The private investment partnership - investor, trader or dealer?

• Author: Sussman, David A.

How should private investment partnerships be treated? As investors, traders or dealers? The distinction is critical and affects a multitude of issues. This article addresses the tax consequences of investing in U.S. hedge funds and recommends strategies to maximize tax benefits for organizers and investors.

EXECUTIVE SUMMARY

* "Trader" status is most desirables for a private investment partnership (commonly, a hedge fund).

* There are differing tax consequences for an individual who invests in securities directly, or through a mutual or hedge fund.

* Some of the issues affected include the PAL rules, investment interest expense limits, limits on deductibility of expenses, and the wash sale, straddle and mark-to-market rules.

The era of "saving pennies for a rainy day" is long gone. More and more Americans hold more and more of their wealth in the form of securities investments. Such investments may be direct (e.g., stock or bonds) or indirect (e.g., mutual and hedge funds).

The tax consequences of investing differ depending on whether an individual invests in the securities markets directly, or indirectly through a mutual or hedge fund. This article addresses the tax consequences of investing in U.S. hedge funds and recommends strategies to maximize tax benefits for organizers and investors.

Mutual vs. Hedge Funds

Mutual Funds

Mutual funds, which are regulated under the Investment Company Act of 1940 (1940 Act), are corporations that pool money from individual investors. A mutual fund is typically run by professional money managers, who invest the pool in stocks, bonds or other securities. The aim is long-term growth, not capitalizing on short-term market swings. While this article does not discuss the tax treatment of mutual fund investing, Exhibit 1 on p. 614 compares some of the tax con sequences of investing in the stock market directly to investing indirectly through a U.S. mutual fund or hedge fund taxed as a partnership.

Hedge Funds

On the other hand, a "hedge" fund is a private investment vehicle (usually organized as a limited partnership) that seeks above-average returns through active portfolio management, rather than long-term growth. Investors tend to be attracted to hedge funds because of the managers' flexibility and strategies for earning positive remains in all market conditions.

Unlike mutual funds (which are heavily regulated), hedge funds are largely unregulated by Federal securities laws. Hedge-fund interests are generally exempt from the registration requirements of the Securities Act of 1933 (1933 Act) contained in Rule 506 of Regulation D, because they offer interests only to "accredited investors" (including natural persons who have a net worth exceeding $1 million (1)). Additionally, hedge funds are generally exempt from the 1940 Act's registration requirements if the investors are limited or are all "qualified purchasers" (e.g., any natural person who owns not less than $5 million). (2) As a result of this relatively unregulated operating environment, hedge funds can make large bets on volatile positions, thereby resulting in big gains or losses.

Organization: A hedge-fund organizer (usually an investment adviser or money manager) typically forms the fund as a limited partnership or limited liability company (LLC) (which is taxed as a partnership). In a limited partnership, the investors are generally limited partners (LPs); the organizer is the general partner (GP). In an LLC, the investors are non-managing-members; the organizer is the managing-member.

Tax considerations: A host of tax considerations need to be addressed when investing in hedge funds. Critical among these is determining whether the fund is an investor, a trader or a dealer. (3) Such status is important in determining the effect of (1) the passive activity loss (PAL) rules; (2) the investment interest expense limits; (3) the limits on deductibility of fund expenses; (4) withholding on foreign partners; (5) the wash sale, straddle and mark-to-market rules; and (6) entity-level taxes in jurisdictions that tax partnerships and LLCs.

Investors, Traders and Dealers

The demarcation among investors, traders and dealers for tax purposes is comparatively clear and longstanding. Well-settled guidelines (4) provide that an investor is any taxpayer that purchases and sells securities for its own account with the principal purpose of realizing investment income in the form of interest, dividends and gains from appreciation in value over a relatively long period of time (generally, one or more years). Most taxpayers who invest in securities are "investors"

A "trader" is an investor whose investment activity is so frequent that it rises to the level of a trade or business. Generally, a trader is not interested in long-term appreciation and is not investing for the dividend or interest that accompany stock ownership; rather, a trader seeks profit on short-term market swings. A "dealer" is a taxpayer that undertakes securities transactions on behalf of customers.

PAL Rules

To the extent losses from passive trade of business activities exceed the income therefrom, Sec. 469 provides that such losses may not be deducted against active income. The excess losses are suspended under Sec. 469(g) until the taxpayer disposes of the activity that generated the losses of, under Sec. 469(b), until he or she generates additional passive activity income.

Definition

Sec. 469(c)(1) defines a passive activity as any activity that involves the conduct of a trade or business in which the taxpayer does not "material]y participate." Generally, under Sec. 469(h)(2), an LP interest in a limited partnership is not material participation. Because an investor partnership is not, by definition, engaged in a trade of business, its losses are not subject to the PAL limits, regardless of...