Service Clarified (or Does It?) Available Deductions for Individual
Hedge Fund and Fund of Fund Investors
W. Roderick Gagné
Pepper Hamilton LLP
Philadelphia, Pennsylvania
Leonard Schneidman
Pepper Hamilton LLP
Boston, Massachusetts
On July 3, the Internal Revenue Service (the Service) issued three related releases (Revenue
Ruling 2008-38, Revenue Ruling 2008-39, and Announcement 2008-65) about the availability
and computation of the deduction of interest expense and management fees for U.S. individuals
investing in hedge fund or fund of fund partnerships.
Management Fees. In Revenue Ruling 2008-39, the Service addressed how management fees
incurred by each of the lower tier partnerships (LTPs) and upper tier partnerships (UTPs) are
considered in computing the tax liability of an individual who is a limited partner in the UTP.
Example
LP, an individual, owns a limited partnership interest in UTP. UTP owns limited
partnership interests in several LTPs, which are engaged in the trade or business
of trading in stocks and securities (i.e. the LTPs are “trader” partnerships). UTP’s
activities consist solely of acquiring, holding and disposing of interests in LTPs,
the activities of which (disregarding the activities of the LTPs) do not constitute a
trade or business.
The two critical conclusions contained in the Revenue Ruling are that: (1) the UTP’s
management fee is not an ordinary and necessary business expense deductible by the UTP under
Section 162 of the Internal Revenue Code, but rather is a separately stated item that is passed
through to its partners and deductible by them as an expense incurred for the production of
income under Section 212 of the Internal Revenue Code; and (2) the LTP’s management fee is
deductible as a Section 162 expense and reduces the income passed through the UTP that is
ultimately passed through to its partners. The pass-through of the expense and the limitations on
deductibility are applied at the individual partner level regardless of the fact that the LTPs are
“trader” partnerships. Thus, unfortunately, the activities of the LTPs are not attributed to the
UTP or the limited partners of the UTP.
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Observations
•
Expenses deductible under Section 212 are subject to a 2 percent floor, with the
result that these expenses often are unavailable to individual limited partners of
high net worth.
•
The management fees imposed by an LTP are deductible in computing its taxable
income or loss; the income or loss then passes up to the UTP in its distributive
share. The management fees of the LTP are not subject to the 2 percent floor and
other limitations on itemized deductions, making them fully deductible.
•
In the ruling, the Service appears to acknowledge that at least some funds can
qualify as “trader” partnerships so that their management fees are deductible as a
business expense under Section 162. The ruling, however, gives no guidance as
to what constitutes a “trader” partnership, but merely assumes that conclusion in
reaching its result.
•
Although not dealt with in the ruling, its treatment of UTP management fees
could adversely affect the typical “master-feeder” structure where management
fees are often imposed at the feeder or UTP level. In that case, the rationale of the
ruling could cause the fees to be treated as Section 212 expenses.
Interest. In Revenue Ruling 2008-38, the Service amplified Revenue Ruling 2008-12 regarding
the application of the investment interest limitations for limited partners in hedge funds that have
debt allocable to property held for investment. The Service also promulgated Announcement
2008-65 to clarify the guidance provided in Revenue Ruling 2008-38 regarding the proper
reporting on the Form 1040, “U.S. Individual Income Tax Return.”
In Revenue Ruling 2008-12, the Service determined that a non-corporate limited partner’s
distributive share of partnership interest expense incurred in the partnership’s trade or business
of trading in securities is subject to the limitation on the deduction on investment interest under
Section 163(d) if the limited partner does not materially participate in the trading activity. In the
ruling, the partnership was engaged solely in the trade or business of trading securities for its
own account, not for customers. The partnership borrowed funds to acquire the securities. The
question was whether the interest expense incurred on the indebtedness was subject to the
investment interest limitation under Section 163(d). The Service first analyzed the partnership
rules under Section 702 and 703, which stated, in part, that the partner, in the process of
determining his or her taxable income, is required to take into account separately the partner’s
distributive share of income, gain, loss and deductions and that the character of any such item in
the hands of the partner is determined as if such item were realized directly from the partnership.
Under Section 163, the Service determined that the limited partner’s distributive share of the
interest expense incurred on indebtedness used to acquire securities in the partnership was
incurred in the trading activity of the partnership and, consequently, was investment interest as
described in Section 163(d)(3) and subject to the investment interest limitation of Section
163(d)(1). The Service determined that the limited partner did not materially participate in the
activity since, under Section 469(h)(2), a limited partner, by definition, does not materially
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participate in the enterprise unless such limited partner renders more than 500 hours of services
to the partnership in managing the securities, or has materially participated in the activity for the
three prior years. Virtually all limited partners of a UTP do not have any participation in the
business of either the UTP or the LTP. Consequently, no limited partner will materially
participate in the partnership, and the interest expense of the partnership passed through to the
individual limited partner is subject to the investment interest limitations under Section 163.
