There is a very real problem within the Internal Revenue Code (IRC) that deserves attention. The IRS generally requires that hedge fund investors pay taxes on huge amounts of “income” that does not exist. This is derived from rules that require investors to pay tax on investment income while denying them an offset for the expenses that were incurred to generate that income. That is the very definition of inequality.
It is simply not uncommon for hedge fund investors to pay tax rates of 70-100% or more on the hedge fund income they earn.
Yes, you read that correctly. 100% or more. In fact, in my practice I see clients every year forced to pay more taxes on an investment than that investment earned. True, it is a small percentage of people affected in any given year, but this does not mitigate the blatant unfairness. How does this injustice take place?
It follows from what is the most inequitable provision of the current tax code, namely, the severe limitation on the ability to deduct the necessary expenses incurred by a hedge fund operator (or any individual taxpayer for that matter) in order to earn income: investment fees and expenses, accountant’s fees, legal fees for collecting a settlement, etc.
The tax code requires those expenses — which include virtually all operating expenses of private equity hedge funds, including fees to the operators — to be listed under the category of “miscellaneous deductions”.
However, these deductions may not be claimed until and unless they reach 2% of the taxpayer’s entire income. The upshot of this is that most taxpayers do not get to benefit from these deductions. To add further insult to injury, that even if investors have expenses which exceed the threshold, these expenses become addbacks for the dreaded alternative minimum tax (“AMT”).
This taxpayer abuse then certainly discourages investment and is a major source of inequity in the code. If Congress were ultimately concerned with reforming the hedge fund industry, this problem — the inability to deduct necessary expenses incurred while earning income — would be the right one for Congress to fix.
