Another reactionary development - Congress targets tax planning on private equity firms and hedge funds

Fund Managers' Taxes May Rise as Senate Targets Fees Stratagem
By Ryan J. Donmoyer

June 19 (Bloomberg) -- Hedge-fund and private-equity managers, already under congressional scrutiny for the lower tax rate they pay on their profits, may also be targeted for a strategy they use to pay less on their management fees.

Congressional aides say the Senate Finance Committee is studying a technique that allows fund managers to qualify most or all of their income for the 15 percent capital-gains rate by structuring their management fee as a share of profits rather than a percentage of assets.

``Among the blue-chip managers, 70 percent do it,'' said Steven Howard, a partner at the New York law firm Thacher Proffitt & Wood LLP who advises investment firms. ``It's become prevalent in the last five years because of the huge amount of money these guys have made.''
The review is part of a broader inquiry by the Senate panel, which made its first major foray into overhauling the tax treatment of hedge funds and private-equity firms last week by introducing legislation that would more than double taxes for Blackstone Group LP and Fortress Investment Group LLC by 2012.

Traditionally, managers have required investors to pay a fee equivalent to 2 percent of a fund's assets, which is then taxed at ordinary rates of up to 35 percent. The managers also receive 20 percent of profits beyond a specified return amount, called ``carried interest,'' which is subject to the capital- gains rate.

Priority Allocation
To get the tax savings, fund managers agree to waive all or most of their management fees. In exchange, they later receive a priority allocation of net profits equivalent to the value of the waived fees. That payout, known as a special distribution, is subject to the 15 percent rate, according to Howard and other tax advisers.

Experts said the technique reduces the tax burden for fund managers, though it also exposes them to greater risk because the payout is contingent on the fund's profits. It also reduces the tax liability of individual investors, who can sidestep limits on deducting investment fees.

``Carry is a big deal for everyone because that's where the home runs are,'' said Simon Friedman, a tax partner in the Los Angeles office of Milbank, Tweed, Hadley & McCloy LLP who specializes in alternative investments.

A Central Element
The pay of managers is one of the central elements of the broader congressional examination of the tax structure of hedge funds and buyout firms, said Victor Fleischer, a University of Illinois tax professor who met with congressional staff in May. Fleischer said that while lawmakers are considering increasing taxes on carried interest, most have assumed that fund managers must pay higher tax rates on their fees.

``It all goes back to the fact that when a fund manager receives a profits interest, those distributions should probably be characterized as service income rather than investment income,'' Fleischer said.

Fleischer said he has made a ``back-of-the-envelope'' analysis based on assets of $1 trillion and an annual rate of return of 15 percent showing that fund managers are saving between $4 billion and $6 billion a year in taxes by paying capital-gains rates on their 20 percent carried interest. He wouldn't estimate how much they save by converting fees into profit shares, though he said the practice ``seems to be taken as standard.''

Lobbying Groups
Robert Stewart, vice president of public affairs for the Private Equity Council, a lobbying group in Washington, declined to comment.
Lisa McGreevy, executive vice president of the Managed Funds Association, the main Washington-based lobbying group for hedge funds, said she wasn't aware of the conversion technique. Still, she said the group is urging Congress to proceed with caution. ``The whole issue is fundamental to entrepreneurship in the United States and the ability to use sweat equity to build long-term investments,'' she said.
While most hedge funds make investments that produce short- term capital gains taxable at the top rate of 35 percent, many managers create longer-term ``side pocket'' investments for illiquid assets that qualify for the preferential 15 percent rate.

Friedman said the conversion of management fees raises questions about tax avoidance by individuals who invest in funds. Managers are sensitive to investor complaints that they can't write off investment fees as a miscellaneous deduction until those expenses exceed 2 percent of gross income, he said.

`Still a Problem'
``The 2 percent floor is still a problem for individuals,'' he said. Structuring the fee as a special distribution to the fund manager is equivalent to a deduction because the fund profits used to make the payment are never transferred to the investor as taxable income.
The conversion technique is described in a September 2001 presentation entitled ``Converting Management Fees Into Carried Interest'' prepared by the Palo Alto, California-based law firm Wilson Sonsini Goodrich & Rosati. The paper says the fee can be converted into carried interest ``without reducing cash flow or adding unacceptable risk.''

The presentation's author, Jonathan Axelrad, said in an interview that the technique generates tax advantages because fund managers assume more risk.

``If you reduce the economic risk you will increase the risk on the tax analysis,'' Axelrad said.