Staying Compliant and Maintaining Confidence: Tax Risks Alternative Investment Funds Can’t Afford to Ignore

For alternative investment funds, tax season has never been a simple, low-effort process. The potential pitfalls are many, from carried interest compliance to proper reporting of complex instruments. As of early 2026, the IRS enforcement landscape is shifting toward a technologically driven, data-focused model, aimed at high-income earners and complex partnerships, including private investment funds. While the agency faces significant budget cuts and staff losses, it is utilizing artificial intelligence and advanced analytics to identify noncompliance, maintaining high-value enforcement despite a lower overall audit rate.

For investors and fund managers, this shift can have financial consequences, in addition to harming a fund/fund manager’s credibility. In the absence of a robust and capable tax team, funds may be at risk of missteps that could trigger amendments, penalties, and a complicated, costly restatement process.

Understanding the most common mistakes is essential for assessing risk and ensuring the fund’s tax positions and documentation are as strong as its investment strategy. While this is not a complete and all compassing list, it does highlight some of the most common issues that we have come across recently.

1. Carried Interest Compliance

Why Fund Managers Should Care

• Section 1061 recharacterizes long‑term gains as short‑term for individuals who receive carried interest (general partners, special limited partners, etc.). Unless the underlying assets that generated a long-term capital gain were held for more than three years, what appears to be long-term gain on a schedule K-1 may be required to be reclassified to short-term on said individual’s individual tax return.
• Incorrect Section 1061 tracking and analysis can cause fund managers to under- or overpay tax significantly, resulting in interest, penalties, and amending personal returns for the year(s) in question.
• Weak documentation at the fund level increases exposure. Having a consistent, traceable, and explainable methodology is key to proper compliance.

Check out our 2025/2026 Tax Planning Guide to read more about carried interest compliance.

2. Improper Structuring

Alternative funds have a variety of structures to accommodate diverse investor profiles, such as master‑feeder funds, blockers, SPVs, and offshore entities. When a fund is improperly structured or doesn’t match the fund’s actual economics or operations, the IRS sees it as a red flag, which may lead to unwanted tax exposure and unexpected tax leakage.

Risks for investors and fund managers

• The allocation/calculation of Unrelated Business Taxable income (UBTI) can expose tax‑exempt to unforeseen liabilities.
• The allocation/calculation of effectively connected Income (ECI) can expose tax‑exempt and foreign investors to unforeseen liabilities.
• Inconsistent treatment between onshore and offshore entities can lead to allocation errors, as well as foreign and U.S. withholding issues, which may lead to unexpected penalties.

A fund’s structure needs to be well thought out and properly executed to achieve the (present and future) goals of all parties involved. Investors increasingly evaluate structural soundness as part of operational due diligence. Fund managers should take a good look at their structure with their tax team to make sure it still matches the needs of their investor base and is executed properly.

For more information on UBTI, please check out our Anchin Alert.

3. Overlooking State‑Level Compliance

State tax authorities have become more aggressive, and many now coordinate directly with the IRS, creating a more complex enforcement environment. Funds that focus solely on federal compliance risk are missing obligations that can cascade into multi‑state audits.

As more states move to a market-based sourcing approach and seek to collect tax where the benefit is received rather than where the fund is or where the work is done, state exposure is more relevant than ever for partnerships.

Partnerships often unknowingly have nexus in multiple states and may be on the hook for years of past due tax and compliance. It is extremely important to have a tax team that understands state and local issues to provide timely guidance and identify which states have filing requirements. Many states have updated their rules in the past few years and will continue to do so. What was considered proper in the past may now be a red flag in current and future years.

Why this matters

• Failure to file in required states can lead to significant penalties with interest, payment of back taxes, and exposing investors to state audits and enforcement.
• Incorrect state sourcing is a critical issue for investors because it directly impacts net returns through unexpected tax liabilities, penalties, and administrative burdens. Missed withholding obligations can create liabilities that expose the fund and its investors to onerous penalties.

Investors increasingly expect funds to demonstrate a comprehensive, multi‑jurisdictional compliance framework that adapts to the rapidly changing and dynamic state and local tax environment.

For more information on state disparities, read our Anchin Alert and visit the State & Local Tax page on our website.

4. PFIC Misclassification: A Silent but Costly Risk

Passive Foreign Investment Company (PFIC) rules are notoriously complex, and funds with foreign investments or offshore vehicles often underestimate the compliance burden.

Investor‑level implications

• Late or incorrect PFIC elections can result in inefficient tax treatment for investors. Default PFIC treatment in the absence of a proper Qualified Electing Fund (QEF) election is purposely punitive and costly from a tax perspective.
• Poor basis tracking can lead to both incorrect gain calculations as well as tax character upon disposition.

For investors, mishandling a PFIC investment can translate directly into a weaker after-tax return on investment and open the door to a costly challenge by the IRS.

5. Misreporting Derivatives and Complex Instruments

Hedge funds frequently trade instruments with specialized tax rules, such as options, swaps, futures, publicly traded partnerships (PTP’s), and structured products. These instruments are fertile ground for IRS adjustments due to their inherent complexity.

Key risks

• Incorrect Section 1256 reporting can result in the misclassification of gains, leading to the under- or overstatement of tax liability for an investor. 1256 treatment is 60% long-term and 40% short-term, so misidentifying transactions subject to 1256 treatment can be extremely costly.
• Improper straddle identification can lead to disallowed losses.
• Miscategorized swap payments can create withholding issues, as well as materially change the character of income/loss reported (ordinary vs capital)
• Failure to track wash sales properly and across multiple brokerage accounts can result in overstated losses and incorrect timing of reversals.

Investors rely on accurate reporting to understand their tax exposure and minimize their risk. Managers must work with their tax team to ensure that all transactions are completely understood and reported accordingly.

7. Partnership Agreements and Side Letters That Don’t Match Tax Reporting

Generally, the first item that the IRS will request is the Fund’s partnership agreement (LPA). Any mismatch between what is outlined in the LPA and what has been reported opens the door to a slew of questions.

Why this matters to stakeholders

• Allocations must reflect the true underlying economics of the fund and its investors according to the economic substance doctrine. If they don’t, the IRS may reallocate income or loss, which can cause a cascading effect, impacting multiple investors and stakeholders.
• Side letters must be incorporated into tax reporting. Preferential terms that aren’t reflected in allocations can create compliance gaps and not capture the intent of the agreement.
• Outdated agreements create ambiguity. If the fund’s strategy and methodology have evolved, the documents must evolve with it to account for the new areas in which there is exposure.

Investors expect the fund’s legal and tax frameworks to be aligned. Any disconnect between the two opens the door to costly errors and challenges.

What Investors and Fund Managers Should
Take Away

The IRS’s renewed focus on the private investment fund space is not a temporary trend; it’s a structural shift. Funds that treat tax compliance as a once‑a‑year exercise are more exposed than ever, while those that invest in strong governance, documentation, oversight, and collaboration with their tax professionals are better positioned to protect returns and maintain investor confidence.

For investors, these issues should be part of due diligence and ongoing monitoring. For fund managers, they are an opportunity to demonstrate operational excellence and differentiate their funds in a competitive market.

For further information and guidance on how you and your fund can ensure it is equipped to handle the complex tax landscape in which it operates, please reach out to George Teixeira, Matthew Talia, or your Anchin Relationship Partner.