How do hedge funds avoid taxes?

Hedge funds avoid taxes through legal tax strategies available to investment partnerships, not illegal evasion, using structures that defer or reduce taxes for managers and investors. Main methods include carried interest, where hedge fund managers' performance fee 20 percent of profits is treated as long-term capital gains taxed at lower rate around 20 percent instead of ordinary income up to 37 percent, if investment held over one year, though recent law extended holding to three years for carried interest to qualify. They use offshore entities in low-tax jurisdictions like Cayman Islands to defer US taxes for foreign investors and tax-exempt investors like pensions, avoiding unrelated business taxable income. They use pass-through partnership structure so fund itself does not pay tax, profits pass to investors who pay individually. They use tax-loss harvesting to offset gains with losses, and use derivatives and short-term trading strategies that can generate different tax treatments. Managers may defer compensation. Some use reinsurance companies or total return swaps to convert short-term gains to long-term. These strategies are legal tax avoidance using loopholes and structuring, though controversial and under scrutiny by Congress for fairness. Unlike illegal evasion, avoidance uses existing code. For ordinary investors, similar legal avoidance includes using retirement accounts like 401k and IRA to defer taxes, and holding investments long-term for lower capital gains rate. Hedge fund tax avoidance is complex and requires expensive lawyers and accountants.