Tag Archives: hedge fund tax

COVID-19 Tax Matters for Private Fund Managers

Leave a reply

Certain tax deadlines in the following salient jurisdictions may or may not be further extended due to disruption caused by COVID-19 as of the time of this publication:

CALIFORNIA

  • The deadline for tax filing and payment is extended until July 15 for all individuals and business entities for the following: 2019 tax returns; 2019 tax return payments; 2020 1st and 2nd quarter estimate payments; 2020 LLC taxes and fees; and 2020 non-wage withholding payments.
  • Interest and penalties for individuals and businesses have also been waived.  Requests for relief from penalties, interest or fees can be made through the California Department of Tax and Fee Administration CDTFA.
  • Payroll Tax: Employers may request up to a 60-day extension to file their state payroll reports and/or deposit payroll taxes without penalty or interest by following the instructions of the Employee Development Department (EDD).

San Francisco

  • Businesses with less than $10 million in gross receipts may defer their first quarter business taxes (which under normal circumstances must be pre-paid by April 30th) until February 2021. The deferral is applicable to gross receipts tax, payroll expense tax, commercial rents tax and homelessness gross receipts tax.
  • No interest payments, fees or fines will accrue as a result of the deferral.  Further details are available in the announcement from the Office of the Mayor.
  • No relief has been provided with respect to property tax.
  • The city has established the Small Business Resiliency Fund which is providing financing to qualified businesses.

Los Angeles

CONNECTICUT

ILLINOIS

  • Illinois has yet to announce an extension of deadlines for tax filings and payments as of the date of this publication.

NEW YORK

  • On March 16, 2020, the New York State Tax Department announced that it had not extended the deadline to file personal income tax or other tax returns.  New York has yet to announce an extension of deadlines for tax filings and payments as of the date of this publication.
  • New York has waived fines for businesses that have missed the sales tax deadline of March 20, 2020.  There is no waiver of accrued interest.

New York City

  • The city is in the process of establishing the Small Business Continuity Fund which intends to provide financing to businesses demonstrating at least a 25% decrease in revenue caused by COVID-19.

For general questions or concerns related to impacts of coronavirus on the operations or compliance of funds and advisers, please contact us.

****

Bart Mallon is a founding partner of Cole-Frieman & Mallon LLP. Cole-Frieman & Mallon is a boutique law firm focused on providing institutional quality legal services to the investment management industry. For more information on this topic, please contact Mr. Mallon directly at 415-868-5345.

Hedge Fund Carried Interest on Chopping Block Again?

President Obama Proposes Taxing Carried Interest as Ordinary Income

Every couple of years there are various proposals floated around congress to tax the hedge fund performance fee (or “carried interest”) as ordinary income (see a previous post on this topic from 2009 here).  This week President Obama announced a proposal to tax the “carried interest” of an investment partnership as ordinary income.  The tax will help to pay for the $447 billion American Jobs Act.  According to the White House’s section-by-section analysis of the proposed legislation, the current capital gains treatment of income from the performance of services “creates an unfair and inefficient tax preference.”

The Proposal

Because the carried interest from an investment partnership is derived from the performance of services, the proposal would tax a service partner’s carried interest as ordinary income and make it subject to self-employment tax.  The proposed language indicates that “in the case of an investment services partnership interest . . . an amount equal to the net capital gain with respect to such interest for any partnership taxable year shall be treated as ordinary income.” An investment services partnership interest is defined as “any interest in an investment partnership acquired or held by any person in connection with the conduct of a trade or business” that includes providing investment advice, managing or acquiring assets, arranging financing with respect to acquiring assets, or any activity in support of providing investment advice.

The proposal excludes any partnership interest that is attributed to invested capital (which is called “qualified capital interest” in the proposal) of a partner providing investment management services from being recharacterized as ordinary income as long as the partnership reasonably allocates its income and loss between the invested capital and any interest derived from the performance of services for the partnership.

The proposed language with respect to the carried interest can be found here under Title IV, Subtitle B – Tax Carried Interest in Investment Partnerships as Ordinary Income.

Time to Worry?

