit condition, the gain is much more in the character of a capital gain than of interest income”).

862 See TAM 9538007 (“creating a ‘doubtful collectibility’ exception to OID accrual without simultaneously denying issuers an OID deduction would cause a significant mismatching of income and expense”).

863 See New York State Bar Association Tax Section, “Report on Proposed Legislation to Amend The Market Discount Rules of Sections 1276-1278,” reprinted in 1999 TNT 124-36 (June 22, 1999) (“even the IRS's position in TAM 9538007 does not necessarily preclude the application of the “doubtful collectibility”exception to accrual of market discount, because such application would not result in the inconsistent treatment of holders and issuers that would exist in the OID context, where issuers would be deducting OID that holders would not be including in income”).

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The Clinton Administration acknowledged the distinction between OID and market discount in its 2000 and 2001 budget proposals, albeit obliquely.864 Under the Clinton proposals, an accrual method taxpayer who acquires a market discount bond would have been required to report the market discount as interest on a current basis.  The proposals applied, however, only to the portion of the yield equal to the greater of (i) the original yield-to-maturity of the bond plus 500 basis points or (ii)the AFR on the date of purchase plus 500 basis points.865 Like the treatment of the “disqualified portion” of the return under the “applicable high yield discount obligation” (AHYDO) rules,866 therefore, these proposals would have treated the excess yield as an equity-like return.
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864 See Joint Committee on Taxation, Description of Revenue Provisions Contained in the President's Fiscal Year 2001 Budget Proposal, dated March 6, 2000 (JCS-2-00).

865 Id. at 332.

866 § 163(e)(5). Under the AHYDO rules, the portion of the yield that exceeds the AFR plus 600 basis points is recharacterized as a dividend and, accordingly, is never deductible to the borrower, even upon payment. § 163(e)(5)(B). For a detailed description of the HYDO rules, see Ginsburg &  Levin, Mergers, Acquisitions, and Leveraged Buyouts at ¶ 1303 et seq (2005). Note that § 163(e)(5)(F) (added by the American Recovery and Reinvestment Act of 2009, P.L. 111-5, Div. B, § 1232(a)) suspends application of § 163(e)(5) for certain obligations issued in debt-for-debt exchanges (including exchanges resulting from significant modifications of debt instruments) after Aug. 31, 2008, and before Jan. 1, 2010 (and grants the Secretary authority to extend the suspension).

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Nor do the market discount rules supersede the basic principles of the accrual method of accounting.  Bonds that trade at steeply-discounted prices do so because the market expects the borrower to default.867 The right to suspend the accrual of interest when ultimate payment is doubtful is a well-established principle of the common law.  One of the leading cases to follow this principle is Liftin v. Comr.868 In Liftin, the taxpayer acquired several notes at steep discounts to their face values.  Each note provided for monthly principal amortization.  The taxpayer reported the later receipt of all payments denominated as interest and all payments denominated as principal as “basis first” recoveries of purchase price.  The IRS contended that the taxpayer should have reported a portion of each principal payment as ordinary income.  If, for example, the taxpayer had purchased a$1000 note for $750, it would report 25% of each payment of principal as ordinary income.  On the question of basis recovery, the Tax Court drew the following distinction:
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867 See New York State Bar Association Tax Section, “Report on Proposed Legislation to Amend The Market Discount Rules of Sections 1276-1278,” reprinted in 1999 TNT 124-36 (June 22, 1999) (“However, in certain circumstances where a large amount of market discount reflects a troubled obligation on which there is no reasonable expectation of payment, the holder should not be required to accrue income”); see also American Bar Association, Section of Taxation, “Comments Regarding the Application of Market Discount Rules to Speculative Bonds,”reprinted in 91 TNT 113-28 (May 23, 1991) (“would be consistent with the tax policy of not requiring the recognition of income that, in general, the taxpayer is doubtful of ultimately realizing”).

868 36 T.C. 909 (1961), aff'd, 317 F.2d 234 (4th Cir. 1963); see also Corn Exchange Bank v. U.S., 37 F.2d 34 (2d Cir. 1930), Jones Lumber Co. v. Comr., 404 F.2d 764 (6th Cir. 1968); Rev. Rul. 80-361, 1980-2 C.B. 164.

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where a taxpayer acquires at a discount contractual obligations calling for periodic payments of parts of the face amount of principal due, where the taxpayer's cost of such obligations is definitely ascertainable, and where there is no doubt whether the contracts will be completely carried out ... it is proper to allocate such payments, part to be considered as a return of cost and part to be considered as the receipt of discount income; but, conversely, where it is shown that the amount of realizable discount gain is uncertain or that there is doubt whether the contract will be completely carried out, the payments should be considered as a return of cost until the full amount thereof has been recovered, and no allocation should be made as between such cost and discount income.

Given the steep discount in Liftin, the Tax Court permitted the taxpayer to treat each payment of principal as a “basis first” recovery of purchase price.  The taxpayer did not contend, and the Tax Court did not address, whether any “excess”recovery represented capital gain.869 The issue before the court was timing.
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869 See Liftin v. Comr., 36 T.C. at 910 (“the parties agree that where note obligations are purchased at a discount the receipt of the discount is ordinary income”).

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When the market determines that a borrower is likely to default on a bond, the price and yield of the bond begin to lose their direct inverse relationship. Without a certain maturity date, the precise effect of discount on  yield is not known.  If the borrower has already defaulted, the relationship between price and yield erodes even further.  In this regard, therefore, discount on a defaulted bond is akin to discount on a demand loan that the borrower will not pay.  But that analogy is a fiction.  It is not possible to issue a true demand loan at a discount, at least in an arm's length transaction.  This type of loan exists in the market only insofar as the parties understand that the lender will waive its right to demand immediate payment for a period of time.870 Otherwise, a loan of this type would have both an infinite yield and an infinitesimal term:
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870 Section 7872, for example, treats a demand note that bears interest at a rate below the AFR as a “below market loan.” See § 7872(e)(i).  The holder of an interest-free demand note foregoes a market rate of interest by failing to demand immediate repayment. In this regard, therefore, an interest-free demand note is no more logical than a discount demand note.  Yet below-market loans are common among friends and family members because they are not arm's length transactions — the act of forbearance by the lender is a gift.  See  § 7872(f)(3) (definition of “gift loan”).

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Example 11-10: On January 1, 2005, X lends $90 to Y in exchange for a non-interest bearing demand note with a principal amount of $100.  If Y repays the loan in one year, X will earn an annualized yield of 11%.  If Y repays the loan in one month, X will earn an annualized yield of 254%.  If Y repays the loan in one week, X will earn an annualized yield of 23,855%.  The more immediate the demand, the higher the return.

As this example makes evident, a true discount demand loan is a paradox.  Accordingly, neither the OID nor market discount provisions of the Code acknowledge their existence.871 But the presence of discount on defaulted debt is not a contradiction.  Discount and immediate maturity do co-exist in a “broken”bond, but time value of money is not the reason.872 The source of the discount is an expected recovery below par on an uncertain date.  Returns of this type bear none of the hallmarks of interest.
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871 See § 1272(a)(2)(C) (excluding from OID rules any obligation with fixed maturity of one year or less); § 1278(a)(1)(B)(i) (same with market discount); see also Staff of the Joint Committee on Taxation, 98th Cong., 2d. Sess., General Explanation of the Deficit Reduction Act of 1984 (Comm. Print 1984) (“it is expected that Treasury regulations will provide that the term market discount bond does not include an obligation that was demand debt when issued”). Finally, under Regs. § 1.1272-1(c)(5), an option of the holder that, if exercised, would increase the debt's yield is treated as exercised for purposes of determining the yield and maturity of the debt.  So even a demand loan with a stated maturity of more than one year would be deemed to have a maturity of less than one year for purposes of computing its yield-to-maturity.

872 See also American Bar Association, Section of Taxation, “Comments Regarding the Application of Market Discount Rules to Speculative Bonds,”reprinted in 91 TNT 113-28 (May 23, 1991):
the legislative history does not address the situation where a bond becomes payable on demand subsequent to its issuance ...For example, bonds which are not demand debt when issued often ...accelerate payment in the event of default.  If such defaulted bonds are subsequently purchased on the open market, there will be no term for the bonds at the time of purchase and thus it may be impossible to calculate accrued market discount ... a question arises as to whether any payments on such a bond should be treated as market discount since most, if not all, of the yield ... would be purely speculative.

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U.S. Income Portfolios: Other Pass-through Entities 
  Portfolio 736-1st: Hedge Funds 
  Detailed Analysis 
  XI. Portfolio Investments by the Fund: Recurring U.S. Tax Issues

C. Straddles 

1. In General 

Suppose that a drug company with a new cancer drug asks the FDA to approve “Phase 3” clinical trials for the treatment.  A portfolio manager expects the stock price to soar if the FDA approves the trials and to plummet if the FDA rejects them.  Although the portfolio manager has special knowledge that the FDA will announce its decision at the end of the month, the decision itself is unknown.  Is this valuable information? Yes.  On the basis of this information, the portfolio manager could buy a call option on the stock and a put option on the stock, each with the same strike price and expiration date.  If the stock moved sharply in either direction (i.e., by more than the combined cost of the two options), the fund would profit.

What if the portfolio manager alone knows that the FDA will postpone its decision for another month? If it does, the stock is likely to languish at or near the current market price. Is this valuable information? Yes.  On the basis of this information, the portfolio manager could sell a call option at a strike price above the current market price and sell a put option at a strike price below the current market price. So long as the stock traded within that “collar,” the fund would profit by the sum of the two option premiums.

The first position is a “straddle”and the second position is a “strangle.”  For tax purposes, however, both positions are straddles.  The purpose of the straddle rules under  § 1092 is to postpone the recognition of loss by a taxpayer who has not yet disposed of an offsetting gain position.   Section 1092(c)(1) defines a straddle as two or more offsetting positions873 with respect to personal property.874 One position offsets the other if it substantially diminishes the risk of loss from holding that position.875 For purposes of these rules, the definition of “personal property” includes stock only if the stock —
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873 Under § 1092(d)(2), a “position”includes a futures or forward contract or an option.

874 Under § 1092(d)(1), “personal property” is property of a type that is actively traded.

875 § 1092(c)(2)(A).

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• is of a type that is actively traded and at least one of the positions offsetting such stock is a position with respect to such stock or substantially similar or related property;876 or
  
•stock of a corporation formed or availed of to take positions in personal property which offset positions taken by any shareholder.877

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876 § 1092(d)(3)(A)(i).

877 § 1092(d)(3)(A)(ii).

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In general, the straddle rules do not apply to hedges under § 1256(e)878 or to “qualified covered call options.”879 Special rules apply to “identified straddles”880 and to “mixed straddles.”881
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878 § 1092(e).

879 Section 1092(c)(4) defines a “qualified covered call option” as an option granted by the taxpayer to purchase stock held by the taxpayer but only if, generally, the option is traded on a registered national securities exchange or similar market approved by the Secretary, has a term of at least 30 days, is not “deep-in-the-money” and is not granted by an options dealer. If a taxpayer either settles a qualified covered call option or sells the stock at a loss, but does not recognize the gain on the other position in the same year, the short option and the stock will be treated as a straddle unless the taxpayer holds the other position on an unhedged basis for at least another 30 days.

880 § 1092(a)(2)(B).

881 See Temp. Regs. § 1.1092(b)-4T.

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Under the straddle rules, a taxpayer may not claim a realized loss from one position except to the extent that the loss exceeds the unrecognized gain on one or more offsetting positions.882 The straddle rules also terminate the holding period of any position that becomes part of a straddle until the taxpayer disposes of the offsetting position, unless the holding period exceeded one year before it became part of the straddle.883 Finally, a taxpayer must capitalize all or a portion of any interest and other carrying costs allocable to a straddle.884
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882 § 1092(a)(1)(A).

883 Temp. Regs. § 1.1092(b)-2T(a). The terminated holding period begins anew on the date of such disposition.

884 See § 263(g).

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Example 11-11: Quark is a hedge fund organized as a partnership for tax purposes.  On January 1, 2007, Quark acquires one share of publicly-traded stock in Nova for $1,000 and a put option on one share of Nova stock for $100.  The put has a strike price of $1,000.  On December 31, 2007, Quark sells the share of Nova on the market for $100.  On that same date, the put option has a fair market value of $950.  On January 2, 2008, Quark settles the put option in cash for $900.  Under § 1092(a), Quark cannot claim $850 of the $900 loss realized in 2007 until 2008.  Under Regs. § 1.1092(b)-2T(a), Quark must report the $800 gain on the put option as short-term capital gain.

2. Unbalanced Straddles 

Until 2004, the “unbalanced” straddle presented a recurring problem to many hedge funds.  An unbalanced straddle is a straddle in which one “leg” of the straddle is larger than the other.  Consider the following example:

Example 11-12: Neutrino, a hedge fund, holds 10 shares of stock in Fermion, a publicly-traded corporation.  Five shares have a tax basis of $10 per share and five shares have a tax basis of $20.  On January 1, 2008, when the Fermion shares are trading at $30 per share, Neutrino acquires a put option on five of the Fermion shares with a strike price of $35 per share. Neutrino pays $15 for the put option.  Under § 1092(c), the shares of Fermion coupled with the long put option constitute a straddle.  Assume that the put option expires when the Fermion shares are trading at$40 per share, resulting in a $15 loss.  Because Neutrino has “unrecognized gain” of $250 on the Fermion shares (i.e., ($40 x$10) – $50 - $100), it cannot claim a current loss.

So how many shares of Fermion must Neutrino sell before it may claim the loss? Before the Jobs Act amendment to § 1092 in 2004,885 the statute would have required Neutrino to sell all 10 shares.  First, each Fermion share has unrecognized gain in excess of the entire $15 loss on the put.  Second, the statute did not distinguish between the unrecognized gain inherent in the Neutrino shares at the time that the shares became part of a straddle and the unrecognized gain in the Neutrino shares that accrued thereafter.886
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885 American Jobs Creation Act of 2004, P.L. 108-357.

886 See § 1092(a)(3)(a)(i) (referring to the “amount of gain which would be taken into account with respect to such position if such position were sold on the last business day of such taxable year ...”).

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Prior to its amendment,  § 1092(c)(2)(B) provided that —

if 1 or more positions offset only a portion of 1 or more other positions, the Secretary shall by regulations prescribe the method for determining the portion of such other positions which is to be taken into account for purposes of this section.

In the 22-year history of § 1092(c)(2)(B), Treasury failed to issue the regulations.  Without the implementing regulations,887 the statute often required taxpayers with large portfolios to suspend losses until well after they had eliminated the relevant hedge.888 In 2004, the Jobs Act replaced § 1092(c)(2)(B) with a modified definition of “identified straddle” under § 1092(a)(2)(B). Under § 1092(a)(2)(B), an “identified straddle” is a properly identified straddle that satisfies certain statutory conditions.  If the straddle in question qualifies as an identified straddle, the general deferral rules of § 1092(a) do not apply.  Instead, the taxpayer may increase the basis of the offsetting gain positions by the disallowed loss on a pro rata basis in accordance with their relative share of the offsetting gain.889 For purposes of measuring each asset's relative share of the offsetting gain, the statute ignores the portion of the gain accruing before the taxpayer identifies the asset as part of a straddle.890
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887 But see PLR 199925024 (permitting taxpayer to identify shares offset by collar under similar principles before the Jobs Act amendments).

888 See H.R. Conf. Rep. No. 755, 108th Cong., 2d Sess. at 741 (2004) (this problem “is exacerbated when the taxpayer has a large portfolio of actively traded personal property that may be offsetting the loss leg of the straddle”).

889 See § 1092(a)(2)(A).

890 See § 1092(a)(3)(B) (special rule for “identified straddles”).

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In the preceding example, therefore, Neutrino would increase its tax basis in the Fermion shares by $15.  For purposes of allocating the $15 basis step-up across the 10 shares, only $100 of the “unrecognized gain” (i.e., $40 - $30 x10) is taken into account, not $250.  In spite of their different tax bases, therefore, each share will have $10 of unrecognized gain. Accordingly, Neutrino will increase the tax basis of each share by$1.50.

U.S. Income Portfolios: Other Pass-through Entities 
  Portfolio 736-1st: Hedge Funds 
  Detailed Analysis 
  XI. Portfolio Investments by the Fund: Recurring U.S. Tax Issues

D. Conversion Transactions 

Section 1258 treats all or a portion of any capital gain from a “conversion transaction”as ordinary income.  The statute defines a “conversion transaction”as a transaction that involves —

• the acquisition of property coupled with the substantially contemporaneous entry into a contract to sell such property (or substantially identical property);

• an “applicable straddle”;

• any transaction marketed or sold as a conversion transaction; or

• any other transaction specified in regulations;891

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891 See § 1258(c).

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if substantially all of the expected return is attributable to the time value of money.

The prototype of a conversion transaction is a forward sale of recently acquired property at a price that conveys a debt-like return:

Example 11-13: X purchases stock for $50 on January 1, 2006 and, on the same date, agrees to sell it to Y in 2 years for $60. The “applicable rate” under  § 1258(d)(2) is 6%. At maturity, X earns a 9.6% return, which X would otherwise report as capital gain.  The future value of $50 at a 7.2% discount rate(120% of the applicable yield) is $57.50 (i.e., $50 x1.072^2).  Under § 1258(a), X must therefore report $7.50 as ordinary income.

Note that the risk that was once inherent in X's ownership of the underlying property is now irrelevant to X. X will derive a 9.6% return in the transaction whether it owns a Treasury security or a lottery ticket.  But  § 1258 does not treat the gain as interest.892 Accordingly, X will defer the gain until maturity instead of reporting the gain on a current yield-to-maturity basis.  Section 263(g), however, may disallow a deduction to X for the interest expense on any debt incurred to purchase or carry the underlying property.893 As an economic matter, therefore, requiring X to capitalize the interest deduction is equivalent to requiring X to report the gain on a current basis.
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892 S. Rep. No. 36, 103d Cong., 1st Sess. 234 (1993) (“gain realized ... will be treated as ordinary income (but not as interest) for all purposes ...”).

893 See § 1258(b) (“the Secretary shall by regulations provide for such reductions in the applicable imputed income amount as may be appropriate by reason of amounts capitalized under  section 263(g) ...”). The capitalized interest under  § 263(g) reduces the portion of the capital gain that might otherwise be recast as ordinary under § 1258.   Section 263(g) applies if the property is part of a “straddle”within the meaning of § 1092(c), and will therefore apply to most conversion transactions.

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In certain situations, what the statute will have defined as a “conversion transaction” will comprise only a component part of a larger economic transaction.  Because  § 1258 will convert up to the entire capital gain in the statutorily-defined transaction to ordinary income, an offsetting capital loss that the statute ignores even though it is part of a larger transaction may increase the taxable conversion amount above the taxpayer's true economic yield:

Example 11-14: Convexity, a hedge fund, purchases stock for $50 on January 1, 2006 and, on the same date, agrees to sell the stock to XYZ investment bank in 2 years for$55. The “applicable rate” under  § 1258(d)(2) is 5.83%and the stock is actively-traded as defined in Regs. § 1.1092(d)-1(a). Immediately before maturity, Convexity sells the stock on the market for $45, generating a $5 loss, and settles the forward contract with Y for $10, generating a $10 gain.  Convexity therefore derives a net gain of $5, earning a 4.88% return on the transaction.  The future value of $50 at a 7% discount rate (120% of the applicable yield)is $57.25 (i.e., $50 x 1.07^2).  Accordingly, Convexity must treat $7.25 of the $10 gain as ordinary, precluding full use of the $5 capital loss.

