Alert August 05, 2008

IRS Issues Guidance Regarding the Deductibility of Management Fees of a Fund of Funds

The Internal Revenue Service (the “IRS”) released Rev. Rul. 2008-39, which relates to the deductibility of management fees paid by an upper-tier partnership and allocable to a U.S. individual investor in a fund of funds.

The ruling addresses the federal income tax consequences to an individual taxpayer who invests in an upper-tier partnership that holds limited partnership interests in various lower-tier partnerships, each of which engages in the business of trading stocks and securities for its own account.  The issue is whether individual taxpayers may deduct their share of the management fees paid by the upper-tier partnerships as a business expense or as an investment expense.  Generally, an item that is deductible as investment expense rather than as business expense is less advantageous to a U.S. individual taxpayer because an investment expense item is taken into account only if it and other miscellaneous itemized deductions exceed 2% of the taxpayer’s adjusted gross income, whereas a business expense item reduces the gross income of a taxpayer without such limitation.  The IRS ruled that the management fees paid by the upper-tier partnership is an investment expense, because the activities of the upper-tier partnership do not constitute a trade or business, but merely the holding of limited partnership interests in the lower-tier partnerships for the production of income.  Thus, an individual investor in a fund of funds structure will be able to deduct an allocable portion of the management fees paid at the upper-tier partnership level only if such amount and other miscellaneous deductions exceed 2% of the individual’s adjusted gross income.  One silver lining of the ruling is that the IRS confirmed that the management fees paid by a lower-tier partnership constitute a business expense that is taken into account in computing the lower-tier partnership’s taxable income or loss. 

Although Rev. Rul. 2008-39 addressed a fund of funds structure, it also may have implications for master-feeder structures with multiple tiers of partnerships if upper-tier/feeder-level partnerships bear separate management fees.  In light of Rev. Rul. 2008-39, funds that use master feeder structures and wish to minimize the adverse tax consequences to U.S. individual investors may need to re-structure the management fees, so that such fees are paid at the lower-tier levels, where the actual trading activities occur.