IRS Probes Hedge Funds, Buyout Firms for Tax Abuses (Update1)

By Alison Fitzgerald and Ryan J. Donmoyer

Nov. 1 (Bloomberg) -- The Internal Revenue Service has begun an inquiry into suspected tax abuses at hedge funds and private- equity firms after determining many firm partners don't file returns and may have improperly characterized transactions.

The tax-collection agency is studying whether funds improperly structured stock swaps to avoid withholding taxes, whether they dictated loan terms to banks before agreeing to buy loan portfolios, and whether they improperly classified income as capital gains to take advantage of the lower rate.

``The Service seeks to identify any areas of possible non- compliance in the income tax reporting of hedge fund and private equity fund investors and managers, as well as possible non- compliance in the reporting of withholding obligations,'' the IRS said in an e-mailed statement to Bloomberg.

The IRS action comes as many lawmakers say hedge funds and buyout firms are too lightly taxed. The House Ways and Means Committee today is poised to approve legislation that would more than double the tax on profits fund managers receive for investment services, called carried interest.

IRS officials, including Chief Counsel Donald Korb and Stuart Mann of the financial services section of the agency's Large and Mid-Sized Businesses Division, described the initiative to tax attorneys at seminars in Washington and New York last month, according to two people who attended the meetings.

Fair Rate

Donald Rocen, a former deputy chief counsel at IRS who became a partner at the Washington law firm Miller & Chevalier in September, said it makes sense that the IRS would begin an inquiry because of the charges by lawmakers that fund managers aren't paying a fair tax rate on their earnings, which can top $1 billion a year.

``The IRS reads the papers, too,'' Rocen said. ``They know they're going to be held accountable for what's going on with hedge funds.''

The compliance initiative is patterned after a similar one in 2004 and 2005 that targeted executive pay at corporations. That probe found cases where corporate officials used tax dodges or failed to file tax returns, a crime. That initiative led to audits of an undisclosed number of corporate executives.

Unlike corporations, which are likely to have in-house tax attorneys, hedge funds and buyout firms are often smaller partnerships less likely to have staff lawyers to prepare filings for the IRS and the Securities and Exchange Commission.

Scope of Inquiry

Donald Alexander, a former IRS commissioner, said the new inquiry may reveal even more abuses than the executive-pay probe, which focused on the use of family limited partnerships, deferred-compensation arrangements, abusive ``split-dollar'' life insurance arrangements, golden parachutes, and stock options involving phantom companies.

``My guess is that hedge-fund types are less likely to comply than corporate CEOs,'' said Alexander, who is now at the Washington law firm Akin Gump Strauss Hauer & Feld LLP. ``Taking risks is their stock in trade.''

According to the IRS, the inquiry is focused on seven areas of potential abuse. They include:

-- suspicions that hedge funds and private equity funds are failing to file or improperly filing tax and information returns;

-- cases where funds are structuring cross-border loans to get around requirements that taxes be withheld on the proceeds;

-- evidence that managers aren't paying tax on all of their income;

-- improperly classifying ordinary income that should be taxed at the 35 percent rate as capital, where gains are taxable at 15 percent and losses can be claimed more liberally;

-- the flow of funds between onshore and offshore entities;

-- how incentive payments and other income is timed and allocated;

-- improper accounting methods that minimize income.

Offshore Funds

IRS officials said the agency was focusing on derivatives that offshore hedge funds use to avoid paying a 30 percent withholding tax on corporate dividends, according to the two people who attended. The derivatives, known as total return swaps, allow an investment bank to pay an offshore hedge fund an amount equal to the dividend and appreciation on a corporate stock.

This structure changes the definition of the income, allowing the offshore fund to claim it didn't earn dividends and therefore doesn't owe the 30 percent withholding tax.

Total Return Swaps

``The Treasury and IRS are well aware of the anomaly created by the disparate treatment of total return swaps,'' said Matthew Stevens, a tax attorney at Alston & Bird LLC in Washington, in an advisory to clients. ``Interested investors should closely monitor this area of the law.''

The IRS is also investigating whether some hedge fund and buyout-firm partners may have been granted shares of profit after profit was already realized, a violation, according to a person who attended the IRS presentation in Washington.

The agency also is questioning how much involvement hedge funds have in dictating the terms of loans that they agree to buy from banks.

If the agency determines that the funds are ``engaged in a trade or business'' rather than simply trading in securities, it would change the nature of the income they earn from such transaction to ordinary from capital gains, subjecting that income to higher tax.

To contact the reporters on this story: Alison Fitzgerald in Washington at Afitzgerald2@bloomberg.net ; Ryan Donmoyer in Washington at rdonmoyer@bloomberg.net

Last Updated: November 1, 2007 11:27 EDT

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