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Like mutual funds, hedge funds immediately pass through any income they realize to investors. But unlike mutual funds, which make cash distributions of their gains (the purpose of which is to remain non-taxed entities), hedge funds send no money. Instead, they deliver a K1 statement detailing the taxable income on which an investor must pay tax.
Even worse, many investors in funds of funds (as well as some hedge funds) often wind up paying tax on more profit than their investment actually earned. How does that happen? Blame it on the structure of hedge funds, which are set up using flow-through vehicles, such as limited partnerships and limited liability companies. The flow-through structure is necessary to accomplish the goal of having the tax responsibility fall only on the holder level, not on the entity level. This the flow-through structure does.
Unfortunately, it also creates a nasty side effect: Before flowing through on a K1, expenses are not netted against income....