At the very beginning of this year there was much discussion about the hedge fund compensation structure in light of the horrible returns from 2008.  Many funds lost money but managers aren’t typically subject to the same types of clawback provisions as private equity fund managers.  Additionally some funds had to close shop because of talent retention issues or because the manager realized that reaching a previous high water mark would take too long.  Generally investors who have lost money will prefer to stay in a fund (all else being equal) because of the high water mark – when investors go into a new fund, there high water mark is their initial investment which means they are going to be subject to hedge fund performance fees sooner than in a fund which has previously lost money.

FAR Alternative

As an alternative to the traditional performance fee/ allocation structure, some hedge funds are instituting a different compensation structure called fund appreciation rights (FARs).  Generally this structure provides a more aligned incentive structure for the manager.  Essentially the FARs provide an option like mechanism for the manager.  This option also has the potential to allow the manager to defer recognition of income which may be an added tax benefit for the manager.  [Note: a longer discussion on this issue will be forthcoming shortly.]

Issues with FARs

FARs are new.  It is not known how many groups have implemented FARs or whether they will catch on (or become the next standard).  It is likely that any movement in this area will be driven by the demand (if any) by institutional investors for such products.  FARs are also untested and it is not clear how they will be viewed by the IRS.  As we have recently seen, there has been a big push to disallow the tax advantages of the performance allocation to hedge fund managers and in the current political climate it is likely that the IRS will scrutinize such transactions.

We will continue to research and report on this and other tax structures for hedge fund managers.

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Other related hedge fund law articles:

• Perspectives on Hedge Fund Tax Issues
• Revising the Hedge Fund Compensation Structure
• Is it time to rethink the high water mark?
• Forex Registration

Bart Mallon, Esq. of Cole-Frieman & Mallon LLP runs the Hedge Fund Law Blog.  He can be reached directly at 415-868-5345.

As we are all well aware, the partnership structure of hedge funds allows the management companies of these funds to receive an “allocation” of the fund’s income.  Under general partnership taxation principles, this allocation is taxed to the management company (and the other investors in the hedge fund) according to the characteristic of that income (at the partnership level).  That is, if the income was long-term capital gain at the partnership level, such income would be allocated to all partners (including the management company) and would retain such characterization.  Long-term capital gains are currently taxed at 15% (as compared to a 35% tax rate for most ordinary income).

Last week Representative Sander Levin reintroduced legislation to tax the carried interest at ordinary tax rates.  The tax would only apply to the managers of partnerships to the extent that such managers did not have an underlying investment in the fund.  I will not introduce any political opinions regarding such a tax, but I will note that I take issue with the way that the press and lawmakers define the issue.  The most glaring omission in all of these reports is that the carried interest (or performance allocation) is only taxed at long-term capital gains rates if there are underlying long-term capital gains.  These articles (including the press release reprinted below) insinuate that all allocations made to a manager will be subject to long-term capital gains rates.  Not all income to hedge funds is long term capital gain – in fact, many hedge funds have no long-term capital gains at all because their programs focus on short term or intermediate term trades.

We have discussed this issue a number of times before and believe that the best way for this issue to be addressed is through the political process and we hope that all lawmakers involved take a considered and academic approach when crafting any future tax legislation (see Hedge Fund Taxes may Increase Under Obama).

The press release below is from the office of Representative Sander Levin and provides a sort of question and answer regarding the proposed legislation.  I am interested to read your comments on this issue below.

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For Immediate Release
April 3, 2009

FOR MORE INFORMATION:
Hilarie Chambers
Office: 202.225.4961

Levin Reintroduces Carried Interest Tax Reform Legislation

Bill to Tax Fund Managers’ Compensation at Same Rates as All Americans

(Washington D.C.)- Rep. Sander Levin today reintroduced legislation to tax carried interest compensation at the same ordinary income tax rates paid by other Americans.  Currently, the managers of private investment partnerships are able to receive compensation for these services at the much lower capital gains tax rate rather that the ordinary income tax rate by virtue of their fund’s partnership structure.

