Source: Getty Images

Hedge Funds Still Can't Figure Out a Way to Avoid a $25 Billion Tax Bill

  • Loophole for fund managers slams shut at the end of 2017
  • Experts searched but ‘no one has come up with magic bullet’

The tax man cometh for some of the richest money managers in the U.S. They’ve had eight years to dream up a dodge. So far, no luck.

The deadline they face is Dec. 31, 2017. That’s when a loophole closes, and hedge-fund managers will have to pay taxes on performance fees parked offshore. Some have brought the money home, taking the hit, but others have waited to benefit from the magic of tax-deferred compounding. And in the hope that clever advisers would come up with a workaround for a total that some estimates put at $100 billion -- at least.

“They figured that by the time we got to 2017, someone would have found a way to eliminate all of the tax,” says Richard LeVine, of counsel at Withers Bergman, a New Haven, Connecticut, law firm that has been a pioneer in tax planning to the ultra-wealthy. That didn’t happen. “Now we are halfway through 2016, and it’s going to get very busy.”

The experts’ failure to find a fix is excellent news for the U.S. Treasury and states including Connecticut and New York, where many hedge funders live and work. The combined bill for the likes of Steven Cohen, David Tepper and John Paulson could reach tens of billions. Charities could benefit too, because the best way for the rich to cut liabilities is to donate to an IRS-approved cause.

Not Talking

The $100 billion number, it should be noted, is a very rough estimate, based on tax-advisers’ conversations with clients, brokers and fund-service providers. The law covers fees paid by hedge-fund clients not subject to U.S. taxes that managers have invested in their offshore funds. They’re not required to report the amount of this deferred compensation to the government, and they aren’t keen on talking about it.

When lawmakers closed the loophole in 2008, the Joint Committee on Taxation figured the tax-code change would generate about $25 billion over the ensuing decade, culminating with $8 billion in 2017. But the congressional committee didn’t disclose how it made its calculations, and staff members declined to comment when contacted recently.

Tax lawyers say the panel’s revenue forecasts are low -- given what they know about individuals who could single-handedly account for big chunks of the forecast just for 2017.

Choosing Florida

George Soros, for example, had by the end of 2013 amassed $13.3 billion through Soros Fund Management by taking advantage of the deferrals, according to Irish regulatory filings. Soros declined to comment, as did Cohen, Tepper, Paulson and other fund managers contacted for this story.

Tepper, once the wealthiest resident of New Jersey, decamped last year to Florida, where the state income tax is zero. While a person with knowledge of his thinking says Tepper’s move to Miami Beach was made primarily for family reasons, tax planning was a factor. Laws in Connecticut and New York say they can collect taxes on the income earned when people worked or resided there, no matter where they live at the moment, but New Jersey has no such statute.

Congress gave fund managers nearly a decade to bring their money home because lawmakers didn’t see the loophole as especially outrageous, since they figured the tax bill would have to be paid at some point anyway.

Charity Play

It seems the bill really can’t be avoided. LeVine and fellow Withers Bergman partner Stanley Bergman, along with other tax lawyers, are telling clients there’s a way to ease the pain, though, for future generations at least.

It works like this: Dump the money into a charitable lead annuity trust, CLAT for short, and have the trust purchase a private-placement life insurance policy. The U.S. allows the taxpayer to deduct up to 30 percent of adjusted gross income for contributions to the trust, so the manager saves right off the bat. What’s in the trust can be invested, and only the original deposit plus government-set interest must be donated.

The Internal Revenue Service adjusts the interest-rate threshold; right now gains over 1.8 percent stay in the life-insurance policy, where they grow, un-taxed, for later distribution.

Scott Sambur, a partner at Seward & Kissel in New York, figures the kids of a middle-aged manager with $100 million offshore who goes the CLAT-insurance policy route would end up pretty happy. Assuming an annualized rate of return on investments of 7 percent for 28 years, Sambur says the manager could leave more than $260 million to his heirs tax free.

It’s perfectly legal, and just the kind of maneuver that raises ire in an election year where much of the campaign rhetoric has focused on the country’s income inequality. The rich and their tax experts always manage to figure something out, says Steven Rosenthal, a senior fellow at the Urban-Brookings Tax Policy Center. “In this cat and mouse game, the advisers have the edge.”

But only in helping enrich fund managers’ heirs. “You are still paying tax on 70 percent,” LeVine says. “No one has come up with the magic bullet.”

Before it's here, it's on the Bloomberg Terminal. LEARN MORE