Taxation of Hedge Fund and Private Equity Managers

Taxation of Hedge Fund and
Private Equity Managers
Mark Jickling
Specialist in Public Finance
Government and Finance Division
Donald J. Marples
Specialist in Public Finance
Government and Finance Division
Summary
Hedge funds and private equity funds are investment pools generally available only
to institutions and wealthy individuals. Private equity funds acquire ownership stakes
in other companies and seek to profit by improving operating results or through financial
restructuring. Hedge funds follow many strategies, investing in any market where
managers see profit opportunities. The two kinds of funds are generally structured as
partnerships: the fund managers act as general partners, while the outside investors are
limited partners. General partners are compensated in two ways. First, to the extent that
they invest their own capital in the funds, they share in the appreciation of fund assets.
Second, they charge the limited partners two kinds of annual fees: a percentage of total
fund assets, and a percentage of the fund’s earnings. The latter performance fee is called
“carried interest” and is treated as capital gains under current tax rules.
Several bills relating to the hedge fund issue have been introduced to date in the
110^th Congress. S. 1624 would require private equity firms organized as publicly traded
partnerships to pay corporate income tax. H.R. 2834, H.R. 3996, and H.R. 6275 would
make carried interest taxable as ordinary income. H.R. 4351 and H.R. 6049 would
include in gross income the portion of carried interest currently deferred offshore in
foreign-chartered funds. In addition to summarizing the legislation, this report provides
background on hedge funds and private equity and summarizes the tax issues. It will be
updated as legislative developments warrant.
Background
Private Equity. Private equity firms buy and sell other businesses. The industry
can be roughly divided into two parts: venture capital and buyout funds. Venture
capitalists invest in small, startup firms, providing financing and management expertise.
Their payoff usually comes when the firms are sold, either by selling shares into the

public stock market through an initial public offering (IPO), or by an outright sale to a
larger company.
Buyout funds acquire ownership stakes in businesses of all sizes, from small
concerns to industrial giants like Chrysler. The best-known form of transaction is the
leveraged buyout (LBO), in which private equity investors use the proceeds of debt issued
by the target company to acquire all the outstanding shares of a public company, which
then becomes private. The LBO deal can be very lucrative for the private equity
investors: they receive a premium above the going market price for their stake in the
target, and at the end of the transaction they own the entire target company, even though
they have sold their shares. After completion of the LBO, as owners of a private
corporation, they can pay themselves fees, salaries, and dividends without having to
answer to public shareholders or Wall Street analysts. An increasingly common practice
is to issue debt and use the proceeds to pay a special dividend to the shareholders — who
are the private equity investors themselves.¹ At the end of the process, usually several
years after the acquisition, the company is resold, either to public investors through an
IPO (in this case called a “reverse LBO”), or to another firm.
Hedge Funds. Hedge funds trade in all financial markets, employing a very broad
range of investment strategies. Some take simple speculative positions on the direction
of prices of financial assets — stocks, bonds, commodities, currencies, etc. — while
others construct very complex portfolios based on price relationships across asset classes
and across markets, designed to produce positive returns whatever the direction of prices
in the underlying markets. Some funds follow high risk strategies; others are quite
conservative. Hedge fund trading is not always based on short-term strategies, but in
general their investment horizons are shorter than those of private equity funds, whose
holding periods average six to ten years.
The line between private equity and hedge funds is often blurred. A significant
subset of hedge funds, called “activist” funds, also operates in the corporate takeover
market. Such funds typically buy a stake in a public company and then pressure the target
firm to make changes in operations (such as spinning off underperforming units or assets),
governance (e.g., replacing top executives or appointing a hedge fund designee to the
board of directors), or financial structure (announcing a stock buyback or a special
dividend) that will boost the share price. If these efforts do not succeed in the short-term,
the funds may hold on to their investments for years, in essence replicating the strategy
of value investors like Warren Buffett.
The Boom. Over the past several years, both private equity and hedge funds have
grown rapidly in size and number, because of a number of factors that some call a “perfect
storm.” When the bull market ended in 2000 and interest rates fell, institutional investors
such as pension funds and foundations turned to “alternative” investments to make up for
low yields in traditional asset classes. Hedge funds and private equity were the primary
beneficiaries of this shift. Falling share prices and the availability of low-cost debt capital
created an unusually favorable situation for private equity funds: they could borrow to
finance acquisitions at relatively low cost, and expect to sell into a recovering stock
market.

¹ Kate Kelly, “Executives Hedge Their Own IPOs,” Wall Street Journal, April 13, 2007, p. C1.

