- March 17, 2017
- Posted by: Vincent Sarullo
- Category: Analysis, Hedge Funds
Investors in U.S share in the profits and losses of investment funds in proportion to their relative ownership of the fund. In most cases, the fund is a limited partnership or limited liability company where the characteristics of the fund’s activities flow through to the individual investors for US tax purposes. So, the investors are allocated the dividends, interest, short-term gains/losses, long-term gains/losses, unrealized gains/losses, fund expenses and any other tax-categorized activity which they in turn will report on their personal tax returns.
During the year, investors share in the fund’s performance based on their percentage ownership of the fund. This percentage is determined by comparing an individual investor’s capital balance to the total capital of all the investors in the fund. This methodology is referred as “economic allocations.” The basis for allocating the individual components of this performance for tax purposes is not so straightforward.
Tax basis allocations are done based on an investor’s “tax capital account,” which is different than the capital account reported to them as their monthly NAV. Whoever is preparing your fund’s tax return will have to calculate and track each investor’s tax capital account from year to year to effectively allocate tax items to the investors. This is reported on the investor’s Form K-1 at the end of the year.
Both capital account types start out as the same, the amount of capital contributed to the fund by the investor. From that point on, the basis can change materially. The economic basis capital account is a simple calculation compared to the tax basis. The differences between the two capital accounts, on a simplistic level, comes down to the unrealized gains/losses on securities in the fund and timing differences for tax recognition.
Before I get into an example of how specific items are allocated to investors for tax purposes, I want to share a bit of insight with you. Investors don’t focus much on their monthly NAV statements (unless there is a huge drop), and they rarely even open the annual audited financials, but they dig into every number on their K-1! Depending on how much you communicate to your investors during the year on what is happening in the fund from a tax perspective, you can get calls from some very unhappy investors.
On several occasions, I have seen a fund’s strategy generate a large amount of short-term realized gains from high levels of trading during the year, and then during the latter part of the year the market declined significantly and the fund did not make as many trades, but the positions held at year-end had large unrealized losses. There was a decline in the value of the investors’ capital account for the year, which doesn’t make anyone happy. Then to add insult to injury, the investors got a K-1 with large amounts of short-term capital gains listed, which they had to pick up on their tax return and pay taxes on!
There is a multi-step process for allocating items among investors for tax purposes. Similar to economic allocations, tax allocations should be done on a monthly basis. The theory behind this is that the tax results during any given point of the year would be allocated among investors based on the same ratios, unless those ratios changed due to a new investor coming into the fund or an investor removing capital.
To start our tax allocation example, we begin with the investor’s capital contributed. For ordinary income or expense items for tax purposes such as dividends, interest, and expenses, these items are first allocated to all investors based on their economic capital account balance ratio. Now comes the fun part. We allocate the ordinary tax items to the starting tax basis amount and we compare that balance to the investor’s economic capital account balance. The difference between the two is what we call the disparity amount. The remaining tax items of long-term capital gains, short-term capital gains, long-term capital losses and short-term capital loses are then ready to be allocated. I specifically listed each long-term and short-term gain or loss category because each is allocated separately. The realized capital gains and losses are allocated individually based on the investor’s disparity amounts. The ultimate goal, which will eventually be achieved when the fund closes, is to have each investor’s disparity amount go to zero. Since the disparity amount is made up of timing items and unrealized gains/losses, these all would have reversed at the end of the fund to become realized.