How The President's Tax Reform Has Changed The Compensation Structures Of Hedge And Private Equity Funds

Now that the dust has somewhat settled on the sweeping changes imposed by the Tax Cut and Jobs Act of 2017 (TCJA), hedge and private equity fund owners have started to adjust their employee compensation packages as well as their own investor fee structures.

To better understand the alterations being implemented, let's first discuss how alternative investment managers are compensated and then the options available to them for securing premier talent.

Management Fees and Profit Reallocation

Hedge and private equity fund managers generally make their money through two avenues.

A fixed percentage of the net assets under management (that is, each investor's capital) is typically charged quarterly and collectible regardless of profits. This management fee is commonly 2% unless the investor is given a break as a founder/provider of seed money. Increasingly, founders are dictating the terms of their fees, demanding they be charged a smaller percentage. Management fees, generally sourced as sales to a specific state (which will be discussed further below), are self-employment income subject to that tax if flowing to an individual, and, when paid to a New York City-based non-corporate entity, subject to the 4% Unincorporated Business Tax (UBT).As these management fees are taxed in all these ways with no beneficial lower tax rate, their cash flow is generally designated by the fund to cover payroll, rent, utilities, consultants, software, and equipment such as chairs or computers. This income is generally not eligible for the new 20% deduction afforded certain pass-through entities through the new Internal Revenue Code (IRC) §199A as it probably is one of the "specified trades or businesses" rendered ineligible. A variable portion of the profits is sometimes named the incentive reallocation, carry, promote or carve-out. Historically, a typical rate charged is 20%. As with the reduced management fees mentioned above, seed investors sometimes negotiate being charged a smaller percentage or, in some cases, no carry at all. Often, hurdle rates (for example, a fixed percentage or the federal LIBOR rate must be cleared) and/or high-water marks (an investor's cumulative losses to date must be recovered first) are utilized.If this profit is paid as a reallocation through a pass-through entity such as a limited liability company or limited partnership instead of as a fee for services rendered as an independent party, there are tax advantages. The most salient being that the portion of current income attributable to unrealized gains remains unrealized for the manager because the character of the income (ordinary, long-term capital gain, portfolio deduction) is retained when passed through a partnership to its partners.The partners of the managing entity can also benefit from the lower tax rates granted to long term capital gains and qualifying dividends (the highest rate of which from a federal standpoint is currently 20%). However, this is another facet of the law that changed with the TCJA - in order to get the beneficial tax rate on long-term capital gains under new IRC §1061, the general partner entity must have held its carry interest three years and the investments themselves must have been held for three years as well.The trading strategy of the entity granting the profits interest does, however, have a substantial effect on the benefits offered, especially in light of the TCJA. If the fund turns over its portfolio frequently and is classified as a "trader," the fund's expenses are classified as "above-the-line" deductions and directly reduce an individual investor's Adjusted Gross Income (AGI) when passed through. If the fund holds onto investments and tries to benefit from long-term appreciation, it will be classified as an "investor" and the professional expenses and management fees will instead be classified as miscellaneous itemized deductions if flowing to an individual. Miscellaneous itemized deductions are no longer deductible at all under TCJA. For years prior to 2018, these were deductible, if they exceeded 2% of AGI, as individual itemized deductions if the standard deduction was not elected, and the taxpayer did not pay Alternative Minimum Tax.

The Net Investment Income tax of 3.8% also applies to individuals with modified AGI in excess of $200,000 ($250,000 for married filing joint taxpayers). Corporate partners are not subject to similar deduction limitations and are indifferent to the fund's classification as a "trader" or "investor," as they are indifferent to the holding period of the investments - setting up a potential conflict between different types of investors. A common misperception is that this classification is an election.

It is not. It is based on the strategy employed and the implementation of such, not on how the fund wishes to be classified. Managers interested in having their own IRA accounts invested in the carry vehicle should be wary of use of leverage or any business-like income such as loan origination fees, oil and gas royalties or real estate rental income, as these can possibly create Unrelated Business Taxable Income and a current tax bill. As for sourcing, most states employ a "trading for your own account exception" that classifies investment-type income as being sourced only to where the ultimate investor resides. More recently, star performers and senior staff are more frequently receiving a piece of the carry. Historically, the carry was reserved for the fund's creators.

Partner vs. Employee in Light of New Carry Rules of IRC §1061 and the TCJA

The attractiveness of being a partner versus an employee has changed with implementation of the new IRC §1061. Now that carry interests can only receive the beneficial tax rate on long term capital gains if the holding period exceeds three years, the benefit of being a partner in a hedge fund has slightly diminished as less of their income is likely to be generated by such a longer holding period unless that's the strategy the fund employs. For most private equity enterprises or real estate partnerships, the minimum holding period of three years should have little to no impact. However, new IRS partnership audit rules should also be considered by an employee when he or she is considering the offer to become a partner.

Fund managers regularly use structuring options such as receiving management fee income through a limited partnership or subchapter S corporation to help minimize self-employment taxes. However, proper classification as a limited partner has begun to be looked at more closely by the IRS and should be considered.

Before 2018, some funds paid employees' bonuses (based on how profitable the fund was) out of the management vehicle as wages, creating an ordinary loss in the management company, while receiving long-term or unrealized gains in the carry vehicle. Regardless of whether this practice might motivate governmental jurisdictions such as New York City to argue the management company and general partner are one vehicle instead of two (under the premise that no entity can operate perpetually at a loss) and subject any overall profit to the New York City UBT, it is also affected by the TCJA. Under new IRC §461(l), non-business losses greater than $250,000 for an individual ($500,000 for couples filing married joint - both limits of which are adjusted for inflation after 2018) are disallowed.

An "investor" fund running its management company at a loss could find such losses disallowed at the owner level. As such, these owners may wish to change how they compensate their employees and instead give them a piece of the carry vehicle so that these owners don't receive a management company loss that is deferred.

Another consequence of the TCJA is that many individuals in high income tax rate states such as New York, New Jersey and California are limited on the amount of state income tax they are able to take as an itemized deduction on their individual returns. Entity level taxes such as the NYC UBT, however, are deductible at the entity level and are creditable against the individual's New York City income tax.

By leaving profit in the management company that is subject to the NYC UBT, the owners can essentially get some credit for New York City UBT paid on their New York City returns. Depending on the individual's overall tax picture and taking into consideration the other issues below, leaving profit in the management company and instead paying bonuses as part of the carry vehicle as partnership interests might be more beneficial for the owners.

Impact Imposed by Method of Accounting

If the management company utilizes the accrual method of accounting, the actual exchange of cash would not have to take place up to 75 days after year end, giving the company more time to determine its actual profitability and how much it would like to pay high performers, as well as offering a short respite if cash flow is an issue. This delay is only available for unrelated parties under IRC §267. Unless one related party includes in income the expense owed by another related party, the other party must wait to deduct the expense until the same period as the year of income inclusion regardless of whether each uses the accrual or cash methods of accounting.

For purposes of this rule, a partnership and "any person who owns (directly or indirectly) any capital interest or profits interest of such partnership" would be considered a related party. So, too, would an S corporation and "any person who owns (directly or indirectly) any of the stock of such corporation." This rule should not be forgotten when a fund pays its management fee at quarter-end and the cash does not change hands until the following year - depending on the ownership, the management company must pick up the income in the same period as the deduction is taken by the investors.

Historically, management companies employed the cash basis method of accounting to benefit...

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