While there are no official or comprehensive statistics on the size of either industry,
an often cited estimate is that there are now 8,000-9,000 hedge funds, with about $1.2
trillion in investor funds under management. A decade ago, the comparable estimates
were 2,500 funds and $200 billion in capital. In private equity, firms have raised more
than $1 trillion in the past decade, with about $200-250 billion in 2006 alone. In 2006,
LBOs accounted for 18% of the dollar value of all corporate mergers, up from about 2%
in the late 1990s.² In short, private equity and hedge funds, once marginal players, now
exert significant influence in the markets where they operate.
Fund Structure and Compensation
While private equity firms and hedge funds may differ in their investment strategies,
their structures are similar. Nearly all are organized as partnerships, which means that
their earnings are not taxed at the firm level. Most partnerships are simply
straightforward conduits of taxable income or loss and tax attributes to the individual
partners. They can, however, also be used to manipulate the allocation of tax attributes
and to shelter income and assets from taxation.
There are two kinds of partners. The fund managers, who guide the investment
strategy, are general partners. Their background typically includes experience at a Wall
Street investment bank, although two former Secretaries of the Treasury and a former
Securities and Exchange Commission (SEC) chairman now run hedge funds.
Outside investors, who contribute capital but have no say in investment or
management decisions, are the limited partners. They are generally institutional investors
— public and corporate pension funds, insurance companies, foundations, and
endowments — or wealthy individuals. The general partners often invest their own
capital in the funds, but this is usually a small share of the total.³
Hedge funds typically establish multiple funds to accommodate the tax planning
preferences of different investors. While they generally share a common pool of
underlying assets, they are chartered in different jurisdictions to cater to different
clientele. Foreign investors and U.S. tax-exempt institutions may prefer to invest in
foreign-chartered funds, while other types of U.S. investors find it disadvantageous to
invest in foreign funds. By one estimate, about 7,000 hedge funds, or about 80% of the
total, are registered in the Cayman Islands as well as their home country.⁴
Excluded from the list of limited partners is the small public investor. Under U.S.
law, the sale of shares, or interests, in an investment partnership constitutes an offering
of securities, and must be registered with the SEC if the offering is public. In order to

² “M&A Almanac,” Mergers & Acquisitions, February 2007, p. 82.
³ According to media reports, general partners accounted for about 3% of funds raised by private
equity firms in 2005. “Here’s Where the Capital Came From In 2005,” Dow Jones Private Equity
Analyst, April 2006, p. 16.
⁴ James Eedes, “Special Supplement: Cayman Islands - Funds Flourish,” The Banker, July 1,

2006, p. 1.

avoid registration, and the associated disclosure requirements,⁵ most funds rely on
exemptions in the securities laws that allow them to make unregulated “private” offerings.
In order to qualify for these exemptions, prospective limited partners must meet various
income and asset thresholds. (The most basic is the “accredited investor” standard —
income of $200,000 or more in the past two years and at least $1 million in assets.)
Recently, a number of hedge funds and private equity partnerships have gone public,
by selling shares (or units) in an IPO. Their securities are now traded on the New York
Stock Exchange and other major markets, and may be purchased by anyone. These firms,
which include the Fortress Investment Group and Blackstone, will operate much as
before, but will be required to file quarterly and annual financial statements and make the
full range of disclosures required by the SEC.
Types of Compensation. When the funds’ investments yield a positive return,
both limited and general partners receive income, as the value of their share of the fund
increases. This income, as mentioned above, is not taxed at the partnership level; only
the individual partners pay taxes, usually at the capital gains rate.
In addition, the general partners receive compensation from the limited partners.
Compensation structures may vary from fund to fund, but the standard pay formula is
called “2 and 20.” That is, fund managers take 2% of the fund’s assets each year as a
management fee, and 20% of the total profits as a kind of performance bonus.⁶
The percentage-of-assets management fee is usually paid in cash and is taxed at
ordinary income rates.
The 20% performance fee is sometimes paid in cash, and sometimes credited to the
manager’s account. Because the amount is often carried over from year to year until a
cash payment is made, usually following the closing out of an investment, it is called
“carried interest.” The carried interest is taxed at the capital gains rate.
Amounts of Compensation. Given the fact that these funds are private, no
comprehensive figures on managers’ compensation are available, although a number of
consultants and trade groups do publish estimates. According to Alpha magazine, the top
25 hedge fund managers earned $14 billion in 2006.⁷ Comparable annual lists are not
published for private equity managers, probably because cash distributions occur less
frequently than in hedge funds, and there is greater year-to-year variation. One estimate
is that managers earned $45 billion over the past six years.⁸

