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16 Jul 2008

IRS Restricts Deduction of Fund of Funds’ Management Fees

In a recent IRS Revenue Ruling addressing the tax treatment of management fees incurred in a “fund of funds” structure, the IRS’s has severely restricted UPTs (upper tier partnerships) from obtaining tax benefits from management fees.

In a typical fund of funds structure, an investment is made by a limited partner into an UTP which in turn invests in several lower teir partnerships (LTPs). Both groups pay an annual management fee to an investment manager based on assets under management. Since each LTP was, on the facts assumed by the IRS, engaged in the trading of securities, the management fee is an ordinary and necessary business expense and can still recieve tax benefits.

However, the UTP’s sole activity consisted of acquiring, holding, and disposing of interests in the LTPs while receiving a share of income, gain, loss, deduction and credit, therefore ruling these fees non-deductable in most cases.

In the ruling, the IRS examined prior cases of entitlement to deductions and these cases also viewed the partner, even a limited partner, as engaged in the trade or business of the partnership.

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