By Gregory Zuckerman and Rob Copeland
Hedge-fund managers for years accumulated offshore gains without
paying federal and state taxes. Now Uncle Sam is going to get
paid.
Steven Cohen is one of many managers preparing to write huge
checks in early 2018 due to a crisis-era decision to close a tax
loophole that long benefited some of Wall Street's wealthiest
investors.
The billionaire founder of SAC Capital Advisors LP amassed
deferred offshore income of more than $1 billion likely subject to
the taxation, said people familiar with the matter. Other
hedge-fund managers facing personal tax bills of over $100 million
include David Einhorn of Greenlight Capital Inc. and Daniel Loeb of
Third Point LLC, said people familiar.
Total payments from all managers could amount to $25 billion,
according to a 2008 estimate from the Joint Committee on Taxation.
Some tax specialists say the bill could be even higher: $100
billion or more.
This will likely mean a surge of tax revenue for Connecticut,
historically the center of the hedge-fund industry. The state isn't
yet sure how much it will reap, said a spokesman for the governor's
budget office.
"Any projection would be too speculative to be reliable," the
spokesman said.
Hedge-fund managers are considering a variety of steps to raise
cash or soften the tax blow. Some will trim stakes in their funds
to raise cash, says Brett Barth of hedge-fund investor BBR Partners
LLC.
Hedge funds often invest through vehicles based inside and
outside the U.S. They make money from their cut of 20% or more of
trading profits.
For decades, the Internal Revenue Service allowed managers of
offshore funds to defer receipt of this compensation and both avoid
an immediate tax bill and grow the savings tax-free. The IRS
generally permits businesses to allow executives to defer
compensation because such deferrals lower the firms' compensation
costs, forcing them to pay higher taxes on profits. That offsets
income taxes not immediately paid by employees.
But this practice cost the Treasury income in the case of
offshore hedge funds that don't pay any offsetting U.S. taxes.
Managers in some cases let those deferred trading fees compound
tax-free for 10 years or longer. Some also deferred management
fees, even as they amassed large fortunes from gains earned by
their U.S.-based funds.
"They kept rolling and rolling the money," says Richard Zarin, a
partner at Morgan, Lewis & Bockius LLP.
The New York Times in 2007 highlighted this loophole, and
Congress overwhelmingly voted to close it the following year as a
way of raising revenue and stabilizing the financial sector during
the 2008 financial crisis. The change, part of the Emergency
Economic Stabilization Act of October 2008, was made in section
457A of the IRS code.
The legislation gave managers a decade to pay taxes on money
accumulated before the law changed. That deadline is now nine
months away.
The deferred fees will be taxed at ordinary tax rates that can
be close to 50% depending on where the managers live and work,
according to tax experts.
"These are smart, aggressive people who don't want to pay more
than they have to and writing a huge check can be quite
demoralizing," said Jonathan Brenner, a tax partner at Caplin &
Drysdale. "Most recognize they've had a good run and now have to
pay the piper, though not after first asking six different ways if
there's some silver bullet" to eliminate or reduce the taxes.
Mr. Cohen, who ran SAC Capital before it pleaded guilty to
criminal insider-trading charges in 2013, is nearing a launch of a
new firm to manage as much as $20 billion, The Wall Street Journal
earlier reported.
He has set that target, which would exceed the $16 billion
managed at peak by SAC, partly because he wants to generate income
to help pay the large tax bill, a person close to him said.
Other fund managers are shifting headquarters to Florida to
mitigate the tax impact, said a local official. Florida doesn't
have a state income tax on personal income.
"Even four or five years ago they saw this coming, they knew
they'd bring money back in and needed to be in a state with lower
taxes," said Kelly Smallridge, president of the Business
Development Board of Palm Beach County.
Those moves are no guarantee of a smaller tax bite because
states generally examine where and when deferred compensation was
earned, experts say.
"People have been banging on our doors since the provision was
enacted looking for a solution and we still have clients coming in,
but one hasn't been found," says Mr. Brenner. "Every tax lawyer who
touches hedge funds has had these kinds of calls...there's
frustration among some clients that a solution has not been
found."
Some charities say managers anticipating a tax bite are
discussing donations -- to receive an immediate tax deduction --
rather than handing money to the government.
Other managers are turning to charitable lead annuity trusts,
said Henry Bregstein, an attorney at Katten Muchin Rosenman LLP.
These trusts give a donor an upfront deduction of 100% as well as
the opportunity to transfer to heirs, free of gift and estate tax,
the trust's remaining value at the term's end after making annual,
fixed distributions to charities.
Eileen Heisman, chief executive officer of National
Philanthropic Trust says her organization is speaking to roughly 50
fund managers about establishing donor-advised funds by the end of
year, three-times the usual pace. She attributes the increase to
the looming tax bills.
Such funds make grants to charities on behalf of donors after
they contribute assets, enabling immediate tax deductions. Assets
can be invested and grow tax-free even before the charities are
chosen.
Sometimes, these funds can be invested in the manager's own
funds, with restrictions, Ms. Heisman says.
"There's no way of knowing how much" money will be paid in taxes
or how much will be shifted to charitable organizations, says Ms.
Heisman. "But we think it will be very large."
Write to Gregory Zuckerman at gregory.zuckerman@wsj.com and Rob
Copeland at rob.copeland@wsj.com
(END) Dow Jones Newswires
July 20, 2017 05:44 ET (09:44 GMT)
Copyright (c) 2017 Dow Jones & Company, Inc.