Lot Layering: The New Frontier for Hedge Fund Partnership Allocations

Abstract

Lot layering may help hedge funds improve the alignment between tax outcomes and the economic experience of their investors. Although lot layering is considered by most tax experts to be the most precise method of partnership allocations, this commonly understood precision is reduced upon redemptions due to the cumbersome and uneconomic basis adjustment method stipulated by Treasury regulations. We propose that changes be made to the current regulations that could remedy this problem. Despite its unavoidable deficiency caused by the basis adjustment requirements under the current regulations, we believe that lot layering aligns tax and economics more closely than do any of the aggregation methods presently used by most hedge funds. TOPICS: Wealth management, legal/regulatory/public policy Key Findings • Lot layering is considered by most tax experts to be the most precise method of partnership allocations, where the precision relates to the alignment between tax and economic outcomes of partners in a partnership. • We explain how this commonly understood precision is reduced upon redemptions due to the cumbersome and uneconomic basis adjustment method stipulated by Treasury regulations and propose changes to the current regulations that could remedy this problem. • Despite its unavoidable deficiency caused by the basis adjustment requirements under the current regulations, lot layering both eliminates the need for stuffing allocations and aligns tax and economics more closely than do any of the aggregation methods presently used by most hedge funds.