Loophole Closed: Hedge-Fund Managers Prepare Huge Tax Checks

By Gregory Zuckerman and Rob Copeland Features Dow Jones Newswires

Hedge-fund managers for years accumulated offshore gains without paying federal and state taxes. Now Uncle Sam is going to get paid.

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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.

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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)