“This is a basic issue of fairness,” said Rep. Levin. “Fund managers are receiving compensation for managing their investors’ money.  They should not pay the 15% capital gains rate on their compensation when millions of other hard-working Americans, many of whose income is performance-based, pay ordinary rates of up to 35%.  The President’s budget recognizes that this is unfair.  The House of Representatives has recognized that it is unfair, and this year I hope we can act to change the law.”

The legislation clarifies that any income received from a partnership, capital or otherwise, in compensation for services provided by the employee is subject to ordinary tax rates.  As a result, the managers of investment partnerships who receive a carried interest as compensation will pay regular income tax rates rather than capital gains rates on that compensation.  The capital gains rate will continue to apply to the extent that the managers’ income represents a reasonable return on capital they have actually invested themselves in the partnership.

“This proposal is not about taxing investment, it’s about ensuring that all compensation is treated equally for tax purposes.  Anyone who actually invests money in these funds will continue to receive capital gains treatment, including the managers.  So there is no reason to expect that the amount of capital available for these kinds of investments will be reduced,” concluded Levin.

Levin introduced similar legislation in the 110th Congress, which was subsequently included in several tax packages approved by the Ways & Means Committee and the House of Representatives.  A similar proposal is also included in President Obama’s FY 2010 budget request.

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Levin Carried Interest Legislation – H.R. 1935

H.R. 1935 would treat the “carried interest” compensation received by investment fund managers as ordinary income rather than capital gains.  In exchange for providing the service of managing their investors’ assets, fund managers often they receive a portion of the fund’s profits, or carried interest, usually 20 percent.  H.R. 1935 clarifies that this income is subject to ordinary income tax rates rather than the much lower capital gains rate.

Carried Interest: The Basics

Why is Congress concerned about this issue?

Many investment funds are structured as partnerships in which investors become limited partners and the funds’ managers are the general partner.  The managers often take a considerable portion of their compensation for managing the funds’ investments as a share of the funds’ profits using a mechanism called “carried interest.”  Partnership profits are taxed not to the partnership; instead partners are taxed on allocations of partnership income, and the nature of that income (capital or ordinary) “flows-through” to the partners.  As a result, the investment managers are able to have income for performance of services taxed at the 15% capital gains rate.  Essentially they are able to pay a lower tax rate on income from their work than other Americans simply because of the structure of their firm.

What does the legislation do?

It clarifies that any income received from a partnership, capital or otherwise, in compensation for services is ordinary income for tax purposes.  As a result, the managers of investment partnerships who receive a carried interest as compensation will pay regular income tax rates rather than capital gains rates on that compensation.  The capital gains rate will continue to apply to the extent that the managers’ income represents a reasonable return on capital they have actually invested in the partnership.

What kinds of investment firms will be affected?

This is part of a broad consideration of tax fairness.  The principle at work is that compensation for services should be treated as ordinary income and taxed accordingly, regardless of its source.  Any investment management firm that takes a share of an investment fund’s profits as its compensation (i.e. in the form of carried interest), will be affected.  This will apply to any investment management firm without regard to the type of assets, whether they are financial assets or real estate.  The test is the form of compensation, not the type of assets the firm is managing, its investment strategy, or the amount of compensation involved.

What is the effective date of the legislation?

This legislation is designed to create a structure under which this income should be taxed.  Decisions on the effective date will be made as part of the legislative process.

Carried Interest: Myths vs. Facts

Fact: Investors are not affected by this legislation at all.

Any person or institution who invests money in a fund whose managers receive a carried interest will continue to pay the capital gains rate on their profits.  In fact, the bill explicitly protects the investments that fund managers make themselves.  To the extent they have put their own money in the fund, managers still get capital gains treatment, but to the extent they are being compensated for managing the fund, they will have to pay ordinary income tax rates like other service providers.   Since investors are not affected, there is no reason to believe that the amount of capital available for these kinds of investments will be reduced at all.

Myth: Taxing carried interest is just about raising revenue.

Fact: Fairness requires treating all taxpayers who provide services the same.

