Hedge funds: Tax structuring, planning, and compliance

Hedge funds continue to be a dominant force in the investment world, employing sophisticated strategies that continue to attract high–net–worth individuals and institutional investors. Perhaps unsurprisingly, the tax regime for these vehicles is nuanced and ever–evolving. As 2026 brings increased IRS scrutiny, particularly of partnership basis and allocations, tax practitioners who advise hedge funds must consider and navigate various complexities ranging from wash–sale and carried–interest rules to mark–to–market elections under Sec. 475(f), the use of blocker entities, and expanded transparency and reporting obligations. Managing tax exposure requires proactive planning, detailed compliance, and a thorough understanding of both fund–level and investor–level considerations.

This article explores various tax rules relevant to the hedge fund industry, highlighting entity structure trends, recent legislative developments, and key planning strategies and compliance requirements.

Fund structure: Partnerships, blockers, and tax optimization

Despite evolving market dynamics and increased regulatory scrutiny, partnerships remain the preferred structure for hedge funds. Most funds continue to operate as limited partnerships (LPs) or limited liability companies (LLCs) taxed as partnerships under Subchapter K of the Internal Revenue Code. This passthrough treatment allows income, gain, losses, and deductions to be reported directly by investors, avoiding double taxation associated with corporate entities.

Fund sponsors typically establish separate management entities, commonly LLCs taxed as partnerships, to receive management fees and incentive allocations (carried interest). This separation also facilitates planning around self–employment taxes and the application of Sec. 1061. However, structuring a hedge fund is rarely straightforward. Common configurations such as master–feeder arrangements, offshore blockers, and tiered partnerships introduce significant complexity. These structures must be carefully analyzed to ensure compliance with Subchapter K’s anti–abuse provisions, including disguised–sale rules under Sec. 707(a), guaranteed payments under Sec. 707(c), and the Sec. 704(b) substantial–economic–effect regulations.

Blocker corporations and offshore feeder funds

To accommodate tax–exempt and non–U.S. investors, many hedge funds create offshore corporations (often domiciled in jurisdictions such as the Cayman Islands) as feeder funds or blockers. These structures are designed to shield investors from undesirable tax consequences. “Blocker” refers to a blocker corporation, typically a C corporation or an LLC treated as a C corporation for U.S. tax purposes. A blocker entity is placed between the investors and funds’ underlying investments, preventing passthrough taxable income from directly flowing to the investors. Feeder funds are investment vehicles that pool capital from multiple investors and invest it into a larger master fund, providing smaller investors access to private or institutional–level investments and allowing fund sponsors to accommodate different investor types, such as taxable and tax–exempt investors, through separate feeder structures.

• For tax-exempt investors, such as pension plans and endowments, blocker corporations mitigate exposure to unrelated business taxable income (UBTI) that may otherwise result from debt-financed investments or underlying trade or business activity.
• For foreign investors, blocker entities limit exposure to effectively connected income (ECI), which could otherwise trigger U.S. tax filing obligations and withholding requirements.

While these blockers serve important tax purposes, they are not without complications. Earnings and profits (E&P) generated within foreign blockers can lead to dividend distributions that may be subject to U.S. withholding under Sec. 1441 of up to 30%.

Sec. 1446(f) adds additional complexity on any transfers/dispositions of a partnership interest by foreign partners, requiring a 10% withholding obligation on the amount realized unless exceptions apply.

Fund sponsors must evaluate the long–term tax impact of E&P accumulation, repatriation strategies, and potential withholding obligations. Managing timing and leveraging debt–financed distributions can mitigate these exposures, although interest deductions must be reviewed under Sec. 163(j) limitations.

Key considerations for structuring

• Master-feeder structures continue to be widely used for pooling U.S. taxable investors (through domestic feeders) and foreign or tax-exempt investors (through offshore feeders) into a common master fund to avoid passthrough of UBTI and ECI.
• Subchapter K compliance is critical, especially with respect to allocations of income and loss, the application of Sec. 704(c) for built-in gains, and the use of target allocations.
• Funds must implement systems to track transfers and diligently onboard foreign investors.
• Careful coordination among fund counsel, tax advisers, and administrators is essential to ensure structural integrity and optimal tax outcomes.