In effect,  § 1258 produces a character mismatch by taxing Convexity at ordinary income rates on its gross rather than net gain.  In recognition of this problem, the regulations under  § 1258 would allow Convexity under certain conditions to first net the $5 capital loss against the $10 of capital gain before applying § 1258(a).894 Among those conditions, Convexity must designate the sale of the stock and the cash settlement of the forward contract as “an identified netting transaction” on its books and records and must terminate both positions within a 14-day period during a single taxable year.895 If it does so, Convexity would report only $5 of the $10 capital gain as ordinary, allowing it to shelter the remaining $5 gain with the capital loss.
——————————————————————————————

894 See Regs. § 1.1258-1(b).

895 Id.

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In practice,  § 1258 rarely applies.  The reason is that “substantially all” of the expected return on the transaction must reflect the time value of money.896 Most transactions that reflect an implicit loan also include some other type of speculative return:
——————————————————————————————

896 § 1258(c)(1).

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Example 11-15: Convexity, a hedge fund, purchases stock for $50 on January 1, 2006 and, on the same date, acquires a two-year put option at a strike price of $60 from X and sells a two-year call option at a strike price of $70 to Y. Ignoring the price of the two options, Convexity will earn a return of between $10-20.  Although the $10 in this example is like interest, § 1258 should not apply because Convexity may earn $20.897

——————————————————————————————

897 See Schizer, 186 T.M., Financial Instruments: Special Rules.

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U.S. Income Portfolios: Other Pass-through Entities 
  Portfolio 736-1st: Hedge Funds 
  Detailed Analysis 
  XI. Portfolio Investments by the Fund: Recurring U.S. Tax Issues

E. Constructive Sales of Appreciated Financial Positions 

Suppose a hedge fund holds appreciated stock. The portfolio manager expects the price of the stock to rise even higher, but also fears that the price will fall.  It would like to hold the stock, therefore, but hedge its risk of loss on the built-in gain.

Under these conditions, a portfolio manager has a number of alternatives.  It may borrow against the stock on a non-recourse basis.  It may acquire a long-dated put option on the stock.  Until 1997, it may even have sold the stock short.898 Under the common law, these transactions rarely triggered a taxable sale, due in substantial part to the status of stock as a marketable security.899 Marketable securities tend to be fungible securities. The attribute of fungibility provides more latitude to “mix”attributes of tax ownership among different parties, permitting the shareholder in many cases to convey most (or even all) of the economic return to another without effecting a transfer of tax ownership. If, for example, a shareholder in one of these transactions were to retain legal title, the right to vote, and perhaps the right to dividends, it would probably possess sufficient indicia of tax ownership to avoid an immediate sale.
——————————————————————————————

898 For a discussion of “shorting against the box,” see VII, F, above.

899 For an excellent discussion of the common law tax treatment of various types of hedging transactions, see 186 T.M., Financial Instruments: Special Rules.

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Under § 1259, however, these types of transactions may trigger a “constructive”sale.  Although a full discussion of  § 1259 is beyond the scope of this portfolio,  § 1259 applies to many types of derivative contracts popular among hedge funds, among them —

• short sales;

• swaps; and

•futures and forward contracts.900

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900 See § 1259(c)(1)(A), (B) and (C).

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If the subject matter of the contract is an “appreciated financial position,”901  § 1259 will treat the taxpayer as having sold and immediately repurchased the position for its fair market value.902 An “appreciated financial position”includes stock, debt (other than straight debt) and a partnership interest, even if these positions are not marketable.903
——————————————————————————————

901 § 1259(a).

902 Id.

903 § 1259(b)(1).  If the position is not marketable, however, a constructive sale will not occur unless the contract must settle after one year.  See § 1259(c)(2).

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Example 11-16: Occlude, a domestic hedge fund with taxable U.S. investors, holds 100 shares of publicly-traded stock in Google worth $1 million.  The shares have a tax basis of$1,000.  Occlude enters into an equity swap with ABC bank.  Under the terms of the swap, Occlude agrees to pay ABC an amount equal to any dividends paid on the shares of Google over a three-year term, together with an amount equal to any appreciation in the Google shares above $1 million at maturity.  ABC in turn agrees to pay to Occlude a floating rate of interest on a “notional” amount of$1 million over three years, together with an amount equal to any decline in value of the shares over the same period.

In this example, provided that the swap does not otherwise effect a common law disposition of the Google shares, Occlude will be treated as having sold the shares under § 1259.  The swap requires Occlude to pay the entire economic return from the Google shares over the swap term and to receive in lieu thereof an interest-like return on a guaranteed principal sum, and is therefore an “offsetting notional principal contract” under § 1259(d)(2).904
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904 See   § 1259(d)(2) (defining an offsetting swap as “an agreement which includes ...a requirement to pay ... all or substantially all of the investment yield ... on such property for a specified period, and ...a right to be reimbursed for ... all or substantially all of any decline in the value of such property”).

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But suppose that the same fund instead enters into the following transaction:

Example 11-17: Assume the same facts as in Example 11-16, but that Occlude enters into a variable forward contract with ABC bank on the Google shares.  Under the terms of the contract, ABC pays $1 million to Occlude at the inception of the contract and Occlude agrees to deliver a variable number of Google shares to ABC at the end of three years plus the intervening dividends. If the stock is worth less than $1 million in three years, Occlude must deliver all 100 shares to ABC.  If the stock is worth between$1-1.2 million, Occlude must deliver shares of Google worth $1 million. If the stock is worth more than $1.2 million, Occlude must deliver 83% of the shares.  To secure its obligations under the contract, Occlude pledges 100% of the Google shares to ABC.  In all cases, however, Occlude may recover the Google shares by retiring its contractual obligations with cash or other property.

As an economic matter, Occlude has divested itself of all risk of loss in the transaction: it holds $1 million of cash, and if the value of the Google shares declines to zero, it need only tender the worthless stock to ABC in three years. In addition, Occlude retains 100% of the first 20% of appreciation in the Google shares and 17% of any further appreciation over the three-year period.

However, this is not a constructive sale.  Although the Google shares represent an “appreciated financial position,”905 the variable forward contract with ABC is not a “forward contract.”   Section 1259(d)(1) defines a forward contract as “a contract to deliver a substantially fixed amount of property (including cash) for a substantially fixed price.”  According to the legislative history, a forward contract that provides for the delivery of an amount of stock that is subject to “significant variation” under the terms of the contract is not a forward contract within the meaning of § 1259.906
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905 See § 1259(b).

906 See S. Rep. No. 33, 105th Cong., 1st Sess. 125-26 (1997); see also Rev. Rul. 2003-7, 2003-5 I.R.B. 363.

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On the basis of this analysis, many of the investment banks market variable prepaid forward contracts on publicly-traded stocks under a range of different acronyms, each as a vehicle that purports to effect an economic sale of the stock without immediate recognition of gain.907 Although the precise scope of  § 1259 is not entirely clear, a transaction will usually avoid constructive sale treatment under  § 1259 if it bears either of the following economic attributes:
——————————————————————————————

907 For an excellent discussion of the economic terms and related tax issues with these products, see Kleinbard &  Nijenhuis, “Everything I Know About New Financial Products I Learned from DECs,” 517 PLI/Tax 1183 (2001).

——————————————————————————————

• it eliminates all downside risk but leaves significant upside exposure with the taxpayer;or

• it retains full upside and downside over the term of the contract, but only within a relatively narrow “collar” above and below the current market price.908

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908 How wide a collar is necessary to avoid a constructive sale is not entirely clear, but will depend in part on the term of the contract and the volatility of the underlying asset.  A long maturity, for example, would tend to require a wider collar to avoid a constructive sale.

——————————————————————————————

The statute applies only if the taxpayer departs with “substantially” all economic attributes of ownership.909 Standing alone, therefore, the receipt of cash at the inception of the contract will not suffice to trigger a taxable sale.
——————————————————————————————

909 See, e.g., § 1259(d)(2) (swap included if taxpayer must pay and receive “all or substantially all”of return on underlying property);  § 1259(d)(1) (forward contract included if property to be delivered is “substantially fixed”); Treasury's General Explanation of Administration Revenue Proposals, reprinted in 96 TNT 56-9 (3/20/96) (constructive sale results because taxpayer has “substantially eliminate[d]risk of loss and opportunity for gain”).  For an excellent overview of how “perfect” a hedge must be to trigger a constructive sale of appreciated property under § 1259, see 186 T.M., Financial Instruments: Special Rules.

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U.S. Income Portfolios: Other Pass-through Entities 
  Portfolio 736-1st: Hedge Funds 
  Detailed Analysis 
  XI. Portfolio Investments by the Fund: Recurring U.S. Tax Issues

F. Short Sales 

In a typical short sale of stock, the short seller will borrow shares from another person (the “lender”)and, immediately thereafter, sell the shares on the market for cash;at the maturity of the short sale, the short seller will return either a like number of shares or cash of equivalent value to the lender of the shares.910 If the short seller intends to close out the short sale in kind, it will usually buy the shares on the market at or before the maturity of the short sale.  If the short seller already owns the shares, however, it may deliver those shares to the lender.  This is called “shorting against the box.”  If the borrowed stock pays a dividend before maturity, the short seller will also make a “substitute payment” to the lender of the shares.  The reason for the substitute payment is that the lender in the short sale does not receive the actual dividend — the issuer will have paid the dividend to the person who acquired the stock from the short seller.
——————————————————————————————

910 See Provost v. U.S., 269 U.S. 443, 450-451 (1926) (“a short sale is a contract for the sale of shares which the seller does not own or the certificates for which are not within his control so as to be available for delivery at the time when, under the rules of the Exchange, delivery must be made”); see also Comr. v. Wiesler, 161 F.2d 997 (6th Cir. 1947), cert. denied, 332 U.S. 842 (1947).

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The fundamental economic attribute of a short sale, therefore, is the obligation of the short seller to deliver either the asset itself or its cash value at maturity:

Example 11-18: Amorphous, a domestic hedge fund, believes that a pending merger of X Corp. and Z Corp. will not close because it will not receive the necessary regulatory approvals.  Amorphous sells 100 shares of X stock at the current market price of $10 per share.  Because Amorphous does not own the X stock, it borrows the shares from B. Amorphous deposits the cash proceeds of $1,000 as security for the stock loan.  Six months later, X and Z terminate the merger agreement, causing the X shares to drop to$8 per share. Amorphous buys 100 shares of X stock for $8 per share and delivers them to B.  Ignoring fees, Amorphous realizes a $200 gain on the short sale.  Had the shares increased in value, either because the merger did in fact close or for other reasons, Amorphous would have realized a loss.

In a short sale, therefore, the seller realizes a gain if the underlying asset, typically stock or securities, declines in value over the term of the sale.  A hedge fund usually shorts a stock or security for one of two reasons.  First, it may be making a speculative bet that the stock or security will decline in value. Second, it may be hedging a long position in its portfolio.  In the latter case, the fund will be both long and short on the same asset. If the asset declines in value, therefore, the short position will appreciate; if the asset appreciates, the short position will decline in value.

The remainder of this section summarizes the federal income tax consequences of a short sale of stock, assuming that the hedge fund acts as the short seller.911 In general,  § 1233 governs short sales of stock.912 Under § 1233, a short sale is treated as an “open transaction”until the short seller returns the underlying stock to the lender.913 Subject to § 1259, therefore, the short seller recognizes no gain or loss on the short sale before maturity, even though the seller already has the cash proceeds.914 The reason is that the seller has no “basis”to offset against those proceeds until the seller actually acquires the shares on the market to close out the short sale.915
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911 The lender generally does not recognize gain or loss when it “lends” stock to the short seller under § 1058. Substitute payments are generally taxable as ordinary income.  See Rev. Rul. 80-135, 1980-1 C.B. 18; see also Prop. Regs. § 1.1058-1(d). Even though the payments compensate the lender for the foregone dividends, a noncorporate lender may not report the payment as qualified dividend income.  For the same reason, a corporate lender may not claim the dividends-received deduction.  See Rev. Rul. 60-177, 1960-1 C.B. 1; see also Prop. Regs. § 1.1058-1(d). For withholding tax purposes, special source rules apply to cross-border payments.  See Regs. § § 1.861-2(a)(7); 1.861-3(a)(6); 1.864-5(b)(2)(iii); 1.871-7(b)(2); 1.881-2(b)(2); 1.894-1(c); 1.1441-2(a).  For a comprehensive discussion of the short sale rules, see, e.g., Kramer, Financial Products — Taxation, Regulation and Design (3rd ed. 2000)(Chapter 28); see also Keyes, Federal Taxation of Financial Instruments and Transactions at ¶  16 (1997).

912 Hedging transactions in commodity futures, however, are exempt from § 1233.  See § 1233(g).  The straddle rules do not apply to short sales “against the box” because a straddle requires “two legs,” not one.  See § 1233(e)(2)(A).

913 See Regs.  § 1233-1(a) (“a short sale is not deemed to be consummated until the delivery of property to close the short sale”).

914 If the borrowed stock becomes substantially worthless, the short seller recognizes gain as if it had closed the short sale on the date that the stock became substantially worthless.  See § 1233(h)(1).  Congress amended  § 1233 to require gain recognition to prevent taxpayers from “postponing indefinitely gain on short positions where the underlying property becomes substantially worthless”by not closing the short sale.  See Staff of Joint Committee on Taxation, 105th Cong., 1st Sess., General Explanation of Tax Legislation Enacted in 1997 at 188 (Comm. Print 1997).

915 If the short seller holds different lots of stock, it may designate which lot it intends to close out the short sale. See Regs.  § 1233-1(c)(6) (Ex. 5) (short seller permitted to designate lot that results in least gain).

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Gain or loss on a short sale is capital in nature so long as the asset sold short is a capital asset.916 Because a hedge fund is not a dealer, its gains and losses from a short sale will generally qualify as capital in nature.917 Gain or loss is sourced by the residence of the short seller.918 Thus, a domestic hedge fund will realize U.S. source gain or loss from a short sale of stock.  In general, the holding period of the stock returned to the lender to close out the short sale will determine whether the capital gain or loss is short-term or long-term to the short seller.919 If the short seller already owns the shares to close out the short sale, however, special rules may apply to “toll”the holding period during the term of the short sale.920 These rules seek to prevent the conversion of short-term gains and losses into long-term gains and losses.
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916 See § 1233(a); Regs. § 1.1233-1(a)(2).

917 See § 1221(a)(1), (6).

918 See § 865(a).

919 See Regs. § 1.1233-1(a)(3), (4).

920 See § 1233(b)(1); § 1233(d); Regs. § 1.1233-1(c)(2), (4).

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In general, substitute payments, together with any fees paid to the lender as compensation for participating in the short sale, qualify as deductible expenses under either  § 162(a) or § 212.921  Section 163(d) may also apply.922 If, however, the seller closes out the short sale within less than 46 days,  § 263(h)(1) will prohibit the deduction, requiring the seller to capitalize that cost into the basis of the stock returned to the lender.  Moreover, if the short sale is part of a “straddle,” then  § 263(g) may also deny a deduction for the substitute payments.
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921 See Comr. v. Wiesler, 161 F.2d 997 (6th Cir. 1947), cert. denied, 332 U.S. 842 (1947) (taxpayer engaged in business of trading securities entitled to deduct amounts equal to ordinary cash dividends paid on borrowed stock under § 112(a); see also Rev. Rul. 72-521, 1972-2 C.B. 178 (premiums paid in acquisition of stock borrowed to cover short sales and substitute payments for ordinary cash dividends on such stock both deductible under § 212).  For a discussion of whether  § 162(a) or  § 212 applies to a hedge fund partnership, see VIII, A, above.

922 See Keyes, Federal Taxation of Financial Instruments and Transactions at ¶  16.03[5][b](1997) (arguing, without citation, that “a compensating payment in lieu of a dividend is treated as investment interest expense”).

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Short sales have other tax consequences as well. For example, a short sale “against the box” is often a “constructive sale” under § 1259.923 For all intents and purposes, therefore, § 1233 is no longer relevant to funds that sell short to hedge an appreciated position in their portfolio. Moreover, a short sale may toll the holding period of stock that is “substantially identical” to the stock that is subject to the short sale.924
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923 § 1259(c)(1)(A) (treating short sale as constructive sale of “appreciated financial position”). For a discussion of constructive sales under § 1259, see XI, E, above.

924 See § 1233(b)(2); Temp. Regs.  § 1.1092(b)-2T(a) (terminating holding period for certain positions that become part of straddle); see also § 263(h)(4); § 246(c)(1)(B); § 1(h)(11)(B)(iii).

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U.S. Income Portfolios: Other Pass-through Entities 
  Portfolio 736-1st: Hedge Funds 
  Detailed Analysis 
  XI. Portfolio Investments by the Fund: Recurring U.S. Tax Issues

G. Transactions in Foreign Currency 

Most U.S. hedge funds report gains and losses in U.S. dollars.  They do so because the dollar is their “functional currency.”  Some of their transactions, however, call for payment in a different currency.  A taxpayer that conducts business in its own currency deals in money.  A taxpayer that conducts business in a foreign currency deals in property.925 Because property has its own tax basis, the very act of spending the currency may trigger a gain or loss.926
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925 See, e.g., Gillin v. U.S., 423 F.2d 309 (Ct. Cl. 1970).

926 § 1001.  For an excellent discussion of the many tax issues with foreign currency not addressed in this portfolio, see 921 T.M., Tax Aspects of Foreign Currency.

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For a hedge fund, the decision to deal in a foreign currency may serve a speculative purpose; alternatively, it may hedge another position that is itself denominated in the same currency.  In either case, however, a disposition of foreign currency may generate an “amount realized” that differs from its tax basis, each as expressed in U.S. dollars.  With foreign currency, tax basis and amount realized will differ if the relevant exchange rates on the dates of purchase and sale differ.  On occasion, a hedge fund will directly acquire or short a foreign currency.  More often than not, however, the foreign currency in question will be embedded within a larger transaction involving a different class of property(e.g., a debt instrument).  To measure exchange gain or loss in the latter case, the taxpayer must bifurcate the transaction into its component parts: the actual transaction and the implicit currency transaction.

Under § 988, if a taxpayer enters into a transaction denominated in a non-functional currency or that is determined by reference to non-functional currency, it must separately account for foreign currency gain or loss and treat it as ordinary for tax purposes.927 In general, the residence of the taxpayer will establish the source of the foreign currency gain or loss.928 If the taxpayer is a partnership, the source of foreign currency gain or loss will depend upon the domicile of the partnership.929 For a partnership that relies on the  § 864(b) trading safe harbor, however, the regulations determine residence at the partner level.930 For most hedge fund partnerships, therefore, the source of foreign currency gain, and therefore U.S. taxing nexus over the foreign partners, will not depend upon the domicile of the fund.  Instead, any foreign currency gain allocable to a foreign investor in a domestic or foreign hedge fund should avoid U.S. withholding tax as foreign source income.931
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927 See § 988(a); Regs. § 1.988-1(a)(1);Regs.  § 1.988-3(a) and (c).

928 § 988(a)(3).

929 See § 988(a)(3)(B)(i)(II) (domestic partnership has domestic residence); § 988(a)(3)(B)(i)(III) (foreign partnership has foreign residence).

930 See Regs. § 1.988-4(d)(3). Foreign currency gain that is ECI to a foreign person, however, is sourced in the United States and subject to net basis taxation.  See Regs. § 1.988-4(c).

931 See § 871(a)(1), § 881(a) (FDAP income “from sources within the United States” is subject to potential 30% withholding tax).

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The statute defines a “§ 988 transaction” as a transaction in which the amount a taxpayer is entitled to receive or is obligated to pay is either denominated in or determined by reference to the value of a non-functional currency.932 For example, a  § 988 transaction may include —
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932 See § 988(c)(1)(A).

