Guest Contributor: Ron Kashden, President, TKS Solutions
Common wisdom holds that fund of funds ( hedge funds that invest in other hedge funds) are simpler to operate and manage than traditional funds because they don’t have the headaches of stock splits and mergers. While this may be true on the portfolio accounting side, book keeping for tax purposes is often devilishly complicated for three reasons.
Challenge #1 – Handling the Fund’s Income
The first issue is handling the fund’s income for taxes. On a regular basis throughout the year – weekly, monthly, or quarterly, funds receive statements from their investments. Statements typically contain one number indicating the gain or loss for that investment. However, the performance for tax purposes is opaque until the end of the year when the fund receives the K-1 tax form from the investment. Because the one monthly performance number may actually consist of ordinary dividends, realized gains, and interest, along with non-taxable items such as unrealized gains, the taxable income almost never dovetails exactly with the monthly performance statements, and fund of fund’s handle this variance through a series of tax adjustments.
Challenge #2 – Allocating Tax Adjustments
Once you know the tax adjustments, how do you fairly allocate them among investors? Some funds just take the ownership percentages at the end of the year. The downside to that method is that it doesn’t account for investors that joined or left during the year. Other funds try to use the allocated financial gains as a basis, however, typically a portion of that would be non-taxable and as a result the math can quickly become very convoluted. The issue is further compounded by side pockets, which are fairly common in Fund of Funds. Ideally, you would spread the tax numbers evenly, over the break periods in the year, applying the appropriate investor ownership percentages. But implementing this best practice solution is a data and time series heavy calculation that is almost impossible with spreadsheets.
Challenge #3 – Tracking Tax Forms
Finally, the process of getting the investments’ tax forms at the end of the year poses an operational issue for the fund. How do you know when you’ve received all the forms? Life would be complicated, but manageable, if each investment sent one tax form at the end of the year. The fund could have a checklist and mark off each investment as the form is received. Unfortunately, each investment might be comprised of several legal/tax entities that each send a tax form. Furthermore, those underlying legal entities can file an extension with the IRS, so you might not receive their tax information until the middle of the following year – well beyond April 15. To address this issue, some funds will maintain constant contact with their investments to get up-to-date information on when and how many tax forms they should expect. Others use the investment’s reported financial activity as a basis to cross-check against received forms to know when all the information has been received.
Avoiding the Pitfalls
While the reputation of Fund of Funds being easy to manage continues, when it comes to taxes this is more the case of the “Grass being not so green on the other side”. The first step in avoiding the problems is to be aware of the issues. The second step is putting accounting processes in place throughout the year to avoid a last minute scramble. And, the third step we think makes sense (admittedly, we have a bias since we are in the industry!) is to implement an accounting package that can accommodate the complexities of funds of funds and automate the tax process.