Carried interest: Navigating Sec. 1061

Carried interest remains a cornerstone of compensation for fund managers, typically structured as an allocation of partnership profits rather than a fixed fee and typically earned after investors have received their capital and any applicable preferred return. It is often seen as a key motivator for fund managers and encourages them to focus on generating strong returns.

The law known as the One Big Beautiful Bill Act (OBBBA), H.R. 1, P.L. 119–21, did not alter the taxation of carried interest, leaving Sec. 1061, originally enacted under the Tax Cuts and Jobs Act, P.L. 115–97, intact. Final regulations under Sec. 1061¹ continue to recharacterize certain long–term capital gains as short–term unless the underlying assets are held for more than three years for capital gains allocated with respect to any applicable partnership interest.

The IRS continues to scrutinize fee waiver arrangements and complex partnership structures designed to circumvent Sec. 1061.

Key Sec. 1061 planning considerations

• Structure carried interest allocations to comply with Sec. 1061’s applicable holding period thresholds. Multiyear performance targets and deferral mechanisms can help align fund economics with the holding-period requirement.
• Carefully document capital account treatment for carried interest reinvestments to substantiate eligibility for long-term capital gain treatment.
• Reevaluate clawback provisions, vesting schedules, and hurdle rate mechanics to ensure they reflect bona fide entrepreneurial risk, especially in hybrid structures involving both general partner capital and carried interests.

Hurdles and waterfalls: Funds often include a “hurdle rate,” which sets the minimum return that LPs must achieve before general partners (GPs) can earn carried interest. Funds also use a “waterfall” structure, outlining the sequence in which profits are allocated between LPs and GPs. Together, these provisions make calculating carried interest complex and heavily dependent on fund performance.

Clawbacks: These are provisions where, if a fund underperforms, GPs may be required to return a portion of the carried interest they have already received, adding further complexity, as clawbacks must be monitored and reconciled accurately to ensure proper distribution.

Management fee waivers

Many fund managers use management fee waivers to convert compensation income for services (ordinary income) into profits interests, which are taxed at favorable long–term capital gain rates. While permissible under current law, these arrangements face increased IRS examination, particularly where the waiver mechanics appear too calculated or lack genuine entrepreneurial risk.

To withstand scrutiny and avoid recharacterization as disguised compensation under Sec. 707, fee waivers must carry real entrepreneurial risk and comply with safe harbors outlined in Rev. Proc. 93–27.

Rev. Proc. 93-27

As per Rev. Proc. 93–27,² the receipt of a partnership profits interest for services to or for the benefit of a partnership is not a taxable event if the person receives that interest either in a partner capacity or in anticipation of being a partner and if all of the following conditions are met:

1. The profits interest does not relate to a substantially certain and predictable stream of income from partnership assets;
2. The partner does not dispose of the profits interest within two years of receipt; and
3. The profits interest is not a limited partnership interest in a publicly traded partnership within the meaning of Sec. 7704(b).

Disguised payments for services under Sec. 707(a)(2)(A)

The OBBBA amended Sec. 707(a)(2) by striking the phrase “[u]nder regulations prescribed” by the IRS and replacing it with the phrase “[e]xcept as provided.” This change in the language of Sec. 707(a) which applies to transactions occurring after the date of enactment of the OBBBA (July 4, 2025), clarifies that Sec. 707(a)(2) is self–executing and effective without any regulations. Although the IRS has issued final regulations on disguised sales of property, it has not finalized regulations on disguised payments for services or disguised sales of partnership interests.

