Carried Interest in Jeopardy

Special Topic:
House Democrats Propose Bill to Tax Carried Interest at Ordinary Rates.

Warning! If this proposed tax bill is enacted, many advisors and investors in hedge funds will face significantly higher tax liabilities.

Money managers typically charge 2-percent management fees and 20-percent incentive fees or "carried interest" profit allocations.

By treating an incentive fee as a carried interest in a fund, advisors are able to subject the lion's share of their compensation to lower long-term capital gains tax rates; plus they significantly reduce their income subject to self-employment (SE) taxes.

Recent media reports of billion-dollar pay days for hedge fund and private equity firms going public is attracting U.S. and UK government tax officials to attack (and possibly repeal) the precious "carried interest" tax loophole.

An obvious reason is to repeal what's deemed to be an unfair special tax break for the (perceived) super rich. But these rule changes will also raise the tax bills for many investors in these funds. Perhaps tax officials also consider these investors fair targets for tax increases.

Currently, the tax advantage of a hedge fund vs. managed accounts is that an advisor can receive a "carried interest" or profit allocation in lieu of an incentive fee. Conversely, with a managed account, an advisor can only receive an incentive fee.

Incentive fees are taxed as "ordinary income," plus they are also subject to SE taxes. Ordinary income tax rates are far higher than long-term capital gains tax rates; ordinary tax rates currently rise to 35 percent (and political winds indicate they will be raised soon) while long-term capital gains tax rates are as high as 15 percent -- that's a 20-percent tax rate difference! SE tax rates are 15.3 percent of the SE tax base ($94,200 for 2007) and 2.9 percent on all income above that base. So the maximum tax difference at stake here can be 35 percent (20-percent income tax plus 15.3-percent SE tax); a huge amount for taxpayers.

By structuring their hedge funds with a "carried interest" rather than an incentive fee, advisors were able to treat this compensation as a capital gain, which also means there is no SE tax to pay. These capital gains are often subject to lower tax rates; 15 percent if a long-term capital gain on securities held longer than a year, and 23 percent if on IRC 1256 contracts with 60/40 treatment. Many Forex funds have futures treatment, too, since they elect out of IRC 988 (the Forex rules).

Investors will be hurt too.
Unless a hedge fund qualifies for "trader tax status" (business treatment), it's taxed as an investment partnership. In that case, compensation/fees paid to advisors are reported on Schedule K-1 as "deductions from portfolio income."

Investors report these fees as "investment expenses" under miscellaneous itemized deductions. Unfortunately, few investors wind up with tax savings in connection with investment-expense deductions. First, investment expenses are subject to a hurdle of 2 percent of adjusted gross income. Second, there is an itemized deduction phase-out. Worst of all, investment expenses are not deductible at all for the Alternative Minimum Tax (AMT), which is snagging many hedge fund investors as their income levels fall into the AMT ranges.

With a carried interest profit allocation, an investor just reports a lower capital gain amount, which is tantamount to a full tax deduction. It's much more efficient.

What advisors may want to do if these rule changes are passed.
In some cases, advisors can reduce SE taxes by using an S-Corp. rather than an LLC. SE income passes through an LLC (partnership tax return) but not an S-Corp return. The IRS does look for reasonable compensation (salaries with payroll taxes) in an S-Corp, but not for the full income amount. Current guidance talks about a 30-percent to 40-percent salary-to-net-income percentage.

If advisory fees and net profits are multi-million dollar amounts, a case can be made that only a portion of the income is subject to SE tax in an LLC, considering some of the income is being derived from the brand and capital rather than services.

Tax planning is complex and important, and we recommend a consultation with us to pursue the best plan for your situation.

There are some other ideas too.
An advisor can look to sell their management company, which still gets long-term capital gains rate treatment.

More information.
For more background information on current tax rules for advisors and fund investors, see Robert Green's article, click here.

For more information about these current tax bill proposals, click here or Google "carried interest."

 

Comments

[Hedge Fund Consultant - Richard Wilson]

I think this recently went through but Bush is suppose to veto it?

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