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• a borrowing transaction;933
  
• a lending transaction;934
  
• the entry into a forward or futures contract;935
  
•the purchase or grant of an option;936 or
  
•the entry into a notional principal contract.937

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933 § 988(c)(1)(B)(i) (“becoming the obligor under a debt instrument”).

934 § 988(c)(1)(B)(i) (“acquisition of a debt instrument”).

935 § 988(c)(1)(B)(iii).

936 Id.

937 Regs. § 1.988-1(a)(b)(iii)(B).

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If a taxpayer disposes of or receives non-functional currency in any of these transactions, it will usually recognize exchange gain or loss under § 988.938 Except in the case of a forward, futures, option contract or other derivative,939 a taxpayer determines exchange gain or loss in accordance with changes in exchange rates between the “booking date” and the “payment date” of the transaction.940 The “booking date” in the case of a debt instrument is the date of the relevant acquisition or borrowing.941 The “payment date” is the date on which payment is made or received.942 For this purpose, a “disposition”includes the act of taking physical delivery under a forward, futures or option contract.943
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938 See Regs. § 1.988-2(a)(1)(i).

939 § 988(b)(3).

940 § 988(b).

941 § 988(c)(2)(A).

942 § 988(c)(3).

943 See § 988(c)(5).

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A transaction not described in  § 988(c) is not subject to § 988, even if denominated in foreign currency.  A transaction in stock, for example, is not described in § 988(c):944
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944 See Regs.  § 1.988-1(a)(6) (Ex. 8, 11).

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Example 11-19: On January 1, 2007, Marx, a hedge fund, acquires 50 shares of A, a company that trades on the Frankfurt Stock Exchange, for 200 euros.  On the date of purchase, the exchange rate is $1.2 dollars per euro.  Marx therefore has an initial tax basis in the A shares of $240.  On June 30, 2008, Marx sells the A shares for 300 euros.  On the date of sale, the exchange rate is $1.4 dollars per euro.  As an economic matter, Marx has $120 of long-term capital gain on the A shares and $60 of foreign currency gain.  Because the purchase and sale of stock is not a  § 988 transaction, however, Marx will report the entire $180 as long-term capital gain.945 If Marx does not immediately convert the$300 euros to dollars, it may realize incremental exchange gain or loss on the conversion date.946

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945 See Mariani Frozen Foods, Inc. v. Comr., 82 T.C. 448 (1983), aff'd, 761 F.2d 1410 (9th Cir. 1985).

946 See Regs.  § 1.988-1(a)(6) (Ex. 8).

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Special rules apply to “qualified hedging transactions” involving debt instruments. When these rules apply, a taxpayer may integrate a debt instrument and related hedge to “create a synthetic debt instrument for income tax purposes.”947 The rules apply whether a taxpayer holds a debt instrument as an asset or issues a debt instrument as a liability.948 If, for example, the taxpayer issues a debt instrument that requires payment in euros but then enters into a series of matching forward contracts to acquire the euros necessary to service the debt, the taxpayer may treat the two transactions as a single borrowing in U.S. dollars.  Accordingly, if a taxpayer reports gains and losses in U.S. dollars and if the currency of the synthetic debt instrument is the U.S. dollar, neither the actual debt instrument nor the related hedge will generate exchange or loss under § 988.949
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947 See Regs. § 1.988-5(a)(9)(ii).

948 See Regs. § 1.988-5(a)(9)(ii)(A).

949 The integration of the two positions will not affect third parties.  For example, the holder of the hedged debt instrument in the foregoing example will continue to receive euros unless it also serves as the counterparty under the series of forward contracts.  Accordingly, if the loan is cross-border, the lender will report the receipt of any payments in euros in accordance with general rules governing FDAP income under  § § 871(a) and 881.  See Regs. § 1.988-5(a)(9)(ii)(A).

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A “qualified hedging transaction”is an integrated economic transaction that involves (i) a “qualifying debt instrument”; and (ii) an eligible hedge under the  § 988 regulations (“eligible hedge”). The two positions together qualify as an “integrated economic transaction” if they meet certain conditions, among them that —

• all payments under the actual debt instrument are fully hedged in a manner that allows the taxpayer to compute the yield-to-maturity of the resulting “synthetic”debt instrument;

• the hedge is identified in accordance with Treasury regulations on or before the date the hedge is settled or closed; and

• the same party both acquires or issues the debt instrument and enters into the hedge.950

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950 See Regs. § 1.988-5(a)(5).

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The regulations define a “qualifying debt instrument” to include most types of debt instruments regardless of their denomination, excluding accounts payable and accounts receivable.951 If a taxpayer hedges only a portion of a debt instrument, then only the portion so hedged is a qualifying debt instrument.952 An eligible hedge includes a spot contract, future, forward or option contract, notional principal contract, currency swap contract or any series or combinations thereof, so long as the hedge allows the taxpayer, after integrating the hedge and the debt instrument, to compute a yield-to-maturity.953
——————————————————————————————

951 See Regs. § 1.988-5(a)(3).

952 See Regs. § 1.988-5(a)(3)(i).

953 See Regs. § 1.988-5(a)(4)(i).

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Example 11-20: C-Note, a hedge fund with a fondness for bank loan syndications, borrows 10 million euros from a Dutch bank.  On the date of the loan, the exchange rate is $1.2 dollars per euro.  The terms of the loan require semi-annual payments of interest at an 8% annual rate, with all principal due in 10 years.  On the same date, C-Note acquires a $12 million participation in a bank loan syndication.  C-Note's share of the syndicated loan entitles it to payments on the same schedule at an 8% annual rate, but payable in U.S. dollars.  To fund the participation, C-Note converts the 10 million euros into $12 million in dollars and pays it over to the lead bank in the syndicate.  C-Note then realizes that if the rate were to decline, it would incur currency losses because the payments it will receive on the syndicated loan in U.S. dollars will not be sufficient to fund its euro-denominated payment obligations to the Dutch bank.  C-Note therefore enters into a contemporaneous swap with XYZ investment bank.  Under the terms of the swap, C-Note agrees to make semi-annual payments at an 8% rate on a “notional”amount of $12 million to XYZ in exchange for semi-annual payments in euros equal to the amounts payable to the Dutch bank.  C-Note reports the $10 million borrowing from the Dutch bank and the swap with XYZ as an “integrated economic transaction.”  For tax purposes, therefore, it reports the entire transaction as a $12 million term loan in U.S. dollars.

As described above,  § 988 requires the taxpayer to report foreign currency gain or loss as ordinary.  A taxpayer may elect, however, to report certain gains and losses from a forward, futures or option contract as capital gain.954 To qualify for the election, the contract —
——————————————————————————————

954 § 988(a)(1)(B); Regs. § 1.988-3(b).

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• must be a “capital asset” to the taxpayer;

•must not be part of a “straddle” within the meaning of § 1092(c);
  
• must meet certain identification requirements; and

• must not be a regulated futures contracts or nonequity option that the taxpayer has elected to treat as a  § 988 transaction.955

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955 See § 988(c)(1)(A).

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U.S. Income Portfolios: Other Pass-through Entities 
  Portfolio 736-1st: Hedge Funds 
  Detailed Analysis 
  XII. Investing in Hedge Fund Derivatives

A. The Potential Appeal of a Hedge Fund Derivative 

A derivative is a type of security that captures part or all of the economic return from an underlying financial asset, but without effecting a transfer of legal ownership.  How the participant is taxed on a derivative return, however, may differ from the taxation of the underlying asset.  If the after-tax return to the participant is higher, the participant will prefer derivative to actual ownership;if the return is lower, it will not.

Most derivatives track a single underlying asset. But suppose that a particular derivative tracks the value of a hedge fund portfolio.  What type of investor would prefer “virtual”to actual ownership? The attraction of this type of security will be greatest to the investor who would otherwise bear a high rate of tax on the returns of the underlying fund.  On this criterion, therefore, a hedge fund derivative has nothing to offer a tax-exempt or foreign investor.  The tax-exempt investor already enjoys complete exemption from U.S. tax on direct investment in a hedge fund,956 provided that it invests through the corporate feeder.957 Similarly, the foreign investor enjoys exemption from tax on direct investment as well, either in whole or in part, so long as the activities of the fund qualify as “trading” under § 864(b).958 More generally, the tax appeal of any derivative investment will tend to decline as the before and after-tax return on the underlying asset converge.
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956 § 512(b).

957 For a discussion of leverage and how it may alter the character of investment income to a tax-exempt investor, see VII, B, 2, above.

958 For a discussion of the trading safe harbor under § 864(b), see VII, B, 1, above.

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If the choice between derivative and actual ownership is tax-driven, therefore, the individual investor is the natural market for a hedge fund derivative.  Unlike a tax-exempt or foreign investor, an individual investor will bear full net basis taxation on his or her hedge fund returns.  The tax rate on these returns will not capture any character preference if the hedge fund in question happens to “churn” the underlying portfolio, which will also deprive the investor of deferral.959 Should the investee fund fail to qualify as a “trader” as well,960 the loss of the tax benefit for the management fee may increase the effective tax rate of the investor above 35%:
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959 See IV, B and VIII, above.

960 An individual may deduct the management fee under  § 162 only if the fund “carries on” a trade or business.  As described in VIII, A, 1, above, whether a fund is a “trader”or an “investor” is a facts-and-circumstances test.  See, e.g., Higgins v. Comr., 312 U.S. 212 (determination “requires an examination of the facts of each case”); Comr. v. Groetzinger, 480 U.S. 23 (1987) (“We therefore adhere to the general position of the Higgins Court, taken 45 years ago, that resolution of this issue ‘requires an examination of the facts in each case’”).

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Example 12-1:961 On January 1, 2006, X, an individual investor, borrows $2 million and invests it in Volatile, a hedge fund partnership.  The Volatile fund charges a 20% carry and a 2% management fee.  Although it generates its entire return in the form of short-term capital gain, the activities of the Volatile fund do not qualify as “trading” for tax purposes.  As of December 31, 2007, the value of X's investment has increased to $3 million.  The Schedules K-1 to X over the two-year period reflect aggregate gains of $1.1 million and aggregate management fees of $100,000.  Ignoring interest expense on the loan, X will bear tax at a 35% rate on the $1.1 million of gross gains if  § 67 suspends the deduction of the management fee.  X's effective tax rate, therefore, is 38.5%(i.e., $385,000 / $1 million).

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961 Examples 12-1 and 12-2 are each based in substantial part upon similar examples in 186 T.M., Financial Instruments: Special Rules.

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For investors like X, a hedge fund derivative may have great appeal:

Example 12-2: On January 1, 2006, assume that X instead enters into a total return swap with ABC, an investment bank subject to § 475.962 On the same date, ABC makes a $2 million investment in the Volatile fund. Over the two-year term of the swap, X agrees to make periodic payments to ABC in an amount equal to the interest it would have paid on the loan in Example 12-1.  Upon termination of the swap, ABC agrees to pay X an amount equal to any increase in the value of its investment in the Volatile fund above $2 million and X agrees to pay ABC an amount equal to any decrease in such value below $2 million.  The swap provides for cash settlement at maturity and does not require ABC to hold shares in the Volatile fund.  Before the enactment of § 1260, X could probably have reported its net gain of $1 million due at the end of the two-year term as long-term capital gain.963 Because ABC reports gains and losses under § 475 and has fully hedged its obligations under the swap, it will bear no incremental tax on the hedge fund returns because it will deduct the matching payment obligations to X under the swap on a mark-to-market basis as well.964

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962 For a discussion of the  § 475(f) election as applied to hedge funds, see IX, B, above.

963 See § 1234A; but see Prop. Regs. § 1.1234A-1(b) (excluding such payment from definition of “termination payment”).

964 This assumes that ABC's investment in the Volatile fund qualifies as a “security” under § 475(c)(2), which is not entirely clear.  See § 475(c)(2)(B) (treating “partnership ...interest in a widely held or publicly traded partnership” as a security).  Because  § 475(c)(2)(F)(ii) treats a “hedge” with respect to a security as itself a security, the interest in the Volatile fund should qualify as a security even if the Volatile fund is not “widely held” because the interest in the Volatile fund hedges ABC's obligations to X under the swap.  See  § 475(c)(2)(D) (treating equity swap as security).

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U.S. Income Portfolios: Other Pass-through Entities 
  Portfolio 736-1st: Hedge Funds 
  Detailed Analysis 
  XII. Investing in Hedge Fund Derivatives

B. Section 1260 

In response to this sort of transaction, Congress enacted  § 1260 of the Code.965 This subsection of the portfolio describes how  § 1260 would apply to this transaction.
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965 Tax Relief Extension Act of 1999, P.L. 106-170.

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Like § 1259, § 1260 applies to certain derivatives that effect the economic sale of an asset, albeit under much narrower circumstances.  Rather than recast the derivative as a sale for tax purposes, however,  § 1260 respects the form of the transaction but recharacterizes long-term capital gain as ordinary income.  It then levies an interest charge on the deferral.

Unlike § 1259,  § 1260 is likely to apply not when a hedge fund enters into a derivative contract with respect to an appreciated security, but when a would-be investor in a hedge fund invests in a hedge fund derivative instead.  The statute applies to a “constructive ownership transaction” (“COT”)with respect to a “financial asset.”966 A taxpayer enters into a COT with respect to a financial asset if —
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966 § 1260(a).

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• the taxpayer holds a long swap position involving the financial asset;

• the taxpayer enters into a forward or futures contract to acquire the financial asset;

•the taxpayer acquires a call option and writes a put option with “substantially equal” strike prices and “substantially contemporaneous”maturity dates; or

• the taxpayer enters into a transaction with “substantially the same effect”as any of the foregoing transactions, but only to the extent provided in regulations.967

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967 See § 1260(d).

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For this purpose, a “financial asset”includes a partnership interest.968 Indeed, a partnership interest in a hedge fund is the primary target of the legislation:969
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968  See  § 1260(c)(2)(D) (equity interest in “pass-thru entity” includes partnership interest).

969 Staff of Joint Committee on Taxation, 106th Cong., General Explanation of Tax Legislation Enacted in 106th Congress at 49-50 (JCS-2-01, 2001).

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One example of a conversion transaction ...is when a taxpayer enters into an arrangement with a securities dealer whereby the dealer agrees to pay the taxpayer any appreciation with respect to a notional investment in a hedge fund.  In return, the taxpayer agrees to pay the securities dealer any depreciation in the value of the notional investment.  The arrangement lasts for more than one year.  The taxpayer is substantially in the same economic position as if he or she owned the interest in the hedge fund.  However, the taxpayer may treat any appreciation resulting from the contractual arrangement as long-term capital gain.  Moreover, any tax attributable to such gain is deferred until the arrangement is terminated.

In the previous example, therefore,  § 1260 would require X to report the entire $1 million of gain as ordinary income.970 In addition, X will incur an interest charge on the resulting tax at the  § 6621 underpayment rate,971 computed as if X had realized the $1 million of gain over the period of deferral at a constant rate equal to the applicable AFR on the closing date of the COT.972
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970 § 1260(a).

971 See  § 1260(b)(2) (referring to “the amount of interest that would have been imposed under section 6601 on the underpayment of tax”);  § 6601 (cross-reference to § 6621).

972 See § 1260(b)(2).

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Example 12-3: Assume the same facts as in Example 12-2 and that the AFR is 4%.  At a 35% tax rate, X would owe tax under  § 1260 of$350,000 on the $1 million of gain.  For purposes of computing the interest charge, X would be deemed to have realized $490,196 of the gain in 2006 and $509,804 of the gain in 2007.

U.S. Income Portfolios: Other Pass-through Entities 
  Portfolio 736-1st: Hedge Funds 
  Detailed Analysis 
  XII. Investing in Hedge Fund Derivatives

C. Insurance Wrappers 

Another type of hedge fund derivative is a variable life or annuity contract.  In a typical “insurance wrapper”transaction, an individual purchases a variable life or annuity contract from an insurance company and the insurance company invests the proceeds(less any premium) in a hedge fund.  The individual therefore achieves effective ownership of the hedge fund, not directly but as the holder of the variable life or annuity contract.  Under current law, the holder of such a policy will defer tax on the inside build-up so long as the “segregated asset account” that owns the wrapped investment meets the diversification requirements of  § 817 and the holder does not control the choice of investments in the account.

Section 817(h)(1) provides that a variable contract based upon a segregated asset account does not qualify as an annuity unless it is “adequately diversified” in accordance with Treasury regulations.  Under the “look through” rules of prior law, the issuer was entitled to treat a pro rata portion of each asset of the hedge fund as an asset of the segregated asset account.  The statute would therefore respect a variable contract as adequately diversified if the hedge fund itself was adequately diversified.  Because the purpose of  § 817(h) is “to discourage the use of tax-preferred variable annuity and variable life insurance primarily as investment vehicles,”973 however, the statute will still deny deferral if the hedge fund is available to the public for direct investment.  Accordingly, if a policy purports to “wrap” such an investment, the holder will nevertheless bear current tax on the inside build-up even though the investment is “adequately diversified.”
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973 See H.R. Conf. Rep. No. 861 at 1055, 98th Cong., 2d Sess. (1984).

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Hedge fund insurance wrappers usually come in two types:

Fund of funds:a hedge fund available only to insurance company investors that invests in other hedge funds. The portfolio manager, rather than the policyholder, has and regularly exercises the discretion to vary the investment among several sub-funds.  The sub-funds solicit capital from “qualified purchasers” or “accredited investors” under the federal securities laws (“eligible investors”).
  
Clone funds: a hedge fund offered only to insurance companies with investment objectives and strategies that mimic those of a hedge fund managed by the same portfolio manager and available to eligible investors.

Under the old  § 817(h) regulations, a life insurance company was permitted to —

(a) “look through”a hedge fund in applying the diversification rules of § 817(h)974 so long as the partnership limited investment to eligible investors; and
  
(b) disregard the equity of the portfolio manager as an interest available to the public only if the return on such equity was “computed in the same manner as the return on an interest held by a segregated asset account.”975

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974 See Regs.  § 1.817-5(f)(2)(ii) (2003)(applying “look-through” rule to a partnership interest “if the partnership interest is not registered under a Federal or State law regulating the offering or sale of securities”).

975 See Regs.  § 1.817-5(f)(3)(ii) (2003).

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On July 30, 2003, the IRS issued proposed regulations under § 817.976 The proposed regulations struck (a) but not (b), and became final in 2005.977 Although the removal of the “eligible investor” exception drew a great deal of attention,978 it was the retention of (b), which requires the manager to hold a fungible equity interest in the fund, that eliminated the viability of insurance wrappers as alternatives to direct hedge fund investment for most policies.  As described more fully in VI, A, above, a typical carried interest in a hedge fund will convey 20%of the portfolio gains to the general partner as compensation for services.  The carried interest therefore reflects economic terms that materially differ from those of any other interest in the fund. Accordingly, a “wrapped” fund with a carried interest cannot qualify for “look through” treatment under  § 817(h) even if every other investor in the fund is an insurance company.979
——————————————————————————————

976 REG-163974-02, 68 Fed. Reg. 44689 (7/30/03) (revoking Regs. § 1.817-5(f)(2)(ii)).  According to the preamble to the proposed regulations, an eligible investor in a private investment partnership is part of the general public for purposes of § 817(h), even though investment in the entity is exempt from registration under the federal securities laws.  If a hedge fund allows both insurance companies and eligible investors into the fund, therefore, the proposed regulations would deny “look through”treatment to the life insurance company.  According to one commentator, this particular change to the regulations did not alter prevailing industry practice because, even before the proposed regulations, few insurance companies invested in hedge funds that allowed non-insurance company investors.  See Neufeld, “New Guidance on Investor Control Rule: Road Map or Roadblock?,” 100 Tax Notes 1191 (Sept. 1, 2003) (noting that, in the wake of PLR 200244001, “most insurance companies offering insurance wrappers ... required all investments in hedge funds to ... be in insurance dedicated hedge funds”).  Accordingly, all beneficial interests in the fund must be owned by segregated asset accounts, with public access to it available only through the variable contract.

