Hedge Funds Can´t Use This Technique Anymore To Pay Less Taxes
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The Players
The IRS
Decisions by the Internal Revenue’s Office appeals unit rarely make the news, but sometimes rulings by this arm of the IRS have dire consequences for unrelated parties involved in similar disputes.
The office investigates IRS audits of applicants, to rule on decisions already made on their cases. It often involves significant amounts of money that hang in the balance as the appeals office rule on tax-avoidance maneuvers. The IRS Office of Appeals has more latitude to negotiate settlements than their counterparts in the IRS Auditors office.
Renaissance Technologies
Renaissance Technologies is considered by many to be the most successful hedge fund in history. Situated in the Setaukets on the North Shore of Long Island, it is the brainchild of one of New York’s most astute billionaire investors, Jim Simons, who founded the fund. Jim Simons became a public figure recently when Gregory Zuckerman’s book about him, titled “The Man Who Solved the Market,” appeared.
GWA Hartford
GWA Hartford is a hedge fund in Connecticut run by George A. Weiss. Recently the IRS appeals office rejected a tax-avoidance maneuver used by Weiss’ firm, and this may cost GWA millions and millions of dollars.
Weiss founded one of the first market-neutral hedge funds in the US. He is a specialist in trading utility stocks. GWA owns Weiss Multi-Strategy Advisers, a fund that manages just under $3 Billion on behalf of investors.
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The Medallion Fund
The Medallion is a hedge fund run by Renaissance Technologies. The employees of Renaissance Technologies own the Medallion fund, and the same used Medallion to shelter $34 Billion of income, resulting in a 20% savings on taxes for investors.
The GWA Dispute With The IRS
In December, in a private ruling, the IRS determined that GWA under-reported income in 2009-2010 by more than $527 million using basket options. GWA spent years sparring with the IRS and going through all available channels before they took their case to the Office of Appeals. The dispute became public knowledge only after the Office of Appeals ruled against Weiss, who subsequently appealed to the Tax Courts for relief earlier in 2019.
What Is At Stake For Weiss
GWA or its investors will face a tax bill of more than $100,000,000 PLUS interest AND a 20 percent accuracy penalty if they lose their appeal.
Basket Options: The Heart Of The Matter
GWA bought so-called basket options from Deutsche Bank AG and informed their clients that these options would lower taxes on some of their profits. The Option is a financial derivative with underlying assets in the form of commodities or securities, which gives the holder the right but not the obligations to buy, or sell the basket at a fixed price or date.
Hence GWA (and Rentech) would never own these securities, nor would they book gains and losses made from trading the same. They would merely buy an option tied to the value of a securities portfolio it held. The fund would instruct the bank to buy or sell these securities from time to time.
For the funds, this resulted in the profits and the options that were held for longer than one year, being classified as long-term capital gains, resulting an a significantly lower tax rate.
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The Critical Question Before The Court
Does the basket option have any function other than to avoid taxes? Weiss argues that it offered better leverage than your typical brokerage agreement while limiting the firm’s risks.
The courts will have to make a ruling on basket options: do these derivatives offer sufficient economic benefits for the IRS to respect their role, or are they merely abusive transactions?
How Does This Impact Jim Simons’ Medallion Fund?
Similarities In Fact
Medallion bought basket options from Deutsche Bank and Barclays Plc to hedge $34 billion in income. The ruling in the GWA case might prove to be disastrous for Jim Simon and the Renaissance Technologies hedge fund if it is a preview of the reasoning the Office of Appeals might follow in their case too.
The Renaissance Technologies dispute is one of the largest ever handled by the IRS and potentially involve back taxes of just under $7 billion, which would be perilous for Jim Simons and his colleagues.
By December 2018 Renaissance was still exploring ways to end the dispute by offering a settlement; however, by March 2019 there was still no resolution in sight.
Readers should note that this article is only intended to convey general information on these issues and that FAS CPA & Consultants (FAS) in no way intends for the contents of this article to be construed as accounting, business, financial, investment, legal, tax, or other professional advice or services. This article cannot serve as a substitute for such professional services or advice. Any decision or action that may affect the reader’s business should not rely solely on the contents of this article, but should rather be consulted on with a qualified professional adviser. FAS shall not be responsible for any loss sustained by any person who relies on this presentation. This article is subject to change at any time and for any reason.
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