Making Hedge Funds More Tax-Efficient
By Robert Gordon, Twenty-First Securities Corporation
Originally published in the Journal of Wealth Management
Summer 2004

Hedge funds are generally tax-unfriendly. They often employ trading strategies that generate attractive pre-tax returns, but unfortunately these strategies also produce income taxed at the highest rate of 35%. In addition, while the funds generate no cash income for their investors, those same investors must nevertheless pay taxes each year on their shares of partnership income.

There are two approaches to minimizing the tax treatment of hedge fund investments: portfolio-level management and investor-level management. None of these ideas will wipe out taxes - rather, they are meant to defer taxes as long as possible and, when tax is to be paid, the goal is to pay only a 15% rate. Care is given to not disturbing the investment goals in achieving tax-efficiency, in other words don’t let the tail wag the dog.

In this article, we break the possibilities into what can be done at the fund level and what investors can do on their own if the hedge funds managers do not employ such opportunities.

Tax Management at The Portfolio Level

At the portfolio level, hedge fund managers can mitigate taxes by following three types of strategies. First, they should track holding periods. Second, they should employ tax-efficient trading strategies. Third, they should use distributions in kind and allocation methods to their utmost.

Portfolio Tax Management: Holding Period Strategies

Different holding period rules apply to different types of investments.

Securities. In general, investors must hold securities for 12 months in order for that security to receive long-term capital treatment. (Long-term capital gains are taxed at 15%, while short-term gains are taxed at 35%.)

Dividends. Individuals must hold dividend-paying securities for 61 days in order to be eligible for the 15% dividend tax. In counting this holding period, investors cannot include any day in which the stock is protected against loss using most basic hedges. Foreign dividends must be held 16 days for the taxpayer to claim a credit for taxes withheld.

In-lieu-of payments. Finally, there is a 46-day period for payment in lieu of dividends made on short sales. When an investor borrows dividend-paying stock to make a short sale, the investor will be required to remit payments to the lender in lieu of the dividends that are paid while the short position is open. Usually, investors can deduct these payments as investment interest. However, the deduction is not permitted unless the investor holds the short sale open for at least 46 days.

Holding period strategies should be tailored to a fund’s investment strategy; certain strategies allow great opportunities for tax efficiency.

Risk Arbitrage Funds. These funds have two possibilities that are often overlooked. The first involves takeovers where the consideration paid is both stock and cash. In this situation the cash portion is considered a dividend. The risk arbitrage hedge fund that holds the target stock for 61 days will capture that profit as dividend taxed at 15%. Cash will only be taxed as a dividend up to the amount of profit on the shares. The second possibility for risk arb investors is to age stock-for-stock deals to long-term gain with no risk. This is accomplished by leaving the positions open until they’ve been held for more than 12 months. When an arbitrageur shorts the shares of the acquiring company, he is betting on the deal closing and locking in the value of the shares that will be received in exchange for his target company shares. When the deal does close he will now hold acquiring shares (received for target shares) and a short position of the same number of acquiring shares. Many arbitrageurs then instruct their brokers to deliver the longs against the shorts, realizing short-term gain taxed at 35%. If instead the long and short positions are not closed out, the holding period clock will keep ticking even though you are perfectly hedged.

Long/Short Funds. The recent tax law changes on dividends also created an opportunity for long/short hedge funds. If a hedge fund is long shares paying a $1 dividend and short other shares paying a $1 dividend, careful day counting can produce a “tax-shelter”. If the fund stays long 61 days the dividend will be taxed at 15% and if the short is open at least 46 days that $1 dividend in lieu payment becomes a 35% deductible item.

Other opportunities present themselves from the fact that different investments with very similar economics have distinctly different after-tax results while pre-tax returns should remain equal.

Distressed Securities Funds. Distressed debt funds take on substantial risks and can reap correspondingly large rewards. If the company underlying a debt should turn itself around, the price of its bonds can jump by 50% or more very quickly. When this happens, the bondholders may find themselves sitting on significant profits.