977 T.D. 9185, reprinted in 2005 TNT 39-10.

978 See Neufeld, “New Guidance on Investor Control Rule:Road Map or Roadblock?,” 100 Tax Notes 1191 (Sept. 1, 2003); see also Luke, “Beating the “Wrap”:The Agency Effort to Control Wraparound Insurance Tax Shelters,”25 Va Tax Rev. 129, 174 (2005).

979 Although the portfolio manager could opt to recast the carry as a fee to permit the insurance company investors to “look-through” the fund, most confine these types of fee arrangements to their offshore corporate feeder.  Because the feeder is a PFIC under § 1297, it is not a suitable investment vehicle for the wrapper.  For a discussion of the treatment of offshore feeders and parallel entities as PFICs, see VII, C, 3, above.  For a discussion of the fee alternative as a deferral vehicle for the portfolio manager and its members, see VI, B, above.

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Even if a wrapped investment satisfies the diversification requirements of § 817(h), the IRS may still disregard the form of the transaction when the policyholder retains dominion and control.  For example, if the policyholder retains the right to vote, to direct investment and to otherwise act on behalf of the insurance company investors in the fund, the IRS may assert that the insurance company is acting as an agent of the policyholder.980 Under published rulings, the mere availability of the same fund to the public may suffice to establish tax ownership.981 Many funds that allow life insurance companies to invest therefore prohibit direct investment by individuals.
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980 See Christoffersen v. U.S., 749 F.2d 513 (8th Cir. 1984); Rev. Rul. 81-225, 1981-2 C.B. 13, clarified and amplified by Rev. Rul. 2003-92, 2003-33 I.R.B. 350; Rev. Rul. 80-274, 1980-2 C.B. 27; Rev. Rul. 77-85, 1977-1 C.B. 12.

981 See, e.g., Rev. Rul. 82-54, 1982-1 C.B. 11 (contract holder not treated as owner of mutual fund accounts when, inter alia, mutual funds not available for sale to general public).

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Until relatively recently, it was not entirely clear whether excessive “investor control” provided an independent basis from  § 817(h) for denying annuity treatment to an insurance wrapper.  According to the legislative history, the purpose of  § 817(h) is to deny annuity treatment to “investments that are publicly available to investors and investments which are made, in effect, at the direction of the investor,”982 suggesting statutory preemption of the investor control issue.983 Although the ABA once endorsed this view,984 the IRS has long maintained that investor control remains an independent theoretical basis for denying tax ownership to the life insurance company.985
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982 Staff of the Joint Committee on Taxation, 98th Cong., Sess., General Explanation of the Deficit Reduction Act of 1984 at 608 (Comm. Print 1984).

983 See 546 T.M., Annuities, Life Insurance, and Long-Term Care Insurance Products for a discussion of “investor control” issues with variable annuities generally.

984 See American Bar Association, Section of Taxation, Committee on Insurance Companies, “A Roadmap to the Federal Income Taxation of Non-Qualified Annuity Contracts,” 45 Tax Law. 123 (1991).

985 See 51 Fed. Reg. 32664 (9/15/86) (preamble to proposed regulations stating that future regulations or rulings would provide guidance on this issue).

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In two recent rulings, the IRS confirmed the continuing application of common law principles to treat the policyholder as the owner of the wrapped investment without regard to whether the contract satisfies the  § 817(h) diversification requirements.  In Revenue Ruling 2003-92,986 a separate asset account of an insurance company had 10 sub-accounts, each of which invested in a private investment partnership.  Investment in the partnership was available to investors other than insurance companies and managed by an independent investment manager.  Under the terms of the contract, the policyholder had the right to allocate the premium among the available sub-accounts.  The IRS ruled that the policyholder rather than the insurance company was the owner of the underlying investment.  In contrast, in Revenue Ruling 2003-91,987 the IRS respected the insurance company as the owner of the underlying investment under similar facts because investment in the sub-accounts was available solely through the purchase of an insurance wrapper.  These rulings appear to establish that the IRS will apply common law ownership principles more restrictively for investments in hedge funds that admit non-life insurance company investors.988
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986 2003-33 I.R.B. 350.

987 2003-33 I.R.B. 347.

988 It should be noted, however, that neither ruling addresses the case in which the policyholder surrenders the right to control the allocation of invested amounts among different funds.

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In Rev. Rul. 2007-7,988.1 the IRS amplified Rev. Rul. 2003-92. Under the facts of Rev. Rul. 2007-7, access to segregated asset accounts was available only to variable annuity or life insurance contract holders and to the limited classes of investors specified in Regs. § 1.817-5(f)(3). The IRS concluded that the general public does not include investors under Regs. § 1.817-5(f)(3) for purposes of determining whether the investor has control of the segregated accounts. Therefore, the holder of the variable contract is not treated as the owner of the investment.
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988.1 2007-7 I.R.B. 468.

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U.S. Income Portfolios: Other Pass-through Entities 
  Portfolio 736-1st: Hedge Funds 
  Detailed Analysis 
  XII. Investing in Hedge Fund Derivatives

D. Hedge Funds Disguised as Insurance Companies 

Life insurance companies invest in hedge funds. As holders of large portfolios of investment assets, many seek a degree of economic exposure to alternative asset classes.  As direct issuers of “wrapped” annuities,989 others seek to hedge their obligation to pay a hedge fund return to a policyholder.  Some life insurance companies invest in hedge funds for both reasons.
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989 For a discussion of tax issues with hedge fund “insurance wrappers,” see XII, C, above.

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But suppose a hedge fund is an insurance company.  Investment securities represent the primary asset on the balance sheet of both businesses.  Unlike a hedge fund, however, an insurance company must assume underwriting risk.  As such, it establishes a loss reserve on the balance sheet to reflect the projected liability associated with future claims from policyholders.  To the regulators, the purpose of the investment securities is to fund these projected losses, which is why these securities do not constitute “passive assets” to an insurance company.990 Because a foreign insurance company is not a PFIC, its U.S. shareholders will defer U.S. tax on their allocable share of the reinvested earnings, but without incurring the “excess distribution” penalty under  § 1291 when they sell the shares.991
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990 See § 1297(b)(2)(B) (excluding from definition of passive income any income “derived in the active conduct of an insurance business by a corporation which is predominantly engaged in an insurance business and which would be subject to tax under subchapter L if it were a domestic corporation”).

991 Special anti-deferral rules apply to “controlled foreign corporations” in the insurance business.  A foreign insurance company is a CFC if “U.S. shareholders”own at least 25% (rather than 50%) of the vote or value of the outstanding shares.  See § 957(b) (lower 25% threshold applies to insurance companies). These shareholders are subject to current tax on their allocable share of the CFC's insurance income, whether or not distributed.  See § 952(a)(1) (“insurance income” treated as subpart F income);  § 953(a)(1) (definition of “insurance income”).  Special anti-deferral rules also apply to related person insurance income (“RPII”), which is a separate species of insurance income.  Under these rules, a U.S. person who owns any shares in the CFC must take into account his or her allocable share of the CFC's RPII on a current basis.  See § 953(c)(1)(A) (defining “U.S. shareholder” as United States person who owns “any”stock of foreign corporation).  In general, RPII is insurance income attributable to a policy of insurance or reinsurance with respect to which the insured party is either a U.S. shareholder of the CFC or a related person to such shareholder.  See § 953(c)(2).

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Accordingly, if a foreign hedge fund is able to qualify as an insurance company,992 the investors in the fund will avoid U.S. tax on their allocable share of the fund's reinvested earnings and will report any gain in a later redemption as capital gain.  If the fund itself operates in a low-tax jurisdiction(e.g., Bermuda) and conducts its affairs to avoid the conduct of a U.S. trade or business, it will bear very little tax at the entity level even though it holds substantial passive assets that, net of the underwriting losses, will inure to the U.S. shareholders.993
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992 As described more fully in VII, C, above, the sponsor usually forms the offshore feeder as a foreign corporation for U. S. tax purposes.

993 Absent future regulations,  § 1260 does not apply because stock in a non-PFIC ‘C’ corporation is not a “financial asset.”  See § 1260(c)(1).

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Is this a viable derivative? In the authors'view, it is not.  An insurance company with assets sufficient to fund projected underwriting losses that invests in fixed income and similar securities is an “active” insurance business under § 1297(b)(2).  By definition, however, it is not also a hedge fund — the very constraints that define such a business as insurance preclude the kind of outsize(albeit more volatile) returns that hedge fund investors demand.

So what if the entity assumes less underwriting risk? With less underwriting risk, the entity may invest a larger percentage of the portfolio in riskier positions without jeopardizing the claims of policyholders.  If the returns from those investments outstrip the underwriting losses by a large enough margin, an individual shareholder may realize a risk-adjusted after-tax return in excess of the return available from an otherwise identical hedge fund that offers no prospect for deferral and no prospect for long-term capital gain.

As described in one article in the financial press:

... a U.S. citizen who invests in a foreign insurance company with a big investment portfolio doesn't pay taxes on his share of the annual investment gains as long as the company's investing is considered a by-product of its core insurance business ... The idea is to dial back somewhat on insurance risk, but to still take on enough risk to qualify as an insurance company.994

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994 Lux, “The Great Hedge Fund Reinsurance Tax Game,” Institutional Investor (April 2001) (emphasis added); see also Willoughby, “Dog Day Deals: Max Re Hopes to Keep Insurance Offerings Hot,” Barron's (Aug. 2001) (describing Max Re as resembling “a hedge fund disguised as an insurer”).

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Here, however, the IRS is likely to contend that the entity is overcapitalized.  The original legislative history to  § 1297 provides in relevant part as follows:

This exception from passive income extends only to income derived by insurance companies that are predominantly engaged in the active conduct of an insurance business ... Thus, income derived by entities engaged in the business of providing insurance will be passive income to the extent the entities maintain financial reserves in excess of the reasonable needs of their insurance business.995

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995 Technical and Miscellaneous Revenue Act of 1988, P.L. 100-647 (emphasis added); see also Sheppard, “News Analysis — Hedge Funds in Insurance Wrappers,” 96 Tax Notes 1671 (Sept. 23, 2002).

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The IRS would argue, therefore, that any business plan that envisions the allocation of substantial “excess”assets for hedge fund investment is not the business plan of an insurance company, even if the plan does not imperil the claims of policyholders. Indeed, that an insurance regulator would permit such investments on a large scale may only prove that the fund is overcapitalized. In a market comprised of insurance companies that invest the bulk of their premium and invested capital in investment grade bonds, a putative insurance company that invests in merger arbitrage is perhaps pursuing a separate line of business.

U.S. Income Portfolios: Other Pass-through Entities 
  Portfolio 736-1st: Hedge Funds 
  Detailed Analysis 
  XIII. Tax Shelter Reporting and List Keeping

A. In General 

In 2003, the IRS issued final tax shelter reporting and list maintenance regulations under § § 6011, 6111 and 6112, generally effective for transactions occurring on or after February 28, 2003.  The IRS later amended these regulations to exclude most confidentiality agreements and other arrangements from the “confidentiality filter.”996 The regulations required taxpayers to disclose their participation in “potentially abusive tax shelters”and required “material advisors” to prepare and maintain “lists”of persons participating in such tax shelters.997 They applied to many transactions bearing none of the traditional indicia of a tax shelter, and even to transactions with well-settled tax consequences.
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996 Regs. § § 1.6011-4(b)(3), (e), (h), 301.6112-1(c)(3)(iii);T.D. 9108, 68 Fed. Reg. 75128 (12/30/03).

997 Regs. § § 1.6011-4, 20.6011, 25.6011-4, 31.6011-4, 53.6011-4, 54.6011-4, 56.6011-4, 301.6111-2, 301.6112-1; T.D. 9046, 68 Fed. Reg. 10161 (03/04/03).

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In 2004, the Jobs Act amended  § § 6111 and 6112.998 These amendments replaced the 2003 tax shelter registration rules with new disclosure rules for “reportable transactions.”  They also broadened the list maintenance rules to include lists of advisees and certain other information.  Practitioners who advise hedge funds should consider whether these regulations apply, either to their clients or to themselves in their capacity as “material advisors.”
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998 See American Jobs Creation Act of 2004, P.L. 108-357, effective for transactions with respect to which material aid, assistance, or advice is provided after Oct. 22, 2004.

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The following discussion does not address the specific information gathering and reporting requirements of the regulations, which are beyond the scope of this portfolio.999 Instead, it provides a brief summary of the relevant rules and their likely application in the hedge fund context.
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999 For a discussion of the practical impact of these regulations, see Rosenthal and Falstrom, “Me, A Material Advisor? What Now?,” 98 Tax Notes 1749(Mar. 17, 2003).  For further guidance on the disclosure of reportable transactions by material advisors and the list maintenance rules, see Notice 2004-80, 2004-50 I.R.B. 963, updated by Notice 2005-17, 2005-8 I.R.B. 606, and clarified and modified by Notice 2005-22, 2005-12 I.R.B. 756.

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U.S. Income Portfolios: Other Pass-through Entities 
  Portfolio 736-1st: Hedge Funds 
  Detailed Analysis 
  XIII. Tax Shelter Reporting and List Keeping

B. Disclosure of Reportable Transactions 

Under the regulations, a taxpayer who participates in a “reportable transaction” must file a disclosure statement.1000 For this purpose, a transaction is “reportable”if it falls into any one of five categories:
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1000 Regs. § 1.6011-4(a).

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• Listed Transactions. A “listed transaction” is any transaction that is “substantially similar to” a transaction that the IRS has, by notice, regulation or other guidance, identified as a tax avoidance transaction.1001
  
• Confidential Transactions. A “confidential transaction” is a transaction offered to a taxpayer under “conditions of confidentiality” for which the taxpayer has paid an advisor a minimum fee.  A transaction is offered under conditions of confidentiality if “the advisor who is paid the minimum fee places a limitation on disclosure by the taxpayer of the tax treatment or tax structure of the transaction and the limitation on disclosure protects the confidentiality of that advisor's tax strategies.”1002 The minimum fee is $250,000 for corporate taxpayers and $50,000 for all other taxpayers.  In the case of a partnership or trust, the minimum fee is $250,000 if each partner or beneficiary of the partnership or trust, respectively, is a corporation.1003
  
• Contractually-Protected Transactions.  A transaction is “contractually protected” if the taxpayer or a related party may obtain a refund of fees, in whole or in part, if all or a part of the intended tax consequences are not sustained or if such fees are contingent upon the ultimate realization of tax benefits from the transaction.1004
  
• Loss Transactions.  A “loss transaction”is a transaction that results in a loss of (i) $10 million in a single taxable year ($20 million in any combination of taxable years) to any corporate taxpayer or to any partnership all of the partners of which are corporate taxpayers; or (ii) $2 million in a single year($4 million in any combination of taxable years) to any individual, S corporation, trust or partnership that includes non-corporate partners.1005 A transaction may also be deemed a “loss transaction” if the taxpayer claims a loss of $50,000 in any single taxable year in connection with certain foreign currency transactions.1006
  
• Transactions Involving Short Holding Periods.  A transaction involves a brief asset holding period if the transaction allows a taxpayer to claim a tax credit in excess of $250,000 with respect to an underlying asset that has a holding period of 45 days or less.1007

——————————————————————————————

1001 Regs. § 1.6011-4(b)(2). For a list of published guidance from the IRS on all “listed transactions” as of Oct. 12, 2004, see Notice 2004-67, 2004-41 I.R.B. 600.

1002 Regs. § 1.6011-4(b)(3)(ii).

1003 Regs. § 1.6011-4(b)(3)(iii).

1004 Regs. § 1.6011-4(b)(4). For guidance on transactions with contractual protection, certain excluded transactions, and the disclosure requirements, see Rev. Proc. 2004-65, 2004-50 I.R.B. 965.

1005 Regs. § 1.6011-4(b)(5). For a list of certain types of excluded losses, see Rev. Proc. 2004-66, 2004-50 I.R.B. 966.

1006 Regs. § 1.6011-4(b)(5).

1007 Regs. § 1.6011-4(b)(7). In November 2006, Treasury issued proposed regulations that would amend this category to exclude transactions involving foreign tax credits. See Prop. Regs. § 1.6001-4(b)(7). The IRS determined that, due to changes to § 901, the short holding period category was no longer needed. The final regulations therefore delete this reportable transaction category entirely. See Preamble to T.D. 9350, 72 Fed. Reg. 43146 (8/3/07). The removal of the category is effective for transactions entered into on or after Aug. 3, 2007. Regs. § 1.6011-4(h)(1).

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Note: In November 2006, Treasury issued proposed regulations that would add a new category of reportable transaction called a “transaction of interest” (“TOI”).1008 Those regulations were finalized in August 2007.1009 A transaction of interest is defined as a transaction that is the same as or substantially the same as one of the types of the transactions that the IRS identifies in published guidance.1009.1 A taxpayer is considered to have participated in a transaction of interest if the taxpayer is one of the types or classes of persons identified by the guidance describing the transaction as participants in the transaction.1009.2 The transaction of interest rules apply to transactions entered into on or after November 2, 2006.1009.3
——————————————————————————————

1008 Prop. Regs. § 1.6011-4(b)(6).

1009 Regs. § 1.6011-4(b)(6).

1009.1 Id.

1009.2 Regs. § 1.6011-4(c)(3)(E).

1009.3 Regs. § 1.6011-4(h)(1). This was the date on which the proposed regulations were published in the Federal Register.

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Until the IRS released interim guidance in Notice 2006-6,1010 a “reportable transaction”also included a transaction with a significant book-tax difference.1011 The book-tax trigger applied to any reporting company under the Exchange Act, as well as to any company with gross assets in excess of $250 million.  For such a company, a transaction was deemed to reflect a significant book-tax difference if the amount for tax purposes of any item or items of income, gain, expense, or loss in the transaction differed by more than $10 million on a gross basis from the amount of the corresponding item or items for book purposes.1012 Notice 2006-6 withdrew this rule after the IRS revised Schedule M-3 for corporate taxpayers and released a draft Schedule M-3 for partnerships.  Because Schedule M-3 already requires a taxpayer to disclose book-tax differences, the IRS determined that further disclosure under the tax shelter reporting rules was unnecessary.
——————————————————————————————

1010 2006-5 I.R.B. 1.

1011 Regs. § 1.6011-4(b)(6).

1012 Regs. § 1.6011-4(b)(6).

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Note: In November 2006, Treasury issued proposed regulations that, in accordance with this interim guidance, would exclude transactions with significant book-tax differences from the definition of a reportable transaction.1013 The final regulations, issued in August 2007, conform to the proposed regulations on this point and do not include book-tax difference transactions in the definition of reportable transactions.1013.1 In September 2007, the IRS issued proposed regulations that would add “patented transactions” as reportable transactions.1013.2 This category is aimed at those who patent tax strategies and those who pay a fee to a patent holder to use patented strategies.1013.3
——————————————————————————————

1013 See Preamble to the proposed regulations, 2006-49 I.R.B. 1049 (11/2/06) (“in accordance with the interim guidance provided in Notice 2006-6, 2006-5 I.R.B. 385, these proposed regulations eliminate the transactions with a significant book-tax difference category of reportable transactions ...”).

