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Here's a tax predicament you wish you had.

When Jeff Vinik

liquidates his famous hedge fund at the end of the year, how bad will the tax hit be to his 160 investors? Sure, these are people who were able to cough up the $2 million minimum required investment, and potentially experienced a 645% gross return over the past four years, so it may be hard to feel sorry for them.

This may strike you as another way for the curious to ogle over the lifestyles of the rich, but the issue has increasingly broad implications. Nowadays, hedge funds aren't only for the fat cats and the institutions. With some minimums as low as $250,000, many more people will have the opportunity to take advantage of these aggressive portfolios that were once exclusively for the rich and famous.

Hedge funds are different from mutual funds in many ways, but on the tax front hedge funds have the option of distributing the actual securities at liquidation. This helps to avoid an unexpected tax hit. On the flip side, when a

mutual fund liquidates, shareholders get smacked with a tax hit, no questions asked. During a liquidation, mutual fund shareholders essentially must sell their shares back to the fund company and that creates a taxable event.

Closing the Hedge Shop

In most cases, a hedge fund is a partnership, whereas a mutual fund is a corporation. So shareholders in a hedge fund are called partners. Every hedge fund has some type of governing document that dictates what management can do in the event of a liquidation, says Charles Vallone, a partner at

Frankel Loughran Starr & Vallone

, a financial advisory firm in New York. But here are the general options: The terminating fund can distribute the actual securities in proportion to your investment, it can sell everything and distribute just cash, or it can distribute some combination of both. At this point, it is not clear which method Vinik will choose, but it's likely he'll opt for the one that's best for investors from a tax standpoint.

When a terminating hedge fund is very large, with total assets in the hundreds of millions, generally the securities are returned to the partners, says Dave Mangefreida, an asset management tax partner at

Ernst & Young

in Washington, D.C. There are a few reasons for this. If a large fund were to have a sidewalk sale and dump all of its securities, it might negatively influence the overall market. In addition, partners in large hedge funds are most likely institutional investors, who generally are pretty tax savvy. These partners know that if that manager sold everything they'd get smacked with an ugly capital gains tax hit. "So they'll scream bloody murder to make sure that doesn't happen," says Mangefreida.

The distribution of securities at liquidation is not a taxable event to the partners. (Check out

section 731 of the tax code for more details.) The partners now hold the actual securities and will owe capital gains tax when they decide to sell those shares. In this way, the partners can control their own tax bill and sell the shares when they are most prepared to do so.

A cash distribution, on the other hand, could be a taxable event depending on your basis in the fund. Just like selling a stock, the tax bill is based on the difference between the cash received and a partner's adjusted basis in the hedge fund.

A partner's basis in a partnership is reported on a

Form 1065 (Schedule K-1) --

Partner's Share of Income, Deductions, Credits

. It must be adjusted by any distributions the hedge fund makes, in the same way that

mutual fund shares must be adjusted for distributions.

There's a difference though. Partners typically don't get any cash when a hedge fund makes a distribution, says Vallone. Everything automatically is reinvested. But that doesn't excuse the partners from the tax bill. They still have to come up with the extra cash to pay that tax bill on their own. This is different from a mutual fund distribution, because you do get the cash. Then you have the option of reinvesting it.

In simplest terms, let's say you contributed $100 to a hedge fund last year. This year it makes a $50 distribution, which is automatically reinvested. That $50 will be reported on a Form K-1 and you'll owe tax on it. Your adjusted tax basis in the fund is now $150. Let's then assume that the fund liquidates the following year and you get $200 in an all-cash distribution. In this instance you'll have $50 gain, says Jim Calvin, an investment management tax partner at

Deloitte & Touche

in Boston.

So it is important -- even for hedge fund folks -- to keep track of the basis in their investment.

The Same but Different

Hedge funds differ from mutual funds in other ways as well. To start, they're unregulated so managers can use risky tactics such as short-selling and derivatives to make big bets or hedges on the direction of security, currency or index prices. Hedge funds typically are designed to make money no matter what's going on in the market. Alternatively, mutual funds are regulated by the

Investment Company Act of 1940

, which limits the amount of big bets and risky tactics it can use.

But mutual funds shareholders pay much lower expenses than hedge fund partners do. Mutual fund companies absorb many of the expenses involved in running a mutual fund so they are not passed on to the shareholders. But since hedge fund shareholders are partners in the company, they must pay a percentage of all associated costs, says Brian McQuade, a principal of the

Hedge Fund Center

, a

Web site that provides educational information on hedge funds. Check out this earlier

story for more differences. (One burgeoning trend in the mutual fund arena is the push by fund firms to roll out

regular offerings with hedge-like characteristics.)

And while the

Internal Revenue Service

knows exactly how much a mutual fund distributes to its shareholders, Uncle Sam doesn't have a clue as to what a hedge fund distributes. They do not issue Form 1099s, like a mutual fund, that report the amount of the distribution. "

The service is trying to get them to go electronic, but it's an enormous undertaking," says Calvin. So no one is keeping an eye on these folks yet.

Any Planning Tips?

Of course, anything partners can do to defer paying tax on that new income will be most beneficial to their tax return. "If I were an investor in the fund, I'd hope the final distribution was in January to delay the reporting of income," says McQuade.

Of course, these people are probably used to some pretty fat tax bills but no one wants to give Uncle Sam 40% of their earnings.

"The most basic thing they can do is to pester the fund to find out what kind of distribution will be made and what are the overall realized gains or losses are for years," suggests Vallone. Once they know that, they can start generating some losses by selling some losers.

Granted, having to tend to a hefty hedge fund distribution is not a bad problem to have. But understanding the inner workings of these things will help even the novice hedge fund investor determine how to handle it wisely.

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