One of the most lucrative tax advantages for hedge fund managers will end at the end of this year—and it’s not just deferral of incentive fees. While the industry has been scrambling to prepare for ways to change compensation practices to accompany the tax change, many haven’t realized the new rule takes a bite elsewhere. Hedge funds also must pay taxes on side-pocketed investments.
“Fund managers may think ‘I don’t do deferrals, so I’m not subject to the rules.’ But if they have a sidepocket in their offshore fund then there’s an issue there,” says Philippe Benedict, a partner in the tax department of law firm Schulte, Roth & Zabel.
The new taxes are part of last year’s emergency financial legislation, which included a new Internal Revenue Service rule that eliminated fund managers’ ability to defer fee income from offshore hedge funds beginning this year. The change was a blow to many hedge fund managers, who have long kept the performance fees they receive for offshore funds within the portfolios they manage, allowing their money to accrue on a tax-free basis—a gigantic 401K for hedge fund employees.
But it’s the side pocket aspect that people may be unprepared for. “A side pocket could potentially run afoul of the deferral rules because of the fact that with a side pocket you only get your carry on a realized basis, unlike a hedge fund where it’s marked to market,” says Benedict.
Firms have used offshore funds as a tax-free way to hold onto a portion of the compensation and bonuses paid to fund managers for a pre-determined period of time—often five years. Such arrangements were a way for firms to ensure that star managers wouldn’t run off and launch their own funds after a particularly good year. Now hedge funds are scrambling to find new ways of locking in fund managers, such as forced reinvestments of bonuses.
“People are either trying to move away from deferrals, or to pay the bonuses and then implement some sort of handcuff mechanism by having people who get bonuses put their after tax dollars in the fund with a vesting schedule,” says Benedict.
If a deadline for tax payments is missed by even one day, the penalties are significant. If the IRS finds a firm in violation it not only can force immediate back taxes, but interest of 10% on the amount being taxed as well as a 20% penalty. “The penalties are huge,” says Steve Elkind, a partner in the tax group of law firm Sadis Goldberg.
-- Britt Erica Tunick