The sky is not falling yet. This proposal affects more groups than simply hedge fund managers – private equity, real estate and VC fund managers would be affected by the proposal as well.  Accordingly, there are a number of interested parties ready to challenge the bill and there is already a strong lobbying presence in Washington. In the past we've seen this issue die relatively quickly and, given we are entering another election year, it is likely that we will see it die again in committee soon.

If enacted, the proposal would be effective for taxable years beginning after December 31, 2012.

****

Cole-Frieman & Mallon LLP provides legal advice to hedge funds and private equity funds.   Bart Mallon can be reached directly at 415-868-5345.

zp8497586rq

In-Kind Contributions

Leave a reply

Hedge Fund In-Kind Contributions

Fund managers may allow investors to make “in-kind” contributions to the fund.  This means that instead of, or in addition to, a cash subscription, the manager may allow the investor to transfer securities or other assets to the fund in exchange for fund interests.  Both managers and investors should be

aware of the tax consequences that arise from such transfers.  This post will provide an overview of the general rule and other issues which managers should be aware of with respect to future transactions after an in-kind contribution.  We always recommend that managers discuss the tax consequences of any in-kind contribution with tax counsel prior to the contribution and then with respect to any future disposition of the assets which were contributed.

Please note that tax issues are often complex and depend on the facts of a situation.  This post is intentionally general and you should not rely on this post with respect to any tax issue.  Please see our disclaimer and note we are not providing tax advice.

General Rule

For hedge fund investors, the general rule with respect to in-kind contributions is:

a gain will be recognized on the transfer of stocks or securities to an “investment company” that results in “diversification” of that investor’s interests

Please note that this is a two part test: the transfer must be

  1. to an “investment company” and
  2. result in “diversification“

If both parts of the test are not met then there will be no gain on the transfer.

What is an “Investment Company”?

The term “investment company” means an entity with more than 80% of the value of its assets consisting of certain properties including money, readily-marketable stocks or other equity interest, options, futures contracts, derivative financial instruments, and foreign currency.  The determination of whether an entity qualifies as an “investment company” is generally made immediately after the transfer of property.

Most hedge funds will qualify as an “investment company” using the 80% test.

What is “Diversification”?

The crucial test for investors is whether or not there is diversification with respect to a transfer.  Diversification happens if, at the time of the transfer (i.e. subscription to the fund), two or more investors transfer non-identical assets.  In most cases, the determination of whether diversification resulted is made immediately after the transfer of property.

In the following situations, there is generally no diversification:

1.  No diversification if identical assets

Example: Individuals A and B organize New Co with 100 shares of common stock.  A and B each contribute $500 worth of the only class of corporation X stock, listed on the NYSE, in exchange for 50 shares of New Co stock each.

2.  No diversification if “insignificant amount of assets” transferred are non-identical.  According to the IRS (in Treasury Regulations and various private letter rulings*), 1% and 5% of non-identical assets were insignificant, but 11% of non-identical assets was significant and resulted in diversification.

Example: Individuals A and B organize New Co with 100 shares of common stock. A contributes $990 worth of the only class of corporation X stock, listed on the NYSE, in exchange for 99 shares of stock.  B contributes $10 of readily-marketable securities in corporation Y in exchange for 1 share of New Co stock.

3.  No diversification if all investors transfer a diversified portfolio of assets.  The term “diversified portfolio of assets” means a portfolio in which not more than 25%  of transferred assets are invested in the stock or securities of one issuer and not more than 50% is invested in the stock or securities of five or fewer issuers.   Cash transfers are not included in these calculations.  There are also restrictions on the inclusion of government securities in these calculations.  Each investor to the transaction must transfer diverse portfolios.  If one transfers a non-diverse portfolio, all will be taxed on the gains.

Example: Individuals A and B organize New Co with 100 shares of common stock.  A and B each contribute $120 worth of the only class of corporation X stock, listed on the NYSE, in exchange for 12 shares of stock; $240 worth of the readily-marketable securities in corporations Y and Z in exchange for 24 shares of stock; and $140 worth of options in exchange for 14 shares of stock.