A short against the box may be the most efficient and protective way to defer the profits from immediate tax on a profitable bond. An investor creates a short against the box on a security with unrealized gains by establishing a short position in the same security in the same quantity as the long position. If the long position loses value, the short will gain a corresponding amount of value, and vice versa, so the investor is completely hedged. The constructive sale rules generally eliminate the use of this strategy for equity investments. However, these rules do not apply to bonds. So a short against the box should allow the investor to defer the capital gains tax on a bond indefinitely. Once this strategy is put in place, it freezes the gain as short-term or long-term. It does not turn long-term gains into short term, nor does it allow short-term gains to age to long-term; it only defers the recognition of the gain.

Portfolio Tax Management: Trading Strategies

Regardless of fund type, hedge fund managers should observe two principles for tax-efficient trading. First, once they have chosen an economic stance, fund managers should take care in choosing the tools that they use to implement that stance. Second, they should systematically employ standard disciplines to harvest both gains and losses in a way that minimizes taxes.

Choose Your Tools Carefully. Different financial products may produce identical pre-tax results but very different after-tax results. In choosing their investment tools, managers need to consider their time frames and the tax ramifications of synthetic ownership.

What Is Your Time Frame? For a bullish investment in the stock market lasting less than a year, the preferred tool is either a futures contract on the S&P 500 index or the equivalent position in listed options. Profits on these investments are automatically treated as 60% long-term and 40% short-term capital gains regardless of holding period, whether long or short the market. At the maximum tax rate, the investor would pay a blended rate of 23% (60% of 15% plus 40% of 35%) on such gains.

In contrast, if the investor purchases a SPDR or a basket of stocks or invests in an open-end mutual fund and sells the position within a few months, all gain is treated as short-term capital gain and taxed at the ordinary income rate of 35%. So while both investment approaches give the investor exposure to the overall market, the futures and listed options enjoy preferential tax status.

Proposed Regs Could Makes Swaps Less Attractive (May 2004).

If a fund manager’s bullish time horizon is over one year, then the best technique would be a swap. A swap is a contractual agreement under which two counterparties exchange payments based on the price changes and distributions from a security as well as the cost to carry the security. A swap investor retains all of the upside and downside potential of the stock or index. The contract can be structured so that the investor makes periodic payments for the cost to carry the position but all payments and receipts with respect to dividends and price movement in the stock are deferred until the end of the swap agreement. The payments are generally treated as ordinary deductions. However, for non-dealers, payments or receipts made with respect to an early termination of a swap are treated as capital in nature. Financing costs are incurred currently and the investor receives an ordinary tax deduction. For individuals, the deduction should be treated as an “other" itemized deduction. There may be some limitation as to the amount the investor may deduct.

As the swap nears maturity, the investor has a choice. If the security has increased in value, the investor can terminate it and recognize a long-term capital gain (or loss). If the security has decreased in value, the investor can choose to make the final payment on the swap and take an ordinary deduction subject to the limitation discussed above, rather than have a capital loss. The choice is theirs, and need be made only after the results of the “bet” made through the swap is known.

In summary, an investor using a swap obtains current ordinary deductions for the carrying costs, ordinary deductions if the security decreases in value and long-term capital gain if the security increases in value.

Only an investor with a very long-term horizon is better off holding the actual shares. In this situation the timing of taking gains can be put off indefinitely or maybe even be totally forgiven by the “step-up in basis” at death.



If an investor is bearish, the tax code penalizes any short sale profits by treating them as short term even if the holding period extends beyond one year. Again the broad-based indexes taxed at 23% would be attractive. For bearish bets over one year, a put held over 12 months would get long-term treatment as would a swap as discussed above.