1013.1 Regs. § 1.6011-4(b). T.D. 9350, 72 Fed. Reg. 43146 (8/3/07).

1013.2 Prop. Regs. § 1.6011-4(b)(7), REG-129916-07, 72 Fed. Reg. 54615 (9/26/07).

1013.3 See Prop. Regs. § 1.6011-4(b)(7)(i).

——————————————————————————————

New penalties apply to a taxpayer or material advisor who fails to comply with these disclosure requirements.  Effective for returns and statements due after October 22, 2004,  § 6707A imposes a penalty on any person who fails to include with any return or statement any information required under  § 6011 with respect to a reportable transaction, whether or not the transaction in fact results in an understatement of tax.  The penalty applies in addition to any accuracy-related penalty under the Code.1014 The amount of the penalty under  § 6707A for failing to disclose a reportable transaction is $10,000 in the case of any natural person and $50,000 in any other case.1015 The penalty increases to $100,000 and$200,000, respectively, for disclosure failures that concern listed transactions.1016
——————————————————————————————

1014 § 6707A(f).

1015 § 6707A(b)(1).

1016 § 6707A(b)(2).

——————————————————————————————

Section 6707A limits the authority of the IRS to rescind or abate these penalties.  First, the IRS has no such authority with respect to a listed transaction.1017 Second, the IRS may rescind or abate any other penalty only if it would “promote compliance with the requirements of this title and effective tax administration.”1018 Even if a rescission satisfies this standard, however, the IRS must place “in the file in the Office of the Commissioner” a legal opinion setting forth the factual and legal basis for the rescission.1019 Third, the IRS must provide Congress with an annual list of any waivers and the reasons therefor.1020 A taxpayer may not appeal the failure of the IRS to rescind a penalty.1021 Finally, a taxpayer subject to periodic Exchange Act reporting must disclose these penalties in its public filings.1022 Because a hedge fund is not subject to Exchange Act reporting,1023 this obligation does not apply to a hedge fund.  Although  § 6707A(c) authorizes the Treasury to issue regulations, the IRS issued Notice 2005-111024 to provide interim guidance.1025
——————————————————————————————

1017 § 6707A(d)(1)(A).

1018 § 6707A(d)(1)(B).

1019 § 6707A(d)(3).

1020 American Jobs Creation Act of 2004, P.L. 108-357, § 811(d); see also Staff of Joint Committee on Taxation, 109th Cong., 1st Sess., General Explanation of Tax Legislation Enacted in 108th Congress (Comm. Print 2005).

1021 § 6707A(d)(2).

1022 § 6707A(e).

1023 For a discussion of the regulatory environment generally applicable to hedge funds, see I, B, above.

1024 2005-7 I.R.B. 493.

1025 For a discussion of compliance with  § 6707A under the interim rules, see 634 T.M., Civil Tax Penalties.

——————————————————————————————

U.S. Income Portfolios: Other Pass-through Entities 
  Portfolio 736-1st: Hedge Funds 
  Detailed Analysis 
  XIII. Tax Shelter Reporting and List Keeping

C. List Maintenance by Material Advisors 

In addition to disclosure, the regulations also require a “material advisor” to prepare and maintain lists of participants and to provide these lists to the IRS upon request. The effect of these rules is to extend the information keeping and reporting regime to attorneys, accountants and other advisors who, although not promoters of or participants in the subject transaction, act as advisors to the participants.  In effect, therefore, the regulations introduce a layer of “redundancy” to the tax shelter reporting regime to facilitate the audit function.1026
——————————————————————————————

1026 See generally Regs. § 301.6112-1(e) (preparation and maintenance of lists by material advisors).

——————————————————————————————

Effective for transactions in which material aid, assistance, or advice is provided after October 22, 2004,1027  § 6111(a) requires each material advisor in a reportable transaction, including a listed transaction, to file an information return that identifies and describes the transaction, including the expected tax benefits.  For this purpose, a “material advisor” is any person: (i) who provides material aid, assistance, or advice about organizing, managing, promoting, selling, implementing, insuring, or carrying out any reportable transaction;and (ii) who directly or indirectly derives gross income of more than$250,000 ($50,000 if substantially all of the tax benefits from the reportable transaction are provided to natural persons), or such other amount as prescribed by Treasury.1028 A person can become a material advisor, however, only by making a “tax statement” to a taxpayer.1029
——————————————————————————————

1027 Sections 6111 and 6112 were amended by the American Jobs Creation Act of 2004, P.L. 108-357.  The American Jobs Creation Act of 2004 eliminated the previous rules under  § 6111 for registration of tax shelters and the related penalties.

1028 Section 6111(c) (as amended by the American Jobs Creation Act of 2004) also authorizes the Secretary to prescribe regulations providing (1) that only one material advisor will be required to file the information return if two or more material advisors would otherwise be required to do so, (2) for exemptions from the new  § 6111 requirements, and (3)such other rules as may be necessary or appropriate to carry out the purposes of § 6111.

1029 See Regs. § 301.6112-1(c)(2)(i).

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Note: In November 2006, Treasury issued proposed regulations that would expand the definition of a “material advisor” to potentially include not only a person who makes a tax statement to a taxpayer, but a person who makes a tax statement to another material advisor.1030 The proposed regulations were finalized in August 2007.1030.1
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1030 Prop. Regs.  § § 301.6111-3(b)(2)(i)(C) and (D).

1030.1 Regs. § 301.6111-3(b)(2)(i)(C) and (D), T.D. 9351, 72 Fed. Reg. 43161 (8/3/07).

——————————————————————————————

Section 6112 also requires each material advisor in a reportable transaction to maintain a list identifying each person to whom the material advisor acted as such in the transaction and to provide any other information required under the regulations.  This obligation applies even if the material advisor is not required to file a return under  § 6111 with respect to the transaction.1031  Section 6112(b)(1) requires the IRS to make any request for list inspection in writing, and permits Treasury by regulation to limit the list maintenance obligation to a single material advisor if two or more such advisors would otherwise be required to maintain such lists.
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1031 § 6112(a).

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The IRS issued interim guidance in Notice 2004-801032 pending the issuance of future regulations. Notice 2004-80 provides that the definition of “reportable transaction” in Regs. § 6011-4(b) will continue to apply, as will existing regulations that address when a transaction is a reportable transaction with respect to a material advisor.  The definition of “material advisor” in Regs. § 301.6112-1(c)(2) will also continue to govern, as will existing regulations under Regs. § 301.6112-1, including the minimum fee thresholds for listed transactions.  Finally, Notice 2004-80 provides special instructions for the filing of Form 8264, Application for Registration of a Tax Shelter, pending future revisions to the form to reflect the statutory amendments.
——————————————————————————————

1032 2004-50 I.R.B. 963.

——————————————————————————————

Notice 2005-221033 modified Notice 2004-80 as follows:
——————————————————————————————

1033 2005-12 I.R.B. 756.

——————————————————————————————

• to clarify that a material advisor must follow the instructions in Notice 2004-80 for completing Form 8264;
  
• to clarify that a material advisor is deemed to exist when (i) the advisor makes a tax statement; (ii) the advisor receives or expects to receive the minimum fees; and (iii) the taxpayer enters into the transaction;

• to clarify that a material advisor will be deemed to have met its filing obligations if it files Form 8264 by the last day of the month following the end of the calendar quarter in which the advisor became a material advisor; and
  
• to provide that a potential material advisor may request a letter ruling on or before the due date of a return under § 6111.1034

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1034 For a fuller discussion of the revised rules, see 798 T.M., Tax Shelters, and 634 T.M., Civil Tax Penalties.

——————————————————————————————

Under regulations issued in 2007, Form 8264 was replaced with Form 8918, Material Advisor Disclosure Statement, for use by material advisors to disclose reportable transactions under the § 6111 rules.1034.1 The regulations are generally applicable to transactions with respect to which a material advisor makes a tax statement after August 2, 2007.1034.2
——————————————————————————————

1034.1 See Regs. § 301.6111-3(d)(1).

1034.2 Regs. § 301.6111-3(i)(1). For transactions of interest, the regulations are effective for transactions after Nov. 1, 2006. Transactions before the effective date of the regulations are governed by Notice 2004-80, as modified by Notice 2005-22. Id.

——————————————————————————————

U.S. Income Portfolios: Other Pass-through Entities 
  Portfolio 736-1st: Hedge Funds 
  Detailed Analysis 
  XIII. Tax Shelter Reporting and List Keeping

D. Application to Hedge Funds 

Depending upon the context, the tax shelter regulations may apply to a fund, to a portfolio manager or general partner of a fund or to a law or accounting firm that advises any of the foregoing.  For purposes of these rules, a fund is a “taxpayer”that “participates” in a reportable transaction even if it is a partnership for tax purposes.1035 The portfolio manager or general partner may be a “material advisor” to the fund or to its investors. Finally, a law or accounting firm may be a “material advisor”to the fund, the portfolio manager or the general partner.
——————————————————————————————

1035 Regs.  § 1.6011-4(c)(1) (“taxpayer”includes any “person” described in § 7701(a)(1)).

——————————————————————————————

1. Hedge Fund Partnership 

As a rule, most hedge funds do not engage in “reportable transactions.”   It is possible, however, that three categories of transactions may trigger a reporting and/or disclosure obligation with respect to a hedge fund or its advisors.

First, certain types of trading strategies, in particular those motivated in substantial part by a desire to achieve a specific albeit legally uncertain tax result, may resemble a listed transaction.1036 Whether it does, however, may not be clear.1037 In certain cases, therefore, a portfolio manager may opt to provide “protective” disclosure merely to avoid the risk of penalties.1038
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1036 See, e.g., Long-Term Capital Holdings v. U.S., 2004-2 USTC ¶  50,351, aff'd, 2005-2 USTC ¶ 50,575 (disallowing loss on transaction involving hedge fund created by two Nobel Prize winning economists; purported new ‘partner’ of fund transferred high basis preferred stock to fund under  § 721 and fund then sold stock and allocated loss to non-contributing partners).

1037 See, e.g., Notice 2002-35, 2001-1 C.B. 992 (treating “transactions that are the same as, or substantially similar to” use of swap to claim current deduction for periodic payments while disregarding accrual of right to receive future payments as “listed transaction”); but see  Notice 2006-16, 2006-9 I.R.B. 538 (swap requiring counterparty to make contingent nonperiodic payment not a “listed transaction” by reason of being “substantially similar to” transaction described in Notice 2002-35 if taxpayer uses “reasonable” amortization method to report income from contingent payment and swap meets certain other conditions).

1038 Regs. § 1.6011-4(f)(2). See also Kosnitzky, “Protective Filings for Hedge Funds After the Jobs Act,” 2005 Tax Notes 215-36 (Oct. 20, 2005) (discussing whether “protective” filing by portfolio manager may precipitate IRS request for identity of investors).

——————————————————————————————

Second, many trades produce losses, some of which will exceed the minimum dollar thresholds.  In the typical case, however, the loss in question will avoid the loss filter as an “angels list” exempted transaction.1039 The exemption most relevant to a hedge fund is a loss attributable to “qualifying basis.”   For this purpose, “qualifying basis” includes basis determined solely by reference to the cash paid to purchase the investment in question.  As a result, a hedge fund that acquires an investment for cash does not become subject to reporting under the loss filter merely because it later disposes of the investment at a loss.
——————————————————————————————

1039 Rev. Proc. 2003-24, 2003-11 I.R.B. 599, modified and superseded by Rev. Proc. 2004-66, 2004-50 I.R.B. 966.

——————————————————————————————

Third, a trade may involve a “brief holding period” if the hedge fund holds the underlying position for no longer than 45 days, provided that the fund realizes the required “tax benefit” from the transaction.1040 The regulations coordinate this particular trigger with § 901(k), which imposes a minimum holding period as a precondition to claiming the foreign tax credit.  Thus, if the trading strategy of the hedge fund complies with § 901(k), it is not a “brief holding period” transaction.1041 The coordination of the reporting rule with the substantive rule is particularly relevant given the expansion of  § 901(k) under the Jobs Act.1042 As amended,  § 901(k) now applies not only to dividend income, but also to other income, including interest income.1043 As a result, the amendments to  § 901(k) should limit the scope of this trigger.
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1040 Regs.  § 1.6011-4(c)(6) (definition of “tax benefit”).

1041 Regs.  § 1.6011-4(b)(7) (third sentence).  Note, however, that the regulation refers only to dividend income.  In view of the amendment to § 901(k), Treasury may need to expand the scope of the regulations.

1042 American Jobs Creation Act of 2004, P.L. 108-357, at § 832.

1043 See Staff of Joint Committee on Taxation, 109th Cong., 1st Sess., General Explanation of Tax Legislation Enacted in 108th Congress (Comm. Print 2005).

——————————————————————————————

Note: In November 2006, Treasury issued proposed regulations that would amend the brief asset holding period category to exclude transactions resulting in a claimed foreign tax credit.1044
——————————————————————————————

1044 See Prop. Regs. § 1.6001-4(b)(7).

——————————————————————————————

2. Hedge Fund Manager 

Whether the tax shelter regulations apply to the portfolio manager will likely depend on whether (i) the portfolio manager is deemed to have made a “tax statement” to a taxpayer with respect to an investment strategy; (ii) the portfolio manager is deemed to have received the minimum fee with respect to such statement; and (iii) the particular trade falls into one of the five “reportable” categories listed above.  Portfolio managers do not routinely provide tax advice to the fund or its investors. They may, however, be deemed to have made a “tax statement,”assuming at least that the relevant PPM includes the typical tax disclosure.1045 Although not entirely free from doubt, this sort of disclosure is unlikely to constitute a “tax statement.”1046 A “tax statement”is a statement that relates to a tax aspect of a transaction “that causes the transaction to be a reportable transaction.”1047 The tax disclosure in a PPM is usually more general in nature, describing reasonably well-settled matters of law concerning the structure of the fund, the tax treatment of its investors, and the likely tax consequences of possible future transactions.  See  Worksheets.
——————————————————————————————

1045 An investor in a hedge fund partnership is generally deemed to “participate” in any reportable transaction to which the hedge fund itself is a party.  See Regs. § 1.6011-4(c)(3) (definition of “participation”).

1046 See letter by John Gaines to the Commissioner dated Feb. 22, 2005, commenting on Notice 2004-80, 2004-50 I.R.B. 963, on behalf of various hedge funds, reprinted in 2005 TNT 47-30; see also Kosnitzky, “Protective Filings for Hedge Funds After the Jobs Act,” 2005 Tax Notes 215-36(Oct. 20, 2005).

1047 Regs.  § 301.6112-1(c)(2)(iii) (emphasis added).

——————————————————————————————

Another issue is whether the tax shelter regulations will treat the portfolio manager as having received the minimum fee from its investors.  For this purpose, the IRS is likely to contend that the portfolio manager received any fee paid by the fund because, although the fund is the payor of the fee as a legal matter, it will have funded the payment with the investors' capital.1048 The definition of “fee,” however, excludes any amount paid to an advisor in its capacity “as a party to the transaction.”1049 Through its participation in the carry, the portfolio manager or its affiliates participate as a party to every single transaction of the fund.
——————————————————————————————

1048 Regs.  § 301.6112-1(c)(3)(iii) (definition of “fee”).

1049 Id.

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3. Law Firms 

Law firms provide substantial legal advice to the portfolio manager of a hedge fund with respect to fund structure and organization, including the use of a pass-through vehicle, the structure of the carry as a partnership allocation or a deferred fee, and so forth.  At the investment stage, however, the role of the law firm tends to diminish.  Because hedge funds generally invest in marketable securities, the execution of a portfolio investment does not require the same degree of law firm involvement as a private equity or venture capital fund investment.  Although a law firm will provide occasional advice to the portfolio manager on the tax treatment of certain types of transactions (e.g., a swap or currency transaction), that sort of advice should not establish the law firm as a “material advisor” within the meaning of the regulations.  As a result, a law firm should not constitute a “material advisor”unless it provides tax advice that specifically relates to an actual transaction or trade that is itself a reportable transaction.1050
——————————————————————————————

1050 If, however, a law firm renders tax advice based on a specific hypothetical transaction that the fund intends to deploy as a “template” for future transactions, it may be a material advisor.

——————————————————————————————

U.S. Income Portfolios: Other Pass-through Entities 
  Portfolio 736-1st: Hedge Funds 
  Working Papers

	
B-101
	
Worksheet 1
	
Single Entity Fund.

B-201
	
Worksheet 2
	
Master-Feeder Fund.

B-301
	
Worksheet 3
	
Fee Deferrals on Capital from Foreign Feeder.

B-401
	
Worksheet 4
	
Sample “Side Pocket” Provision.

B-501
	
Worksheet 5
	
Sample “Mark-to-Market”Definitions of Net Profit/Net Loss.

B-601
	
Worksheet 6
	
Example of Broad Grant to Portfolio Manager in Fund Agreement.

B-701
	
Worksheet 7
	
Sample “Stuffing”Allocations.

B-801
	
Worksheet 8
	
Sample Limitation on Loss Recovery against Incentive Allocation.

B-901
	
Worksheet 9
	
Sample Tax Disclosure for “Onshore” Hedge Fund Feeder.

B-1001
	
Worksheet 10
	
Sample Tax Disclosure for “Offshore” Hedge Fund (PFIC).

B-1101
	
Worksheet 11
	
Sample Withholding Tax Provision of Fund Agreement.

B-1201
	
Worksheet 12
	
Fortress IPO Diagram.

U.S. Income Portfolios: Other Pass-through Entities 
  Portfolio 736-1st: Hedge Funds 
  Working Papers

Worksheet 1 Single Entity Fund 

Single Entity Fund

U.S. Income Portfolios: Other Pass-through Entities 
  Portfolio 736-1st: Hedge Funds 
  Working Papers

Worksheet 2 Master-Feeder Fund 

Master-Feeder Fund

U.S. Income Portfolios: Other Pass-through Entities 
  Portfolio 736-1st: Hedge Funds 
  Working Papers

Worksheet 3 Fee Deferrals on Capital from Foreign Feeder 

Fee Deferrals on Capital from Foreign Feeder

U.S. Income Portfolios: Other Pass-through Entities 
  Portfolio 736-1st: Hedge Funds 
  Working Papers

Worksheet 4 Sample “Side Pocket” Provision 

Section ___. Side Pocket Investments. (a) Except as provided in the next sentence, up to 25 percent (25%) of the Partnership's Net Assets (to be determined at the time of making or classification of each Side Pocket Investment)may be invested in Securities determined by the General Partner in its sole discretion to be illiquid and/or lacking a readily ascertainable market value (“Side Pocket Investments”). A Partner shall only participate in Side Pocket Investments that are made on or after the admission of such Partner to the Partnership, and, unless otherwise provided in this Agreement, each Partner (with the exception of any Limited Partner that has (i) requested a complete withdrawal from its Primary Capital Account or (ii) elected not to participate in Side Pocket Investments pursuant to Section ___) shall participate in all Side Pocket Investments made on or after its admission to the Partnership. Each Partner's Side Pocket Capital Account shall consist of the amount of such Partner's participation, if any, in each Side Pocket Investment made by the Partnership. The Partners' participation amounts in each Side Pocket Investment shall be determined in proportion to the participating Partners' respective Primary Capital Account balances as of the time of the acquisition thereof or at the time of the reclassification of an existing investment as such Side Pocket Investment, as the case may be.