Issues after an In-Kind Contribution

Both the manager and investor should be aware of the potential tax consequences which follow from an in-kind contribution.  The following is a non-exclusive list of tax issues which the manager and investor should consider.

Allocation of Gains and Losses When the Fund Disposes of In-Kind Contributions

If the person making an in-kind contribution does not recognize taxable gains at the time of transfer, then what happens to the gains or losses once there is a disposition of the assets at the fund level?  In general, the fund will be required to first allocate the recognized gains and losses to the contributing investor and then pro rata to the other investors.  This allocation is required to account for the variation between the fund’s adjusted tax basis resulting from the in-kind contribution and the fair market value of those securities when they were contributed.  In essence, the contributing investor will pay the tax, but gets the benefit of the deferral.

Distributing the In-Kind Contributions

If the fund distributes a contributed security (which was not taxed at the time of contribution) to an investor other than the person who made the in-kind contribution anytime within 7 years of the contribution, such person will generally recognize the unrealized gain or loss at the time of the distribution.

Two Year Rule

If the fund makes a distribution of cash to a person who made an in-kind contribution simultaneously with or after the contribution, the contribution may be treated as if such person sold the securities to the fund for fair market value–resulting in recognized gain.   In fact the Treasury Regulations has established a rebuttable presumption about such a situation–if an person who made an in-kind contribution receives a distribution within 2 years after contributing securities, the distribution will be deemed to have been part of a disguised sale.  Such person can rebut the presumption by demonstrating that when it made the contribution, it did not intend to receive a distribution of cash in exchange or that the investment is subject to the appreciation or depreciation of the fund’s assets while invested.

****

Cole-Frieman & Mallon LLP provides comprehensive hedge fund formation and other legal services.  Bart Mallon can be reached directly at 415-868-5345.

Fund Appreciation Rights

2 Replies

Alternative Hedge Fund Compensation Structure

At the very beginning of this year there was much discussion about the hedge fund compensation structure in light of the horrible returns from 2008.  Many funds lost money but managers aren’t typically subject to the same types of clawback provisions as private equity fund managers.  Additionally some funds had to close shop because of talent retention issues or because the manager realized that reaching a previous high water mark would take too long.  Generally investors who have lost money will prefer to stay in a fund (all else being equal) because of the high water mark – when investors go into a new fund, there high water mark is their initial investment which means they are going to be subject to hedge fund performance fees sooner than in a fund which has previously lost money.

FAR Alternative

As an alternative to the traditional performance fee/ allocation structure, some hedge funds are instituting a different compensation structure called fund appreciation rights (FARs).  Generally this structure provides a more aligned incentive structure for the manager.  Essentially the FARs provide an option like mechanism for the manager.  This option also has the potential to allow the manager to defer recognition of income which may be an added tax benefit for the manager.  [Note: a longer discussion on this issue will be forthcoming shortly.]

Issues with FARs

FARs are new.  It is not known how many groups have implemented FARs or whether they will catch on (or become the next standard).  It is likely that any movement in this area will be driven by the demand (if any) by institutional investors for such products.  FARs are also untested and it is not clear how they will be viewed by the IRS.  As we have recently seen, there has been a big push to disallow the tax advantages of the performance allocation to hedge fund managers and in the current political climate it is likely that the IRS will scrutinize such transactions.

We will continue to research and report on this and other tax structures for hedge fund managers.

****

Other related hedge fund law articles:

Bart Mallon, Esq. of Cole-Frieman & Mallon LLP runs the Hedge Fund Law Blog.  He can be reached directly at 415-868-5345.

Hedge Funds, the Secondary Market and PTP Issues

1 Reply

Secondary Hedge Fund Market Poses Issues for Fund Managers

Recently there have been a number of groups springing up to provide a secondary hedge fund market.  While such platforms provide investors with a potential avenue to get out of their illiquid investment (the investment in the fund may be illiquid for a number of reasons including the imposition of a gate provision), they pose problems for the hedge fund manager who will have to deal with the mechanical issues involved in a transfer of the fund interests.  Additionally, as noted in the article below, the manager may have to worry about the PTP issues involved with such potential transfer.

