How Hedge Funds Will Escape The New Carried Interest Law
Tax reform was an important topic during Trump’s run for the presidential seat. According to Bloomberg.com Trump stated, “hedge fund guys are getting away with murder.” Despite the Presidents efforts for tax reform it seems that the many loopholes in the new law are proof that nothing has really changed.
President Trump made it clear that under his desired tax reform, hedge funds would not have the benefit of carried interest. Under federal law, carried interest is taxed as a capital gain, rather than as personal income, enabling hedge fund and private equality executives to pay lower rates than the average taxpayer on some of their earnings. Carried interest is typically computed for each individual asset in a fund and its respective holding period. As a result, some of a fund’s investments may qualify for the lower rate, while others don’t. Hedge funds aren’t required to publically reveal all their dealings aside from a few stock filings so it can be difficult to determine what a manager’s tax assets would be.
The final outcome of Trump’s law required that a funds general partner hold the relevant investments for three years, instead of one (which allowed them to receive the long-term capital gains rate of 20%, the capital gains tax rate), starting in 2018. However, this outcome doesn’t apply to regulated futures contracts or contracts to trade foreign currencies, causing there to be some loopholes in the law. Therefore, managers can continue to be taxed at that lower rate regardless if funds/contracts have been held for three years.
For futures contracts under the new law they will still have time on their side. Because of the loopholes, they can decide what percent of the assets qualifies for the long-term tax rate avoiding the individual income tax rate, which could be as high as 37%.
Another loophole to get around the three-year holding period is for hedge funds to set up a limited liability company for managers entitled to the payouts. Seeing as most funds using the “1256 contracts” didn’t even have to file anything extra, the IRS is issuing procedures to close down that loophole.
While long-short equity fund managers who use futures contracts on broad-based indexes would be able to avoid the three-year holding period; a long-short equity fund using single stock futures contracts could not and would be held accountable to the three-year holding period.
It is still uncertain that anything really changed because the new law doesn’t upset the lightning speed, trading hedge fund manager because they didn’t even collect the 20% tax rate before (unless they were using the “1256 contracts”). Venture capital funds and private equity firms usually invest in businesses for over three years anyway; hence another part of the finance world not affected by the new tax law.
Some tax attorneys have named the period where a hedge fund client holds their assets more than a year, but less than three years the danger zone. You will find hedge fund managers that use the distressed, activist and credit strategies in the danger zone. This is because these investments are usually held onto for one or two years; therefore, the new law affects them. Managers are now looking for new strategies with futures that will take advantage of the exemption for the contracts, while other hedge funds may start using the “1256 contracts” that haven’t in the past.
Before President Trumps’ new tax law, the contracts were “marked to market”, meaning valued on a daily basis. These contracts were usually broken down to a 60/40 ratio. Sixty percent of their gains taxed at the lower long-term capital gains tax rates and the forty percent taxed at the ordinary income tax rates. By the time you add in the 3.8 Obamacare tax with the 20% capital gains rate, the managers were paying about a 30% tax rate on those assets.
Since the new tax law is specific about what securities are included in the three year holding period (which doesn’t include the 1256 contracts) we find yet another loophole for these 1256 contracts. The IRS could still issue regulation saying the 1256 contracts aren’t exempt. It is easy to come to the conclusion that Congress deliberately left the contracts out of the new, three year holding period law. The new law tightens the eligibility of partnership interests for carried interest treatment but dismisses any changes to the assets covered by the contracts and the long and short-term capital gains. It is clear to see how many managers have found a way out of Trump’s new law.
Hedge Funds Aren’t Concerned About Carried Interest Tax Rules
According to the New York Times, hedge fund managers aren’t worried about carried interest tax rules. You’d think they would be; after all, they have a significant amount of income to shelter. But they don’t use the carried interest tax loophole and are instead turning to other, more exotic options.
In fact, the top 25 hedge fund managers make more than twice the annual income of all the kindergarten teachers in the nation, combined. That is over $21 billion dollars a year. That is about 14 times what all of the 20,000 microbiologists in the nation make, combined. Or it’s about the same amount of money that the 262,000 civil engineers in the nation make, combined. It’s three times what all of the 78,000 information security professionals make, combined. The hedge fund managers also made more than five times the income of all the local, state and federal tax, state examiners, collectors and revenue agents in the United States, combined. It’s a big chunk of change for sure.
However, if we just take the segment of the civil engineers as our example, they pay way more taxes than any of the 25 hedge fund managers. What’s getting them so much attention right now is that the hedge fund managers tax strategies aren’t based on the carried interest tax dodge. To clear up any confusion you may have, carried interest is the share of profits that are received by the hedge fund managers in exchange for managing the investments of the fund. Usually the investors of the fund make long-term investments that they hold for more than one year. Then, at some future point, they sell the investment for a profit and that income flows back through to the fund managers and investors in the form of long-term capital gains that are taxed more favorably and at lower rates than ordinary income.
Hedge funds rarely take controlling interests or stakes in companies unlike private equity funds. Instead they invest in other things that are usually liquid securities like derivatives, other debt instruments, commodities, bonds and stocks. Most of these funds don’t hold their position for longer than a year and some funds even change positions by the millisecond, second, minute, hour, day or week. Often times they make their trades based on computer algorithms and make changes frequently. They are able to profit off of short-term capital gains that are taxed at the ordinary income rate. In fact, many investors and managers are able to recognize trading losses or gains as ordinary loss or gain and not capital because they elected to be taxed on a mark-to-market basis.
Hedge fund managers like private equity fund managers in the form of incentive allocation or incentive fees, receive carried interest. If the underlying gains are short-term capital gains or ordinary income then the arrangement bestows no special tax advantage. But that certainly doesn’t mean that hedge fund managers who up until recently have been deferring a portion of their fees to a Cayman Island Corporation; are paying their fair share. By making this deferment, they essentially were able to make a giant tax-deferred retirement account for themselves. Some investments that have been placed offshore were not taxed or deemed repatriated until 2017 even though Congress had closed that loophole in 2009.
When one option becomes closed, all the hedge fund managers went to work on creating a new option. Many of them have used Bermuda-based reinsurance companies and have jumped into the reinsurance business to use these companies as a capital base for investment in their hedge funds. Because Insurance companies are under the obligation to keep a large amount of cash on hand, they have massive amounts of cash sitting around. There are no laws that prohibit these insurance companies from taking that cash on hand and investing it into hedge funds. So essentially these hedge funds are able to take billions of dollars of hedge fund capital, staple it to a small insurance company in Bermuda and then ensure that any profits can be indefinitely deferred from tax because it sits offshore. If/when the fund manager ever sells their interest in the Bermuda Company, then any gain is taxed at a lower long-term capital gains rate. Either way, it’s a win for the fund managers. It’s a game that will continue between the hedge fund managers and the tax collectors.
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