In certain circumstances, Sec. 707(a)(2)(A) and proposed regulations issued in 2015³ would modify the treatment of management fee waivers as allocations and distributions made in connection with a partner’s performance of services on behalf of the partnership, treating them as disguised payments for services if:

1. A service provider, acting either in a partner capacity or in anticipation of becoming a partner, performs services either directly or indirectly for the benefit of the partnership;
2. The service provider receives a direct or indirect allocation and distribution of partnership income; and
3. The performance of services and the allocation and distribution, when viewed together, are properly characterized as a transaction occurring between the partnership and a person acting in a nonpartner capacity.⁴

The 2015 proposed regulations include the following list of nonexclusive factors that would indicate that the arrangement constitutes disguised payments for services:

1. The arrangement lacks significant entrepreneurial risk;
2. The service provider holds, or is expected to hold, a transitory partnership interest or a partnership interest for only a short period;
3. The service provider receives an allocation and distribution in a time frame comparable to the time frame that a nonpartner service provider would typically receive payment;
4. The service provider became a partner primarily to obtain tax benefits that would not have been available if the services were rendered to the partnership in a third-party capacity;
5. The value of the service provider’s interest in general and continuing partnership profits is small in relation to the allocation and distribution; and
6. The arrangement provides for different allocations or distributions as to different services received; the services are provided either by one person or by related parties; and the terms of the differing allocations or distributions are subject to levels of entrepreneurial risk that vary significantly.⁵

Poorly implemented fee waivers can lead to income recharacterization, accuracy–related penalties, and even potential IRS investigation if they are marketed too aggressively.

Navigating wash sales, straddles, and constructive sales in complex portfolios

In today’s dynamic trading environment, hedge funds and institutional investors regularly employ complex strategies involving derivatives, short positions, and synthetic exposures. These tactics offer precision and leverage but often bring unintended tax consequences. Navigating the interplay among Sec. 1091 (wash sales), Sec. 1092 (straddles), Sec. 1256 (contracts), and Sec. 1259 (constructive sales) is essential for accurate tax treatment, loss recognition, and long–term portfolio efficiency.

Wash sales

Under Sec. 1091, a loss on the sale of a security is disallowed if a “substantially identical” security is acquired within 30 days before or after the sale. In high–turnover funds or those using algorithmic systems, violations often occur inadvertently, especially when rotating into options, futures, or exchange–traded funds with correlated exposure. For example, selling a stock at a loss and entering a call option on the same equity within the wash window triggers a disallowed loss, delaying recognition and distorting tax reporting.

Sophisticated funds use tactics such as doubling down (buying more of a security) to establish a new holding period or transitioning into non—substantially identical instruments to maintain market exposure while avoiding wash–sale treatment. Automated detection systems and real–time compliance checks are increasingly vital in minimizing unintended wash–sale disallowances across accounts.

Straddles

The straddle rules under Sec. 1092 further complicate matters. A “straddle” is defined as “offsetting positions with respect to personal property.”⁶ Simultaneous offsetting positions, long and short, on the same or similar securities may trigger the deferral of losses, adjustments to basis, or the conversion of long–term gains to short–term or ordinary income.

Any loss with respect to one or more positions shall be taken into account for any tax year only to the extent that the amount of such loss exceeds the unrecognized gain (if any) with respect to the positions that were offsetting positions with respect to those positions from which the loss arose.⁷ Any loss that is not allowed for the tax year will be treated as sustained in the succeeding tax year.

Also, Sec. 263(g) disallows certain interest and carrying charges related to straddles.

Contracts

Contracts under Sec. 1256 held by the taxpayer at the close of the tax year shall be treated as sold for fair market value (FMV) on the last business day of such tax year (and any gain or loss shall be taken into account for the tax year).⁸ Gain or loss related to a Sec. 1256 contract is generally treated as capital gain under Sec. 1256(a)(3) regardless of how long it was held, allocated with “60/40 treatment”:

• 60% with a long-term holding period; and
• 40% with a short-term holding period.

Traders need to file Form 6781, Gains and Losses From Section 1256 Contracts and Straddles, to report any capital gain or loss on Sec. 1256 contracts or Sec. 1092 straddles.