The following article was written by Doug Cornelius of the Compliance Building blog and is reprinted with permission.  All links in the article are from the original.

****

Classification of Private Funds as Publicly Traded Partnerships

Due to the increasing incidence of fund investors who want to transfer their investment fund interests, private investment funds face a risk of being classified as publicly traded partnerships. That would mean the fund would become taxable as a corporation.

A bad result.

Under Internal Revenue Code § 7704, a partnership will be classified as a publicly traded partnership if (1) the fund interests are traded on an established securities market or (2) the fund interests are readily tradable on a secondary market or its substantial equivalent.

The big problem is determining when you have a “substantial equivalent” of a secondary market. Under the regulations, the IRS uses a facts and circumstances test to determine if “partners are readily able to buy, sell, or exchange their partnership interests in a manner that is comparable, economically, to trading on an established securities market.” You hate to get into a facts and circumstances discussion with the IRS.

Fortunately there are some safeguards in the implementing regulations at 26 C.F.R. § 1.7704-1.

Involvement of the Partnership

For purposes of section 7704(b), interests in a partnership are not readily tradable on a secondary market or the substantial equivalent unless (1) The partnership participates in the establishment of the market or (2) The partnership recognizes any transfers made on the market by (i) redeeming the transferor partner or (ii) admitting the transferee as a partner.

Since most fund partnerships require the general partner to approve the the transferee and then admit the transferee, they are unlikely to be able to take advantage of this safe harbor.

De Minimis Trading Safeharbor

The focus of a fund should be on the 2% de minimis safe harbor. 26 C.F.R. § 1.7704-1(j) provides for interests in a partnership to be deemed not readily tradable on a secondary market or the substantial equivalent thereof if the sum of the percentage interests in partnership capital or profits transferred during the taxable year of the partnership does not exceed 2 percent of the total interests in partnership capital or profits.

You want avoid having more than 2 percent of the partnership interests changing hands each tax year.

If you get close to that number there are several transfers that are disregarded transfers for this safeharbor, including:

  • block transfers by a single partner of more than 2% of the total interests
  • intrafamily transfers
  • transfers at death
  • distributions from a qualified retirement plan
  • Transfers by one or more partners of interests representing  50 percent or more of the total interests in partnership

Private Placement Safeharbor

The regulations deem a transfer to not be a trade if it was a private placement. But the regulations have their own definition of a private placement: (1) the issuance of the partnership interests had to be exempt from registration under the Securities Act of 1933,  and (2) the partnership does not have more than 100 partners at any time during the tax year of the partnership. 26 C.F.R. § 1.7704-1(h)

The first prong should be straight-forward for most private funds. The trickier part is the second prong. In some circumstances the IRS can look through the holder of a partnership interest to its beneficial owners and expand the number of partners to include the beneficial holders of that interest.

Passive Income Safeharbor

If a fund is determined to be a Publicly Traded Partnership, it will nonetheless not be taxed as a corporation if 90% or more of the fund’s gross income is passive-type income. [26 U.S.C. § 7704(c)] Passive-type income generally includes dividends, real property rents, gains from the sale of real property, income from mining and oil and gas properties, gains from the sale of capital assets held to produce income, and gains from commodities (not held primarily for sale in the ordinary course of business), futures, forwards, or options with respect to commodities. The income test is on a taxable year basis and must be have been met each prior year.

References:

****

Please also see the post on hedge fund compliance and twitter which includes another reprint of a Compliance Building article.

Other related hedge fund law articles include:

Bart Mallon, Esq. of Cole-Frieman & Mallon LLP runs the Hedge Fund Law Blog.  He can be reached directly at 415-868-5345.

Proposition Q and Hedge Funds

2 Replies

San Francisco’s Proposition Q and its Impact on Hedge Fund Managers

Proposition Q Passes in a Landslide

On November 4, 2008, San Francisco voters approved Proposition Q modifying the city’s Payroll Expense Tax by a resounding 74% of the vote. This little noticed proposition, which went into effect on January 1, 2009, will impact many hedge fund managers and other businesses in San Francisco.

