12.27.2011
By Terry Flanagan

Tax Issues Irk Hedge Funds

Straddles and wash sales could bedevil fund managers.

Hedge funds that take complex positions using options need to be aware of potential tax issues that could limit or prohibit their use.

In the case of straddles, which involve buying and selling long and short positions, the IRS can flag such transactions as tax shelters if they’re not properly structured.

“The IRS says that you can’t use a straddle to evade taxes,” George Michaels, CEO of G2 FT, told Markets Media. “Straddles are a legitimate trading strategy, but you need to be aware of whether a trade looks like a tax shelter, even if it’s not being used for that purpose.”

The seminal case in tax law on this issue is the “silver butterfly,” said Michaels.
During the 1960s, investors bought butterfly straddles in silver futures, consisting of a package of long and short futures contracts, so constructed that the value of the overall package fluctuates less than the value of the component contracts.

If properly liquidated, the straddle can create short-term capital losses in one year, which are balanced by long-term capital gains in the next. Thus, investors with short-term capital gains can offset them against the short-term losses.

The IRS brought suit against investors who use straddles for this purpose, claiming that since the likelihood of eking out a profit on the straddles was minimal, their only purpose could be tax avoidance, and therefore they should be disallowed.

Another potential problem for hedge funds is a wash sale, which is generally described as selling stock at a loss, and buying substantially identical securities within 30 days before or after the sale.

There are three consequences to executing a wash sale, according to a white paper by Michaels: 1) You are not allowed to claim the loss on your sale. 2) Your disallowed loss is added to the basis of the replacement security. 3) Your holding period for the replacement security includes the holding period of the security you sold.

“The realized loss that is disallowed can have a big impact upon the decision-making process used in tax-aware investment strategies,” said Michaels.

While staying entirely within both the spirit and the letter of the tax code, a savvy
manager can extract the maximum tax benefit for his clients so that the taxable gains of his clients’ portfolios are substantially less than the economic gains.

However, in order to accomplish this, it is necessary to systematically and frequently analyze and re-analyze the structure of the portfolio in order to determine which transactions will or will not lead to positive or negative taxable events, said Michaels.

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