Revenue Ruling 2008-38 amplified Revenue Ruling 2008-12 by determining that interest paid or
accrued on indebtedness allocable to property held for investment is a deduction taken into
account in determining an individual’s adjusted gross income. Moreover, the Service further
clarified the treatment of an individual that has both investment interest expense attributable to
(1) indebtedness allocable to property that is held in the conduct of a trade or business, which is
not a passive activity and in which the taxpayer does not materially participate (passive/trade or
business property) and (2) property that produces income that is not passive income under
Section 469(e)(1) (for example, interest dividends and royalties, referred to as “Investment
Property”). The Service ruled that the income attributable to the passive/trade or business
property and the Investment Property must be allocated based on a reasonable method. They
provided the following examples to illustrate the concepts and computations addressed.
Example 1
A partnership that is engaged solely in the trade or business of trading securities for its own
account (e.g., not for customers) has limited partners who do not materially participate in the
activity. The partnership incurs debt in the trade or business of trading securities and incurs
$200 of interest expense, which is allocable to the limited partner. The limited partner’s share of
distributable investment income is $150. The Service determined that the $200 interest expense
may be applied and deducted against the $150 of investment income. The $50 of excess interest
expense was not allowed since it exceeded investment income, which is treated as an investment
interest expense paid in the subsequent calendar year. Moreover, the Service determined that the
interest expense that is allowed is deductible in arriving at the limited partner’s adjusted gross
income under Section 62(a)(1). Thus, the $150 of the limited partner’s distributed share of
interest expense is deductible in arriving at adjusted gross income, and does not constitute an
itemized deduction, which would be subject to further limitations.
Example 2
In addition to the facts set forth in Example 1, in Example 2 the Service stated that the limited
partner had $100 of interest expense allocable to Investment Property. In the second example,
the Service determined that the $300 of total interest expense ($200 from the partnership as
stated in Example 1 plus the limited partner’s $100 in investment interest as provided in
Example 2) needs to be allocated between interest in the trade or business and interest that is
allocated to the Investment Property. The Service held that a reasonable method would be
allocating the investment interest expense based on the proportionate amount of each expense.
Therefore, the Service determined that two-thirds ($200 divided by $300) of the limited partner’s
investment interest expenses was attributable to the trade or business and one-third ($100 divided
by $300) was attributable to the Investment Property. Thus, two-thirds of the investment income
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is allocable to the distributed share of the interest expense and one-third is allocable to the
investment expense of holding the Investment Property. Thus, $100 was taken into account in
arriving at the limited partner’s adjusted gross income while the remaining $50 constitutes a
deduction on Schedule A. The carrying forward of the $150 investment interest expense to the
following year will be allocable in the same manner.
Announcement 2008-65 clarified that the investment interest associated with the passive/trade or
business property should be placed on the partner’s Schedule E, “Supplemental Income and
Loss,” and should be placed on a separate line in Part II, Line 28, column (a), labeled as
“investment interest,” followed by the name of the trading partnership in which the interest
expense was incurred, and the amount should be entered in column (h). The partnership
investment interest expense should not be reported on Schedule A “Itemized Deductions,”
“Itemized Deductions of Form 1040,” “U.S. Individual Income Tax Return,” but the other
investment interest, not passed through from the partnership, will be reported on
Schedule A.
Observations
•
Interest expenses from hedge fund partnerships are subject to the investment
interest limitations under Section 163(d).
•
Although the interest is deductible only to the extent of investment income, it is
an above-the-line deduction, which is matched with the associated income. If the
limited partner had another investment interest expense, not from a partnership,
the investment interest expense would be reported on Schedule A “Itemized
Deductions” subject to certain limitations and restrictions, not on Schedule E
“Supplemental Income and Loss,” which has fewer restrictions.
•
Since the interest expense is not an itemized deduction, and is above-the-line, it
reduces gross income, potentially increasing the limited partner’s ability to take
other itemized deductions that are subject to the 2 percent floor (such as, for
example, the management fees, as discussed above) and the phase-out limitations.
•
The ruling does not address other “reasonable” allocation methods, such as direct
tracing, which may be beneficial in certain instances or detrimental in others.
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