Domestic fund

Domestic hedge funds are the U.S.-based portion of hedge fund structures. They are specifically designed to provide the best possible tax treatment for U.S. investors who pay taxes, while also meeting U.S. regulatory requirements. These funds often serve as the foundation for more complex investment structures that span multiple countries.

Most domestic hedge funds are organized as limited partnerships or limited liability companies (LLCs). Some use specialized versions called series limited partnershipsSpecialized limited partnership structures that allow for the creation of separate series or compartments within a single legal entity, each with distinct assets, liabilities, and investment objectives. or series LLCsLimited liability company structures that permit the establishment of separate series or cells within one LLC, each having segregated assets and liabilities from other series.. Occasionally, a fund might use a non-U.S. entity that chooses to be treated as a partnership for U.S. tax purposes. Regular U.S. corporations are rarely used as the main hedge fund structure because they must pay full U.S. income tax at the corporate level.

Limited partnerships are the most popular choice for domestic hedge funds. In a limited partnership, the general partner has broad authority to manage the partnership's investments and operations. However, the general partner also faces unlimited liability, meaning they are personally responsible for all the partnership's debts and obligations. Because of this risk, the general partner is typically a limited liability company rather than an individual person. This provides management control while protecting the actual managers from personal liability.

Limited partners—the investors—have their liability limited to the amount they invested, as long as they don't get involved in managing the business. Limited partnerships remain the most popular choice because they have a long-established legal history and investors are familiar with how they work. Delaware is the preferred state for forming these funds because it has extensive case law and business-friendly courts.

Limited liability companies offer another popular structure for domestic hedge funds. LLCs have one or more managing members who have broad authority to run the company. Some LLCs use a managing board or hire a non-member managerAn individual or entity that manages an LLC's operations without holding any ownership interest or membership rights in the company. who doesn't own any equity in the company. Unlike general partners in limited partnerships, managing members enjoy limited liability protection from the company's debts and obligations, even though they actively manage the business. The investors are called "members" of the LLC and also have limited liability protection.

Like limited partnerships, LLCs are "pass-throughTax treatment where business income and tax attributes flow directly to investors rather than being taxed at the entity level." entities for U.S. tax purposes, meaning the company itself doesn't pay taxes—instead, profits and losses pass through to the individual investors. However, LLCs have some disadvantages compared to limited partnerships. The LLC structure is relatively new, so there is less established case law to guide legal decisions. While LLCs now exist in all fifty states, some investors are less familiar and comfortable with this structure. Additionally, certain foreign countries treat LLCs as corporations for tax purposes rather than pass-through vehicles, which can subject the LLC to withholding taxes or other taxes that a limited partnership would avoid.

Investors in domestic hedge funds want to avoid being taxed twice on the same income while still enjoying limited liability protection. In a domestic fund structure, the fund's gains and losses generally are not taxed at the fund level. Instead, they pass through directly to investors, allowing investors to benefit from any favorable tax rates that might apply to their specific income.

Since a domestic fund operates as a partnership for tax purposes, it generally doesn't pay federal income tax at the fund level. Instead, each partner must separately report their share of the fund's gains and losses on their individual tax returns. This includes both long-term and short-term capital gainsProfits realized from the sale of capital assets, typically taxed at preferential rates compared to ordinary income. or losses, as well as ordinary income or loss items. Importantly, each partner is taxed on their share of the fund's taxable income and gain regardless of whether they actually receive cash distributions from the fund.

Domestic funds typically do not accept non-U.S. investors, but they may accept certain U.S. tax-exempt investors. Some tax-exempt U.S. entities—particularly certain state government agencies that believe they are not subject to tax on "unrelated business taxable income Unrelated business taxable income (UBTI) Unrelated business taxable income (UBTI) is income that tax-exempt organizations earn from business activities unrelated to their exempt purpose. When tax-exempt organizations invest in hedge funds, certain fund activities can create UBTI, making these otherwise tax-exempt investors subject to taxation. " (UBTI)—may prefer to invest in a domestic fund rather than an offshore fund Offshore fund An offshore fund is a hedge fund established outside the United States, typically in low-tax jurisdictions like the Cayman Islands or British Virgin Islands. These funds primarily serve non-U.S. investors and U.S. tax-exempt organizations by offering tax advantages and greater regulatory flexibility than domestic fund structures. . This preference exists because they want to avoid U.S. withholding tax on certain types of U.S.-source income that they would indirectly face as investors in an offshore fund.

However, there is a trade-off. Any UBTI generated by a domestic fund will pass through to its tax-exempt U.S. investors, while a tax-exempt U.S. investor generally will not incur UBTI from an unleveraged investment in an offshore corporation.

Domestic funds often work together with offshore hedge funds in what are called master-feeder or side-by-side structure. In a master-feeder structure, the domestic fund serves as one of the "feeder Feeder fund A feeder fund is a type of investment fund that collects money from investors and then invests nearly all of that money into a larger "master fund." This structure allows different types of investors—such as U.S. taxpayers, tax-exempt organizations, and foreign investors—to all participate in the same investment strategy while using the fund structure that works best for their specific tax and regulatory needs. " funds, typically accepting taxable U.S. investors and certain tax-exempt U.S. investors. Meanwhile, an offshore feeder fund accepts non-U.S. investors and other tax-exempt U.S. investors. Both feeder funds invest their money into a single master fund that actually conducts the trading activities.

In fund of funds structures—where one fund invests in multiple other hedge funds—taxable U.S. investors generally prefer that the fund-of-funds invest in underlying hedge funds that are treated as partnerships for U.S. tax purposes. This preference makes domestic funds the preferred investment vehicle for this category of investors.

Domestic hedge funds are typically organized as Delaware limited partnerships or, less commonly, limited liability companies. They are governed by limited partnership agreementThe governing document that establishes the terms, conditions, and operational structure of a limited partnership fund.s or operating agreement Operating agreement An operating agreement is the primary governing document for a hedge fund structured as a limited liability company (LLC). It establishes how the company will be owned, managed, and operated, including rules for capital contributions and profit distributions. s, respectively. These legal documents establish the relationship between the general partner and limited partners, or between managing members and regular members. The agreements detail each party's rights, obligations, economic terms, and operational provisions.

In domestic funds, performance-based compensation is typically structured as an allocation of profits rather than as a fee. Most commonly, these allocations are made to an affiliate of the fund manager. This structure allows the manager to receive pass-through tax treatment on their incentive allocation Incentive allocation Incentive allocation is the performance-based compensation structure in domestic hedge funds where the general partner receives a percentage (typically 20%) of the fund's net profits as an allocation of partnership income, subject to high-water marks and potentially hurdle rates or clawback provisions. , potentially qualifying for favorable capital gains treatment under certain circumstances.

The tax character of the underlying fund income flows through to whoever receives the incentive allocation. However, beginning with calendar year 2018, the domestic fund must generally hold a capital asset for more than thirty-six months for any gain on the asset's sale to qualify as long-term capital gain for the person receiving the incentive allocation.