IRS Revenue Ruling Says Fund of Funds' Management Fees Are Not Deductible as Business Expenses

In a revenue ruling of import to hedge funds, the IRS said that the management fee of a fund of funds is not an ordinary and necessary expense and cannot be treated as a business expense and deducted under IRC Section 162. The IRS reasoned that the activities of a fund of funds consists solely of acquiring and disposing of interests in other funds, and that such activities do not constitute a trade or business within the meaning of § 162. See Revenue Ruling 2008-39. Rather, the management fee of a fund of funds should be treated as an investment expense under IRC Section 212.

According to the IRS, the question of whether the management fee of a fund of funds may be deducted as a business expense under § 162 or an investment expense under § 212 had to be resolved solely by reference to the activities of the fund of funds, and not the activities of the underlying funds in which it invests.

The management fee of an underlying fund is an ordinary and necessary
business expense within the meaning of § 162 in carrying on that fund’s trade or business. But the management fee of the fund of funds is without regard to the activities of its portfolio funds and is an ordinary and necessary expense in carrying on its investment activities. The management fee of the fund of funds is not paid or incurred by the fund on behalf of any underlying fund in connection with that fund’s trade or business.

Thus, the IRS concluded that, because the fund of funds itself is not engaged in a trade or business within the meaning of § 162 and because the management fee is not paid or incurred on behalf of any underlying funds in which it invests in connection with their trade or business, the management fee is not deductible under § 162. Rather, the fund of funds annual management fees are ordinary and necessary expenses described in § 212 paid or incurred in connection with its investment activities. Accordingly, the investor’s share of the fund of funds’ management fee is deductible under § 212.

Further, pursuant to § 703(a)(2)(E) of the IRC, the fund of funds does not take into account its management fees in computing its taxable income Instead, § 1.702-1(8)(a)(i) requires that the fund of funds separately state its management fees and that investors take into account separately their distributive share of the fund of funds management fees.

Because the management fee of each underlying fund is an ordinary and necessary expense paid or incurred in carrying on the trade or business of those funds, the management fee is deductible under § 162. As a result, each fund takes its management fee into account in computing its taxable income or loss described in § 702(a)(8), and the fund of funds takes into account its distributive share of the taxable income or loss of each fund in computing its own taxable income or loss described in § 702(a)(8). The investor takes into account its distributive share of the fund of funds taxable income or loss in computing the investor’s tax liability.