Managing a Hedge Fund’s U.S. Tax Obligations

There are two key questions for an investment manager to consider at the outset: are the assets or investments U.S. sourced, or are services rendered from the U.S.? And are my investors U.S. taxpayers? If the answer to either question is yes, you may have a U.S. tax return filing requirement, a withholding requirement, or in the least an obligation to furnish your investors with informational statements that they can use for their own U.S. tax filings.

Generally, if the income a business is generating is connected to U.S. sources, then there will be a U.S. tax filing obligation. To begin, an Employee Identification Number (“EIN”) will be required. An EIN is a 9-digit number (for example, 12-3456789) assigned to employers, sole proprietors, corporations, partnerships, estates, trusts, certain individuals and other entities for tax filing and reporting purposes. Thanks to improvements in automation at the IRS, this process has become a relatively straightforward process for applicants who already have a valid U.S. taxpayer identification number (TIN), for example SSN, ITIN and EIN, as they should be able to apply online. For those without a TIN, however, the task becomes more complicated and time-consuming as a form SS4 needs to be completed and sent to the IRS (a process that can take up to 6 weeks). The use of a tax professional to assist in that process may help to facilitate obtaining an EIN.

After applying and obtaining an EIN, funds often need to determine their entity form for U.S. tax purposes. This is accomplished through the filing of a Form 8832 (Entity Classification Election). There are three different types of classifications: corporation, partnership, and disregarded entity separate from its owner. Each entity has a default classification based on the number of owners and their respective liability, and whether your entity is U.S. or non U.S. Each designation has a direct effect on which annual U.S. tax forms a fund will be required to file. To complicate matters, there are also default rules for how entities are treated for U.S. tax purposes. In fact, as a protective measure, some managers may wish to make an entity classification election regardless of the default classification to prevent any possibility of being tripped into an unintended designation. Keep in mind, it is extremely important to ensure your entity is properly classified in the eyes of the IRS at inception. If done incorrectly, or if the deadline for making the classification election passes, the tax consequences can be disastrous to the fund and its investors.

Assuming both the EIN is obtained and Form 8832 timely filed, there are additional filings that may be necessary depending on the entity classification with the IRS, how the fund is structured, and the type of investors (i.e. U.S. taxable or U.S. non-taxable). Generally, fund entities with U.S. sourced income and more than one partner that have elected ‘partnership’ status are required to file Form 1065 (U.S. Return of Partnership Income). Those with U.S sourced income and more than one owner that have elected ‘corporate’ status are required to file Form 1120 (U.S. Corporation Income Tax Return). Disregarded entities do not usually have a U.S. Federal tax return filing requirement, but this does not preclude the owners/investors of these entities from having their own personal filing requirements.

Finally, all fund managers should be aware of, and compliant with, the provisions of the Foreign Account Tax Compliance Act (FATCA). FATCA generally requires that foreign financial institutions and certain other non-financial foreign entities (e.g. Cayman funds) report on the foreign assets held by their U.S. account holders or be subject to withholding on withholdable payments.

While the filing and election obligations for funds are myriad, with an appropriate adviser and an eye toward deadlines, they can be straightforward. Note that the preceding is not meant as legal advice and we strongly recommend consulting your tax adviser when considering your tax obligations.