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.
Compensation Structures for Hedge Funds
Most hedge funds are managed under the two and twenty compensation structure or some variation thereof. 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.
A hedge fund manager is also paid a performance fee. The performance fee is a percentage of the profits realized under their 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.
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 the general partners, while the investors are the 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; their income from the fund is taxed as a return on investments as opposed to a salary or compensation for services rendered. The incentive fee is taxed at the long-term capital gains rate of 20% as opposed to ordinary income tax rates, where the top rate is 39.6%. 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 carried interest rule has not yet been overturned despite multiple attempts in Congress. It has become an issue during the 2016 primary election.
Bermuda Reinsurance Business
Many prominent hedge funds use 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. The hedge funds then 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 U.S. Internal Revenue Service (IRS) 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 that is much larger than what it needs to back the insurance that it sells. It is unclear what this standard is, as it has not yet been defined by the IRS.
Despite an indication in 2003 that the IRS might fight the arrangements, no company has been singled out at this point. Although the 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.