(b) When a Side Pocket Investment is made, the Primary Capital Account of each Partner participating in such Side Pocket Investment shall be debited, and the Side Pocket Capital Account of each such Partner credited, with such Partner's pro rata share of the cost of such Side Pocket Investment. When a Side Pocket Investment is realized, the Primary Capital Account of each Partner participating in such Side Pocket Investment shall be credited, and the Side Pocket Capital Account of each such Partner debited, with such Partner's pro rata share of the realization proceeds with respect to such Side Pocket Investment or of the fair market value thereof, as determined in accordance with this Agreement.  If the Partnership continues to hold the investment that constituted the Side Pocket Investment (or a marketable investment that was exchanged for it), then for purposes of determining and allocating any future profit or loss associated with that investment, the Partnership shall treat such investment as having been purchased in the Primary Capital Account at such time at a purchase price equal to the current fair market value thereof.

(c) The General Partner, in its sole discretion, may identify any additional investment in a Side Pocket Investment as a follow-on investment with respect to such Side Pocket Investment(a “Follow-on Investment”) such that only those Partners who participated initially in the relevant Side Pocket Investment shall participate in the Follow-on Investment, and in such event contributions and allocations with respect to such Follow-on Investment shall be based upon each Partner's initial proportional participation (excluding the participation in such Side Pocket Investment by Partners who have fully withdrawn their Primary Capital Accounts) in the relevant Side Pocket Investment; provided, however, that the General Partner may, in its sole discretion, permit other Limited Partners to participate in such Follow-on Investment.

(d) When the General Partner determines in its sole discretion that an investment held in the Partners' Side Pocket Capital Accounts is no longer illiquid or lacking a readily ascertainable market value or otherwise no longer qualifies as a Side Pocket Investment, that investment may be deemed realized and reallocated to the Partners'Primary Capital Accounts in accordance with Section ___.

(e) With respect to each capital contribution made by a Partner to the Partnership, with the consent of the General Partner, a Partner may make an irrevocable written election not to participate in Side Pocket Investments with respect to such capital contribution and any appreciation or depreciation thereon.

(f) For purposes of allocating Net Profit and Net Loss, the General Partner may adjust the provisions of this Agreement to the extent it deems fair and adequate to take into account the provisions of this Section ___.

U.S. Income Portfolios: Other Pass-through Entities 
  Portfolio 736-1st: Hedge Funds 
  Working Papers

Worksheet 5 Sample “Mark-to-Market” Definitions of Net Profit/Net Loss 

“Net Profits”means, with respect to any Accounting Period, the excess of (i) the aggregate income realized during such Accounting Period from all sources whatsoever (other than from the sale or purchase of Securities), plus(ii) the aggregate Realized Gain during such Accounting Period from the sale or purchase of Securities adjusted to reflect that portion of such aggregate Realized Gain with respect to such Securities which was allocated to a Partner during any prior Accounting Period, plus(iii) the aggregate Unrealized Gain during such Accounting Period in the value of Securities held (long or short) at the end of such Accounting Period adjusted to reflect that portion of such aggregate Unrealized Gain with respect to such Securities which was allocated to a Partner during any prior Accounting Period, over (x) all expenses paid or accrued during such Accounting Period by the Partnership, plus (y) the aggregate Realized Loss during such Accounting Period from the sale or purchase of Securities adjusted to reflect that portion of such aggregate Realized Loss with respect to such Securities which was allocated to a Partner during any prior Accounting Period, plus(z) the aggregate Unrealized Loss during such Accounting Period in the value of Securities held (long or short) at the end of such Accounting Period adjusted to reflect that portion of such aggregate Unrealized Loss with respect to such Securities which was allocated to a Partner during any prior Accounting Period.

“Net Losses”means, with respect to any Accounting Period, the excess of (i) all expenses paid or accrued during such Accounting Period by the Partnership, plus (ii) the aggregate Realized Loss during such Accounting Period from the sale or purchase of Securities adjusted to reflect that portion of such aggregate Realized Loss with respect to such Securities which was allocated to a Partner during any prior Accounting Period, plus(iii) the aggregate Unrealized Loss during such Accounting Period in the value of Securities held (long or short) at the end of such Accounting Period adjusted to reflect that portion of such aggregate Unrealized Loss with respect to such Securities which was allocated to a Partner during any prior Accounting Period over (x) the aggregate income realized during such Accounting Period from all sources whatsoever(other than from the sale or purchase of Securities), plus (y) the aggregate Realized Gain during such Accounting Period from the sale or purchase of Securities adjusted to reflect that portion of such aggregate Realized Gain with respect to such Securities which was allocated to a Partner during any prior Accounting Period, plus (z)the aggregate Unrealized Gain during such Accounting Period in the value of Securities held (long or short) at the end of such Accounting Period adjusted to reflect that portion of such aggregate Unrealized Gain with respect to such Securities which was allocated to a Partner during any prior Accounting Period.

“Realized Gain”means, with respect to any Security, the gain recognized thereon for Federal income tax purposes, reduced by any amount of Unrealized Gain thereon included in Net Profits or Net Losses for any prior Accounting Period and increased by any amount of Unrealized Loss thereon included in Net Profits or Net Losses for any prior Accounting Period.

“Realized Loss”means, with respect to any Security, the loss recognized thereon for Federal income tax purposes, reduced by any Unrealized Loss thereon included in Net Profits or Net Losses for any prior Accounting Period and increased by any Unrealized Gain thereon included in Net Profits or Net Losses for any prior Accounting Period.

“Unrealized Gain”and “Unrealized Loss” means, for each Position that is an Open Transaction as of the last day of an Accounting Period, the unrealized appreciation or depreciation with respect to such Position, determined by comparing the fair market value of such Position as of the close of business on the last day of such Accounting Period with the fair market value of such position at the beginning of such Accounting Period or, if or to the extent such Position was not held by the Partnership at the beginning of such Accounting Period, with the tax basis to the Partnership of such Position (determined without regard to any basis adjustment under § 743 of the Code that is allocated under such Section to any particular Partner).

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Worksheet 6 Example of Broad Grant to Portfolio Manager in Fund Agreement 

Article  ___ 

THE PARTNERSHIP AND ITS BUSINESS 

Section ___. Purposes;Powers.  The purposes of the Partnership are to engage, directly, indirectly with or through one or more Affiliates, or otherwise, in the business of acting, for its own account, as an investor, trader and arbitrageur in Securities.  Subject to applicable provisions of the Securities Exchange Act of 1934, and the rules and regulations promulgated thereunder, the Partnership may engage in any transaction necessary or appropriate to the accomplishment of its purposes, including, without limitation, borrowing money and engaging in margin or short sale transactions.

“Securities”means securities and other business interests of any and all types and descriptions, whether issued by governmental bodies, authorities or agencies thereof or by other issuers, whether listed on securities exchanges or not so listed, publicly or privately held, of every type and nature whatsoever, freely transferable or subject to restrictions on transfer, including without limitation, common and preferred stock, trust certificates, collateralized obligations, debentures, bonds, promissory notes, evidences of indebtedness, warrants, financial and commodities futures, including futures contracts for foreign currencies and on market indexes or other stock indexes, contracts for differences, swaps, other futures and forward contracts, any financial instruments issued by banks, options and subscription rights of, and other participating interests in, corporations, partnerships, joint ventures, proprietorships, and other business entities, bank portfolios (including portfolios of loans), trade credits and receivables, and puts, calls, options, straddles, or privileges on any security or group or index of securities, or markets, derivatives, indexes or other mediums of exchange, and other rights or obligations to purchase, sell or subscribe to any of the foregoing.

U.S. Income Portfolios: Other Pass-through Entities 
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Worksheet 7 Sample “Stuffing” Allocations 

Section ___. Tax Allocations.  Items of Partnership gain or loss recognized for income tax purposes and arising from Securities will be allocated among the Partners in accordance with the methods set forth in § 1.704-3(e)(3) of the regulations promulgated under § 704(c) of the Code. All other items of income, deduction, gain, loss or credit that are recognized for income tax purposes will be allocated among the Partners in accordance with their respective Partnership Percentages as of the beginning of the Period to which such items are attributable. Notwithstanding the foregoing, the General Partner will specially allocate items of gain (or loss) to Partners who withdraw capital during any fiscal year in a manner designed to ensure that each withdrawing Partner is allocated gain (or loss) in an amount equal to the difference between that Partner's Capital Account balance (or portion thereof being withdrawn)at the time of the withdrawal and the tax basis for his or her or its Interest at that time (or proportionate amount thereof); provided, however, that the General Partner may, without the consent of any other Partner, (1) alter the allocation of any item of taxable income, gain, loss, deduction or credit in any specific instance where the General Partner, in its sole discretion, determines such alteration to be necessary or appropriate to avoid a materially inequitable result and/or (2) adopt such other method of allocating tax items as the General Partner determines is necessary or appropriate in order to be consistent with the spirit and intent of the regulations under § § 704(b)and 704(c) of the Code.

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Worksheet 8 Sample Limitation on Loss Recovery against Incentive Allocation 

Section ___. Incentive Allocation. The “Incentive Allocation”with respect to any Limited Partner, as of the end of any Performance Period, means 20% of the amount, if any, by which (i) any Net Profit that would otherwise be allocated to such Limited Partner for such Performance Period exceeds (ii) the balance in such Limited Partner's Net Loss Carryforward Account as of the beginning of such Performance Period (including the Management Fee expense allocated to such Limited Partner for such Performance Period).

Section ___. Net Loss Carryforward Account. The Partnership shall establish for each Limited Partner a memorandum account (“Net Loss Carryforward Account”), the initial balance of which for each such Limited Partner shall be zero.  At the end of each Performance Period, the balance of the Net Loss Carry-forward Account of each Limited Partner shall be (i) increased by the amount of any Net Loss allocated to such Limited Partner for such Performance Period, (ii)decreased (but not below zero) by the amount of any Net Profit allocated to such Limited Partner for such Performance Period, and (iii) increased by the amount of Management Fee expense allocated to such Limited Partner for such Performance Period; provided, that the balance in any Limited Partner's Net Loss Carry-forward Account is subject to reduction upon the occurrence of certain events as provided in the following sentence.  As of any date on which the Capital Account balance of a Limited Partner is reduced as a result of a distribution which is not reinvested or a withdrawal of all or any portion of such Limited Partner's Capital Account, the balance of such Limited Partner's Net Loss Carry-forward Account (including the amount of Management Fee expense allocated to such Limited Partner) that is included in determining the Incentive Allocation chargeable to such Limited Partner shall be reduced (but not below zero), effective as of the beginning of the then-current Performance Period, by an amount equal to (a)such amount multiplied by (b) a fraction the numerator of which is equal to the amount of the distribution which is not reinvested or the withdrawal amount and the denominator of which is equal to such Limited Partner's Capital Account balance immediately before giving effect to such distribution or withdrawal.

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Worksheet 9 Sample Tax Disclosure for “Onshore” Hedge Fund Feeder 

The following discussion is a summary of certain material U.S. federal income tax considerations relevant to the purchase, ownership and disposition of the Units and does not purport to be a complete analysis of all potential tax effects relating to an investment in the Fund.  The discussion is based upon the Internal Revenue Code of 1986, as amended (the “Code”), Treasury regulations promulgated thereunder, published rulings and procedures of the Internal Revenue Service (the “IRS”) and judicial decisions, all as in effect on the date of this Memorandum and all of which are subject to change, possibly with retroactive effect.  The discussion does not address all of the tax consequences that may be relevant to the Fund, the Master Fund or to all categories of Members, some of which may be subject to special tax rules.  No ruling has been or will be sought from the IRS regarding any matter discussed herein.  No assurance can be given that the IRS would not assert, or that a court would not sustain, a position contrary to the discussion set forth below. Moreover, the effect of any applicable state, local or foreign tax laws is not discussed.  Each prospective investor is urged to consult its own tax advisers as to the U.S. federal income tax consequences (as well as the effects of state, local and non-U.S. tax laws) of acquiring, holding and disposing of Units in light of such investor's particular circumstances.

This discussion is limited to Members that hold their Units as capital assets.  This discussion is also limited to Members that are, for U.S. federal income tax purposes, one of the following: (i) an individual who is a citizen or resident of the United States; (ii) a corporation or other entity taxable as a corporation created or organized in or under the laws of the United States or a political subdivision thereof; (iii) an estate, the income of which is subject to U.S. federal income tax regardless of its source; (iv)a trust, if a U.S. court can exercise primary supervision over the administration of the trust and one or more U.S. persons can control all substantial trust decisions, or, if the trust was in existence on August 20, 1996, and has elected to continue to be treated as a U.S. person; or (v) a person whose worldwide income or gain is otherwise subject to U.S. federal income tax on a net income basis.

Tax Status of the Master Fund and the Fund.  It is expected that the Master Fund will be classified as a partnership for U.S. federal income tax purposes.  Consequently, the Fund's income, gains, losses, deductions and credits will depend upon the Fund's allocable share of the corresponding items recognized by the Master Fund.  Thus, any reference to or description of the U.S. federal income tax aspects of the Fund's investment practices and activities, in effect, take into account the investment practices and activities of the Master Fund.  It is expected that the Fund will be classified as a partnership, and not an association taxable as corporation, for U.S. federal income tax purposes.  Consequently, the Fund will not be subject to U.S. federal income tax.  If the Fund or the Master Fund were treated as a corporation for U.S. federal income tax purposes, material adverse consequences for the Members would result.

Taxation of Members on Profits and Losses of the Fund.  Because it is treated as a partnership for U.S. federal income tax purposes, the Fund will not be subject to U.S. federal income tax.  Rather, each Member, in computing its U.S. federal income tax liability, will include its allocable share (as determined under the LLC Agreement) of the Fund's items of income, gain, loss, deduction and expense for the taxable year of the Fund ending within or with the taxable year of the Member.  If the IRS successfully challenged the Fund's allocations of income, gain, loss, deduction and expense as not having “substantial economic effect,”the redetermination of such allocations to a particular Member may be less favorable than the allocations set forth in the LLC Agreement. A Member that redeems its Units during the year will be allocated its share of income, gain, loss, deduction and expense realized by the Fund during the portion of the year preceding the redemption. It is possible that a Member's U.S. federal income tax liability with respect to its allocable share of the Fund's earnings in a particular taxable year could exceed the cash distributions made by the Fund to the Member for that year.

An individual Member's allocable share of the Fund's long-term capital gains—net gain on capital assets held more than one year—is subject to tax at a current maximum rate of 15%.  An individual Member's allocable share of the Fund's short-term capital gains—net gain on capital assets held for one year or less—is subject to tax at the same rates as ordinary income, currently at a maximum rate of 35%.

A Member's allocable share of dividends and interest received by the Fund (through the Master Fund) generally will be taxed as ordinary income.  However, “qualified dividends” received by the Fund (through the Master Fund) may be taxable to Members that are individuals at rates generally applicable to long-term capital gains if certain requirements, including holding period requirements, are satisfied. Very generally, qualified dividends are dividends paid by U.S. corporations and certain qualified foreign corporations.

Tax Basis in Units.  A Member's aggregate adjusted tax basis in its Units is equal to the Member's aggregate capital contributions to the Fund, generally adjusted as follows: (i) increased by the Member's allocable share of the Fund's items of income and gain and the Fund's nonrecourse borrowings (if any); and (ii) decreased by the Member's allocable share of the Fund's items of loss, deduction and expense, the amount of any distribution by the Fund to the Member and any reduction in the Member's allocable share of the Fund's nonrecourse borrowings (if any).

Limitations on the Use of Fund Losses. A Member is allowed to deduct its allocable share of Fund losses(if any), deductions and expense only to the extent of such Member's adjusted tax basis in its Units at the end of the taxable year in which the losses, deductions or credits are incurred.  In addition, a Member that is subject to the “at-risk” limitations(generally, non-corporate taxpayers and certain closely-held corporations)can deduct losses only to the extent of such Member's “at-risk”amount with respect to the Fund at the end of the taxable year in which the losses occur.  A Member's at-risk amount generally is equal to the Member's aggregate capital contributions to the Fund.  To the extent that a Member's allocable share of Fund losses is not allowed because the Member has an insufficient amount at-risk in the Fund, such disallowed losses may be carried over by the Member to subsequent taxable years and will be allowed to the extent of the Member's at-risk amount, if any, in subsequent years.

In addition, a Member generally may only deduct its allocable share of the Fund's net capital loss for any year (if any) to the extent of such Member's net capital gain from sources other than the Fund for that year (subject to an exception for individual Members, who may be able to deduct up to an additional $3,000 of such loss).  Accordingly, the Fund could suffer significant losses and a Member could still be required to pay taxes on its allocable share of the Fund's interest income and other ordinary income.

Passive Activity Loss Rules. The Fund's investment activities generally will not constitute a “passive activity” for purposes of the passive activity loss rules. Therefore, subject to the limitations described herein, a Member generally can deduct from its taxable income its allocable share of Fund losses, deductions and credits.  However, a Member will not be able to offset losses from “passive activities” against its allocable share of Fund income or gain.

Investment Interest Limitation. Individuals and other noncorporate Members will be allowed to deduct interest paid or accrued by the Fund (and the Master Fund as applicable)on its indebtedness (so-called “investment interest”)only to the extent of each such Member's net investment income for the taxable year.  A Member's net investment income generally is the excess, if any, of the Member's investment income from all sources(which is gross income from property held for investment) minus investment expenses from all sources (which are deductions allowed that are directly connected with the production of investment income).  Investment income excludes qualified dividend income (i.e., dividend income eligible to be taxed at long-term capital gains rates) and net capital gain attributable to the disposition of property held for investment(and thus would not include any Fund gains on the sale of its investments), unless the Member elects to pay tax on such qualified dividend income or gain at ordinary income rates.

To the extent that a Member's allocable share of Fund investment interest is not allowed as a deduction because the Member has insufficient net investment income, such disallowed investment interest may be carried over by the Member to subsequent taxable years and will be allowed if and to the extent of the Member's net investment income in subsequent years.  If a Member borrows to finance the purchase of Units, any interest paid or accrued on the borrowing will also be investment interest that is subject to these limitations.  Since the amount of a Member's allocable share of Fund investment interest that is subject to this limitation will depend on the Member's aggregate investment interest and net investment income from all sources for any taxable year, the extent, if any, to which Fund investment interest will be disallowed under this rule will depend on each Member's particular circumstances each year.

Other Limitations on Deductions. A Member that is an individual, estate or trust may deduct so-called “miscellaneous itemized deductions,” which include the advisory fee and certain other expenses of the Fund, only to the extent that such deductions exceed 2% of the Member's adjusted gross income.  The amount of a Member's allocable share of such expenses that is subject to this disallowance rule will depend on the Member's aggregate miscellaneous itemized deductions from all sources and adjusted gross income for any taxable year.  Thus, the extent, if any, to which such expenses will be subject to disallowance will depend on each Member's particular circumstances each year.  Other limitations are also imposed on itemized deductions of high-income individuals.

The Manager may allocate to the Accounts of the Members syndication expenses (i.e., expenditures made in connection with the marketing and issuance of Units, including placement fees) and organization expenses of the Fund, as well as the Fund's allocable share of such expenses incurred by the Master Fund.  Organizational expenses are not currently deductible, but may be amortized by the Fund or the Master Fund, as applicable, ratably over a period of not less than 60 months.  Syndication expenses are neither deductible nor amortizable.

Fund Distributions; Redemptions and Sales of Units.  Distributions by the Fund to a Member with respect to its Units, or in redemption of less than all of such Member's Units, generally will not be taxable to the Member to the extent such distribution does not exceed the Member's aggregate adjusted tax basis in its Units.  Instead, such distributions will reduce, but not below zero, the aggregate adjusted tax basis in the Units held by such Member immediately before the distribution, with any excess being taxable as though it were a gain from a sale or exchange of the Units.  It is possible that a partial redemption made during the taxable year could result in taxable gain to a Member where no gain would otherwise have resulted if the same partial redemption were made at the end of the taxable year.

