What Critical Issues Must Hedge Fund Managers Understand to Inform Their Preparation of Schedules K-1 for Distribution to Their Investors?

Most hedge funds are taxed as partnerships and therefore pass through items of income, gains and losses to their fund investors, rather than facing taxation on such items at the partnership level.  As a result, hedge fund managers are responsible for preparing and distributing to their investors a Schedule K-1 to Form 1065, which shows an investor’s share of a fund’s income, gains, losses, credits and other items for each tax year that must be reported to the Internal Revenue Service on the investor’s individual income tax return.  Nonetheless, preparation of this schedule can present a litany of challenges which can confound many hedge fund managers.  Moreover, preparation of K-1s cannot be entirely outsourced to an accounting firm; a manager must understand what the accounting firm is doing and be able to evaluate its work.  Recognizing the complexity and importance of this topic, a recent webinar provided a top-level refresher course on the tax considerations that influence the structuring of hedge funds and addressed numerous issues involved in the preparation of Schedule K-1, such as the difference between “trader funds” and “investor funds,” and allocation and adjustment rules that have tax consequences for hedge fund investors.  This article summarizes key takeaways from that program.

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