Hedge Fund Fairness

Do you believe in the fundamental principles of tax fairness? If you do, then you’re in luck. Next year, the American system of income taxation is scheduled to take a significant step in that direction.

But oh, there are so many more steps yet to be taken!

This particular step, though, involves the issue of income and deductions. Under normal circumstances, when an employer pays compensation to an employee, the employer’s expenditure produces a tax deduction. And the employee’s income is subject to taxation.

Except in the world of hedge funds, where many managers function as both employers and employees. Apparently, according to Dow Jones:

For decades, the Internal Revenue Service allowed managers of offshore funds (as employees) to defer receipt of this compensation and both (as employers and employees to) 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.

That’s pretty dense stuff, isn’t it? In essence, though, the concept isn’t very complicated. The federal government has been allowing hedge fund managers who employ themselves to adopt a pair of tax positions simultaneously. Namely, they have been permitted to avoid paying income taxes on their compensation as employees, and to avoid taking tax deductions as employers.

In theory, the first action decreases government revenue and the second increases government revenue, thereby creating an “offset” effect. But in reality, this “offset” is often only a partial one that ultimately favors hedge fund managers. That’s because the managers can defer income tax payments indefinitely, while investing their compensation in income-producing activities.

So what step in the direction of fairness will be taken next year? Actually, that step was first taken nine years ago. In 2008, in the very heart of the financial crisis, the federal government required hedge fund managers to start paying income taxes in the year they earn their compensation.

But the government then delayed the implementation of that new requirement for ten full years. Thus, it’s finally about to take effect next year.

That will make the tax system more fair, won’t it? Indeed, it will. But many other hedge fund tax loopholes still exist, such as the infamous carried interest treatment of performance fees. That one allows managers to pay low tax rates on compensation, instead of the higher rates that would be incurred in virtually any other industry.

So where do we stand? By all means, we should feel free to celebrate the upcoming victory in the battle for tax fairness. Nevertheless, we should also keep in mind that we aren’t even close to winning the war.