San Francisco’s Payroll Expense Tax

Companies with one or more employees within the City and County of San Francisco and a payroll greater than $250,000 are required to pay a Payroll Expense Tax to the city equal to 1.5 percent of their taxable payroll. In 2007, the Payroll Tax generated over $350 million in revenues for San Francisco. Prior to Proposition Q, the law was unclear about whether compensation for services related to “pass through” entities such as partnerships and limited liability companies was considered “compensation paid to employees” and therefore subject to the Payroll Expense Tax. In reality, for most hedge fund managers in San Francisco, this meant that the distributions made to owners of the company or partnership were not subject to the tax.

Effect of Proposition Q

Proposition Q clarified that such distributions for payments to partners/owners for work done in San Francisco must be included in the calculation of the Payroll Expense Tax. For example, if a hedge fund manager earns $5 million per year, pays $250,000 in salaries to its employees, and distributes $4 million in profits to its partners or owners, prior to Proposition Q only the $250,000 paid to the employees was definitely subject to the Payroll Expense Tax. Beginning in 2009, however, the entire $4 million paid to the partners or owners, will also be subject to the Payroll Expense Tax.

Lack of Guidance and Recommendations

Proposition Q garnered scant attention in the news media, and will no doubt catch many hedge fund managers by surprise this year. The website of the San Francisco Office of the Treasurer and Tax Collector provides almost no information for business owners about the proposition. We advise that hedge fund managers keep Proposition Q and the Payroll Expense Tax in mind when making employment and compensation decisions. In particular, managers should keep in mind the safe harbor provision when determining the owner’s own W2 compensation, as well as the compensation of the top 25% of employees. Managers should also consult with their tax advisors to anticipate the impact of Proposition Q on their 2009 Payroll Expense Taxes, and determine whether they need to adjust their pre-payments of those taxes.

To find out more about Proposition Q and other topics relating to compensation and employment law issues for hedge fund managers, please contact Karl Cole-Frieman of Cole-Frieman & Mallon LLP (www.colefrieman.com) at 415-352-2300.

****

Bart Mallon, Esq. of Cole-Frieman & Mallon LLP runs Hedge Fund Law Blog and can be reached directly at 415-868-5345.

Hedge Fund Carried Interest Tax Increase?

3 Replies

Legislation Introduced to Eliminate Carried Interest “Loophole”

As we are all well aware, the partnership structure of hedge funds allows the management companies of these funds to receive an “allocation” of the fund’s income.  Under general partnership taxation principles, this allocation is taxed to the management company (and the other investors in the hedge fund) according to the characteristic of that income (at the partnership level).  That is, if the income was long-term capital gain at the partnership level, such income would be allocated to all partners (including the management company) and would retain such characterization.  Long-term capital gains are currently taxed at 15% (as compared to a 35% tax rate for most ordinary income).

Last week Representative Sander Levin reintroduced legislation to tax the carried interest at ordinary tax rates.  The tax would only apply to the managers of partnerships to the extent that such managers did not have an underlying investment in the fund.  I will not introduce any political opinions regarding such a tax, but I will note that I take issue with the way that the press and lawmakers define the issue.  The most glaring omission in all of these reports is that the carried interest (or performance allocation) is only taxed at long-term capital gains rates if there are underlying long-term capital gains.  These articles (including the press release reprinted below) insinuate that all allocations made to a manager will be subject to long-term capital gains rates.  Not all income to hedge funds is long term capital gain – in fact, many hedge funds have no long-term capital gains at all because their programs focus on short term or intermediate term trades.

We have discussed this issue a number of times before and believe that the best way for this issue to be addressed is through the political process and we hope that all lawmakers involved take a considered and academic approach when crafting any future tax legislation (see Hedge Fund Taxes may Increase Under Obama).

The press release below is from the office of Representative Sander Levin and provides a sort of question and answer regarding the proposed legislation.  I am interested to read your comments on this issue below.