A Member that sells its Units (a complete redemption of a Member's Units will be treated as a sale for this purpose) will recognize gain or loss measured by the difference between the amount realized on the sale and the Member's adjusted tax basis in the Units sold (as described in “Tax Basis in Units” above).  Such gain or loss generally will be long-term capital gain or loss if the Member held the sold Units for more than one year.  The amount realized will include the Member's allocable share of Master Fund nonrecourse borrowings (as defined for U.S. federal income tax purposes), if any, as well as any proceeds from the sale.

Taxation of the Fund's Investments. Certain of the Fund's investment practices (through the Master Fund)are subject to special and complex U.S. federal income tax provisions that may, among other things, (i) disallow, suspend or otherwise limit the allowance of certain losses or deductions, (ii) convert lower taxed long-term capital gains into higher taxed short-term capital gains or ordinary income, (iii) convert an ordinary loss or a deduction into a capital loss (the deductibility of which is more limited),(iv) cause the Fund to recognize income or gain without a corresponding receipt of cash, (v) adversely affect the timing as to when a purchase or sale of stock or securities is deemed to occur and (vi) adversely alter the characterization of certain Fund investments.  For example, the Fund's investment (through the Master Fund) in so-called “section 1256 contracts,” such as futures contracts, certain options traded on U.S. exchanges and certain foreign currency contracts, that are held by the Fund (through the Master Fund) at the end of its taxable year are required to be marked to their market value, and any unrealized gain or loss on those positions will be included in the Fund's income as if each position had been sold for its fair market value at the end of the taxable year.  The resulting gain or loss on each § 1256 contract is generally characterized as 60% long-term capital gain or loss and 40% short-term capital gain or loss, regardless of the period of time the positions were actually held by the Fund.

The Fund (through the Master Fund) may invest in non-U.S. corporations that could be classified as “passive foreign investment companies,” “controlled foreign corporations”and “foreign personal holding companies” (each as defined for federal income tax purposes).  For federal income tax purposes, these investments may, among other things, cause a Member to recognize taxable income without a corresponding receipt of cash, to incur an interest charge on taxable income that is deemed to have been deferred or to recognize ordinary income that would have otherwise been treated as capital gains.

If the Fund (through the Master Fund) makes an investment or obtains financing denominated in a currency other than the U.S. dollar, then the Fund may recognize gain or loss attributable to fluctuations in such currency relative to the U.S. dollar.  The Fund may also recognize gain or loss on such fluctuations occurring between the time it obtains and disposes of non-U.S. currency, between the time it accrues and collects income denominated in a non-U.S. currency, or between the time it accrues and pays liabilities denominated in a non-U.S. currency.  Such gains or losses generally will be treated as ordinary income or loss.

Non-U.S. Taxes.  Certain dividends and interest received by the Fund (through the Master Fund)from sources outside of the United Sates may be subject to withholding taxes imposed by other countries.  The Fund may also be subject to capital gains taxes in certain other countries where it (through the Master Fund) purchases and sells stocks and securities.  Tax treaties between the United States and other countries may reduce or eliminate such taxes.  Members will be required to include such taxes in their income and generally will be entitled to claim either a credit (subject, however, to various limitations on foreign tax credits) or a deduction(subject to the limitations generally applicable to deductions) for their share of such non-U.S. taxes in computing their federal income taxes.

Alternative Minimum Tax. In certain circumstances, individuals, corporations and other categories of Members may be subject to the alternative minimum tax.  A Member's potential alternative minimum tax liability may be affected by reason of an investment in the Fund.  The extent, if any, to which the alternative minimum tax applies to a Member will depend on such Member's particular circumstances for each taxable year.

Tax Elections.  The Fund does not currently intend to make an election under § 754 of the Code (which election would adjust the Fund's tax basis in its assets in connection with, among other things, a sale of Units).  The Manager has the authority to make all tax elections for the Fund.

Reports to Members.  Each year the Fund will provide a Schedule K-1 to each of the Members, describing such Member's allocable share of Fund's items of income, gain, loss, deduction and expense for the taxable year.

Tax Audits.  An IRS audit of the Fund would be conducted at the Fund level rather than at the Member level.  The Manager would represent the Fund at any such audit as the Fund's so-called “tax matters partner” and has considerable authority to make decisions affecting the tax treatment and procedural rights of the Members.  The Manager may also generally enter into settlement agreements with the IRS that bind Members and consent on behalf of the Fund to extend the statute of limitations for assessing a deficiency with respect to a Fund item.  Successful adjustments by the IRS of Fund items of income, gain, loss, deduction or expense could affect a Member's U.S. federal income tax liability.

Tax Shelter Regulations. As part of its campaign against abusive tax shelter activity, the Treasury Department has recently adopted regulations that may require special tax filings and record retention for numerous transactions that are not conventionally regarded as tax shelters.  Depending upon the nature of transactions effected by the Fund (through the Master Fund), when U.S. Members file their tax returns, they may be required to report the transactions on IRS Form 8886.  The information required on Form 8886 includes the name, address, telephone number and fee paid to all persons who either promoted, solicited or recommended an investment in the Fund to the Member or to whom the Member paid a fee for tax advice regarding the investment.  If an investment in the Fund or the Fund's transactions are “reportable transactions,”a “material adviser” to the transaction is required to maintain records, including investor lists containing identifying information, and to furnish those records to the IRS upon demand. If the Fund effects a transaction that it believes is “reportable,”it will advise the affected Members.  Prospective investors should consult their own tax advisers regarding their filing obligations and any information that should be maintained with respect to an investment in the Fund.

Backup Withholding.  The Fund may be required to withhold, for U.S. federal income tax purposes, a portion of the distributions and redemption proceeds payable to Members that fail to provide the Fund with their correct taxpayer identification number or to make required certifications, or who have been notified by the IRS that they are subject to backup withholding. Certain Members are exempt from backup withholding.  Backup withholding is not an additional tax and any amount withheld may be credited against a Member's U.S. federal income tax liabilities.

State, Local and Non-U.S. Tax Consequences. The Members, as well as the Fund and the Master Fund, may be subject to various state, local and non-U.S. taxes.

YOU ARE URGED TO CONSULT YOUR TAX ADVISER BEFORE DECIDING WHETHER TO INVEST IN THE FUND.

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Worksheet 10 Sample Tax Disclosure for “Offshore” Hedge Fund(PFIC) 

The following discussion is a summary of certain material U.S. federal income tax considerations relevant to the purchase, ownership and disposition of the Participating Shares by U.S. Tax-Exempt Persons (as defined below) and Non-U.S. Shareholders (as defined below)and does not purport to be a complete analysis of all potential tax effects relating to an investment in the Fund.  The discussion is based upon the Internal Revenue Code of 1986, as amended (the “Code”), Treasury regulations promulgated thereunder, published rulings and procedures of the Internal Revenue Service (the “IRS”)and judicial decisions, all as in effect on the date of this Memorandum and all of which are subject to change, possibly with retroactive effect.  The discussion does not address all of the tax consequences that may be relevant to the Fund, the Master Fund or to all categories of participating shareholders, some of which may be subject to special tax rules.  This discussion is limited to participating shareholders that hold their Participating Shares as capital assets.  No ruling has been or will be sought from the IRS regarding any matter discussed herein.  No assurance can be given that the IRS would not assert, or that a court would not sustain, a position contrary to the discussion set forth below.  Moreover, the effect of any applicable state, local or foreign tax laws is not discussed.  Each prospective investor is urged to consult its own tax advisers as to the U.S. federal income tax consequences (as well as the effects of state, local and non-U.S. tax laws) of acquiring, holding and disposing of Participating Shares in light of such investor's particular circumstances.

For purposes of this discussion, a “U.S. Shareholder” means a participating shareholder that is one of the following: (i) an individual who is a citizen or resident of the United States; (ii) a corporation or other entity taxable as a corporation created or organized in or under the laws of the United States or a political subdivision thereof; (iii) an estate, the income of which is subject to U.S. federal income tax regardless of its source; (iv)a trust, if a U.S. court can exercise primary supervision over the administration of the trust and one or more U.S. persons can control all substantial trust decisions, or, if the trust was in existence on August 20, 1996, and has elected to continue to be treated as a U.S. person; or (v) a person whose worldwide income or gain is otherwise subject to U.S. federal income tax on a net income basis.  A “Non-U.S. Shareholder” means any participating shareholder that is not a “U.S. Shareholder.”

Tax Status of the Master Fund and the Fund.  It is expected that the Master Fund will be classified as a partnership for U.S. federal income tax purposes.  Consequently, the Fund's income, gains, losses, deductions and credits will depend upon the Fund's allocable share of the corresponding items recognized by the Master Fund.  The Fund is classified as a corporation for U.S. federal income tax purposes.  Thus, subject to the PFIC rules discussed below, the income, gains, losses, deductions and credits of the Fund will not be passed through to participating shareholders, and all distributions by the Fund to participating shareholders will be treated as dividends, return of capital and/or gains.

Given the nature of the Fund's and the Master Fund's activities, each of the Fund and the Master Fund expects that it will not be engaged in a U.S. trade or business (as determined for U.S. federal income tax purposes).  However, no assurances can be given in this regard.  If, contrary to expectations, the Fund or the Master Fund were treated as being engaged in a U.S. trade or business, then any income attributable or allocable to the Fund that is effectively connected with such U.S. trade or business generally would be subject to U.S. federal income taxation at regular corporate tax rates (and may also be subject to a 30% U.S. branch profits tax), thereby materially adversely affecting the Fund's ability to make distributions to participating shareholders.

Certain dividends and interest received by the Master Fund from sources outside of the United States may be subject to withholding taxes imposed by other countries.  The Master Fund may also be subject to capital gains taxes in certain countries where it purchases and sells stock or securities.  Certain types of periodic income from sources in the United States received by the Master Fund and allocable to the Fund may be subject to U.S. withholding tax at a rate of 30%.

Tax-Exempt Persons.  Participating Shares will be offered to U.S. pension and profit-sharing plans and other organizations that are exempt from U.S. federal income tax on their passive income (each a “U.S. Tax-Exempt Person”). An investment in Participating Shares will not generate unrelated business taxable income or income from debt-financed property for U.S. federal income tax purposes (collectively, “UBTI”)for a U.S. Tax-Exempt Person, provided that such U.S. Tax-Exempt Person does not incur “acquisition indebtedness” (as defined for U.S. federal income tax purposes) with respect to its investment in Participating Shares.

The Fund will be a passive foreign investment company(“PFIC”) for U.S. federal income tax purposes.  U.S. Tax-Exempt Persons, however, generally are not subject to the potentially adverse effects of the PFIC rules.  A U.S. Tax-Exempt Person may not make a “qualified electing fund” (a “QEF”) election with respect to the Fund unless the U.S. Tax-Exempt Person is taxable under the UBTI rules with respect to distributions received from the Fund (which would occur only if a U.S. Tax-Exempt Person financed its investment in Participating Shares with borrowings).  The Fund does not intend to provide the information that a U.S. Tax-Exempt Person would need to make a QEF election.

INVESTMENT IN THE FUND IS NOT SUITABLE FOR U.S. PERSONS OTHER THAN U.S. TAX-EXEMPT PERSONS.  U.S. TAX-EXEMPT PERSONS ARE URGED TO CONSULT THEIR OWN TAX ADVISERS CONCERNING THE TAX CONSEQUENCES OF AN INVESTMENT IN THE FUND.

Non-U.S. Shareholders. A Non-U.S. Shareholder generally will not be subject to U.S. federal income taxation on Fund distributions or on gains recognized on the sale, exchange or redemption of Participating Shares where such Non-U.S. Shareholder's nexus with the United States is solely as a result of an investment in Participating Shares.  However, in the case of a Non-U.S. Shareholder (i) that has an office or fixed place of business in the United States or is otherwise carrying on a U.S. trade or business,(ii) who is an individual present in the United States for 183 days or more in a taxable year or has a “tax home” in the United States for U.S. federal income tax purposes, or (iii) who is a former citizen of the United States, rules different from those described above will apply and such Non-U.S. Shareholder may be subject to U.S. federal income taxation on Fund distributions or on gains recognized on the sale, exchange or redemption of Participating Shares.

Tax Shelter Regulations. As part of its campaign against abusive tax shelter activity, the Treasury Department has recently adopted regulations that may require special tax filings and record retention for numerous transactions that are not conventionally regarded as tax shelters.  Depending upon the nature of transactions effected by the Fund (through the Master Fund), when U.S. Shareholders file their tax returns, they may be required to report the transactions on IRS Form 8886.  The information required on Form 8886 includes the name, address, telephone number and fee paid to all persons who either promoted, solicited or recommended an investment in the Fund to the U.S. Shareholder or to whom the U.S. Shareholder paid a fee for tax advice regarding the investment.  If an investment in the Fund or the Fund's transactions are “reportable transactions,” a “material adviser” to the transaction is required to maintain records, including investor lists containing identifying information, and to furnish those records to the IRS upon demand.  If the Fund effects a transaction that it believes is “reportable,”it will advise the affected U.S. Shareholders.  Prospective investors should consult their own tax advisers regarding their filing obligations and any information that should be maintained with respect to an investment in the Fund.

YOU ARE URGED TO CONSULT YOUR TAX ADVISER BEFORE DECIDING WHETHER TO INVEST IN THE FUND.

U.S. Income Portfolios: Other Pass-through Entities 
  Portfolio 736-1st: Hedge Funds 
  Working Papers

Worksheet 11 Sample Withholding Tax Provision of Fund Agreement 

Section ____ Tax Withholding.

To the extent the Partnership is required by law to withhold or to make tax payments on behalf of or with respect to any Partner (“Tax Advances”), the General Partner may cause the Partnership to withhold those amounts and make those tax payments as so required. All Tax Advances made on behalf of a Partner will, at the option of the General Partner, (i) be promptly paid to the Partnership by the Partner on whose behalf the Tax Advances were made or (ii) reduce any current withdrawal being made by that Partner(or, if no such withdrawal is being made by that Partner, be treated as a distribution to such Partner as of the last day of the Period that includes the date the Tax Advance was remitted by the Partnership to the taxing authorities). Whenever the General Partner selects option(i), from the date ten days after the receipt by the Partner on whose behalf the Tax Advance was made of Notice of the Tax Advance, the Tax Advance will bear interest at the highest rate permitted by law until repaid. Whenever the General Partner selects option (ii), for all other purposes of this Agreement, the Partner on whose behalf the Tax Advance was made will be treated as having received the full amount of the withdrawal, unreduced by the amount of the Tax Advance. Each Partner hereby agrees to indemnify and hold harmless the Partnership and the General Partner from and against any liability with respect to Tax Advances required on behalf of or with respect to that Partner. Each Partner hereby agrees to promptly give the General Partner or the Partnership any true certification or affidavit that the General Partner may request in connection with this Section ___.

U.S. Income Portfolios: Other Pass-through Entities 
  Portfolio 736-1st: Hedge Funds 
  Working Papers

Worksheet 12 Fortress IPO Diagram 

Fortress IPO Diagram

U.S. Income Portfolios: Other Pass-through Entities 
  Portfolio 736-1st: Hedge Funds 
  Bibliography

OFFICIAL 

Statutes: 

Internal Revenue Code: § § 1, 11, 56, 61, 62, 64, 65, 67, 68, 83, 162, 163, 166, 212, 263, 263A, 246, 267, 269, 312, 351, 367, 385, 409A, 446, 448, 451, 461, 465, 469, 475, 511, 512, 513, 514, 581, 702, 703, 704, 705, 706, 707, 708, 721, 722, 731, 732, 734, 743, 751, 752, 754, 755, 761, 851, 864, 865, 860L, 871, 872, 875, 881, 884, 894, 901, 953. 954, 957, 988, 1001, 1045, 1058, 1091, 1092, 1211, 1221, 1233, 1234, 1234A, 1256, 1258, 1259, 1260, 1272, 1273, 1275, 1276, 1277, 1278, 1291, 1292, 1293, 1294, 1295, 1296, 1297, 1298, 1402, 1441, 1442, 1446, 4371, 4372, 6011, 6111, 6112, 6621, 6707A, 7704, 7872.

Regulations: 

See the Treasury Regulations promulgated pursuant to the above cited Internal Revenue Code sections.

Public Laws: 

Technical and Miscellaneous Revenue Act of 1988, P.L. 100-647.

Revenue Reconciliation Act of 1993, P.L. 103-66.

Taxpayer Relief Act of 1997, P.L. 105-34.

IRS Restructuring and Reform Act of 1998, P.L. 105-206.

Tax Relief Extension Act of 1999, P.L. 106-170.

Jobs and Growth Tax Relief Reconciliation Act of 2003, P.L. 108-27.

American Jobs Creation Act of 2004, P.L. 108-357.

Legislative History: 

Staff of the Joint Committee on Taxation, 98th Cong., 2d Sess., General Explanation of the Tax Reform Act of 1976, 1976-3 C.B. 1.

H.R. Rep. No. 432, 98th Cong., 2d Sess.(1984).

H.R. Conf. Rep. No. 861, 98th Cong., 2d Sess. (1984).

S. Rep. No. 369, 98th Cong., 2d Sess.(1984).

Staff of the Joint Committee on Taxation, 98th Cong., 2d Sess., General Explanation of the Deficit Reduction Act of 1984 (Comm. Print 1984).

H.R. Rep. No. 100-391 (1987).

H.R. Conf. Rep. No. 495, 100th Cong. 1st Sess. (1987).

S. Rep. No. 36, 103d Cong., 1st Sess. 234 (1993).

H.R. Rep. No. 111, 103d Cong., 1st Sess.(1993).

H.R. Conf. Rep. No. 103-213 (1993).

H.R. Rep. No. 148, 105th Cong., 1st Sess.(1997).

S. Rep. No. 33, 105th Cong., 1st Sess.(1997).

H.R. Rep. No. 220, 105th Cong., 1st Sess.(1997).

Staff of Joint Committee on Taxation, 105th Cong., 1st Sess., General Explanation of Tax Legislation Enacted in 1997 (Comm. Print 1997).

Staff of Joint Committee on Taxation, 105th Cong., 2d Sess., General Explanation of Tax Legislation Enacted in 1998 (Comm. Print 1998).

Staff of Joint Committee on Taxation, 106th Cong., General Explanation of Tax Legislation Enacted in 106th Congress at 49-50 (JCS-2-01, 2001).

H.R. Rep. No. 548, 108th Cong., 2d Sess.(2004).

H.R. Rep. No. 755, 108th Cong., 2d Sess.(2004).

Staff of Joint Committee on Taxation, 109th Cong., 1st Sess., General Explanation of Tax Legislation Enacted in 108th Congress (Comm. Print 2005).

S. Rep. No. 110-1, 110th Cong., 1st Sess. (2007).

IRS Rulings: 

Notice 2002-35, 2001-1 C.B. 992.

Notice 2004-52, 2004-32 I.R.B. 168.

Notice 2004-67, 2004-41 I.R.B. 600.

Notice 2004-80, 2004-50 I.R.B. 963.

Notice 2005-1, 2005-2 I.R.B. 274.

Notice 2005-17, 2005-8 I.R.B. 606.

Notice 2005-32, 2005-16 I.R.B. 1.

Notice 2005-22, 2005-12 I.R.B. 756.

Notice 2005-43, 2005-24 I.R.B. 1221.

Notice 2006-16, 2006-9 I.R.B. 1.

Rev. Proc. 71-19, 1971-1 C.B. 698.

Rev. Proc. 92-64, 1992-2 C.B. 422.

Rev. Proc. 92-65, 1992-2 C.B. 428.

