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The Internal Revenue Service has issued a ruling regarding the federal income tax treatment of management fees paid by an investment partnership that invests in other partnerships (Revenue Ruling 2008-39).
Under the facts of the recent ruling, the “upper tier” partnership’s activities were limited to acquiring, holding and disposing of interests in “lower tier” partnerships. The lower tier partnerships were engaged in the trade or business of trading in securities. Management fees were payable by both upper tier and lower tier partnerships. This investment structure would describe a typical fund of hedge funds.
The ruling holds that management fees paid by the upper tier partnership are deductible only as investment expenses under Section 212 of the Internal Revenue Code of 1986 (the Code), and are not trade or business expenses deductible under Section 162 of the Code. The IRS reasoned that the management fee paid by the upper tier partnership must be characterized solely by reference to that partnership’s own “investment” activities, since the upper tier management fee is not paid on behalf of any lower tier partnership.
As a consequence of this ruling, an individual partner of the upper tier partnership will be able to deduct his or her share of the upper tier management fees only to the extent that such fees, together with the partner’s other miscellaneous expenses, exceed two percent of the partner’s adjusted gross income. In addition, if the partner is subject to alternative minimum tax, the management fees are not deductible at all in computing alternative minimum tax.
In contrast, the ruling holds that management fees payable by the lower tier partnership are trade or business expenses under Section 162 of the Code that are not subject to the above limitations on deductibility. Such fees are deductible in determining the taxable income of the lower tier partnership that is reported to the upper tier partnership and by the upper tier partnership to its partners.
Thus, the upper tier partnership is effectively treated as being in a trade or business with respect to the management fees and other expenses that flow through (as part of taxable income or loss) from the lower tier partnership, even though the upper tier partnership is not in a trade or business for purposes of characterizing its own direct fees and expenses. Note that the ruling assumes that the lower tier partnership’s securities activities constitute a trade or business for tax purposes. Whether a particular hedge fund or other investment entity is engaged in a trade or business is a question of fact.
It is unclear how the IRS ruling will be applied to investment structures other than funds of funds. For example, many hedge funds are structured using feeder funds and other holding entities that do not directly conduct securities trading activity. Many of these entities would be “upper tier” partnerships under the ruling, with the consequence that individual investors’ shares of any fees or other expenses at the level of these entities could be subject to limited deductibility.
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