Memo to Hedge Fund Managers – Tax Efficiency Counts

Frank Boutillette, the creator and author of this blog, is extremely busy this time of the year auditing broker-dealers and registered investment advisors.  As one of his tax partners, I am not sure what this auditing stuff entails, but Frank tells me it is exciting and fulfilling.  Can’t be as exciting as tax planning but, hey, whatever turns you on!

Since I cannot do my tax thing until Frank finishes his thing, I volunteered to write Frank’s blog for the month of February.  Never heard Frank say yes so fast!  I feel like Joan Rivers substituting for Johnny Carson.

So what should I do for my opening act?  I am going to use my 15 minutes of fame to criticize hedge fund managers for ignoring the tax effects of their transactions to their investors.  By ignoring the tax effects, they make investors’ tax accountants work harder and create more stress.  So, on behalf of all tax accountants, I am airing my gripe!

Here is an example… On October 10, 2012 (everyone knows the final due date for individuals to file income tax returns is October 15th), a hedge fund investor called me to make it clear that not only was I an incompetent CPA but that I probably failed second grade math.  The problem was that the investor was told that his hedge fund investment had a 10% return for 2012.  In his mind, he earned $500,000.  However, after reviewing his tax return, I reported to the government that he earned $750,000 from this investment for 2012.  Obviously, I enjoyed throwing his money away.

I explained that yes, the market value of his hedge fund increased by 10%.

However:

  1. The Fund realized significant gains in the early portion of the year and then invested the proceeds into a new investment which dropped in value during the balance of the year.
  2. These gains were almost all short term since the fund does not “buy and hold.”
  3. The Fund did not realize losses at the end of the year to offset the gains realized earlier in the year.  The fund does not “harvest losses.”
  4. Other than capital gains, most of the income was interest income, not dividends qualifying for the lower rate.
  5. The management fee paid by the fund and other fund expenses was not deductible because the investor was under AMT.

So, while the Fund informs its investors that it earned 10% by comparing the beginning market value to the end of the year market value, for tax purposes the tax basis was much higher and taxed at a higher rate.  The effect of all this?  The investor paid about $260,000 of Federal income tax on the tax basis income reported by the fund.  The net after-tax earnings for 2011 was not 10% but approximately 4.8%.  I continued to explain that the tax bite in prior years may have been much smaller because tax basis income was less than the “book income,” so you have to look at return on the investment for the full period of the investment.  However, my client stopped listening once I told him the current tax bill.

Hedge fund managers, please do a tax accountant a good deed, and disclose estimated after tax return on investments.  It will certainly help me sleep better in October.

 

Bob Demmett

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3 replies

  1. Great tax info and well written – made it interesting to read. However, I would have liked to know who wrote it and no name is mentioned (unless I missed it). Who are you?

  2. Bob – on behalf of tax accountants across the country – THANK YOU! Now if we can only get the hedge fund guys to report the income in the right boxes on the K1 we will be all set!

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