Hedge Funds Should Take These Steps to Prep for IRS Tax Audits

Recently, the IRS publicly announced the start of an audit campaign focusing on high-income earners, partnerships, large corporations, and certain promoters. The campaign, which proposes to be a “sweeping, historic effort to restore fairness in tax compliance,” specifically cited hedge funds and real estate investment partnerships as examples of partnerships to be audited.

The announcement is part of an overall plan to prioritize tax enforcement of complex partnership arrangements that investment funds and their investors commonly use, and to increase the audit rate of taxpayers involved. It follows prior steps that include the adoption of a new US partnership tax audit program in 2015 (referred to as the Bipartisan Budget Act, or BBA, after the statute that adopted it), and the rollout of an IRS pilot program in 2021 that focused on information gathering.

Hedge fund sponsors and their investors may wish to consider the following in anticipation of any uptick in IRS audit activity.

Preparing for the BBA Process

Identify partnerships and tiered arrangements in scope. All investment funds and other legal entities or arrangements that are treated as partnerships under US tax principles, and that either file or are required to file a US partnership tax return (Form 1065) are captured by BBA. Investment funds and their investors that invest via multiple tiers of partnerships that they don’t control also should consider monitoring the BBA audit exposure of any lower-tier partnerships through which they invest.

Consider tax years open for audit. The IRS generally can assess tax within three years after a relevant fund or partnership’s tax return was timely filed. For calendar year funds that typically file on extension by Sept. 15, this means that a new audit for the 2019 income year generally expires as of Sept. 15, 2023. This will inform the materiality of the issues involved and how to allocate resources in preparation of any audit.

Consider contractual exposure. Many sponsors have provided comfort to investors in limited partnership agreements and side letters. It would be prudent for sponsors to map out the scope and timeline of these provisions, both to anticipate likely tensions among investor groups with differing tax profile and to protect against foot-fault risk (such as notification requirements).

When an Audit Notice Arrives

Establish process. Under BBA, the central figure of the audit process vis-à-vis the IRS will be the partnership representative or its designated individual. This is a person identified by the fund on the partnership tax return of the year under audit. If the fund failed to appoint a partnership representative, then the IRS will notify the fund and request a designation. The partnership representative has broad authority to deal with the IRS and resolve the audit and, as a matter of law, isn’t required to keep investors informed. However, notification and communication processes typically are set forth in the fund’s operating documents and side letters.

Gather the necessary documents. The IRS may require, as part of standard audit practice, an organizational chart, the fund’s limited partnership agreement and financial statements, and may ask for certain other documents. If there were material transactions (such as substantial sale events or a fund merger), transaction documents may be requested. Specific tax audit requests also may be informed by the specialization of the relevant audit official. For example, a general audit at the master fund level may be followed by an audit of an offshore feeder in a fund using a traditional master-feeder structure by an international tax specialist.

Review the fund’s operating agreements. Fund sponsors and their investors alike should review early on the agreed upon process for handling the audit. Specifically, certain efforts may be needed to reach a certain outcome, and certain tax elections may be needed (or not). The fund agreement also typically states how the audit result will be allocated and whether it impacts the investor capital accounts and incentive compensation calculation.

Consult advisers. The fund’s regular US tax accountants typically will offer representation upon audit. It’s therefore generally appropriate for the partnership representative to consult existing advisers to help organize the audit process and to better understand the filing positions that were taken from a general consistency and audit trend perspective. Thorny tax issues, particular IRS requests and the preservation of privileged information, may warrant a consultation with legal counsel.

Heightened Potential for Audits

Campaigns listed on the IRS website that are relevant for the alternative investment industry include US loan origination issues for credit-focused funds, investing or trading in cryptocurrency and other digital assets, US investor compliance with the CFC tax-filing system (Form 5471), and offshore feeder and other non-US investor tax filing requirements associated with the conduct of a US trade or business (Form 1120-F). For funds sponsors, the limited-partner exception from self-employment tax continues to be a hot issue.

While the specific issues that may arise will depend on the facts, issues that historically have been a focus of the IRS upon a fund-level audit include book/tax reconciliation for large partnerships (Schedule M-3), character and timing of income issues, and consistency of filing positions. For offshore funds and feeders, meeting the requirements of the securities and commodities trading safe harbors and compliance with US withholding issues may be a focus of attention.

In conclusion, given the anticipated increase in audit activity, it would be prudent for fund sponsors and their investors to assess their readiness and monitor their exposure to future audits under the BBA partnership tax audit program. Consulting with their existing advisers as needed is also recommended.

This article does not necessarily reflect the opinion of Bloomberg Industry Group, Inc., the publisher of Bloomberg Law and Bloomberg Tax, or its owners.

Author Information

Olivier De Moor is a partner in Akin’s international tax practice. He advises hedge and private equity funds on federal tax and tax treaty aspects of the structuring and restructuring of their investments.