Hi,

This is a tax question about notes. I guess what I did is put money into a hedge fund that buys real estate notes. I invested using money in an LLC that is taxed as a partnership (form 1065). So far I have been getting all the distributions and life is good.

However, now that I am doing taxes for 2014 (I extended), tax man says that that interest is subject to self-employment taxes.  That's roughly a 15% loss, so it's not exactly something that I'm happy with.  If I had known that beforehand, I probably would have just used personal money, which I believe would not have been subject to self-employment (or maybe it would?) because I just look at it as interest similar to interest earned at wells fargo, which would be ordinary income, but not subject to self-employment tax.  

Any tax professionals have any input?  If I had bought the notes personally, would that tax implications have been the same?

I'm not the tax pro on this, but I would guess that 1099 income will be self-employment income whether or not it is funneled through your LLC or your personal name. It is the income source (1099) this is self-employed income vs. employed income (W-2).

The term "hedge fund" gets tossed around like hotcakes. As such, we believe it to mean 'something' while in reality each instance is a standalone. Not all hedge funds are the same in taxation because not all funds are structurally the same in setup. These are important details found in the fund's subscription documentation.

I will also add that in everyday conversation the term "hedge fund" gets tossed around by investors and quite frankly there is no structure that remotely functions like a fund investment. Folks tend to use the term in conversation hoping it helps give them creditability or for whatever other reason they think is of merit. An example of this is joining an LLC which is managed by someone else who runs the company and makes the investments. Even if you are a member and have no direct control you are not investing in a "fund" structure. So taxation in that case can not be altered. You will be taxed as income on the distributions of that LLC. This same misuse of the term also happens with JV agreements but to a slightly lesser amount.

Typically a fund will be setup as a Limited Partnership. (Mind you, we are talking about the fund not the investor, which the OP stated is an LLC) The general partners run the fund and the investors invest into the LP as limited partners.

The main point here I suppose is the tax treatment that you have from the fund is from the fund not from the vehicle that invested in it. All of those entities are pass through. So the investment into the fund passes through to the LLC and the investment in the LLC passes through to your personal taxes. If you are a sole member LLC then the LLC doesn't do much in taxation alteration, it is considered disregarded. Moral of the story, the tax treatment that you suffer from starts at the top and rolls downhill toward you.

How the fund pays you will also affect the treatment. If you receive a guaranteed payment or preferred rate of return that will always be treated like income and subject to SET. The funds investments will pass down to you and be treated as short or long term gains depending on each asset. Provided you are acting fully as a Limited Partner the asset returns or losses should hit you as a capital gain in line with the term of the investment (short or long). If you excluded yourself from being treated like a Limited Partner in full, by actually managing or the fund not being setup in the proper manner - say like an LLC instead of an LP then those capital gains can be treated as income as well which is what happens to the General Partner.

So the take-a-way here is, grab your subscription documents and sit down with your tax proffesional and have them explain what in the fund causes the finds distributions to you to be treated as income instead of gain. They should also be able to show you what expense allocations pass down to you to offset the taxation. From there you will have an understanding to some degree if you can affect any change in taxation or if you should speak to the fund manager in regards to its setup.