Accounting and Tax Issues

Under Advisers Act Rule 204-2(a)(1), (2), (4), (5), and (6), a registered adviser is required to keep certain accounting records relating to its advisory business. Such records include (i) all journals (including cash receipts and cash disbursements journals) that form the basis of entries in any ledger, (ii) general (and auxiliary) ledgers reflecting all assets, liability, reserve, capital, income, and expense accounts, (iii) all check books, canceled checks, bank statements, and bank reconciliation’s of the adviser, (iv) all trial balances, financial statements, and internal audit work papers relating to the business of the adviser, and (v) copies of all bills and statements, both paid and unpaid, relating to the business of the adviser. Registered advisers must also keep such accounting records for each investment partnership, which the adviser serves as general partner.

Reports and Audit
General partners of partnerships and advisers to funds generally provide for an annual independent audit of the financial statements of the partnership or fund, and either monthly or quarterly unaudited reports to investors. The Advisers Act does not require audits of financial or periodic reports other than with respect to custody or the Form. The basic principals of hedge fund and partnership taxation follow what’s known as the “Conduit Principle of Taxation.” One of the primary benefits of the partnership structure as a form of organization is the conduit principle of taxation. Under the conduit principle of taxation, a partnership’s items of income, expense, gain, and loss flow through to its partners and are taxed at the partner level, rather than at the partnership level. This flow-through approach eliminates the double taxation inherent in the corporate form of organization. As items of income, expense, gain, and loss through from the partnership, they retain their tax character, time, and source.

Regulation D (pursuant to Rule 502(b)) requires that hedge funds offered to non-accredited investors have audited financial statements to include an audited balance sheet, statement of cash flows, and an income statement (as required in Item 310 of Regulation S-B).

Selected Accounting Issues

THE BREAK PERIODS (THE PARTNERSHIP ALLOCATIONS)

The heart of hedge fund accounting is the partnership allocations. The allocations are then broken into sections called break periods. Break periods will always occur when a partner withdraws fully or partially, contributes more capital or a new partner is admitted. The break period will usually end on the last day of a given month (dictated by the partnership agreement). The partnership then needs to be valued on that date and the new capital activity and percentages will become effective on the following day (the first of the month). Basically, anything that affects the partnership percentages is going to result in a break period. Let’s use an example to show a typical break period and the allocation of the performance for the break period: Phil is the general partner of Hedge Fund Homepage Partners, L.P., he has decided to start this partnership. Paul and Gene have also joined in as limited partners. On 1/1/97 they start the partnership, Phil contributes $100,000, Paul contributes $500,000, Gene contributes 200,000. The partnership begins trading and has net income from 1/1/97 – 3/31/97 of $50,000, on 4/1/97 they add a new partner, Linda, she contributes $250,000. This has now resulted in a 3/31/97 break, with new partnership percentages taking effect on 4/1/97.

On the date of the break period, the revenue and expenses are all accounted for, the securities are marked to market and a valuation of the partnership is determined. The net income is $50,000.
For example:

Allocations
Partner name 1/1/97 % 3/31/97 3/31/97 4/1/97 4/1/97 4/1/97
Capital Performance Capital Additions Capital

%

Phil 100,000 12.50 6,250 106,250 106,250 9.66
Paul 500,000 62.50 31,250 531,250 531,250 48.30
Gene 200,000 25.00 12,500 212,500 212,500 19.32
Linda 250,000 250,000 22.72
Total 800,000 100.00 50,000 850,000 250,000 1,100,000 100.00

The above schedule is a simple example of what is called book allocations. When a limited partner invests in a hedge fund, it is important to make sure that the investment partnership is audited by a reputable accounting firm. Book allocations must adhere to the partnership agreement. There are other items that will be part of book allocations, such as, management fees and performance fees, it is important for an independent auditor to make sure that the hedge fund manager is adhering to the limited partnership agreement. A hedge fund manager may interpret the agreement incorrectly, resulting in either an overcharge or undercharge to the limited partners. So, if you are investing in a limited partnership you should make to sure to read the partnership agreement, find out what the management fee is (usually 1% a year) and how the performance fee is determined (usually 20% of net income)*
*Performance fees may have benchmarks and hurdles

MANAGEMENT FEES
The percentage and method of calculation depends on your partnership agreement. The typical fee structure is as follows:

  • 1.00%/year charged quarterly

The fee is usually charged on 1/1, 4/1, 7/1, 10/1. The partnerships net asset value is determined on the specified date and is charged to the partnership. the are instances where some funds do not charge all the limited partners this fee. Some funds may have relatives or others who they do not wish to charge. If a fund does not charge this fee to everyone, a break period will result on the dates that the management fee is charged. Over a length of time, certain inequities may result to those who are charged due to the dilution of their partnership percentages. There will also need to be a separate allocation of the management fee whenever charged.

REALIZED GAINS & LOSSES
Carefully track your realized gains and losses on a break period basis. It is important for the fund to track gains and losses on a TRADE DATE basis. Most good prime brokers offer trade date monthly realized gains and losses reports on a monthly and YTD basis. For audit and tax purposes, hold on to all your brokerage reports and schedules prepared by your accountants. For tax purposes, keep track of gains and losses that are considered short-term and long-term on a monthly and break period basis. Having the accounting firms recreate this for you can increase your audit and tax fees.

