Section 199A deduction

The Section 199A deduction became law as part of the Tax Cuts and Jobs Act of 2017Federal legislation enacted in 2017 that significantly reformed the U.S. tax code, including provisions for FDII and GILTI.. This tax rule provides a significant benefit for owners of pass-through entities. Pass-through entities are business structures like partnerships and limited liability companies (LLCs) that do not pay corporate taxes. Instead, profits "pass through" to the owners, who report this income on their personal tax returns.

Many hedge fund managers structure their businesses as partnerships or LLCs. This means they can potentially benefit from the Section 199A deduction, which can substantially reduce the effective tax rateThe actual percentage of income paid in taxes after applying all deductions, credits, and other tax benefits. on their business income. As of July 2025, Congress made this deduction permanent, removing the previous expiration date that would have ended the benefit.

Pass-through entity owners can claim a deduction for a specified percentage of their qualified business income. Qualified business income refers to the ordinary income, gains, deductions, and losses from any qualified trade or business conducted within the United States.

However, income from securities transactions and investment activities faces major obstacles in qualifying for this deduction. For most domestic hedge funds, investment income will not qualify as eligible business income. The primary exception involves certain types of ordinary income. This includes specific dividends from real estate investment trusts (REITs)A company that owns, operates, or finances income-generating real estate and trades like a stock on major exchanges. and profits from investments in other partnership entities that conduct non-securities business activities.

Recent legislation that takes effect for tax years beginning after December 31, 2025, has adjusted the allowable deduction percentage and phase-out ranges. These changes expand the potential availability of the deduction for certain higher-income taxpayers who were previously subject to complete phase-out.

The deduction faces significant limitations that directly affect hedge fund managers. When taxpayers exceed specified income thresholds, the deduction becomes limited. The limitation is based on either the wages paid by the business or the qualified property employed in the business.

Investment management and related financial services qualify as a "specified service trade or business" under federal tax law. This classification is critical because it triggers income-based phase-out restrictions. A specified service trade or business includes any trade or business involving the performance of services in fields such as investment management, consulting, and financial services.

For managers whose total taxable income exceeds threshold amounts, eligibility for the deduction becomes progressively limited. As income rises further, the deduction is eventually eliminated entirely. This classification reflects a tax policy distinction. The law treats businesses primarily built on the skill and reputation of their owners differently from those that generate income from capital deployment.

For hedge fund managers, qualification for the Section 199A deduction depends on several interconnected factors. These include the legal structure of the management company, the manager's total taxable income, the wages paid to employees, and whether management activities trigger the specified service business classification.

The exclusion of most securities-related income from qualifying business income creates substantial obstacles. Traditional hedge fund management fees and incentive allocations 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. face significant barriers in benefiting from this deduction.

The most significant barrier for hedge fund managers involves how the tax code characterizes investment management income. The law treats this income as service income that becomes subject to limitations under high-income phase-out provisions. These determinations often require careful tax planning and frequently influence decisions about business entity structure.

Some managers have opted for mini-master fund structures or alternative compensation mechanisms to optimize access to any available tax benefits. A mini-master fund structure involves creating multiple feeder funds 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. that invest in a single master fundThe central investment vehicle in a master-feeder structure where multiple feeder funds pool their capital for consolidated investment management., potentially allowing for more favorable tax treatment of certain income streams.

Managers should monitor ongoing regulatory developments and legislative changes. The deduction framework continues to evolve, with recent amendments affecting the treatment of pass-through entity compensationIncome earned by owners of pass-through entities such as partnerships and limited liability companies that flows through to owners' personal tax returns for individual taxation rather than being taxed at the entity level. and income classification.