This proposal would raise revenue, but it is not just an offset.  Congress has a responsibility ensure that our tax code is fair, that it makes sense.  A broad spectrum of experts, including the Chairman of the Cato Institute and senior economic advisors to the last three Republican Presidents, agree that carried interest really represents a performance based fee that investors are paying to fund managers and that it should be taxed accordingly.  Allowing some service providers to pay the 15 percent capital gains rate on their income when everyone else has to pay up to 35 percent risks undermining people’s confidence in our voluntary tax system.

Myth: Fund Managers are just like entrepreneurs who get founder’s stock in their company, so they too should be taxed at the capital gains rate.

Fact: Fund Managers are fundamentally different than the founder of a company.

When someone starts an enterprise, he or she actually owns that business.  Sometimes that business becomes enormously valuable, but quite often it fails altogether and the entrepreneur loses her business. When an investment partnership purchases an asset, be it a stake in a small start-up company, a large corporation that wants to go private, a portfolio of securities, or a piece of real estate, the partnership does truly own those assets.  The general partner or fund manager though is really only an “owner” to the extent he or she has contributed capital to the partnership.  The carried interest the general partner receives for managing the fund’s assets is a right to a portion of the fund’s profit, not to the fund’s actual assets: the manager has no downside risk.  If the fund fails completely and all of the partnership’s assets are lost, the limited partners have lost their money.  The manager has lost the time and energy he has put into the running the fund, and the potential to share in the profits, but he is not actually out of pocket.

Myth: Fund managers deserve capital gains treatment because a carried interest is risky.

Fact: Many other forms of compensation are risky, and they are all ordinary income.

When a company gives its CEO stock options, it is trying to give her an incentive to increase the company’s share price, to growth the value of shareholders’ investment.  If the CEO does a good job and the share price goes up, she pays ordinary income tax rates when she exercises those options.  Real estate agents only make money if they actually sell a house, no matter how hard they work.  Authors receive a portion of their book’s profits.  Waiters get tips based on the quality of the service they provide.  All of these people pay ordinary income tax rates on their compensation.  Only private equity and other fund managers get to pay capital gains rates on their compensation.

Myth: Taxing carried interest will hurt the pension funds that invest in these funds.

Fact: This has nothing to do with pension funds and their returns will not be affected.

One pension trustee, who also happens to be a hedge fund manager, called the idea that this debate is about workers’ pensions “ludicrous.”  As tax-exempt investors, pension fund certainly will not be affected directly, and the assumption that fund managers can charge higher fees than they do today as a result of their having to pay ordinary income rates is extremely questionable. In fact, an attorney representing the hedge fund industry testified before the Ways & Means Committee that investors would be unlikely to accept increased fees.  The National Conference on Public Employee Retirement Systems has said that its members do not believe this legislation will affect them.

Myth: This change to the taxation of carried interest will harm every “mom and pop” partnership in America.

Fact: The change would only affect those partnerships where service income is being improperly converted to capital gains.

This legislation would have no effect whatsoever on the vast majority of partnerships that are engaged in ongoing businesses and whose profits are already being properly taxed an ordinary income tax rates.  It does apply to investment fund partnerships where the investors in the fund choose to compensate the people managing their assets through a carried interest.  In practice, this means hedge funds, private equity funds, venture capital funds and real estate partnerships.  The reality is that the fund managers and general partners who would be asked to pay ordinary income tax rates on their compensation are a very small, very well-paid group of professionals.  It is also important to note that the bill does not discriminate among partnerships based on the kind of assets they purchase.

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Other related hedge fund tax articles:

• Hedge Fund Taxation Overview
• IRC Subchapter K
• Hedge Fund Tax

Groups such as the New York Times and Daily Finance are reporting that Obama’s proposed fiscal 2010 budget, which will be released tomorrow, will include provisions which will increase taxes for hedge fund managers (and private equity fund managers).   Such a provision would likely be written to provide that a carried interest (also called a performance allocation) paid to a management company would be characterized as ordinary income instead of capital gain (to the extent the underlying profits were long term capital gains which are subject to a lower tax rate).

Hedge fund managers are not likely to receive much sympathy from the general public, but this is a hot button issue which will likely incense many of Obama’s supporters.  Hedge fund taxation has been an issue batted around in the media and was especially popular a year and a half ago when the Blackston group was preparing to go public (see Bloomberg article).  The issue has been smoldering for a while (see Hedge Fund Tax Issues 2007), but groups are beginning to examine and analyze this issue (see the abstract of an academic report below) rather than react in a knee-jerk manner.

