Paul L. Caron

Tuesday, December 23, 2008

Hedge Funds Should Restructure by Year-End to Avoid Obama Tax Increase

From today's Bloomberg: Buyout, Hedge Funds Must Reorganize to Avoid Taxes, Lawyers Say, by Ryan J. Donmoyer & Gillian Wee:

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% or more instead of the 15% 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. ...

Some funds are also trying to guard against being forced to pay the 2.9% Medicare-funding self-employment tax on management fees, which they collect even if the fund doesn’t record a profit, [Schiller & Flexner's Mike] 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.

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.”

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