The hedge fund industry has found itself in the crosshairs of various regulators and legislators recently, with a spate of bills and proposed regulations relating to governance of the industry.  What’s less known, yet equally if not more relevant, is that the Internal Revenue Service (IRS) has a managed funds audit team that was created two years ago and is currently stepping up its audits of hedge funds and hedge fund managers and its investigations of hedge fund tax compliance issues.  (The unit also focuses on private equity funds and their managers.)  The IRS noted in a statement: “The service seeks to identify any areas of possible non-compliance in the income tax reporting of hedge fund and private equity fund investors and managers, as well as possible non-compliance in the reporting of withholding obligations.”  The managed funds audit team focuses on areas such as compliance with filing requirements, income recognition, characterization of income as ordinary or capital gains, the flow of funds between onshore and offshore entities, the allocation and timing of incentive payments and other income and the accounting methods used to reflect and record income.  The IRS has focused significantly on training auditors on tax issues related to the hedge fund industry.  Within the hedge fund industry, tax audit activity has increased in the last year.  In September 2008, hedge funds experienced the team’s first real push to conduct audits.  We discuss the formation of the managed funds audit team; what actions may trigger an audit; key areas of focus in audits (including a discussion of the wash sale and straddle tax rules); offshore concerns (including deferral and UBTI issues); violations and remedies; how to prepare for an IRS audit; differences between IRS audits and SEC or financial audits; and the length of audits and appeals.