Potential Changes to Partnership Income Allocation Rules May Alter the Timing and Manner of Receipt of Income by Key Personnel at Hedge Fund Managers

On April 13, 2009, the Internal Revenue Service proposed regulations under Section 706(d) of the Internal Revenue Code (IRC) that could affect the timing and manner of receipt of income, gains and losses by key personnel at hedge fund management companies organized as partnerships or limited liability companies taxed as partnerships.  The proposed regulations will become effective upon adoption, but no earlier than the first partnership taxable year beginning in 2010.  Generally, the proposed regulations would require partnerships to take into account variations in partners’ interests during a taxable year and would prescribe two methods for doing so – an “interim closing of the books” method and a “proration” method.  In addition, the proposed regulations provide guidance on the appropriate allocation of “extraordinary items” and the effect on allocations of changes to partnership agreements.  Finally, the proposed regulations contain a safe harbor for services partnerships and publicly traded partnerships, clarify the allocation of deemed dispositions and amend the minority interest rule.  This article discusses the current “varying interest rule” under IRC Section 706 and details the ways in which the proposed regulations would change the current allocation regime.  In particular, this article discusses the mechanics of the two alternative allocation methods provided in the proposed regulations, timing conventions, changes in partnership allocations among contemporaneous partners, safe harbors, deemed dispositions and the minority interest rule.  This article also discusses the implications of the proposed regulations for hedge fund managers and hedge funds.  In brief, the proposed regulations are likely to have a greater impact on managers than funds because variations in interests of limited partners in hedge funds are and are accounted for as ordinary course events, while variations in interests of partners in hedge fund management companies are non-ordinary course.  That is, subscriptions to and redemptions from a hedge fund occur routinely, whereas the admission of a new partner to a management company, or the termination of such a partner, occur only once in a while.  It is the admission or termination of such key hedge fund manager personnel, or changes in interests of existing key personnel, that could be more directly impacted by the proposed regulations.

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