This paper was written in 2002 while the author was a student at Columbia Business School and updated as an alumna in 2003. The opinions and analysis in this paper are solely those of the author and do not reflect the views or opinions of, or constitute advice from, her current employer, Goldman Sachs International.
By their nature, hedge funds are not designed as tax-exempt investments. Returns on hedge fund investments typically generate large tax bills for three reasons: because returns themselves are large, because these types of investments typically don't qualify for tax-exempt status, and because the inherent nature of hedge funds is a short-term philosophy. Tax rates are typically nearer the ordinary 40-percent tax rate than the long-term, 20-percent capital gains tax rate.
This paper examines the taxation of U.S. investors in domestic and offshore hedge funds and reviews some tax-planning techniques that were inspired by the current high state of taxation.
Investors now follow three strategies to take advantage of the tax benefits of other instruments. These include: Investing in a hedge fund through insurance companies' variable annuities; buying insurance policies that invest premiums in hedge funds; investing in hedge funds that are part of an offshore private insurance company.
The paper concludes by examining a response from the Internal Revenue Service, which is beginning to more closely scrutinize these types of tax-planning strategies.