The Fund of One

The Fund of One

The “fund of one”, it sounds very Zen-like. I could imagine the phrase being used in a marketing campaign for some private bank or trust company. However, the “fund of one” is much more practical than spiritual.

Imagine you are a high net worth individual (I imagine that a lot…), and you have $100 million invested with a particular money manager. The manager charges a 2% asset management fee. At the end of the year your accountant informs you that the $2 million management fee you paid the manager is not wholly deductible because the fee is what’s called a Section 212 expense and, like your other miscellaneous itemized deductions, is subject to a floor of 2% of your adjusted gross income (i.e., no deduction is permitted for this pool of expenses until such expenses, in the aggregate, exceed 2% of your adjusted gross income). Moreover, if you’re a normal upper income American living in the northeast United States, your accountant might shock you with some more bad news and tell you that you essentially get no deduction for these expenses because you’re subject to the alternative minimum tax or AMT. This is reality for many high net worth investors in the U.S. – no deduction for investment related expenses. My partner, Robert Demmett, blogged, earlier this year, on how this phenomenon (and other hedge fund tax effects) helps to skew investors’ after-tax returns in ways they typically would not have imagined (see Bob’s blog piece here).

Along comes the “fund of one” to the rescue. Basically, the “fund of one” simply moves your assets with a particular money manager into a partnership. The money manager remains the same – just the legal form has changed. The only other partner besides you is the money manager who essentially takes a carried interest in the partnership the way a fund manager would if the investment were a hedge fund. As you might imagine, there are some more bells and whistles around this carry, since the manager expects the economics to mimic a fee but the substance is the same. The tax result to this structure is that what used to be a “management fee” subject to AMT or AGI limitations is now a partnership distribution. While a partnership distribution to another partner is not technically tax deductible, it draws otherwise taxable income away from you which effectively mimics a tax deduction. Moreover, from the manager’s perspective, what used to be ordinary income (i.e., management fee), is now a partnership distribution which may be capital gain or qualified dividend income.

Thus, in particular circumstances, the fund of one can cause non-deductible investment expenses of the investor to become deductible in full while at the same time tax benefiting the investment manager to some extent. Come to think of it, maybe the fund of one is Zen-like. Any U.S. taxable investor utilizing a money manager or separately managed account should consider the benefits of a fund of one.

If you have any questions about the “fund of one” concept or any other tax issue please contact your normal WithumSmith+Brown partner.

Tony Tuths

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