Is Your Hedge Fund a Trader or an Investor?

Abstract

The author first observes that it is a well-accepted fact that most hedge funds are often somewhat tax-inefficient, though there are ways for hedge fund managers to make their trading more tax-efficient. In this article, he turns to a somewhat different question, highlighting a problem that most hedge fund investors will face even when their hedge funds employ such tax-friendly trading tools. Indeed, the answer to the apparently innocuous question of whether a hedge fund manager is classified as a trader or an investor could well be the burning issue for individuals investing in hedge funds. For most individuals, the “wrong” answer can cause taxes to be paid on “phantom” profits, and the IRS definition of “trader” may surprise many. The author discusses a variety of possible solutions, ranging from the characterization of fees, to wrap-vehicles and derivative contracts, but offers the important caveat that no solution is absolutely bulletproof, though most address one or another of the aspects of the problem.