How U.S. Hedge Fund Investors Have Lost A Key Tax Break for Management Expenses
According to accountingtoday.com, some hedge fund investors could see negative effects from President Donald Trump’s tax overhaul.
Certain expenses that taxpayers could previously itemize on their returns, such as mandatory management fees paid to hedge fund managers, can no longer be deducted. Those investors are now liable for those expenses, even if the fund investments lose money.
Billionaire Mike Novogratz, founder of Galaxy Digital LP, stated that the tax change “makes hedge funds, which are already struggling, even less appealing”. Novogratz ran a hedge fund that was liquidated in 2015 following poor performance.
Embattled hedge fund managers are shuttering in anticipation of year-end withdrawals. They have lost money as hedge funds are suffering their worst month since October 2011. Due to years of mediocre performance and fund closures, the $3.2 trillion industry has been hit hard with investors pulling out $68.8 billion since the start of 2016.
Although hedge fund managers justify their fees by suggesting their funds as better at making money and protecting investors during downturns, in the three decades since such investments took off, they have not done much better than the Standard & Poor’s 500 Index, according to Hedge Fund Research Inc.
The tax change could put more pressure on hedge funds to lower their fees if they are performing poorly. Historically, funds have charged an annual management fee of 2 percent of assets being managed with an additional 20 percent charged as a performance fee on profits. However, according to an August report from Credit Suisse Group AG, funds today have average fees of 1.45 percent of assets being managed and 17 percent on profits.
According to Donald Steinbrugge, founder and chief executive of Agecroft Partners LLC, there is already a hedge fund that began offering a 0 percent management fee due to the deduction change. He has also stated that, “They’re not going to be along”.
Brandon Colon, senior vice president at Meketa Investment Group suggests that smaller funds will have a difficult time cutting their management fees in a down market, even with the windfall of deductibility gone. Those fees can cover a broad array of expenses from printing costs to “a manager’s lobster Thermidor dinner,” Colon stated.
Hedge Fund Hypothetical
In addition to the management fees discussed above, taxpayers could also claim other miscellaneous itemized deductions on expenses such as work-related travel costs that were not reimbursed under the old tax code. These expenses do have to exceed 2 percent of AGI which is easily achieved by most investors.
Those most affected by the change of eliminating the management fee deduction are those who have money in activist funds or those that have the tendency to buy and hold securities. Those investors that use swap payments, a type of derivative involving exchanged financial instruments, are also at risk.
Those that pay their performance fees in cash will get hit especially hard as those payments can no longer deduct those fees as miscellaneous itemized deductions either.
Trader funds, or funds that rapidly and frequently trade high volumes of securities as their core businesses, are not affected. This is die to these funds never being able to take the management fees as itemized deductions. Those funds can still, under the tax law, write off management fees as business expenses and pass those savings to investors.
For poor performing hedge funds, the deduction change can make the loss even more significant. One example comes from David Einhorn’s Greenlight Capital LP fund. Without the 1.5 percent management fee write-off, this fund would have suffered a net 25.2 percent loss this year compared to the funds gross 23.7 percent decline.
Funds with stronger returns could still deliver bad news to taxpayers that can no longer take advantage of management fee write-offs. For example, if a fund gave a return of 7.3 percent, the investor would be left with a 4.24 percent return after the 2 and 20 management and performance fees were taken out. However, investors would be taxed on a 6.24 percent return because the 2 percent management fee would be added back in, even though the investor received a net return of 4.24 percent.
The loss of this deduction, however, can be softened by the long-term capital gains rate that investors in hedge funds could be eligible to receive. Assets held for at least three years can qualify for a reduced rate of 23.8 percent while assets held for shorter terms are taxed at the ordinary income tax rates. Investors in trader funds will be subject to ordinary income tax rates and should do the math to see which type of fund is most beneficial.
Despite that bad news on the discontinuation of the management fee deductions, Trump’s law could provide offsetting benefits that could benefit top earners, such as the reduction of the top rate to 37 percent instead of 39.6 percent. The thresholds for the alternative minimum tax also increased which could be beneficial. Wealthy tax payers may face limits on deductions for mortgage interest and for state and local taxes.
Fund managers can reassess their fees and convert them from management fees to performance fees. This change, however, would put more pressure on fund managers to perform better than the market without regular income to support day-to-day costs of managing the fund.
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