Generally, Sec. 1256 contracts are not subject to wash–sale rules. If there is a loss on Sec. 1256 contracts, taxpayers may be able to carry it back up to three years, potentially allowing them to offset Sec. 1256 gains in a prior tax year.⁹

Constructive sales

Constructive sales under Sec. 1259 may be triggered even without an actual transaction if a position is economically neutralized, such as a short sale of the same or substantially identical property. If there is a constructive sale of an appreciated financial position, the taxpayer must recognize gain as if the position were sold at its FMV on the date of the constructive sale, and any gain must be taken into account for that tax year. Left unmonitored, these events can result in premature gain recognition and unexpected tax liabilities.

To hedge without tripping constructive–sale rules, many funds now rely on basket swaps, customized derivatives that represent a weighted pool of underlying assets rather than individual securities. If properly structured, these instruments provide market exposure or hedging benefits while avoiding the substantially–identical and offsetting–position thresholds under Sec. 1091 and Sec. 1259. However, careful drafting and documentation are critical; a poorly structured swap can easily trigger reclassification or constructive realization.

Regularly analyzing and segregating hedging and speculative positions, along with maintaining detailed trade logs and documenting the economic purpose and structure, while implementing pre–trade compliance checks to detect wash sales and straddle exposure, can efficiently identify hidden tax pitfalls in complex funds.

Leveraging the Sec. 475(f) mark-to-market election

Sec. 475(f) allows eligible traders in securities or commodities to elect mark–to–market accounting, converting capital gains and losses into ordinary income and losses. Under this election, securities held at year end are treated as sold at their FMV, and any resulting gain or loss is recognized as ordinary income or loss, regardless of the holding period.

This election eliminates the $3,000 capital loss deduction limit,¹⁰ allowing full deduction of ordinary trading losses, and provides exemptions from complex wash–sale, constructive–sale, and straddle rules, simplifying reporting and improving tax efficiency for active traders. However, the election also requires careful planning, as it results in taxation of unrealized gains and forfeits favorable long–term capital gain treatment, which may result in higher current tax liability.

Key Sec. 475(f) election considerations

Below are the key eligibility requirements and procedural steps for making, maintaining, or revoking a Sec. 475(f) election:

• The fund must qualify as a “trader in securities” based on a facts-and-circumstances test. To be engaged in business as a trader in securities, the fund must meet all of the following conditions: It seeks to profit from daily market movements in the prices of securities and not from dividends, interest, or capital appreciation; its activity is substantial; and it carries on the activity with continuity and regularity.¹¹
• Existing taxpayers: An existing taxpayer must file a statement (that satisfies the requirements in Section 5.04 of Rev. Proc. 99-17) no later than the due date (without regard to extensions) of the original federal income tax return for the tax year immediately preceding the year for which the election is being made, and the statement must be attached either to that return or, if applicable, to a request for an extension of time to file that return.¹²
• New taxpayers: A new taxpayer makes the election by placing in its books and records a statement (that satisfies the requirements of Section 5.04 of Rev. Proc. 99-17) no later than two months and 15 days after the first day of the election year. A copy of the statement must be attached to the new taxpayer’s original federal income tax return for the election year to inform the IRS of the election.¹³
• Method change filing: In addition to the election statement, unless the election year is the first tax year in which the taxpayer owns securities or commodities, whichever is applicable, the taxpayer is required to file a Form 3115, Application for Change in Accounting Method,with its federal income tax return for the year of change (the election year).¹⁴
• To revoke a valid Sec. 475(f) election, taxpayers must file both a notification statement that satisfies the requirements in Rev. Proc. 2025-23, Section 24.02, and a Form 3115 to change their method of accounting for securities from the mark-to-market method to a realization method.¹⁵
• If a taxpayer revokes a Sec. 475(f) election within five years of making the election, the taxpayer must file the required notification statement (see above) and file Form 3115 under the nonautomatic change procedures of Rev. Proc. 2015-13. Similarly, if a taxpayer makes a Sec. 475(f) election within five years of revoking a Sec. 475 election, the taxpayer must file the required election statement (see above) and file Form 3115 under the nonautomatic change procedures of Rev. Proc. 2015-13.¹⁶

The Sec. 475(f) election can provide significant tax advantages for qualifying traders, particularly those operating in high–volume, short–term strategies. However, it requires precise execution and compliance with IRS procedures, along with a clear understanding of its long–term implications. When properly executed, it can be a valuable tool for improving tax efficiency and simplifying compliance for active trading operations.