What we will ask of the President, lawmakers and regulators is that they examine the issue from an academic perspective and make informed decisions.  Hopefully reports like the one below will persuade lawmakers to ultimately keep the carried interest tax preference for hedge funds and private equity funds.

We will continue to report on this issue and will release any applicable information once the fiscal budget is released.  Please feel free to contact us if you have any questions if you have any hedge fund law questions.

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Measuring the Tax Subsidy in Private Equity and Hedge Fund Compensation

Karl Okamoto
Drexel University College of Law

Thomas J. Brennan
Northwestern University School of Law

February 26, 2008

Drexel College of Law Research Paper No. 2008-W-01

Abstract:

A debate is raging over the taxation of private equity and hedge fund managers. It is being played out in the headlines, in Congress and among legal scholars. This paper offers a new analysis of the subject. We provide an analytical model that allows us to compare the relative risk-reward benefit enjoyed by private equity and hedge fund managers and other managerial types such as corporate executives and entrepreneurs. We look to relative benefits in order to determine the extent to which the current state of the world favors the services of a private equity or hedge fund manager over these other workers. Our conclusion is that private equity and hedge fund managers do outperform other workers on a risk-adjusted, after-tax basis. In the case of hedge fund managers, this superiority persists even after the preferential tax treatment is eliminated, suggesting that taxes alone do not provide a complete explanation. We assume that over time compensation of private equity and hedge fund managers should approach equilibrium on a risk-adjusted basis with other comparable compensation opportunities. In the meantime, however, our model suggests that differences in tax account for a substantial portion of the disjuncture that exists at the moment. It also quantifies the significant excess returns to private fund managers that must be taken into account by arguments in support of their current tax treatment by analogy to entrepreneurs and corporate executives. This analysis is important for two reasons. It provides a perspective on the current issue that has so far been ignored by answering the question of how taxation may affect behavior in the market for allocating human capital. It also provides quantitative precision to the current debate which relies significantly on loosely drawn analogies between fund managers on the one hand and entrepreneurs and corporate executives on the other. This paper provides the mathematics that these comparisons imply.

Other hedge fund tax and law articles include:

• Hedge Fund Taxation Overview
• IRC Subchapter K
• Hedge Fund Tax

The following is a reprint of the Joseph Bankman’s testimony before Congress.  Mr. Bankman is a professor at Stanford Law School.  While the testimony has a bias against the current hedge fund taxation structure, it provides a great overview of hedge fund tax issue, specifically the taxation of the hedge fund performance fee (also known as a “performance allocation,” “carried interest” or “carry”).  Ultimately the future of the hedge fund taxation regime will be decided in the political arena, but this article provides a good overview of the arguments for changing the current tax code. 

With this article we are establishing a new hedge fund taxation section where we will include articles about the practical aspects of hedge fund tax, as well as updates on the political process.  Please feel free to contact us if you have any questions if you have any hedge fund law questions.  Other related articles include:

• IRC Subchapter K
• Hedge Fund Taxation Overview
• Overview of Schedule K-1
• Hedge Fund UBTI
• Hedge Fund Tax
• Overview of Hedge Fund Law

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House of Representatives Committee on Oversight and Government Reform
November 13, 2008

Testimony of Joseph Bankman
Ralph M. Parsons Professor of Law and Business, Stanford Law School

Mr. Chairman, Ranking Member Davis and Members of the Committee, thank you for inviting me here today to testify on the tax treatment of hedge fund managers. The views expressed here are my own and do not necessarily reflect the views of Stanford University.

1. Overview of Hedge Fund Organization and the Taxation of “Carry”

Briefly stated, hedge funds are investment partnerships. The investors — institutions and affluent individuals – are limited partners. The fund managers are general partners. Virtually all institutional investors are organized and located in the United States. Similarly most individual investors and managers are United States citizens who live and work in the United States. The hedge fund partnership, however, is often organized offshore, in tax havens as the Cayman Islands.[1] In recent years, hedge funds have held over a trillion dollars of stock and other assets. Many individual hedge funds have over a billion dollars of assets under management.

