Investment Management Update

New Tax Law Strokes Hedge Fund Managers

After tense moments in the great tax debates of 2010, two important tax breaks for hedge funds and investment managers survived repeal efforts from Congress and the White House. Although Democrats tried hard to repeal “carried interest” tax breaks for investment managers, along with a related repeal of the S-Corp self-employment (SE) tax reduction breaks for professionals (including investment managers), Republicans saved the day with a successful filibuster blocking cloture on tax increases. We covered that drama on our blog and in our podcasts.

Finally, in the year-end lame-duck session of Congress, after Republicans won majority in the House in the midterm elections, Congress agreed to extend all Bush-era tax cuts for two additional tax years (through Dec. 31, 2012), along with other important “tax extenders” too. There was no time or votes to include repeal of carried-interest and the S-Corp SE tax breaks. With a new Republican-controlled House in 2011 and 2012, it’s unlikely that carried-interest or the S-Corp SE tax break will be repealed during this session of Congress.

This translates to good news for investment advisers. Managers can continue to start up new hedge funds and structure in a “profit allocation” clause, so they receive performance income — it’s not compensation or pay — based on their profit allocation share of each income tax-category in the fund. The carried-interest tax break means the manager/partner receives a special allocation (his share) of long-term capital gains and qualifying dividends taxed at lower tax rates (currently up to 15 percent), futures gains taxed at lower 60/40 tax rates (currently up to 23 percent), and short-term capital gains taxed at ordinary income tax rates but not subject to separate SE tax rates (currently up to 15.3 percent of the base amount currently at $106,800, and 2.9 percent unlimited Medicare tax portion thereafter). That’s meaningful tax savings too. Carried-interest tax breaks can be good for investors as well.

It’s different with separately managed accounts. Although investment managers can’t use profit-allocation clauses on these accounts, they can at least use the S-Corp SE tax reduction break, which becomes even more important with incentive fees being classified as earned income (rather than profit allocation of trading gains). Managed accounts pay advisory fees which include management and incentive fees, whereas funds using profit allocation clauses only pay management fees.

In an LLC filing a partnership tax return, earned income passes through to the LLC owners subject to SE tax, unless an owner is not involved in operations (which is beyond the scope of this content).

Investment managers can only use profit allocation with investment funds and not on separately managed accounts, because only partners can share special allocations of underlying income. Special allocations are permitted and useful on fund partnership tax filings, but not with S-Corp tax returns, since special allocations reverse (taint) S-Corp elections. The IRS only allows S-Corps to have one class of stock and they insist on equal ownership treatment, meaning no special allocations are allowed.

That makes S-Corp elections a wise choice for management companies focused on reducing SE tax on underlying advisory fee earned income. Conversely, partnership tax returns are a better choice for investment funds focused on carried-interest tax breaks using special allocations, plus there is generally no underlying income subjected to SE tax anyway.

Check with us about these strategies, as there are some states such as California that have higher franchise taxes on S-Corps, but usually materially less than the possible SE tax savings. New York City taxes S-Corps like C-Corps and those tax rates are high.

An existing LLC or C-Corp can file an S-Corp election (Form 2553) by March 15th of the current tax year. The IRS automatically grants late relief under a special Revenue Procedure, up until the due date of the tax return including extensions. Check with us about your home state too.

This article is just a recap on the recent saga of two important tax breaks for investment managers. There are plenty of other important matters to consider too, including trader tax status and Section 475 MTM accounting, lower 60/40 Section 1256g forex tax treatment breaks, international tax planning including PFIC and QEF elections, mini-master feeders, good offshore fund destinations, other tax and regulation changes and more.