Is the Tax Code unfair to hedge fund investors?

Much of the election-year criticism of hedge funds misses the point when it focuses on the claim that hedge fund operators get unfair tax breaks, experts say.

There is abuse in the current Tax Code when it comes to hedge funds, but it affects the investors, according to Alan Dlugash, a tax partner at New York-based CPA and business advisory firm Marks Paneth & Shron. They’re often subjected to taxes that wipe out nearly all — or more than all — of the income that they made from the fund, he observed.

“Hedge funds are not really tax-advantaged, they’re tax-disadvantaged,” he said. “Interestingly, investors, and even hedge fund operators, are generally unaware of this abusive dimension of the current Tax Code — at least until they take a close look at their tax return.”

The reason for the excessive taxes that many hedge fund investors must pay is the fact that the Tax Code doesn’t allow them to directly deduct fees or other operating expenses incurred in many hedge fund investments. The code requires that those expenses be claimed only as miscellaneous deductions, and those deductions can’t be used unless and until they reach 2 percent of the taxpayer’s entire income. And even if it gets over this hurdle, the Alternative Minimum Tax usually wipes out any remaining benefit. Accordingly, most taxpayers don’t get to benefit from those miscellaneous deductions.

“If you have an account with Merrill Lynch and they charge you an investment management fee, you would think that it’s deductible and will save you some tax, but because of the type of deduction, it is not likely,” Dlugash explained.

“Congress changed the law 20 years ago, and as a result, the vast majority of investors will not get the deduction,” he said. “If you make $100,000, the first $2,000 doesn’t count, and on top of that it’s not deductible for AMT purposes.”

Many believe that the code is unfair in this way.

“The code severely limits the ability of hedge fund investors to deduct expenses that are necessary to earn income — investment fees and expenses, accountants’ fees, and legal fees, for example,” Dlugash said.

The concept of deducting expenses incurred to earn income actually represents the most important tax deduction to make the code fair and equitable. “It shouldn’t be treated as a loophole-type of deduction subject to limitations and the AMT,” he said.

“From a purist’s point of view, what should be taxed is income less the expenses incurred to earn that income. Mortgage interest, charitable contributions, real property tax and all the rest are all important and politically loved, but there’s no logical reason they’re in the code other than political and social engineering,” said Dlugash. “They have nothing to do with a fair tax system, which deducts the cost of earning income against the income. The whole concept of miscellaneous itemized deductions has made second-class citizens of a class of investors — people who end up paying tax on income they never get.”

BACK AT THE FUND ...

Of course, hedge funds can be structured in a multitude of ways that take into consideration different tax consequences, noted Selva Ozelli, a New York-based international tax attorney and CPA.

“For example, some U.S. investors make investments in hedge funds through a variable annuity contract, where the income tax is deferred during the duration of the contract,” she explained. “Another option could be a foreign hedge fund that elects to be treated as a qualified foreign corporation for U.S. tax purposes. In these cases, the investor would get qualified dividend income taxed at the same rates that apply to net capital gain.”

A growing resentment of hedge fund managers is based on the capital gains treatment that they receive for their share of the profits of the partnership, observed Martin B. Tittle, a Washington-based tax attorney.

“Most hedge funds are organized as partnerships, so that the income and expenses flow through to the partners. The general partners are usually compensated in two ways,” he explained. “First, if they place capital of their own in the fund, they share in the fund’s earnings in proportion to the capital they’ve invested. Second, they usually receive 2 percent of the fund’s assets each year as a management fee, and 20 percent of the fund’s earnings as a profits interest.”

It’s the 20 percent profits interest that has been coined “carried interest,” and is under attack, said Tittle. “Under current tax rules, it’s usually characterized as a capital gain,” he said. “That concerns some people, because carried interest can be viewed as compensation for the services performed by the general partners in managing the fund.”

A change in capital gains treatment for hedge fund managers’ carried interest is seen as a potential revenue raiser in current proposals before Congress.

Several bills, including one introduced by Ways and Means Committee Chair Rep. Charles Rangel, D-N.Y., in November 2007, contain a new Code Section 710. The proposed section contains an income re-characterization rule that would treat income received by partners for performing investment management services as ordinary income received for the performance of services.

Dlugash objects to the proposal. “It’s unreasonable to claim that hedge fund operators get an unfair tax break,” he said. “The reality is that part of their income is, in fact, from capital gains, so it should be treated that way. The complaint is invalid — it represents an argument that one can only make by distorting the true nature of the gain. The best remedy is to just do nothing. The system works fine the way it is.”