Structuring a Hedge Fund Business
A successful business is built before there is one. The way any business is structured has very long term implications on how it is taxed. Also since markets provide almost the same return to everyone, the ability to avoid taxation is a major competitive advantage for any hedge fund.
Therefore, over the years hedge funds have used several different types of corporate entities to conduct their business with minimal taxation. This article lists down the several ways in which hedge fund businesses are usually structured.
The most rudimentary way of structuring a hedge fund business is in the form of a corporation. Corporations are legal entities created for the purpose of conducting a business. Since the corporation is considered to be an artificial person in the eyes of law, the shareholders have a limited liability. This means that they are liable only to the extent of their paid up capital and that their personal property cannot be attached to make good the losses.
This feature is extremely important for a high risk business such as hedge funds. It is for this reason that many hedge funds choose this form of organizational structure. Also, most hedge funds in the United States are structured in the state of Delaware because of the relatively lax rules pertaining to bankruptcy and taxation.
The negative point of structuring a hedge fund as a corporation is that investors are taxed twice. First a corporate income tax is levied and then a dividend distribution tax is levied. Hence about half the earnings have to be paid out as taxes! The tax inefficiencies built into this structure make it an unviable option for many investors.
Another old fashioned way of structuring a hedge fund is called a partnership. A partnership does not constitute the creation of an artificial person. Therefore partners are jointly as well as separately liable for the losses incurred by their firm. This means that their personal properties can indeed be attached to make good the loss in case the firm runs out of money. This obviously is a huge disadvantage.
However, the partnership structure has certain advantages. For instance, the taxation is extremely low. This is because the income is taxed only once. Partnership is a flow through structure. This means that income is not taxed at the partnership level. Instead, it simply flows through to the investors individual incomes where it is taxed at the relevant rate. The highest possible rate of such taxation would be close to 35% i.e. significantly less than the corporate rate.
A modern way of structuring risky businesses like hedge funds is to use the features of a general and limited partnership. Such kind of partnership necessitates the presence of at least one general partner and at least one limited partner. A limited partner has a limited liability. This means that they are like the shareholders of a company. However, the general partners personal property can be attached to recover the dues. The taxation rules governing this kind of entity are also favorable as compared to the ones governing corporate tax.
A nested structure combines the best features of both the partnership as well as the corporation. This is because although it is structured in the form of a corporation but the partners are corporations. Therefore there is limited liability and the benefit of favorable taxation as well. Also this structure enables the fund to keep the number of partners small which is one of the regulations of the Securities and Exchange Commission (SEC).
A lot of hedge funds have investors from within the United States as well as abroad. The investors from abroad want to avoid the excessive taxation prevalent in the United States. Therefore in such cases, the hedge fund company usually runs two parallel structures. One of them is structured in the United States whereas the other one is structured in a tax haven like the Bahamas. The hedge fund tried to maintain the exact same portfolio of investments at both places so as to mirror the returns. However, in practice this is often difficult to achieve which is why these structures are not preferred by hedge funds.
This structure is one of the best when it comes to minimizing tax liability. Under this structure there is one holding company in the United States and then there is a subsidiary fund which is mostly based out of a tax haven.
In this structure, the domestic fund has only one asset i.e. 100% of its money is invested in the international fund. The offshore fund on the other hand completely evades the US tax structure since it is based out of another nation.
The investors are given an option. In case they can invest directly in the offshore fund, they are asked to do so and US taxation rules do not apply. On the other hand, if they invest in the holding company fund which is incorporated in the US, they have to pay the Internal Revenue Service their fair share!
Hence, a wide variety of corporate structures have been used to operate hedge funds in the past. The present holds an even wider variety. Part of staying on top of the hedge fund game involves staying abreast with all these issues.
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