****

For Immediate Release
April 3, 2009

FOR MORE INFORMATION:
Hilarie Chambers
Office: 202.225.4961

Levin Reintroduces Carried Interest Tax Reform Legislation

Bill to Tax Fund Managers’ Compensation at Same Rates as All Americans

(Washington D.C.)- Rep. Sander Levin today reintroduced legislation to tax carried interest compensation at the same ordinary income tax rates paid by other Americans.  Currently, the managers of private investment partnerships are able to receive compensation for these services at the much lower capital gains tax rate rather that the ordinary income tax rate by virtue of their fund’s partnership structure.

“This is a basic issue of fairness,” said Rep. Levin. “Fund managers are receiving compensation for managing their investors’ money.  They should not pay the 15% capital gains rate on their compensation when millions of other hard-working Americans, many of whose income is performance-based, pay ordinary rates of up to 35%.  The President’s budget recognizes that this is unfair.  The House of Representatives has recognized that it is unfair, and this year I hope we can act to change the law.”

The legislation clarifies that any income received from a partnership, capital or otherwise, in compensation for services provided by the employee is subject to ordinary tax rates.  As a result, the managers of investment partnerships who receive a carried interest as compensation will pay regular income tax rates rather than capital gains rates on that compensation.  The capital gains rate will continue to apply to the extent that the managers’ income represents a reasonable return on capital they have actually invested themselves in the partnership.

“This proposal is not about taxing investment, it’s about ensuring that all compensation is treated equally for tax purposes.  Anyone who actually invests money in these funds will continue to receive capital gains treatment, including the managers.  So there is no reason to expect that the amount of capital available for these kinds of investments will be reduced,” concluded Levin.

Levin introduced similar legislation in the 110th Congress, which was subsequently included in several tax packages approved by the Ways & Means Committee and the House of Representatives.  A similar proposal is also included in President Obama’s FY 2010 budget request.

——————————————————————————————————————–

Levin Carried Interest Legislation – H.R. 1935

H.R. 1935 would treat the “carried interest” compensation received by investment fund managers as ordinary income rather than capital gains.  In exchange for providing the service of managing their investors’ assets, fund managers often they receive a portion of the fund’s profits, or carried interest, usually 20 percent.  H.R. 1935 clarifies that this income is subject to ordinary income tax rates rather than the much lower capital gains rate.

Carried Interest: The Basics

Why is Congress concerned about this issue?

Many investment funds are structured as partnerships in which investors become limited partners and the funds’ managers are the general partner.  The managers often take a considerable portion of their compensation for managing the funds’ investments as a share of the funds’ profits using a mechanism called “carried interest.”  Partnership profits are taxed not to the partnership; instead partners are taxed on allocations of partnership income, and the nature of that income (capital or ordinary) “flows-through” to the partners.  As a result, the investment managers are able to have income for performance of services taxed at the 15% capital gains rate.  Essentially they are able to pay a lower tax rate on income from their work than other Americans simply because of the structure of their firm.

What does the legislation do?

It clarifies that any income received from a partnership, capital or otherwise, in compensation for services is ordinary income for tax purposes.  As a result, the managers of investment partnerships who receive a carried interest as compensation will pay regular income tax rates rather than capital gains rates on that compensation.  The capital gains rate will continue to apply to the extent that the managers’ income represents a reasonable return on capital they have actually invested in the partnership.

What kinds of investment firms will be affected?

This is part of a broad consideration of tax fairness.  The principle at work is that compensation for services should be treated as ordinary income and taxed accordingly, regardless of its source.  Any investment management firm that takes a share of an investment fund’s profits as its compensation (i.e. in the form of carried interest), will be affected.  This will apply to any investment management firm without regard to the type of assets, whether they are financial assets or real estate.  The test is the form of compensation, not the type of assets the firm is managing, its investment strategy, or the amount of compensation involved.

What is the effective date of the legislation?

This legislation is designed to create a structure under which this income should be taxed.  Decisions on the effective date will be made as part of the legislative process.

Carried Interest: Myths vs. Facts

Myth: This is a tax increase on investment that will hurt economic growth.

Fact: Investors are not affected by this legislation at all.

