One major tax planning strategy for hedge funds is to use carried interest from a hedge fund to the general partners for performance fees paid to hedge fund managers. A newer tax strategy many funds are using is to enter the reinsurance business with a company based in Bermuda. These two methods allow hedge funds to reduce their tax liabilities substantially. In this article, we look at how both strategies work, along with how hedge funds are compensated.

Key Takeaways

  • Hedge funds are alternative investments that are available to accredited investors on the private market.
  • Managers are compensated through a flat 2% management fee and a 20% performance fee.
  • Hedge funds have been able to avoid taxation by using carried interest, which allows funds to be treated as partnerships.
  • Funds are also able to avoid paying taxes by sending profits to reinsurers offshore to Bermuda, where they grow tax-free and are later reinvested back in the fund.

What Is a Hedge Fund?

A hedge fund is an alternative investment class that try to earn active returns for their investors by taking advantage of different market opportunities. They are often set up as private investment partnerships. Because of their large minimum investment requirements, they are usually cut off to the average investor. Instead, they cater to accredited investors—those who have a high net worth, high income, and whose asset size is fairly large. Hedge funds are generally considered illiquid, which means investors need to have a long-term horizon and can't capitalize on short-term gains.

Compensation Structures

Most hedge funds are managed under the two and twenty compensation structure or some other variation. This structure normally comprises of a management fee and a performance fee. These fees depend on and can vary between funds.

The hedge fund manager charges a flat 2% fee management fee based on the value of the total amount of assets in the fund. These management fees cover the operating costs for the fund including trading costs.

The performance fee is a percentage of the profits realized under the hedge fund's management. The most common performance fee is 20% of profits. This number may be higher or lower depending on the individual fund. Many funds also utilize high-water marks to ensure the manager is not paid for subpar performance.

Carried Interest

Many hedge funds are structured to take advantage of carried interest. Under this structure, a fund is treated as a partnership. The founders and fund managers are considered general partners, while the investors are referred to as limited partners. The founders also own the management company that runs the hedge fund. The managers earn the 20% performance fee of the carried interest as the general partner of the fund.

Hedge fund managers are compensated with this carried interest. The income they receive from the fund is taxed as a return on investment as opposed to a salary or compensation for services rendered. The incentive fee is taxed at the long-term capital gains rate of 23.8%—20% on net capital gains and another 3.8% for the net income tax on investments—as opposed to ordinary income tax rates, where the top rate is 37%. This represents significant tax savings for hedge fund managers.

This business arrangement has its critics, who say that the structure is a loophole that allows hedge funds to avoid paying taxes. The Trump administration's Tax Cuts and Jobs Act made some changes to the carried interest rule. Under the law, funds must hold assets for more than three years for gains to be considered long-term. Any gains held for less than three years are considered to be short-term, and are taxed at a rate of 40.8%. But this change rarely applies to most hedge funds, which generally hold assets for more than five years.

Under the Tax Cuts and Jobs Act, funds must hold assets for longer than three years or face taxation.

Bermuda Reinsurance Business

Many prominent hedge funds use the reinsurance businesses in Bermuda to reduce their tax liabilities. Bermuda does not charge a corporate income tax, so hedge funds set up their own reinsurance companies in Bermuda. Remember, a reinsurance company is a type of insurer that provides protection to insurance companies. They handle risks that are considered to be too large for insurance companies to take on on their own. Therefore, insurance companies can share the risk with reinsurers, and keep less capital on the books to cover any potential losses.

Hedge funds send money to the reinsurance companies in Bermuda. These reinsurers, in turn, invest those funds back into the hedge funds. Any profits from the hedge funds go to the reinsurers in Bermuda, where they owe no corporate income tax. The profits from the hedge fund investments grow without any tax liability. Taxes are only owed once the investors sell their stakes in the reinsurers.

The business in Bermuda must be an insurance business. Any other type of business would likely incur penalties from the Internal Revenue Service (IRS) in the United States for passive foreign investment companies. The IRS defines insurance as an active business. To qualify as an active business, the reinsurance company cannot have a pool of capital much larger than what it needs to back the insurance it sells. Although many reinsurance companies do engage in business, it appears to be fairly minor when compared to the pool of money from the hedge fund used to form the companies.