Surprise IRS Hedge Fund Ruling Could Mean Big Tax Bills

November 6, 2002 ( - Investors who put money into hedge funds through life insurance policies could get hit with a hefty tax bill after the government ruled that the hedge fund returns are not tax free.

That’s despite assurances from insurance companies when they sold the product that the returns would be sheltered from the tax man, the Financial Times reported.

The Internal Revenue Service (IRS) ruling, issued in response to an insurance company request, is a major hit for the hedge fund industry, which is already facing an investigation by the US Securities and Exchange Commission (SEC).

To maintain the tax-free status, hedge managers will have to set up separate funds to be sold purely through insurance companies, the Financial Times said. This will make it more complicated for hedge funds to tap into smaller, private investors through annuity products.

“This is pretty embarrassing for insurance companies that set up the arrangement that did not get a favorable ruling and will make it more complicated for hedge funds,” Lee Sheppard, a contributing editor to Tax Notes, a weekly tax journal, told the Financial Times.

Normally, hedge fund gains for US investors are taxed as ordinary income. By wrapping hedge fund investments into tax-favored life insurance or annuity contracts, life insurance companies believed the returns could be sheltered, according to the Financial Times.

Insurance companies can bring small investors into hedge funds, which otherwise have to register with the SEC in order to be able to sell directly to individuals.

Hedge fund managers said the IRS’s private ruling, has left investors uncertain about the tax implications.One hedge fund manager said it was still unclear whether investors would be hit with large tax bills.

The SEC is investigating hedge funds following a spate of fraud cases and the spread of hedge fund products to retail investors, who regulators fear might not understand the risks associated with such sophisticated products, according to the Financial Times. (See  SEC Widens Hedge Fund Probe ).