INCENTIVE FEES
This fee is usually 20% of the net profits of the partnership. Calculation of the fee is determined by the partnership agreement. The fee is a reallocation on the book and tax allocations on the income of the limited partners to the general partner. Incentive fees may have hurdles, benchmarks, complicated scenarios, etc. There are also certain SEC rules regarding the incentive fees and Registered Investment Advisors.

INTEREST DUE TO WITHDRAWING PARTNER
Depending on how the partnership agreement is structured, when a partner fully withdraws from a hedge fund, the hedge fund manager will usually pay the limited partner that is leaving 90-95% of the amount due to him/her within 10-15 days of the break period. The remaining 5-10% will be paid pending a verification of capital amounts on the date the partner decides to leave. This 5-10% is usually paid a certain amount of interest until paid to the withdrawing limited partner. Please read your partnership agreement (offering memorandum) to see if this applies to you.

LOSS CARRYFORWARDS & HGH WATER MARKS
Some partnership agreements provide for loss-carryforwards. This protects the limited partner from being charged an incentive fee on an “up” year when total cumulative return is a loss. For example, if a limited partner enters into a partnership on 1/1/96 and has a net loss of $60,000 for the year, the general partner will not be entitled to an incentive fee. If in 1997 the limited partner has a net appreciation for the year of $50,000 the general partner will still not be able to charge an incentive fee, even though there was a net gain for the year. In addition, the general partner must make up another $10,000 loss in 1998. This is a loss carry-forward, the general partner cannot charge an incentive fee till the limited partners are made whole. Each limited partner must be tracked individually. Please read your partnership agreement to see if this pertains to you. A high water mark is similar except that the manager must recoup lost profits on the limited partner’s interest.

HOT ISSUES:
Hedge funds frequently trade in what are called “Hot Issues”. Hot issues are basically IPOs. When a partnership trades in Hot Issues, only certain investors are allowed to participate, there are certain rules that will restrict certain partners. Hot Issue activity such as profit and loss, interest income and expense, dividends, etc. must be separated from regular trading activity. A separate brokerage account must also be maintained for Hot Issues. If you trade hot issues and you’re a hedge fund, your prime broker will ask you for an “opinion letter”, at least they’re required to. This letter is usually prepared by your attorney. When preparing book or tax allocations, one must create a separate allocation of performance for those who can participate in Hot Issues.

10% LOOKTHROUGH
For purposes of counting investors, a 3(c) 1 fund must carefully consider capital contributions made by registered investment companies, 3(c) 1 funds and 3(c) 7 funds. If any of these entities hold more than 10% of the funds capital, the fund will have to count the investors in the contributing fund as well for purposes of the 99 partner limit. Fund managers operating a 3(c) 1 fund that wishes to accept large contributions from these entities should consider starting a 3(c)7 fund or converting their fund to a 3(c)7. When your accountant prepares your allocations, a check should be performed at each break period for limited partners exceeding 10% of the fund’s assets.

ORGANIZATION COSTS
Legal, accounting fees and other fee associated with starting the fund can be charged through the fund.

PROFESSIONAL FEES
The fund will normally incur accounting and legal fees throughout it’s life. Fees that are directly related to the fund should be expense through the fund. Audit and accounting fees should be accrued on a monthly basis, rather than when paid. If your anticipated audit and tax fees are $24,000/yr. You should expense $2,000 a month for accounting and audit expenses.

INTEREST INCOME/EXPENSES, DIVIDEND INCOME/EXPENSE
These characters of income should be recorded when earned and not when received. Interest should be accrued on a monthly basis based on interest rates or coupon dates. Dividends should be recorded on ex-date rather than pay-date.

THE TAX ALLOCATIONS
By and large the most complicated area. There are several federal and state tax issues that a hedge fund must consider when starting a hedge fund, management company or/and affiliate management company of a hedge fund. Below you will find some some information on tax allocations. Tax allocations are created to determine the amounts to be reported on the K-1s. The tax allocations are the area that some of the hedge fund software manufacturers try to facilitate. For tax purposes your accountants will create a tax allocation of your partnership. The tax allocations are derived from the book allocations. The difference between the book allocations and tax allocations are outlined below:

  • For book allocation purposes, performance need not be broken out by character of income, for tax purposes all the components that make up the partnership’s performance must be broken out (i.e.; Interest, dividends, realized long term, realized short tem, etc.). Unrealized is not taxed.
  • The performance must be broken out by period, by character.
  • For book allocations a general partner can take 20% of the total performance and reallocate that amount to his/her account. For tax purposes, the accountant must hit every component of income for the 20% performance fee.
    • This means that the GP must take 20% of interest income, 20% of dividends, 20% of realized short term, etc.
  • What results at the end of the tax allocation is every partners share of each component of income for the tax year net of any performance fee to be reported on the K-1s

There are a couple of methods that accountants use to account for realized gains for tax purposes (layering, aggregate, etc.).

In addition to determining what the character of income for each partner is for tax purposes, the accountant will review the partnerships trading activity to determine if there are any tax adjustments to made. Certain tax laws require these adjustments. Contact RND Resources, Inc. for information on these adjustment.