Many other types of hedge funds would do well for their investors if their investments were made through derivatives instead of the securities themselves. By owning investments “synthetically” in a derivative security, one type of income can be captured as a more favorably taxed type of income. As an example, if a fund invests in distressed bonds the profits are interest income, market discount and then capital gain. If the fund holds the bonds through a swap (or other derivative like a forward), all profits are automatically converted to capital gain.

Cross-border investing creates a disparity between investment products as well. When offshore funds invest in dividend-paying stocks, they should consider doing so through synthetic vehicles. If they purchase these stocks directly, then dividends will be subject to withholding without a corresponding tax credit since the fund is not a US taxpayer. In contrast, if they approach the same stocks through options, futures or swaps, then they will receive the full value of the dividends.

If U.S. funds own foreign shares (or debt), then there is a possibility for a tax credit for any withholding, but certain holding period rules need to be monitored. An investment in foreign securities through a derivative will sidestep any withholding tax.

Manage Your Portfolio Methodically. In addition to choosing their investment vehicles with care, managers should also implement certain trading disciplines on a methodical basis. In particular, they need to harvest both gains and losses tax efficiently.

Consider Taking Profits On Your Bonds. Once a profitable bond has been held for more than one year, the best approach is often to sell it, then immediately repurchase it and amortize any premium.

The main drawback associated with a profitable bond sale is that the seller will be subject to an immediate capital gains tax. But in exchange for paying this 15% capital gains tax, a fund can decrease its taxable interest income in the years remaining until bond maturity – while still receiving the same cash flow. Bond income is currently taxed at 35%. By amortizing the repurchased bond’s premium, a hedge fund should be able to pay tax only on the bond yield, not the high coupon.

Suppose that a fund has a long-term holding of a 5% bond, purchased at par, that is due to mature in one year. The bond is now trading at $103. If the fund manager simply holds it for the next year until maturity, the fund will receive interest payments of $5. These payments will be taxed at 35%. Conversely, if the manager sells the bond for $103, the long-term capital gain of $3 is taxed at 15%. The manager then repurchases the bond at $103 and amortizes that $3 premium; then, the fund will be taxed at 35% on only $2 of interest. By selling and repurchasing the bond, the manager has produced a 133% after-tax internal rate of return using a simple strategy entailing very little additional economic risk. As bond maturities extend beyond one year, the return from this strategy drops. If the bond were due to mature in 10 years, the strategy would produce an after-tax return of 19.36%.

Note: This technique is best for corporate bonds, possibly less robust for government issues (due to state taxes), and ineffective for municipal bonds.

Additionally, hedge funds with capital losses can use those losses to offset the capital gains tax triggered by the bond sale increasing after tax returns substantially.

Capital losses can be quite powerful in the quest for tax efficiency. Arnott et al. [2001]* suggest that the average after-tax improvement from loss harvesting on a long only passive portfolio is worth about 80 basis points per year. Imagine what systematic loss harvesting could add to a rapid turnover fund (or double that for a long/short fund). The main problem with loss harvesting is that it may trigger the wash sale rules. The wash rules deny capital losses when an asset is repurchased within one month of its sale. Because of these rules, investors are often reluctant to harvest the loss on a stock that looks as if it is poised to recover. Investors in this situation typically wonder if the stock's gain in the next month will be worth more than the capital loss's value.

The conventional way to avoid triggering wash sales is to double the position in the selected stock, wait 31 days, and then sell the stock. Conversely, the investor can sell the shares, wait 31 days, and then buy the shares back. The obvious risk is that the investor’s exposure is doubled during the waiting period.

A more sophisticated solution would employ the doubling-up forward conversion to remove risk. The doubling-up forward conversion involves three steps. First, purchase the additional shares as discussed above. Second, purchase a put on the new shares. Third, sell a call on the new shares with the same strike price as the put. This strategy enables the investor to recognize the loss, avoid additional market risk, and also avoid a wash sale. Losses on short sales can best be harvested by first covering the short and then buying a put on the same stock. Although this method is allowed on shorts, ironically, investors can not sell stock and then buy a call without violating the wash sale rules.

