Hedge fund management fees: What do they mean for you?

Hedge fund management fees: What do they mean for you?

For many years, tax advantages over separately managed accounts (SMA) are where hedge fund investors benefited from. The difference by suspending all miscellaneous itemized deductions including investment fees are widened by the 2017 Tax Cuts and Job Act (TCJA). Using carried-interest tax breaks, hedge fund investors can limit the negative impact, and SMA investors are out of luck. Qualified business income in which certain hedge fund investors might be eligible for is provided by TCJA a new 20% deduction if they are under income caps for a service business. 

Investors with separately managed accounts are penalized by TCJA

Since an outside manager conducts trading, not the investor, SMA investors cannot claim trader tax status (TTS). Therefore, advisory fees paid are where investment treatment applies. 

All miscellaneous itemized deductions for individuals are being suspended by TCJA beginning in 2018, and it includes expenses and investment fees. An individual may no longer deduct those investment fees for income tax purposes if a manager charges a 2% management fee and a 20% incentive fee. Miscellaneous itemized deductions greater than 2% of AGI was allowed by the IRS before 2018, but for alternative minimum tax (AMT), no deduction was allowed; there was also a limitation of Pease itemized deduction. (In calculating the Net Investment Tax, taxpayers are still entitled to deduct investment fees and expenses for calculating it.)

For example, in 2018 let’s assume that an SMA investor has net capital gains of $110,000. Combining the management fee of $10,000 and incentive fees of $20,000, the total advisory fees are $30,000. The SMA for the investor will be $80,000 as the net cash flow ($100,000 income minus $30,000 fees). Since TCJA suspended the miscellaneous itemized deduction for investment fees and expenses, the SMA investor owes income tax on $110,000. The tax hike might be as high as $12,000 if the individual’s federal and state marginal tax rates are 40%. 

Investment managers in terms of SMAs       

The investment manager reports $30,000 as service business revenues in the previous example. After deducting business expenses from the net income, it will then be subject to ordinary tax rates. 

60/40 rates on Section 1256 contract, or a carried-interest share in long-term capital gains, which have lower rates vs. ordinary income is not eligible for SMA investment managers. Carried interest, a profit allocation of capital gains and portfolio income are received by hedge fund managers as owners of the investment fund. 

Additionally, subject to SE taxes (FICA and Medicare), net income is considered self-employment income if the manager is an LLC filing a partnership tax return. It should have reasonable compensation if the LLC has S-Corp treatment, which is subject to payroll tax (FICA and Medicare).

Tax advantages provided by hedge funds to investors

Investors and investment managers are helped by carried interest. A paid special allocation (“profit allocation”) of capital gains, Section 475 of ordinary income and other income is being paid to the investment manager acting as a partner in the hedge fund rather than charging an incentive fee. 

Hedge fund manages might increase incentive allocations and reduce management fees to improve tax savings for investors. 

Carried interest rules modified by TCJA for managers

To benefit from long-term capital gains allocated through profit allocation (carried interest), hedge fund managers must now hold an underlying position in the fund for three tax years. Regularly, the holding period is one year for long-term capital gains. Carried interest would have unduly penalized investors, but luckily, the Congress did not outright repeal it. Benefits for managers have been trimmed and benefits for investors have been protected because of that rule. Section 1256 contracts with a lower 60/40 (60% for a long-term capital gain, 40% for the short term) don’t relate to the three-year holding period. 

Section 475 and Trader tax status advantages

Deductible business expenses to investors are then allocated if a hedge fund qualifies for TTS, not suspended investment expenses. Since the profit allocation clause might bring tax advantages to the investment managers, there’s a high possibility many hedge funds will still use it. 

Pass-through entities with QBI deduction

Pass-through entities are given by the TCJS a lucrative tax cut. Whichever is lower, the individual may deduct either 20% of their taxable income minus net capital gains, subject to limitations too, or 20% of qualified business income (QBI) from pass-through entities. (Other QBI includes qualified publicly traded partnership PTP income and qualified real estate trust REIT dividends). 

There are several other issues and tax treatment is just one critical element between SMAs vs. hedge funds. 

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