Hedge fund managers are compensated in two ways. First, they receive a management fee. This is typically 2% of the fund’s assets. Second, they receive a profits percentage. This is typically set equal to 20% of the fund’s profits. The profits interest is sometimes referred to as a carried interest, or carry. [2]

[1] There are often one or more partnerships or other legal entities interposed between the offshore operating partnership and the investors. These entities are used to accomplish other tax, regulatory or business-related objectives but do not significantly affect my analysis. The organizational structure is described in greater detail in Joint Committee on Taxation, “Present Law and Analysis Relating to Tax Treatment of Partnership Carried Interests and Related Issues, Part II,” (JCX-53-07), September 4, 2007, available at www.house.gov/jct.

[2] A summary description of the hedge fund and private equity industry, together with a description of the tax treatment of manager compensation, can be found in Joint Committee on Taxation, “Present Law and Analysis Relating to Tax Treatment of Partnership Carried Interests and Related Issues, Part I,” (JCX-53-07), September 4, 2007, available at www.house.gov/jct.

The portion of compensation received as a management fee is taxed as ordinary income. The tax characterization of compensation attributable to a profits interest is more complex. That characterization is made at the fund level. If the fund’s profits are from the sale of capital assets held for over a year, the income will “flow through” to the limited partner investors as long-term capital gain. The amounts paid to the general partners as carry will also be taxed as long-term capital gain.

The amount of compensation received pursuant to a profits interest obviously depends on the profitability of the fund. Over time, however, the vast majority of income realized by a fund manager at a successful fund will come from his or her profits interest, and that income will be substantial. As an average over time, carry in excess of $10 million a year is common. Top hedge fund managers have earned carry well in excess of $100 million a year. One study found hedge fund managers earn far more than CEOs of publicly traded companies, and that hedge fund management is the most highly compensated of any profession. [3]

[3] Steven N. Kaplan and Joshua Rauh, Wall Street and Main Street: What Contributes to the Rise in the Highest Incomes? (July 2007) CRSP Working Paper No. 615, available at SSRN: http://ssrn.com/abstract=931280.

Private equity managers, such as venture capitalists or buy-out specialists, operate under similar compensation arrangements.

Capital gain is taxed at a maximum federal income tax rate of 15%. In contrast, the maximum rate on ordinary income is 35%. To the extent fund managers benefit from the capital gain preference they pay tax at less than half the rate as other highly paid professionals. That portion of manager compensation is taxed at a lower rate than compensation received by many, if not most, working individuals. A single individual, for example, pays tax at a 25% rate on any income in excess of $32,500 a year. That is ten percentage points, or 40% (10%/25%) higher than the rate paid by the fund manager.

Carry is not only subject to a lower income tax rate than other income, it is exempt from payroll taxes. As a result, carry is exempt from the 2.9% Medicare tax that must be paid on compensation received by other high-income individuals.

The amounts paid as management fees generate a deduction that flows through to the fund investors and can be deducted from ordinary income. Amounts paid as carry reduce the investment income that fund investors recognize. To the extent the fund profits are capital gains, carry paid to managers reduces the capital gain recognized by investors.

In theory, structuring compensation as carry rather than management fees or other salary costs the investors a deduction that can be used to reduce taxes on ordinary income. In practice, however, the loss of this deduction is not important. Many hedge fund investors are tax-exempt and the individual investors often cannot deduct their portion of management fees due to Section 67 of the Internal Revenue Code (which allows deduction for this and other miscellaneous items only to the extent such items exceed 2% of adjusted gross income).

The tax-favored treatment of carry has been estimated to save fund managers $31 billion over the next 10 years.[4] That figure encompasses both hedge fund and private equity managers. There are no official statistics as to the breakdown between those two (somewhat overlapping) groups, but the widespread perception is that private equity managers have realized a disproportionate share of this tax benefit. The reason for this is that many hedge funds currently have trading strategies that make long-term capital gain and loss unlikely and many hedge funds have elected to mark to market, precluding long-term capital gain treatment of gains. However, hedge funds that have not elected to mark to market are eligible for this benefit and it is possible that trading strategies in the future may change, making this benefit more valuable to hedge funds.

