Each year our firm prepares thousands of K-1’s for hedge fund investors. And each year we are inundated with questions on why the K-1 allocation figures do not agree to the amounts on the year-end account statements. There are several aspects of hedge funds that can lead to this confusion, two of the most prevalent and defining facets common to Wipfli’s hedge funds include 1) the effects of having investments in numerous marketable securities and 2) that these funds are open ended - allowing partners to invest and redeem capital periodically throughout the year.
A fund’s investments in marketable securities give rise to unrealized gains and losses that are not recognized for tax purposes. Although gains and losses due to changes in security values are required to be recorded by GAAP, there is no taxable event until the securities are sold or liquidated. This variation in treatment, combined with the fact that funds may be buying and selling securities throughout the year while at the same time investors are putting money in and redeeming throughout the year, can result in tax allocations that vary significantly from the expectations of the investor.
Over the years, an industry standard has evolved to ensure that allocations are done in a way that is consistent with governing tax laws. One critical component of the law directing partnership tax treatment is that allocations are consistent with the economic arrangement. For instance, if a partner is allocated the gain or loss for book purposes, that same partner should be allocated the gain or loss for tax purposes as well. It’s easy to understand why the IRS would not accept a tax gain that is being distributed among all the partners of the fund for book purposes, to then be collectively allocated to only one tax exempt partner on the partnership’s return.
Another IRS mandate when performing partnership allocations is to minimize disparity. Disparity refers to the difference between the gains and losses that a partner has recognized for book purposes and the gains and losses that same partner is taxed on. For investment partnerships, these differences are mainly caused by unrealized gains but are also a result of any other temporary M-1 or book/tax difference. Logically, reducing disparity makes sense. For example, a partner that participated in a fund when unrealized gains increased their account value, should also recognize more taxable gains than an investor that did not enjoy a similar increase in their book account value. However, with the complexities of a hedge fund’s moving parts mentioned above, performing this equitable allocation is easier said than done.
In order to figure out how to allocate the gains and losses, the difference between each partner's book basis and tax basis must be tracked and a formula applied to allocate the income in such a way as to decrease each partner’s disparity as much as possible.
This is the basics of what is happening in our allocation process: First, ordinary income and expenses are allocated based on ownership percentages. Secondly, “stuffing” is performed for partners with full and partial withdrawals. Then book basis is compared to tax basis, and realized gains and losses are allocated based on this disparity. Finally, unrealized gains make up the difference between book and tax allocations.
Stuffing, referred to in the previous paragraph, is a term used to describe the process of replacing the unrealized gains of partners exiting the fund, with realized gains. Stuffing is once again trying to match book and tax gains, only it relates to partners that are withdrawing from the fund. Upon withdrawal of a partner, all of its gains and losses become realized. As such, the partner’s total unrealized gains over the life of the fund should net to zero upon withdrawal. Stuffing calculates that net unrealized amount and replaces realized gains and losses for any unrealized portion the partner would otherwise be allocated in that year.
This allocation calculation must be reset for every instance in which capital is moved throughout the year. We call each period between capital transactions a break period. Break periods can arise from any event affecting the partners’ ownership percentages, whether through performance allocations, transfers of capital between partners, or contributions and distributions.
Although I have touched on some of the major aspects of hedge funds that take part in making this area of tax law so complicated, there are many particulars I have not addressed here. A few additional potential features include performance allocation and other incentive arrangements, in-kind redemptions, built-in-gains from contributed securities, disallowed losses, and whether you select to allocate on the full or partial aggregate method. One can easily see how these additional complications, layered on top of the hedge fund’s numerous moving parts, result in confused investors not able to make sense of the balances flowing through to their Schedule K-1s.