LB&I International Practice Service Concept Unit

LB&I International Practice Service Concept Unit

General Overview

Hedge Fund Basics

Hedge funds are investment vehicles available to investors meeting certain net worth criteria.
A typical hedge fund structure includes one entity formed as a partnership for U.S. tax purposes that acts as the Investment Manager 
(IM). Another entity functions as the General Partner (GP) of the Master Fund. The IM receives a management fee (usually 2% of the 
underlying fund’s net asset value) to manage the portfolio and to cover for operating and administering the fund (e.g., overhead, 
personnel compensation, office leases, and fixed asset costs). The GP receives an incentive compensation allocation based upon the 
performance of the master fund (usually 20% of the profits in excess of prior losses and net of management fees) in the form of an 
allocation of partnership profits. 
 
Hedge funds are not private equity funds, mutual funds, ETFs, bond funds, regulated investment companies (RICs) or real estate 
investment trusts (REITS). Hedge funds’ investments are more liquid than private equity funds. A hedge fund’s investment time 
horizons are generally much shorter than a private equity fund’s, which generally has investment horizons of 2 to 10 years. Unlike 
mutual funds, hedge funds are minimally regulated. Hedge funds are privately owned unlike ETFs, RICs, REITS, and bond funds 
which are publicly traded vehicles.
Most hedge funds use one of the following organization structures: 1) a single entity fund, 2) a master feeder fund, 3) a parallel fund, 
or 4) a fund of funds. For purposes of this IPS unit, we will be focusing on master feeder funds as they are more common in 
International tax examinations. The master feeder fund structure illustrated in the Diagram of Concept is a simple structure and
taxpayers may be using more complicated structures. 
This IPS unit will focus on tax issues related to a master fund.

Facts of Concept

Who is the taxpayer?
 
1. Master Fund- The Master Fund is generally a foreign entity or U.S. limited partnership or LLC (treated as a partnership for U.S. tax 
purposes). The Master Fund invests the capital of both the foreign feeder and domestic feeder according to the Fund’s investment 
strategy. Investments may include stocks, bonds, securities and other financial instruments. Generally, the Master Fund files Form 
1065, U.S. Return of Partnership Income.
2. Investment Manager- The Investment Manager generally is a U.S. partnership or LLC whose partners include an individual 
investment advisor(s) and other individuals or entities. The Investment Manager manages the portfolio of the Master Fund on behalf of 
the investors. As consideration for managing the portfolio, the Master Fund enters into a Management Agreement including provisions 
to pay the Investment Manager a management fee equal to a fixed percentage (generally 2%) of the fair market value (or net asset 
value) of the underlying portfolio of investments. 
3. General Partner- The General Partner is a U.S. partnership owned by the same or similar partners or members of the Investment
Manager. It usually holds a small general percentage interest (1% or more) in the Master Fund and/or feeder funds. The general 
partner participates in the economic performance of the Master Fund through the “carried interest.” The Master Fund will issue the 
General Partner a profits interest (generally 20% of the annual master fund profit that exceeds a specified amount) that is treated as a 
partnership interest as opposed to a fee for services rendered.

LB&I International Practice Service Concept Unit