Undisclosed tax risk gambling with the (using investor money) is legal -- Some fund managers intentionally take tax risks to hype the fund's returns. The question is do you own the Contingent Risk from the manager's tax gambling without knowing tt? The fund can have a Clean Audit Opinion without the manager's disclosure of certain important risks! Read on to see how this is possible.
FASB Interpretation (FIN) 48 allows funds to carry significant contingent tax liabilities on the fund’s books without disclosure to the investor.
See FASB Interpretation (FIN) 48, Accounting for Uncertainty in Income Taxes—An Interpretation of Statement of Financial Accounting Standards (SFAS) 109, Accounting for Income Taxes. http://www.fasb.org/pdf/fin%2048.pdf
FIN 48 employs two primary standards:
Uncertain tax positions should be recorded on a more-likely-than-not basis; that is, if there is a greater than 50% chance that the position would not be sustainable on its merits, a liability should be recorded (paragraph 6); and It must be assumed that the taxing authority
FIN 48 -- True Tax Risk Transparency?
"Why sometimes I've believed as many as six impossible things before breakfast." (the White Queen)~Lewis Carroll~
1) will audit the enterprise,
2) will address the issue, and
3) will have all information available to the taxpayer (paragraph 7a and b).
The Investor may be Completely Uniformed as to Contingent Tax Liabilities
In other words, FIN 48 is an accounting pronouncement which only requires tax problems to be disclosed if the chance of losing a future tax controversy with the IRS is more likely than not. But what if the chances are 50-50? Might it be possible that FIN 48 allows fund managers to expose the fund to huge tax risks without investor disclosure so long as the manager and the fund’s auditor perceive that the fund manager is playing a fair 50-50 tax game of chance?
Let's call a Fund which takes Contingent Tax Risk a “Bernoulli Fund” -- Contemplate entering into a transaction with significant but uncertain tax risk. Equate the transaction to a coin flip. Think of this risky tax transaction as a fair coin with a .5 probability of being tax-free and a .5 probability of being fully taxable.
Example of The St. Petersburg Paradox as applied to a Fund:
Peter, a fund manager, tosses a fair coin repeatedly until it shows heads. He knows he will pay the IRS two dollars of the fund's money if it shows heads on the first toss, four dollars if the first head appears on the second toss, eight dollars if the first head appears on the third toss, sixteen if on the fourth toss, etc. How much of the investor's money should Peter escrow for eventual payment to the IRS so that the game will be fair? How many times should Peter be allowed to flip the coin before the fund has to set aside cash in an escrow account to pay the IRS?
Bernstein, P. L. (1996), Against the Gods: The Remarkable Story of Risk, New York: Wiley. p. 106
Szekley, Gábor J. and St. P. Richards, Donald The American Statistician, August 2004, Vol. 58, No.3
Contact us for a tax due diligence proposal.
Are You Invested in a “Bernoulli Fund”? -- The St. Petersburg Paradox and the “Bernoulli Fund”
Jeff Lonsdale
Logical Formulas
4516 Lovers Lane #122
Dallas, TX 75225
(214) 769-3322
jeff@logicalformulas.com