Rev. Proc. 93-27, 1993-2 C.B. 343.

Rev. Proc. 99-17, 1997-2 C.B. 52.

Rev. Proc. 2001-43, 2001-34 I.R.B. 191.

Rev. Proc. 2003-24, 2003-11 I.R.B. 599, modified and superseded by Rev. Proc. 2004-66, 2004-50 I.R.B. 966.

Rev. Proc. 2004-65, 2004-50 I.R.B. 965.

Rev. Proc.  2004-66, 2004-50 I.R.B. 966.

Rev. Proc. 2006-3, 2006-1 I.R.B. 122.

Rev. Rul. 58-63, 1958-1 C.B. 624.

Rev. Rul. 60-31, 1960-1 C.B. 174.

Rev. Rul. 60–177, 1960-1 C.B. 1.

Rev. Rul. 60-249, 1960-2 C.B. 264.

Rev. Rul. 68-601, 1968-2 C.B. 124.

Rev. Rul. 72-134, 1972-1 C.B. 29.

Rev. Rul. 72-521, 1972-2 C.B. 178.

Rev. Rul. 74-197, 1974-1 C.B. 143.

Rev. Rul. 76-78, 1976-1 C.B. 25.

Rev. Rul. 77-85, 1977-1 C.B. 12.

Rev. Rul. 77-310, 1977-2 C.B. 217.

Rev. Rul. 77-311, 1977-2 C.B. 218.

Rev. Rul. 78-118, 1978-1 C.B. 219.

Rev. Rul. 80-135, 1980-1 C.B. 18.

Rev. Rul. 80-274, 1980-2 C.B. 27.

Rev. Rul. 80-361, 1980-2 C.B. 164.

Rev. Rul. 81-225, 1981-2 C.B. 13.

Rev. Rul. 81-251, 1981-2 C.B. 156.

Rev. Rul. 81-300, 1981-2 C.B. 143.

Rev. Rul. 82-54, 1982-1 C.B. 11.

Rev. Rul. 83-22, 1983-1 C.B. 17.

Rev. Rul. 84-31, 1984-1 C.B. 127.

Rev. Rul. 84-131, 1984-1 C.B. 37.

Rev. Rul. 87-115, 1987-2 C.B. 163.

Rev. Rul. 90-80, 1990-2 C.B. 170.

Rev. Rul. 90-109, 1990-2 C.B. 191.

Rev. Rul. 91-32, 1991-1 C.B. 107.

Rev. Rul. 92-15, 1992-1 C.B. 215.

Rev. Rul. 93-68, 93-2 C.B. 72.

Rev. Rul. 97-39, 97-2 C.B. 62.

Rev. Rul. 2003-7, 2003-5 I.R.B. 363.

Rev. Rul. 2003-91, 2003-33 I.R.B. 347.

Rev. Rul. 2003-92, 2003-33 I.R.B. 350.

Cases: 

Abegg v. Comr., 50 T.C. 145 (1968), aff'd, 429 F.2d 1209 (2d Cir. 1970).

Allied Fidelity Corp. v. Comr., 572 F.2d 1190 (7th Cir. 1978).

Arkansas Best Corp. v. Comr., 485 U.S. 212 (1988).

Baker v. Comr., T.C. Memo 1995-385.

Bank of America v. U.S., 680 F.2d 142 (Ct. Cl. 1982).

Bienfeldt v. Comr., 231 F.3d 1035 (7th Cir. 2000).

Boatner v. Comr., T.C. Memo 1997-379.

Brannen v. Comr., 78 T.C. 471, aff'd, 722 F.2d 695 (11th Cir. 1984).

Caldwell v. Comr., 202 F.2d 112 (2d Cir. 1953).

Campbell v. Comr., T.C. Memo 1990-162, rev'd, 943 F.2d 815 (8th Cir. 1991).

Centel Communications Co. v. Comr., 920 F.2d 1335 (7th Cir. 1990).

Chen v. Comr., T.C. Memo 2004-132.

Chicago &  North Western Railway Company v. Comr., 29 T.C. 989 (1958).

Christoffersen v. U.S., 749 F.2d 513 (8th Cir. 1984).

Cont'l Trading, Inc. v. Comr., 265 F.2d 40 (9th Cir. 1959).

Corn Exchange Bank v. Comr., 37 F.2d 34 (2d Cir. 1930).

Cottage Savings Ass'n v. Comr., 499 U.S. 554 (1991).

Covington v. Comr., 120 F.2d 768(5th Cir. 1941), cert. denied, 315 U.S. 22 (1942).

Diamond v. Comr., 56 T.C. 530(1971), aff'd, 492 F.2d 286 (7th Cir. 1974).

Donroy, Ltd. v. U.S., 301 F.2d 200 (9th Cir. 1962).

Eberhart v. Comr., T.C. Memo 1977-155.

Epmeier v. U.S., 199 F.2d 508 (7th Cir. 1952).

Federal National Mortgage Association v. Comr., 100 T.C. 541 (1993).

Fong v. Comr., T.C. Memo 1984-402.

Fuld v. Comr., 139 F.2d 465 (2d Cir. 1943).

Gillin v. U.S., 423 F.2d 309 (Ct. Cl. 1970).

Goldstein v. Securities and Exchange Commission, 451 F.3d 873 (D.C. Cir. 2006).

Groetzinger v. Comr., 82 T.C. 793 (1984).

Groetzinger v. Comr., 771 F.2d 269 (7th Cir. 1985).

Groetzinger, Comr. v., 480 U.S. 23 (1987).

Hale v. Comr., T.C. Memo 1965-274.

Higgins v. Comr., 312 U.S. 212 (1941).

Imel v. Comr., 61 T.C. 318 (1973).

InverWorld Inc. v. Comr., T.C. Memo 1996-301.

Jack Daniel Distillery v. U.S., 379 F.2d 569 (Ct. Cl. 1967).

Johnston v. Comr., 24 T.C. 920 (1955).

Jones Lumber v. Comr., 404 F.2d 764 (6th Cir. 1968).

Kelly v. Patterson, 331 F.2d 753 (5th Cir. 1964).

Kemon v. Comr., 16 T.C. 1026 (1951).

Kenroy, Inc. v. Comr., T.C. Memo 1984-232.

King v. Comr., 89 T.C. 445 (1987), acq. 1988-2 C.B. 1.

LeGierse, Helvering v., 312 U.S. 531 (1941).

Levin v. U.S., 597 F.2d 760 (Ct. Cl. 1979).

Liang v. Comr., 23 T.C. 1040 (1955).

Liftin v. Comr., 36 T.C. 909 (1961), aff'd, 317 F. 2d 234 (4th Cir. 1963).

Long-Term Capital Holdings v. U.S., 2004-2 USTC ¶  50,351, aff'd, 2005-2 USTC ¶  50,575.

Luna v. Comr., 42 T.C. 1067 (1964).

Mariana Frozen Foods, Inc. v. Comr., 82 T.C. 448 (1983), aff'd, 761 F.2d 1410 (9th Cir. 1985).

Marrin v. Comr., 147 F.3d 147 (2d Cir. 1998).

Mayer v. Comr., T.C. Memo 1994-209.

Milsap v. Comr., 46 T.C. 751 (1966).

Moller v. Comr., 721 F.2d 810 (Fed. Cir. 1983), cert. denied, 467 U.S. 1251 (1984).

Pacheco, U.S. v., 912 F.2d 297 (9th Cir. 1990).

Paoli v. Comr., T.C. Memo 1991-351.

Pasquel v. Comr., 12 T.C.M. 1431 (1953).

Pinchot v. Comr., 113 F.2d 718 (2d Cir 1940).

Pratt v. Comr., 64 T.C. 203 (1975), aff'd in part, rev'd in part, 550 F.2d 1023 (5th Cir. 1977).

Provost v. U.S., 269 U.S. 443 (1926).

Purvis v. Comr., 530 F.2d 1332 (9th Cir. 1976).

Realty Co. v. U.S., 382 F.2d 298 (Ct. Cl. 1967).

St. John v. U.S., 53 AFTR.2d 84-718 (C.D. Ill. 1983).

Siegel v. Comr., 45 T.C. 566 (1966).

Sproull v. Comr., 16 T.C. 244 (1951).

Steffler v. Comr., T.C. Memo 1995-271.

Unger v. Comr., 936 F.2d 1316 (D.C. Cir. 1991).

Whipple v. Comr., 373 U.S. 193 (1963).

Wiesler, Comr. v., 161 F.2d 997 (6th Cir. 1947), cert. denied, 332 U.S. 842 (1947).

Wilson v. Comr., 49 T.C. 406 (1968), rev'd, 412 F.2d 314 (9th Cir. 1969).

Yaeger Est. v. Comr., T.C. Memo 1988-264.

U.S. Income Portfolios: Other Pass-through Entities 
  Portfolio 736-1st: Hedge Funds 
  Bibliography

UNOFFICIAL 

Tax Management Portfolios: 

186 T. M., Financial Instruments: Special Rules.

385 T.M., Deferred Compensation Arrangements.

535 T.M., Time Value of Money:OID and Imputed Interest.

538 T.M., Bad Debts.

543 T.M., The Mark-to-Market Rules of Section 475.

546 T.M., Annuities, Life Insurance, and Long-Term Care Insurance Products.

549 T.M., Passive Loss Rules.

634 T.M., Civil Tax Penalties.

710 T.M., Partnerships —Conceptual Overview.

712 T.M., Partnerships — Taxable Income; Allocation of Distributive Shares; Capital Accounts.

716 T.M., Partnerships —Current and Liquidating Distributions; Death or Retirement of a Partner.

718 T.M., Partnerships —Disposition of Partnership Interests or Partnership Business; Partnership Termination.

730 T.M., S Corporations: Formation and Termination.

735 T.M., Private Equity Funds.

798 T.M., Tax Shelters.

921 T.M., Tax Aspects of Foreign Currency.

923 T.M., PFICs.

Treatises: 

Avi-Yonah, Newman &  Ring, Taxation of Financial Instruments (1999).

Garlock, Federal Income Taxation of Debt Instruments (5th ed. 2005).

Ginsburg &  Levin, Mergers, Acquisitions, and Leveraged Buyouts (2005).

Keyes, Federal Taxation of Financial Instruments and Transactions (1997).

Kramer, Financial Products —Taxation, Regulation and Design (3d ed. 2000).

McKee, Nelson &  Whitmire, Federal Taxation of Partnerships and Partners (3d ed. 1997).

Miller, “An Overview of the Taxation of Credit Derivatives,” (Chapter) in  Fabozzi &  Molay, The Use of Derivatives in Tax Planning (1998);

Peaslee/Nirenberg, Federal Income Taxation of Securitization Transactions (3d ed. 2001).

Willis, Pennell and Postlewaite, Partnership Taxation (6th ed. 1998).

Willis et al., Partnership Taxation (1971).

Periodicals: 

1987 

Bowers &  Albaral, “Planning to Avoid the Cash Basis Limitations Under the New Temp. Regs.,”67 J. Tax'n 204 (Oct.).

1988 

New York Bar State Bar Association Tax Association, “Report on Issues Concerning the Definition of Publicly Traded Partnerships,” reprinted in 88 TNT 130-8(June 15).

1989 

New York State Bar Association Tax Section, “Report on Tax Accounting for Notional Principal Contracts,” reprinted in 89 TNT 211 (Sept. 28).

1991 

American Bar Association, Section of Taxation, “Comments Regarding the Application of Market Discount Rules to Speculative Bonds,” reprinted in 91 TNT 113-28(May 23).

American Bar Association, Section of Taxation, Committee on Insurance Companies, “A Roadmap to the Federal Income Taxation of Non-Qualified Annuity Contracts,”45 Tax Law. 123.

Kleinbard, “Equity Derivative Products:Financial Innovation's Newest Challenge to the Tax System,”69 Tex. L. Rev. 1319.

1992 

New York State Bar Association Tax Section, “Report on Proposed Regulations on Methods of Accounting for Notional Principal Contracts,” reprinted in 54 Tax Notes 1127 (Jan. 15).

Pennell &  Postlewaite, “Adjusting the Basis of Assets in Tiered Partnerships Under IRS’ Questionable new Ruling,” 77 J. Tax'n 4.

Sheppard, “To Withhold or Not To Withhold on Equity Swaps,” reprinted in 92 TNT 133-12(June 29).

Shapiro, “Private Securities Partnership —The Trade or Business Issue Examined,” 56 Tax Notes 85(July 6).

1997 

Blanchard, “Rev. Rul. 91-32: Extrastatutory Attribution of Partnership Activities to Partners,” 1776 Tax Notes 1331 (Sept. 8).

Mullin, “The Impact of the ‘97 Tax Act on Private Investment Funds,” 15 J. Tax'n Investments 91.

Nierenberg &  Kopp, “Credit Derivatives: Tax Treatment of Total Return Swaps, Default Swaps, and Credit Linked Notes,” 87 J. Tax'n 82 (1997).

1998 

Melone, “Distributive Shares and the Varying Interests Rule: Planning Ideas and Open Issues,” J. P'ship Tax'n, Vol. 14, No. 4 (Winter).

New York State Bar Association Tax Section, “Notional Principal Contract Character and Timing Issues,” reprinted in 79 Tax Notes 1303 (June 8).

Reich, “Taxing Foreign Investors'Portfolio Investments: Developments and Discontinuities,” reprinted in 98 TNT 114-71 (June 15).

1999 

Metzger, “Clarifying Tax Issues Will Increase Liquidity of U.S. Capital Markets, Writer Says,”reprinted in 1999 TNT 37-23 (Feb. 25).

New York State Bar Association Tax Section, “Report on Proposed Legislation to Amend The Market Discount Rules of Sections 1276-1278,” reprinted in 1999 TNT 124-36 (June 22).

2000 

Alster, “Shifts of Partnership Capital in the New Service Economy,” Tax Club (Nov. 27).

Cuff, “Basis Adjustments after Distributions of Partnership Assets: The Section 734/755 Regs,”93 J. Tax'n 18 (July).

Schneider, O'Connor, “LLC Capital Shifts: Avoiding Problems When Applying Corporate Principles,”92 J. Tax'n 13 (Jan.).

Weigel, “Private Investment Fund Interests Held by Employees — Campbell, Section 83(b) and Other Considerations,” Tax Forum No. 543 (June 5).

2001 

Baneman, Roger J., “Selected Tax Issues in Equity-Based Compensation for Partnerships and LLCs,” Tax Club (Jan.).

Kalinka, “Rev. Proc. 2001-43 and the Transfer of a Nonvested Partnership Profits Interest,” 79 Taxes 11 (Dec.).

Kleinbard &  Nijenhuis, “Everything I Know About New Financial Products I Learned from DECs,” 517 PLI/Tax 1183.

Mincey et al., “Rev. Proc. 2001-43, Section 83(b), and Unvested Profits Interests — The Final Facet of Diamond?,” 95 J. Tax'n 205 (Oct.).

Sheppard, “Moving Deferred Compensation Offshore,” 92 Tax Notes 1140 (Aug. 27).

2002 

Humphries, “The Way (Securitization)Things Ought To Be,” Tax Forum No. 561 (Nov. 4).

Leblang &  Rosenberg, “Toward an Active Finance Standard for Inbound Lenders,” 31 Tax Mgmt Int'l 131.

Miller, “Distinguishing Risk: The Disparate Tax Treatment of Insurance and Financial Contracts in a Converging Marketplace,” 55 Tax Law. 481 (Winter).

New York State Bar Association Tax Section, “Report on Taxation of Partnership Options and Convertible Securities,”reprinted in 2002 TNT 21-24 (Jan. 29).

Sheppard, “News Analysis —Hedge Funds in Insurance Wrappers,” 96 Tax Notes 1671(Sept. 23).

Scharfstein, “§ 7704 and Publicly(or Non Publicly) Traded Partnerships,” Tax Club (Nov. 17).

2003 

Neufeld, “New Guidance on Investor Control Rule: Road Map or Roadblock?,” 100 Tax Notes 1191(Sept. 1).

New York State Bar Association Tax Section, “Report on Securitization Reform Measures,” 98 Tax Notes 795(Special Supplement Feb. 10).

Rosenthal and Falstrom, “Me, A Material Advisor? What Now?,” 98 Tax Notes 1749(Mar. 17).

Sicular, “Selected Current Effectively Connected Income Issues for Investment Funds,” 56 Tax Law. 719 (Summer).

Schwartz, “How Many Trades Must a Trader Make to Be in the Trading Business?,” 22 Va. Tax Rev. 395.

2004 

Garlock, “The Proposed Notional Principal Contract Regulations: What's Fixed? What's Still Broken?”102 Tax Notes 1515 (Mar. 22).

Kennard, “The Hedge Fund Versus the Mutual Fund,” 57 Tax Law. 133.

Rubinger, “Can FIRPTA Be Avoided with Financial Instruments?” 78 Fla. B. J. 44 (Mar.).

2005 

Dugan, “Big Hedge Funds Feel Right at Home in Greenwich, Conn.,” Wall St. J. (Aug.).

Furci, Lee, Beurrier, “Certain U.S. Tax Considerations for Organizing U.S. Hedge Funds,” 658 PLI/Tax 130.

Garlock, Keinan, Leventhal, Monro, “Proposals Regarding the Taxation of Credit Default Swaps,” 15 J. Tax'n F. Inst. 5.

Gordon, “Concerned Whether a Hedge Fund Will Fail to Qualify For Trader Status? Investors Can Protect Themselves From the Negative Tax Effects,” Journal of Taxation and Regulation of Financial Institutions (Nov./Dec.).

Gross, “Tax Planning for Offshore Hedge Funds — the Potential Benefits of Investing in a PFIC,” J. Tax'n Investments 187.

Kayle, “The Federal Income Tax Treatment of Credit Derivative Transactions,” 658 PLI/Tax 115.

Kosnitzky, “Protective Filings for Hedge Funds After the Jobs Act,” 2005 Tax Notes 215-36(Oct. 20).

Leeds, “When the Exotic Embraces the Mundane: The Total Return Swap Business Expands to Bank Loans,”reprinted in 2005 TNT 69-30 (Apr. 12).

Luke, “Beating the “Wrap”:The Agency Effort to Control Wraparound Insurance Tax Shelters,”25 Va. Tax Rev. 129.

Mahler, “From Simple to Complex, Hedge Funds Gain Ground,” New York Times (Feb.).

Market Notes, “Qualified Matching Service for Hedge Funds Avoids Established Securities Market Designation and Corporate Treatment,” J. Tax'n Investments 343.

New York State Bar Association Tax Section, “Report on Section 409A of the Internal Revenue Code and Internal Revenue Service Notice 2005-1,” 108 Tax Notes 198 (July 11).

New York State Bar Association Tax Section, “Report on Credit Default Swaps,” reprinted in TNT 176-21(Sept. 9).

New York State Bar Association Tax Section, “Report on the Proposed Regulations and Rev. Proc. relating to Partnership Equity Transferred in Connection with the Performance of Services,”109 Tax Notes 1311 (Oct. 26).

New York State Bar Association Tax Section, “Report on Disguised Sales of Partnership Interests Responding to Reg-149519-03,”2005 Tax Notes 78-42 (Apr. 22).

Sheppard, “Massive Giveaway in Partnership Compensatory Options Regs,” 107 Tax Notes 1487(June 20).

Sheppard, “News Analysis —Neither a Dealer Nor a Lender Be, Part 2: Hedge Fund Lending,”reprinted in TNT 157-3 (Aug. 16).

2006 

Mollerus, “Disguised Sales of Partnership Interests and the Proposed Section 707(a)(2)(B) Regulations,” PLI/Partnerships Vol. 7.