[4] Committee on Taxation, “Estimated Revenue Effects Of H.R. 6275, The “Alternative Minimum Tax Relief Act Of 2008,” Scheduled For Markup By The Committee On Ways And Means On June 18, 2008” (JCX-51-08), June 17, 2008 available at www.house .gov/jct. The tax benefits are a function of the amount of carry, which in turn is a function of the amount of profits. The recent economic crisis will undoubtedly reduce the tax benefits realized in 2008 and most likely, in 2009.

The low rate of tax on carry would be relevant in assessing the overall tax and regulatory burden faced by the hedge fund and private equity industry, even if that low rate reflected good tax policy. In my opinion, it does not. It is neither fair nor efficient.

2. Fairness and Efficiency of Capital Gain Treatment of Carry.

Tax scholars and policymakers generally divide fairness into two related concepts – vertical and horizontal equity. Vertical equity refers to the proper distribution of the tax burden among high-income and low-income individuals. The current (and past) tax law is progressive: high-income individuals pay a higher rate of tax than low-income individuals. For married individuals filing jointly, the first $16,005 dollars earned are taxed at a 10% rate; additional income is taxed at progressively higher rates until income hits $357,000. At that point, all additional income is taxed at a 35% rate. Some scholars, policymakers and legislators support a “flat tax.” Under a flat tax, income above a certain threshold amount (of around $20,000) is taxed at a flat rate. Income below that amount is not taxed. The 0% tax rate on income below the threshold amount makes the flat tax progressive, though less progressive than the current tax structure.

No one, to my knowledge, has ever seriously proposed a regressive tax, under which the rate drops as income rises. Yet, as described above, that is exactly the effect of taxing the carry at capital gain rates. The fund manager who performs services is taxed at a rate of 15% on his carry, while the factory worker might be taxed at a rate of 25% on his overtime. A fund manager who in 2007 earned $80 million paid tax at a lower average rate than a high school principal who earned $80 thousand.

The favorable tax treatment of carry is sometimes defended on grounds of horizontal equity. Horizontal equity is concerned with treating like taxpayers in the same manner. Supporters of the present treatment compare the fund manager to the entrepreneur, who is taxed at capital gain rates on the sale of her business. One problem with this argument is that fund managers do not perform the same functions or face the same risks as entrepreneurs. An entrepreneur may work for years with little or not pay, betting her entire economic future on the success of her idea, invention or efforts. If she is successful, she will have started a company that will itself recognize ordinary income on its profits. In contrast, fund managers perform intermediation and advisory services. They receive generous management fees and benefit from the performance of a portfolio of companies, the success of each of which is dependent on the inspiration and efforts of the entrepreneur.

One measure of how closely connected carry is to the provision of services is that some amounts taxed as carry are actually management fees that fund managers have simply elected to convert into carry. It is also worth noting that in statements to investors and to the Securities and Exchange Commission, some publicly traded fund management firms have described their business as the active provision of services.

A more fundamental problem with this argument is that entrepreneurs with whom the fund managers wish to be compared comprise a minute slice of American workers and a small slice even of those who go into business-related careers. Only a handful of students at Stanford Law and Business Schools, for example, fall into the category of serial entrepreneurs, starting and selling one company after another. For fairness (and efficiency purposes) it seems more sensible to compare fund managers to the far greater portion of their cohort who are taxed on their professional income at ordinary income rates.

The above analysis suggests that if the tax break on carry is justified at all, it would have to be justified on efficiency, rather than fairness, grounds. But the tax break on carry is inefficient. It reduces the size of our economic pie by distorting individuals’ career choice. Presently, our best and brightest young people can become doctors, nurses, educators or scientists. Those with an interest in business might become executives, farmers, stockbrokers, lawyers, consultants or investment bankers. Income from all of those occupations, and countless other occupations as well, is taxed at a maximum rate of 35% (and bears an additional payroll tax). Alternatively, they can become fund managers, and face a maximum tax rate of 15% on much of their income.