Passthrough entity tax (PTET) elections: Unlocking the SALT deduction

Passthrough entities, such as partnerships and S corporations, may elect to pay state and local taxes (SALT) at the entity level through a PTET regime. These taxes are deductible by the entity, which in turn reduces the taxable income allocated to individual owners. This effectively shifts the SALT deduction from the individual to the entity level, allowing it to bypass the individual SALT deduction cap, and provides relief to businesses in high–tax states.

Thirty–six states and one locality¹⁷ have implemented a PTET deduction that is allowed under Notice 2020–75, which subjects the passthrough entity to an entity–level tax in lieu of the owners’ being subject to an individual income tax on their distributive share of earnings.

Proper modeling is critical to assess the investor benefit from electing into a PTET regime. The rules for PTET elections vary significantly by state, and as states revise PTET laws or allow existing provisions to expire, it is critical to identify optimal strategies and confirm the rules for the fund’s state to ensure it can elect and receive the intended benefits.

SALT cap expansion under OBBBA

The OBBBA temporarily increased the SALT deduction cap to $40,000 ($20,000 for married filing separately) beginning in 2025 through tax year 2029, from the previous SALT deduction cap of $10,000 ($5,000 for married filing separately). The deduction is phased out for taxpayers with modified adjusted gross income (MAGI) over $500,000 ($250,000 for married filing separately) in 2025. Under this phaseout, the deduction is reduced by 30% of the excess of a taxpayer’s MAGI above the threshold amount; however, the deduction is not reduced below $10,000. Both the SALT deduction cap and the MAGI threshold are increased by 1% each year through 2029. Beginning in 2030, the SALT deduction cap reverts to $10,000.

The OBBBA preserves federal deductibility of PTETs, allowing passthrough entities to continue paying state income taxes at the entity level.

Planning essential

In today’s complex and highly regulated environment, strategic tax planning is essential for hedge funds. From entity structuring and carried–interest compliance to navigating mark–to–market elections and the PTET regime, funds must adopt a strategic and forward–looking approach to tax. With increased IRS scrutiny, expanded disclosure requirements, and changing laws, hedge funds that invest in strong internal processes, cross–functional coordination, and technology–enabled compliance, while staying ahead of tax developments, will be better equipped to reduce risk and navigate uncertainties in protecting investor returns and to strengthen their long–term competitive edge.

---

Contributor

Vibha Bhanushali, CPA, ACA (Chartered Accountant, India), is a CPA at Holsinger PC in Pittsburgh. For more information about this article, contact thetaxadviser@aicpa.org.

---

Footnotes

¹T.D. 9945.

²Clarified by Rev. Proc. 2001-43.

³REG-115452-14, 80 Fed. Reg. 43652.

⁴Prop. Regs. Sec. 1.707-2(b)(1).

⁵Prop. Regs. Sec. 1.707-2(c).

⁶Sec. 1092(c)(1).

⁷Sec. 1092(a)(1)(A).

⁸Sec. 1256(a)(1).

⁹Sec. 1212(c).

¹⁰Sec. 1211(b)(1).

¹¹IRS, Tax Topic No. 429, Traders in Securities (Information for Form 1040 or 1040-SR Filers) (rev. Jan. 16, 2026).

¹²Rev. Proc. 99-17, §5.03.

¹³Id.

¹⁴Rev. Proc. 2025-23, §24.01(5).

¹⁵IRS, Tax Topic No. 429, Traders in Securities (Information for Form 1040 or 1040-SR Filers) (rev. Jan. 16, 2026).

¹⁶Id.

¹⁷Myers and Sherr, “Recent Developments in States’ PTETs,” 55-9 The Tax Adviser 58 (September 2024); AICPA, State Pass-Through Entity (PTE) Map.

---

MEMBER RESOURCES

Online tools and resources

Tax Section homepage

Annual Tax Compliance Kit