Mini-master structure

The mini-master structure combines features from two other common hedge fund arrangements: and . Here's how it works: an puts all of its investment money into a separate entity that the IRS treats as a partnership for tax purposes. This offshore fund then operates alongside a that has the same investment manager.

When there is no master fund managing the domestic hedge fund, the domestic fund works directly alongside the offshore fund's subsidiary entity. Industry professionals typically call this subsidiary entity a "mini-master fund."

This structure developed mainly because of of the Internal Revenue Code. This tax rule contains that make it difficult for fund managers to structure complex compensation arrangements in a tax-efficient way.

After Section 457A took effect in 2009, investment managers found it generally impractical to delay paying taxes on when that compensation was structured as fees. To solve this problem, many managers of offshore funds now structure their incentive compensation as profit allocations instead of fees. This approach allows them to get similar tax treatment to the compensation they receive from their domestic funds.

To get the tax benefits they want, offshore corporations typically invest their money through a subsidiary mini-master fund. This subsidiary chooses to be classified as a partnership for U.S. tax purposes. It then issues special ownership interests to the or a related company.

These special ownership interests receive two types of returns. First, they get a proportionate return based on the capital investment. Second, they receive an , which works similarly to how general partners receive performance-based compensation in domestic partnerships or limited liability companies.

Within these structures, the mini-master fund allocates performance compensation to an investment manager affiliate. This affiliate is typically the domestic hedge fund's general partner. The compensation relates specifically to the offshore fund's assets.

Since the mini-master fund operates as a partnership for U.S. federal tax purposes, the performance compensation flows through as a partnership allocation. This means the general partner entity receives on this income, which is generally more favorable than being taxed as regular fee income.

An offshore fund can operate as the only feeder in a mini-master structure when there is no domestic involved. Alternatively, both the mini-master fund and a domestic feeder fund can feed into a . In this second scenario, practitioners often call the mini-master fund an "intermediate fund."

This structure gives the manager flexibility in how they structure incentive compensation. Instead of treating compensation related to the offshore fund as a fee, they can structure it as an allocation of profits at the mini-master level.

From the manager's perspective, investors in an offshore fund typically don't care from a tax standpoint whether the fund pays performance-based allocations or . However, managers often prefer structuring incentive compensation as profit allocations for their own tax purposes.

This preference stems from anti-deferral provisions in the Internal Revenue Code that apply specifically to fees. These provisions become particularly important when incentive compensation terms are complex, such as arrangements that span multiple years.

There is one potential drawback for managers to consider. If the incentive allocation comes from a fund that operates as an "investor" rather than a "trader," the resulting income may not be usable by the manager's partners to offset business expenses that the allocates to them.

The structure does add operational complexity compared to simpler arrangements. However, it can provide meaningful tax advantages for fund managers while addressing the different needs of various investor categories.

The mini-master structure differs from a full master-feeder structure in an important way. In a master-feeder structure, all investments flow through a single master fund. In contrast, the mini-master structure maintains some separation between the domestic and offshore vehicles.

This separation potentially allows for greater flexibility in adapting to the different needs of various investor types. Most offshore funds operate as entities that the IRS treats as corporations for U.S. tax purposes. This corporate treatment ensures that non-U.S. investors and tax-exempt U.S. investors avoid complications related to "" or "."