Buyout and Hedge Funds Must Reorganize to Avoid Taxes, Lawyers Say
By Ryan J. Donmoyer and Gillian Wee
Dec. 23 (Bloomberg) -- Tax lawyers are urging private- equity and hedge-fund clients to restructure their partnerships so they can sidestep the higher taxes that President-elect Barack Obama has vowed to impose on their profits.
Obama’s promise to revive a failed 2007 bill forcing executives to pay rates of 35 percent or more instead of the 15 percent capital-gains tax has prompted lawyers to advise the firms to take measures such as setting up offshore entities. That would help circumvent higher taxes on so-called carried- interest profits that executives at the firms typically earn.
The lawyers say they are pressing their clients to act before the year’s end on the assumption that any law or regulatory change won’t apply before 2009.
“If you wait to do it, then to unwind or restructure later will be very difficult and trigger significant tax penalties,” said Mike Kosnitzky, who heads Boies Schiller & Flexner’s tax practice in New York and is advising clients.
Neither Kosnitzky nor other lawyers would disclose the names of their clients. While companies such as Blackstone Group LP and Carlyle Group have led the charge against paying higher taxes, the lawyers say it’s mostly smaller firms they are advising on how to get around the levies.
A tax increase may not have much immediate effect as fund investors struggle to stem losses in the financial crisis. Still, Kosnitzky said future laws could dent returns when markets rebound.
Offshore Entities
The attorneys are advising firms to create offshore companies and to convert carried interest into loans for fund executives. Both methods would make the funds eligible for lower tax rates. They’re also counseling them to restructure the funds to shield executives from a potential increase in Medicare taxes, currently 2.9 percent.
Kosnitzky said he’s helping clients revise their legal structure to use a passive foreign investment company, an overseas entity that follows special tax rules. That would allow fund executives to continue paying capital-gains tax rates on income routed through the unit, under some circumstances.
Executives of hedge funds and buyout firms mainly receive two fees: an annual management fee, usually 2 percent of the fund’s total assets; and carried interest, usually a 20 percent share of profits paid after a fund returns a predetermined amount.
The management fee is taxed at ordinary income rates, currently as high as 35 percent. Carried interest often qualifies for the 15 percent capital-gains tax rate, especially for private-equity firm executives who take their profit years after they acquire a company.
Unfair System
Congressional Democrats led by Michigan Representative Sander Levin and New York Representative Charles Rangel last year said the lower tax treatment for carried interest was unfair because the compensation was like other wages.
Obama pledged during the campaign to enact the House proposal. He’s also considering raising the capital-gains rate to 20 percent and the top rate for ordinary income to 39.6 percent.
Tony James, president of New York-based Blackstone Group, told investors on a recent conference call “that at some point the tax system that we’ve all been operating under will move in adverse ways for a long period of time.”
Chris Roman, a tax lawyer at the New York law firm Clifford Chance, said almost every new fund he advised this year has structured itself in a way to give managing partners the ability to avoid the possible tax increase. One such strategy, he said, is to use a loan to the fund’s general partners from its investors that replicates carried interest.
Greater Risk
“People have tried to think about using things like loans and other types of structures” to preserve the lower rate, he said. While legal, most of those techniques would also require managing partners to assume greater risk to get paid at a lower tax rate.
Some funds are also trying to guard against being forced to pay the 2.9 percent Medicare-funding self-employment tax on management fees, which they collect even if the fund doesn’t record a profit, Kosnitzky said. They are aiming to do this by converting the management companies into S Corporations, which don’t pay corporate-level taxes and are common structures for small businesses.
Like Doctors, Lawyers
Victor Fleischer, a University of Illinois law professor who has testified to Congress on the taxation of carried interest, said that strategy is commonly used by doctors and law firms to duck the liability. Former Democratic presidential nominee John Edwards, who worked for hedge-fund management company Fortress Investment Group LLC, was criticized for avoiding Medicare taxes using this technique.
Kosnitzky said his method arbitrages tax rules governing a passive foreign investment company to sidestep the anticipated tax increase on carried interest.
Under such an arrangement, he said, carried interest would still qualify for capital-gains tax treatment when it is distributed to fund executives in the U.S. The difficulty, he said, is to avoid running afoul of other international tax rules concerning ownership percentages that could negate the savings and even trigger higher liabilities.
No matter the obstacles, the firms will try to find a way around higher taxes, said Michael Knoll, a University of Pennsylvania law professor and expert on the issue.
“If Congress passes a bill changing the tax treatment of carried interest, the issue will not end there,” said Knoll. “There is simply too much money at stake.”
To contact the reporters on this story: Ryan J. Donmoyer in Washington at rdonmoyer@bloomberg.net; Gillian Wee in New York at gwee3@bloomberg.net.
Last Updated: December 23, 2008 00:01 EST |
