Bills in Congress Pose the Most Credible Threat to Date to the Continued Tax Treatment of Hedge Fund Performance Allocations as Capital Gains

On December 9, 2009, the U.S. House of Representatives passed the Tax Extenders Act of 2009 (Extenders bill), H.R. 4213.  The bill, if it were to become law, would extend through the end of 2010 a package of tax relief provisions that otherwise would expire at the end of 2009.  Of particular interest to hedge fund managers are several provisions of the Extenders bill included with the goal of raising revenue to offset extended tax relief measures.  Specifically, the bill includes a provision that would tax as ordinary income any net income derived with respect to an “investment services partnership interest.”  The bill defines “investment services partnership interest” as a partnership interest held by a person where it is reasonably expected that the partner or a person related to the partner will provide substantial investment services to the partnership.  The result of this provision would be to change the tax treatment of the performance allocation that constitutes, in up years, the bulk of hedge fund manager revenue.  Currently, most managers structure performance allocations so that all or most of such compensation is taxed as long-term capital gains at a rate of 15 percent.  The Extenders bill would tax such compensation as ordinary income, generally for hedge fund managers at a marginal rate of approximately 35 percent.  In addition, as ordinary income, such compensation would be subject to any applicable self-employment taxes and state and local taxes.  See generally “IRS ‘Managed Funds Audit Team’ Steps Up Audits of Hedge Funds and Hedge Fund Managers, and Investigations of Hedge Fund Tax Compliance Issues,” Hedge Fund Law Report, Vol. 2, No. 34 (Aug. 27, 2009).  As discussed in more detail in this article, the Extenders bill also includes provisions that are similar to the reporting provisions in the proposed Foreign Account Tax Compliance Act of 2009 (FATCA), introduced in the Senate as S. 1934 and in the House (with the same name) as H.R. 3933.  With the support of President Obama and Treasury Secretary Geithner, FATCA was introduced on October 27, 2009 as a means of combating overseas tax havens.  FATCA would affect all foreign financial institutions (FFIs) that invest in U.S. stocks and securities.  Complying FFIs would be required to report financial account information of all U.S. persons to the Internal Revenue Service or subject all payments of U.S. source passive income and gross proceeds from the sale of U.S. securities to a 30 percent withholding tax.  This article details and analyzes the provisions of the Extenders bill and FATCA that are most relevant to hedge fund managers.  Where provisions of the two bills are similar, this article compares specific mechanics.  This article also highlights the differences between the two bills, and discusses, with the benefit of insight from leading practitioners, the implications of the bills for hedge fund manager compensation, tax planning, domicile, structuring, reporting, treatment of so-called “recalcitrant account holders” and more.

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