22 July 2017

Why Hedge Funds Don’t Worry About Carried Interest Tax Rules

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Hedge fund managers don’t use the carried interest tax loophole. They need something more exotic.

Hedge fund managers, after all, have a lot of income to shelter. According to Institutional Investor’s Alpha magazine, the top 25 hedge fund managers collectively earned more than $21 billion last year. As noted by the website Vox, this sum is more than twice the annual income of all the kindergarten teachers in the United States, combined.

Pick any comparison group, and $21 billion is still a lot of money. It’s roughly the same amount of money that all the 262,000 civil engineers in the United States make, combined. Or about 14 times what all the 20,000 microbiologists make. Or three times what all the 78,000 information security professionals make.

Yet the civil engineers, in the aggregate, probably pay more in taxes than the 25 hedge fund managers. The hedge fund managers’ tax strategies, though, are not based on the carried interest tax dodge that has received so much attention. This confusion may be the most common misconception about carried interest.

Carried interest is the share of profits that fund managers receive in exchange for managing investments. In the case of a private equity or venture capital fund, the investors make long-term investments that last more than one year. Thus, when the investment is sold at a profit, the income flows through to investors and managers as long-term capital gains, which are taxed at a lower rate than ordinary income.

Hedge funds can invest in anything, but they typically traffic in liquid securities like stocks, bonds and other debt instruments, commodities and derivatives. Unlike private equity funds, hedge funds rarely take controlling stakes in companies. Few funds hold a position for more than a year. Indeed, some funds trade based on computer algorithms, changing positions by the day, hour, minute, second or millisecond. For tax purposes, hedge fund profits are usually short-term capital gains, taxed at the ordinary income rate. Many funds elect to be taxed on a mark-to-market basis, meaning that managers and investors recognize trading gains or losses as ordinary income or loss, not capital.

Like private equity fund managers, hedge fund managers receive carried interest in the form of an incentive fee or incentive allocation, but the arrangement bestows no special tax advantage if the underlying gains are ordinary income or short-term capital gain.

This is not to say that hedge fund managers are paying their fair share. Until recently, many fund managers would defer a portion of their fees in a Cayman Islands corporation, which would act as the equivalent of a titanic tax-deferred retirement account. Congress closed that loophole in 2009, although some investments parked offshore will not be deemed repatriated (and will not be taxed) until 2017.

To replace the Cayman strategy, many top hedge fund managers have entered the business of reinsurance, using Bermuda-based reinsurance companies as a capital base for investment in their hedge funds. Insurance companies must hold capital in reserve, and there is nothing to stop an insurance company from holding a huge reserve and investing that capital in a hedge fund. By stapling a small reinsurance business onto billions of dollars of hedge fund capital, any profits can be indefinitely deferred from tax offshore. Better yet, when the fund manager sells an interest in the Bermuda company, the gain may be taxed at the lower long-term capital gains rates.

So no matter what happens with the carried interest tax legislation, the chess match between tax collectors and fund managers will continue.

Click here for the full article in the New York Times DealBook.

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