A basic and common-sense rule of tax policy is that we ought to have the same rate of tax apply across different occupations or investments. The relative profitability of different professions, or investments, ought to be dictated by the market, not the tax law. The subsidy given to fund managers distorts their career choices, and in so doing reduces economic welfare.

It is sometimes argued that the risk inherent in the profits interest justifies capital gains treatment. As noted above, the fundamental problem with this argument is that it is generally efficient to have the same rate of tax on all forms of investment or compensation. There is no particular reason why the tax law should encourage (or discourage) risky investments, or risky forms of compensation. In this connection, it is relevant to note (as a matter of fairness, as well as efficiency) that other forms of risky compensation are not tax-favored. The electrician who starts his own business is taking a risk, as is the lawyer who takes a case on a contingency-fee basis. Yet the income of the electrician and lawyer is taxed as ordinary income, and subject to a maximum rate of 35%.

Industry spokespersons have made a number of other efficiency-based arguments in support of the preferential treatment of carry. They have argued that the low tax rate is justified by the importance of the work fund managers perform, or as a way to reduce the tax rate on key industries, or as a way to reduce the tax rate on investment in general. In my written statement accompanying testimony before the Senate Finance Committee in 2007, I explain why I believe these arguments are incorrect.[5] In the interests of space, I will not repeat that explanation here. However, I would be happy to discuss these or any other arguments in my testimony today.

[5] Testimony of Joseph Bankman before Senate Finance Committee, July 31, 2007, available at http://finance.senate.gov/sitepages/hearing073107.htm.

3. Tax deferral enjoyed by hedge fund managers.

In addition to benefiting from the low rate of tax on carry, hedge fund managers benefit from deferral of managements fees or carry-like contractual arrangements. Hedge funds have traditionally allowed managers to defer payment of these amounts. The deferred payment earns interest or investment return that is credited to the manager. No current income is recognized on the deferred fees or interest and investment return attributable to the deferred fees. Instead, the manager recognizes income only when, at his or her election, he or she receives cash in the amount of the deferred fees and investment return.

Through the arrangement, the fund manager can therefore limit his income to the amount he or she needs to spend or invest outside the hedge fund. The remainder can be saved on a tax-deferred basis

The tax law provides that where employees defer income on compensation, the deduction for the employer is similarly deferred. This matching principle usually limits the advantage of this sort of deferred compensation arrangement. As noted above, investors in hedge fund generally cannot use the deduction for fees paid to managers. They are thus indifferent to whether that deduction is deferred. The matching principle therefore does not limit the advantage of deferral of hedge fund compensation.
The benefit of deferral to fund managers is widely thought to be about as great as the benefit of the capital gain rate of tax on carry. Consistent with this assumption, the Joint Committee estimated the cost to the fisc (and benefit to taxpayers) of this form of deferral for the years 2009-2018 at over $24 billion.[6]

[6] Committee on Taxation, “Estimated Budget Effects Of H.R. 7060, The “Renewable Energy And Job Creation Tax Act Of 2008,” Scheduled For Consideration By The House Of Representatives On September 25, 2008” (JCX-76-08), September 25, 2008 available at www.house.gov/jct.

4. Recommendations.

The tax advantage of deferral of management fees was eliminated by new Internal Revenue Code Section 457, enacted as part of the Emergency Economic Stabilization Act of 2008. That provision is effective beginning in calendar year 2009. Thus, 2008 will be the last year in which fund managers will benefit from deferral. The Alternative Minimum Tax Relief Act of 2008 contained a provision that would have taxed carry at ordinary income rates. That Act passed the House of Representatives in June, 2008, but died in the Senate. Thus, carry remains tax-favored. I recommend that Congress eliminate the tax advantage given to carry by again passing a measure similar to that contained in the Alternative Minimum Tax Relief Act of 2008. I recommend, though, that such a measure be amended to address the concerns expressed in the New York State Bar Association Report on Proposed Carried Interest and Deferred Fee Legislation.[7]

[7] New York State Bar Association, Report on Proposed Carried Interest and Deferred Fee Legislation, September 28, 2008., available at http://www.nysba.org/AM/Template.cfm?Section=Tax_Section_Reports_2008&TEMPLATE=/CM/ContentDisplay.cfm&CONTENTID=20706