Any person or institution who invests money in a fund whose managers receive a carried interest will continue to pay the capital gains rate on their profits.  In fact, the bill explicitly protects the investments that fund managers make themselves.  To the extent they have put their own money in the fund, managers still get capital gains treatment, but to the extent they are being compensated for managing the fund, they will have to pay ordinary income tax rates like other service providers.   Since investors are not affected, there is no reason to believe that the amount of capital available for these kinds of investments will be reduced at all.

Myth: Taxing carried interest is just about raising revenue.

Fact: Fairness requires treating all taxpayers who provide services the same.

This proposal would raise revenue, but it is not just an offset.  Congress has a responsibility ensure that our tax code is fair, that it makes sense.  A broad spectrum of experts, including the Chairman of the Cato Institute and senior economic advisors to the last three Republican Presidents, agree that carried interest really represents a performance based fee that investors are paying to fund managers and that it should be taxed accordingly.  Allowing some service providers to pay the 15 percent capital gains rate on their income when everyone else has to pay up to 35 percent risks undermining people’s confidence in our voluntary tax system.

Myth: Fund Managers are just like entrepreneurs who get founder’s stock in their company, so they too should be taxed at the capital gains rate.

Fact: Fund Managers are fundamentally different than the founder of a company.

When someone starts an enterprise, he or she actually owns that business.  Sometimes that business becomes enormously valuable, but quite often it fails altogether and the entrepreneur loses her business. When an investment partnership purchases an asset, be it a stake in a small start-up company, a large corporation that wants to go private, a portfolio of securities, or a piece of real estate, the partnership does truly own those assets.  The general partner or fund manager though is really only an “owner” to the extent he or she has contributed capital to the partnership.  The carried interest the general partner receives for managing the fund’s assets is a right to a portion of the fund’s profit, not to the fund’s actual assets: the manager has no downside risk.  If the fund fails completely and all of the partnership’s assets are lost, the limited partners have lost their money.  The manager has lost the time and energy he has put into the running the fund, and the potential to share in the profits, but he is not actually out of pocket.

Myth: Fund managers deserve capital gains treatment because a carried interest is risky.

Fact: Many other forms of compensation are risky, and they are all ordinary income.

When a company gives its CEO stock options, it is trying to give her an incentive to increase the company’s share price, to growth the value of shareholders’ investment.  If the CEO does a good job and the share price goes up, she pays ordinary income tax rates when she exercises those options.  Real estate agents only make money if they actually sell a house, no matter how hard they work.  Authors receive a portion of their book’s profits.  Waiters get tips based on the quality of the service they provide.  All of these people pay ordinary income tax rates on their compensation.  Only private equity and other fund managers get to pay capital gains rates on their compensation.

Myth: Taxing carried interest will hurt the pension funds that invest in these funds.

Fact: This has nothing to do with pension funds and their returns will not be affected.

One pension trustee, who also happens to be a hedge fund manager, called the idea that this debate is about workers’ pensions “ludicrous.”  As tax-exempt investors, pension fund certainly will not be affected directly, and the assumption that fund managers can charge higher fees than they do today as a result of their having to pay ordinary income rates is extremely questionable. In fact, an attorney representing the hedge fund industry testified before the Ways & Means Committee that investors would be unlikely to accept increased fees.  The National Conference on Public Employee Retirement Systems has said that its members do not believe this legislation will affect them.

Myth: This change to the taxation of carried interest will harm every “mom and pop” partnership in America.

Fact: The change would only affect those partnerships where service income is being improperly converted to capital gains.

This legislation would have no effect whatsoever on the vast majority of partnerships that are engaged in ongoing businesses and whose profits are already being properly taxed an ordinary income tax rates.  It does apply to investment fund partnerships where the investors in the fund choose to compensate the people managing their assets through a carried interest.  In practice, this means hedge funds, private equity funds, venture capital funds and real estate partnerships.  The reality is that the fund managers and general partners who would be asked to pay ordinary income tax rates on their compensation are a very small, very well-paid group of professionals.  It is also important to note that the bill does not discriminate among partnerships based on the kind of assets they purchase.

