These Hedge Fund Trades Can Escape New Carried Interest Limits

  • Trump tax law only allows break if assets held for three years
  • Regulated futures contracts don’t have to meet holding period

A man walks past the Internal Revenue Service headquarters in Washington, D.C.

Photographer: Andrew Harrer/Bloomberg

The Internal Revenue Service knocked down one way for hedge fund managers to dodge restrictions in President Donald Trump’s tax law. But for some managers, there’s still a way out.

New limits on carried interest profits don’t apply to regulated futures contracts or contracts to trade foreign currencies. For managers who rely heavily on those strategies, a chunk of their assets can continue to be taxed at a much lower rate, even if they don’t hold them for three years as the law requires.

Under the old tax regime, hedge funds and private equity managers had to hold their investments for one year to get the long-term capital gains rate of 20 percent. Otherwise, they had to pay individual income tax rates, which now top out at 37 percent. But those holding the futures or foreign currency contracts didn’t have to meet any time period -- they could elect to have 60 percent of the trade qualify for the long-term rate. And despite the new tax law, they’ll still be able to do so, according to half a dozen tax experts.

“For many of these hedge funds, the new law has all the bite of a mosquito on an elephant’s butt,” said Michael Kosnitzky, a tax lawyer at Pillsbury Winthrop Shaw Pittman LLP.

Trump turned carried interest into a battle cry during his populist presidential campaign, declaring that “hedge fund guys are getting away with murder.” Treasury Secretary Steven Mnuchin, a former hedge fund manager, added during last year’s tax debate that “the president has made it very clear that for hedge funds, they will not have the benefit of carried interest.”

Read more on Wall Street’s favorite tax break in this QuickTake explainer

Money managers have argued for years that carried interest, or their slice of investment returns -- typically 20 percent -- is a capital gain. After the new law took effect this year, Bloomberg News reported that hedge funds were rushing to take advantage of a potential workaround for the new three-year holding period by setting up thousands of limited liability companies for managers entitled to the payouts. The IRS said last month that it would issue regulations to close that loophole.

But funds that mostly use so-called 1256 contracts -- such as some macro, commodity and foreign currency funds -- didn’t even have to bother with the extra paperwork.

Carried interest is typically calculated for each individual asset in a fund and its respective holding period. So while some of a fund’s investments are eligible for the lower rate, others aren’t. Hedge funds generally don’t publicly disclose their individual holdings, aside from some mandatory regulatory filings showing certain stock positions every quarter, so it’s difficult to figure out the percentage of a fund that’s allocated to 1256 contracts -- and what a manager’s tax benefits would be.

Long-short equity fund managers who use futures contracts on broad-based indexes, such as the Standard & Poor’s 500 Index, would also be able to avoid the three-year holding period, said Daniel Nicholas, a tax lawyer at Eversheds Sutherland (US) LLP. Still, long-short equity funds using single stock futures contracts would be subject to the three-year holding requirement, said Stephen Hamilton, a tax lawyer at Drinker Biddle & Reath LLP.

Danger Zone

The common image of a hedge fund manager is of an opportunist who races in and out of holdings in seconds via computer-driven trading. The new law doesn’t affect that fast-money crowd because they didn’t qualify for the preferential tax rate under the old rule, unless they were using 1256 contracts. It also doesn’t affect most private equity and venture capital funds, because they typically invest in businesses for several years.

Hedge funds that follow activist, credit and distressed strategies, which sometimes keep investments for one or two years, are particularly affected by the new three-year holding requirement.

Tax attorneys Michael Spiro at Finn Dixon & Herling LLP and Steven Bortnick at Pepper Hamilton LLP said they’ve been hearing from many hedge fund clients who hold their assets in the danger zone of more than a year, but less than three years, and would be affected by the tax law.

Spiro said he’s been talking to managers about “replicating certain strategies with futures to take advantage” of the exemption for the contracts.

Cynthia Pedersen, a manager in tax advisory services at Cohen & Co., said she also thought that some hedge funds that don’t currently use 1256 contracts would consider using them now because of the tax incentive.

Long-Term Gains

Under the old tax code, the contracts were “marked to market,” meaning valued on a daily basis. At the end of each year, they were generally closed out for tax reporting purposes, with 60 percent of their gains taxed at the lower long-term capital gains rate and 40 percent at ordinary income tax rates. Including the 3.8 Obamacare tax that was tacked onto the 20 percent capital gains rate, managers faced a blended rate of about 30 percent on those assets.

Since the new tax law spells out which securities are covered by the new three-year hurdle -- a definition that doesn’t include 1256 contracts -- it appears that they’re off the hook, Hamilton of Drinker Biddle said. It’s still possible the IRS could issue guidance saying that 1256 contracts aren’t exempt.

It seems that Congress deliberately left the contracts out of the new three-year requirement: The old law already recognized that assets covered by 1256 contracts had mixed characteristics and split the handling of long and short-term capital gains, said Julia Lawless, a spokeswoman for the tax-writing Senate Finance Committee. She added that the new tax law tightens the eligibility of partnership interests for carried interest treatment.

“Nobody’s throwing a party” for the tax law’s new holding period, said Robert Velotta, a tax partner and certified public accountant at Cohen & Co. “But the carve out does help.”

— With assistance by Katherine Burton, and Miles Weiss

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