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Hedge Funds Lose Tax Break For Management Expenses

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The TCJA eliminated deductions for expenses that taxpayers used to be able to itemize on their returns.  This included compulsory management fees paid to hedge fund managers.  This means that the wealthy investors in hedge funds will have to absorb these costs even if the funds lose money.

 

Struggling hedge funds will probably become even more unappealing to investors following this.  For hedge funds October 2019 was the worst month since 2011.  The industry, worth $3.2 trillion, has been in decline due to mediocre performance and many funds are closing down as investors already pulled out more than $68 billion since 2016.  Many more withdrawals are expected for the end of this year (2019).

 

The mechanics of hedge fund management fees were based on the argument that hedge funds were better at making money and protecting investors during downturns in the economy.  The facts do not really back this claim up.  Over the last thirty years, the industry has rarely outperformed the S&P 500 Index, says Hedge Fund Research Inc.

 

So now the pressure is on and poor performing hedge funds might have to lower their fees.  The typical industry charge, “2 & 20,” an annual management fee of two-percent of assets under management plus 20-percent of profits, is now probably too expensive. Funds that still charge this much has become the minority. Most funds now charge an average of 1.45 and 17-percent.

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Smaller funds will have a tough time cutting their management fees in a down-market.  Those fees often cover the necessary costs, from printing to the ‘manager’s lobster Thermidor dinner’ pundits tease.

 

Now miscellaneous itemized deductions on expenses like ‘work-related travel costs’ – if it exceeded  2-percent of adjusted gross income – that wasn’t reimbursed before 2017, is also a thing of the past.  Investors in activist funds or those that buy and hold securities will be the hardest hit.  The same goes for investors in funds that utilize swap payments, a derivative of exchanged financial instruments.  Investors who used to pay their management fees in cash lose even more: they can no longer deduct the expenses as miscellaneous itemized deductions either.

 

Trader funds remain unaffected however. Investors in these funds never had the ability to itemize and deduct management fees, but they are entitled to write off management fees as business expenses, and thereby pass the savings to investors. This can still be done.

 

The mathematics will not even work for hedge funds with stronger results.  Even a return of 7.3% will result in a performance of 4.24% after management fees. Since these cannot be deducted from tax by the investor any longer, his tax bill will be on a 6.24% return while he only got 4.24%.

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The only light in the tunnel might be the long-term capital gains rate investors in hedge funds often qualify for with assets that are held for more than three years. The rate of 23.8% is lower than the ordinary income tax rate for short-term assets.  It all depends on the math, of course.

 

Another light in the tunnel, for top-earners, is the lowered top rate, down to 37% from 39.6%. Thresholds for alternative minimum tax (those who pay the AMT are not able to take miscellaneous itemized deductions) also increased.  Of course, this is again impeded by the new limits on deductions for mortgage interest and for state and local taxes.

 

If the hedge funds were to convert their management fees to performance fees, this might help. It will add pressure for the fund managers to perform and bet the market, but it does not leave much of a margin to keep the lights on.

 

Readers should note that this article is only intended to convey general information on these issues and that FAS CPA & Consultants (FAS) in no way intends for the contents of this article to be construed as accounting, business, financial, investment, legal, tax, or other professional advice or services.  This article cannot serve as a substitute for such professional services or advice.  Any decision or action that may affect the reader’s business should not rely solely on the contents of this article, but should rather be consulted on with a qualified professional adviser. FAS shall not be responsible for any loss sustained by any person who relies on this presentation.  This article is subject to change at any time and for any reason.

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