(####)

Other related hedge fund tax articles:

Hedge Fund Taxes May Increase under Obama

Leave a reply

Obama to Propos Taxing Hedge Fund Carried Interest

Groups such as the New York Times and Daily Finance are reporting that Obama’s proposed fiscal 2010 budget, which will be released tomorrow, will include provisions which will increase taxes for hedge fund managers (and private equity fund managers).   Such a provision would likely be written to provide that a carried interest (also called a performance allocation) paid to a management company would be characterized as ordinary income instead of capital gain (to the extent the underlying profits were long term capital gains which are subject to a lower tax rate).

Hedge fund managers are not likely to receive much sympathy from the general public, but this is a hot button issue which will likely incense many of Obama’s supporters.  Hedge fund taxation has been an issue batted around in the media and was especially popular a year and a half ago when the Blackston group was preparing to go public (see Bloomberg article).  The issue has been smoldering for a while (see Hedge Fund Tax Issues 2007), but groups are beginning to examine and analyze this issue (see the abstract of an academic report below) rather than react in a knee-jerk manner.

What we will ask of the President, lawmakers and regulators is that they examine the issue from an academic perspective and make informed decisions.  Hopefully reports like the one below will persuade lawmakers to ultimately keep the carried interest tax preference for hedge funds and private equity funds.

We will continue to report on this issue and will release any applicable information once the fiscal budget is released.  Please feel free to contact us if you have any questions if you have any hedge fund law questions.

****

Measuring the Tax Subsidy in Private Equity and Hedge Fund Compensation

Karl Okamoto
Drexel University College of Law

Thomas J. Brennan
Northwestern University School of Law

February 26, 2008

Drexel College of Law Research Paper No. 2008-W-01

Abstract:

A debate is raging over the taxation of private equity and hedge fund managers. It is being played out in the headlines, in Congress and among legal scholars. This paper offers a new analysis of the subject. We provide an analytical model that allows us to compare the relative risk-reward benefit enjoyed by private equity and hedge fund managers and other managerial types such as corporate executives and entrepreneurs. We look to relative benefits in order to determine the extent to which the current state of the world favors the services of a private equity or hedge fund manager over these other workers. Our conclusion is that private equity and hedge fund managers do outperform other workers on a risk-adjusted, after-tax basis. In the case of hedge fund managers, this superiority persists even after the preferential tax treatment is eliminated, suggesting that taxes alone do not provide a complete explanation. We assume that over time compensation of private equity and hedge fund managers should approach equilibrium on a risk-adjusted basis with other comparable compensation opportunities. In the meantime, however, our model suggests that differences in tax account for a substantial portion of the disjuncture that exists at the moment. It also quantifies the significant excess returns to private fund managers that must be taken into account by arguments in support of their current tax treatment by analogy to entrepreneurs and corporate executives. This analysis is important for two reasons. It provides a perspective on the current issue that has so far been ignored by answering the question of how taxation may affect behavior in the market for allocating human capital. It also provides quantitative precision to the current debate which relies significantly on loosely drawn analogies between fund managers on the one hand and entrepreneurs and corporate executives on the other. This paper provides the mathematics that these comparisons imply.

Other hedge fund tax and law articles include:

Revising Hedge Fund Offering Documents

1 Reply

It is very important that hedge fund managers always provide potential investors with hedge fund offering documents which are current and up to date.* Because of certain changes to the various hedge fund laws within the past few months (and because of the increased likelihood of future rules/regulations changes) a hedge fund private placement memorandum which was current 3 months ago will likely need to be revised.

*As always, hedge fund offering documents should only be drafted by a knowledgeable hedge fund attorney.

Specifically, there are two changes which will need to be implemented immediately – the change of the new issue rule (applicable to most funds) and the abolition of Section 409 (applicable to a small number of hedge funds). This article will detail the changes that will need to be made and will discuss how your hedge fund attorney will go about this. Continue reading →

IRC Subchapter K – Partners and Partnerships

1 Reply

Below is Subchapter K of the Internal Revenue Code.  Most hedge funds are taxed as partnerships and we discuss some of these provisions from time to time on this website.  Please let us know if you have any questions on hedge fund tax or if you would like to start a hedge fund.  Continue reading →