Portfolio Tax Management: Distributions in Kind and Allocation Methods

Hedge funds can make distributions in kind just like SPDRs. If an investor put $9 million in a fund and withdrew when the net asset value was $10 million, she would pay tax on one million dollars, whether she received money or securities -- even if those securities had a zero basis in the hedge fund. Further, a distribution to a partner is not a taxable event to the fund and thus no gain would go on the K1. Investors need to be more willing to accept distributions in kind and not look at them as a penalty for withdrawing from a fund.

A hedge fund has a choice of how to allocate gains and losses among its partners; it is too complicated to go through here, but this too holds great promise for tax efficiency.

Tax Management at The Investor Level

While hedge fund managers should address taxes at the portfolio level, fund investors can manage their taxes directly by properly structuring their hedge fund investments. In particular, hedge fund investors could consider using derivatives on hedge fund indexes, simple call options funds on hedge funds themselves, and insurance wrappers.

Individual Tax Management: Hedge Fund Indexes

The constructive ownership rules apply to derivatives that mimic the ownership of flow-through entities such as limited partnerships and limited liability companies. They specifically also cover derivatives on the offshore corporations that hedge funds typically employ. However, they do not apply to derivatives that mimic ownership of hedge fund indexes. And there are now some investable indexes that can be used that can compete with fund of funds because they give diversification while removing a second layer of incentive fees. When investing in these indexes through a derivative all profits are deferred and turned into long-term gains taxed at 15%.

Individual Tax Management: Call Options on Hedge Funds – Simpler is Better

The constructive ownership penalties only apply if a derivative (or other vehicle) gives the investor all the upside and downside of the underlying security. The downside of a “plain vanilla” call purchase is limited to its cost. If the call is not too “deep in-the-money,” its downside is only a fraction of direct fund ownership, so it should not trigger the constructive ownership rules.

At-the-money five-year calls on hedge funds are currently available in the marketplace at 20–25% of the funds’ cost. Many have special features or economics other than simple at-the-money calls. Twenty-First Securities believes these provisions can change the investment’s payoff profile enough to trigger the constructive ownership penalties; care needs to be taken here.

Individual Tax Management: Insurance “Wrappers”

Investors fortunate enough to be able to dedicate certain funds exclusively to the benefit of future generations should consider setting up a variable life insurance policy owned by an irrevocable life insurance trust (ILIT). For those without that luxury we would not advise insurance “wrappers”

Investment earnings within a life insurance policy are not subject to current income tax, and the death benefits from an ILIT escape estate tax. So by setting up a variable life policy within an ILIT, an investor should be able to avoid income tax on the investment earnings in the trust. In addition, the insurance death benefit, including all untaxed investment earnings in the segregated account, should escape estate tax. Since federal estate taxes currently range up to 55%, the potential tax savings are substantial. (As most investors know, the estate tax is scheduled to decline over the next decade and eventually be eliminated.)

The establishment of a variable life insurance policy does involve administrative and other expenses. While the potential mitigation of income tax on investment earnings is substantial, the technique is much more efficient when it involves a long period of time for pre-tax returns to compound. (Indeed, some sellers of variable life suggest that the investment is most appropriate for investors with time horizons of 20 years or more). Furthermore, private placement life only defers tax; it does not convert it into long-term gain (and who knows what tax rates will be when you cash out).

Biggest Obstacles to Proactive Tax Management

Hedge fund investors need to be more aware of these possibilities. As an example, when choosing a risk arbitrage fund, don’t just look at their performance pre-tax; demand to see the K1s. If the bulk of the return is short-term gain, the managers have told you what they think about tax efficiency. Many risk arbitrage managers’ K1s are quite tax-friendly and deserve your attention. Managers must be told you care about taxes and that they should not squander the opportunities that present themselves at the portfolio level.

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