⁵ Public offerors of securities must make public audited financial statements and detailed figures
on executive pay, among other information.
⁶ The actual percentages may be higher or lower, but the fees charged by hedge funds and private
equity are generally very high compared to other investments — public mutual fund fees, for
example, average about 1.1%.
⁷ Andrei Postelnicu, “For Hedge Fund Head, Very Good Year; Simons Led Industry Again,
Earning $1.7 Billion in 2006,” Washington Post, April 25, 2007, p. D3.
⁸ Jenny Anderson and Andrew Ross Sorkin, “Hedge Fund Operators May Lose U.S. Tax Break:
(continued...)

Tax Issues and Proposals
Several bills before the 110^th Congress propose to change the tax treatment of fund
manager earnings, or of the funds themselves. Fund manager compensation also raises
other tax issues, which are set out below.
Tax Treatment of Carried Interest. As noted above, carried interest is the
portion of fund managers’ compensation that represents a percentage of the funds’ total
investment gains. Under current tax rules, it is generally taxed at the capital gains rate
(generally 15%) when realized. Under proposals made in H.R. 2834, H.R. 3996, and H.R.

6275 carried interest “shall be treated as ordinary income for the performance of services”

and thus taxed at rates up to 35%. Supporters of the proposals argue that carried interest
is essentially a fee for investment advisory services, and that the appropriate treatment is
to tax it like other ordinary income. Opponents maintain that since the source of carried
interest is earnings on the fund’s investments, it should be treated like any other
investment income: capital gains if held for more than a year, ordinary income if the
holding period is less. H.R. 6275 was passed by the House of Representatives on June

25, 2008, and subsequently received by the Committee on Finance.

Publicly Traded Partnerships. Publicly traded partnerships are partnerships
whose interests are traded on an established exchange or in a secondary market. They are
generally treated as corporations for tax purposes and subject to the corporation income
tax with its 35% general rate, with two exceptions. One exception consists of
partnerships with at least 90% of their gross income from passive investments, such as
dividends, interest, rents, capital gains, and mining and natural resources income.⁹ These
partnerships are not taxed at the corporate level.
S. 1624, introduced on June 14, 2007, by Senator Max Baucus, and others, with
Senator Chuck Grassley as an original co-sponsor, would change the tax treatment of
publicly traded partnerships that provide investment advisory and related asset
management services: they would be taxed as though they were corporations. That is,
they would pay the corporate income tax on their earnings, rather than pass those earnings
through to be taxed only as the partners’ individual income. In a news release, Senator
Baucus stated that the bill was needed
to ensure that some corporations are not disadvantaged because they conduct business
in the corporate form and pay taxes as a corporation. Asset management service and
investment advisory partnerships provide the same types of active business services
as their corporate competitors. Our tax system functions best when it is fair. The tax

⁸ (...continued)
Lawmakers Look at Private Equity Wealth,” International Herald Tribune, June 22, 2007, p. 14.
⁹ A second exception consists of those partnerships that were publicly traded on December 17,
1987; these partnerships, originally grandfathered in for 10 years, may now elect to retain
partnership treatment by paying a tax of 3.5% of gross income from the active conduct of
business.

law ought to treat similarly situated taxpayers the same. Thus, these publicly traded¹⁰
partnerships should be taxed as corporations.
The bill has been criticized by Henry Paulson, Secretary of the Treasury, on the
grounds that tax policy ought not to single out one industry sector.¹¹ Chairman Baucus
held a hearing on the bill in the Finance Committee in August 2007.
Deferral of Income. Along with its reduced tax rates, capital gains income
receives another benefit — termed a tax deferral — because it is not taxed until realized.
Carried interest shares this benefit. The concept of tax deferral relates to the timing of tax
payments — with the idea that a taxpayer prefers to pay taxes in the future, rather than
today because he or she can control the funds longer and use them in some other way.
Deferral increases in value with both the length of the deferral period and the taxpayer’s
marginal tax rate. Carried interest, discussed above, benefits from deferral since it is only
taxed when realized — as is the case with capital gains.
In addition, hedge fund managers can amplify the benefits of deferral by electing to
receive their compensation in shares of foreign-chartered funds. As mentioned above,
these foreign-chartered funds may appeal to different types of investors than their U.S.
chartered counterparts. In addition to deferring U.S. tax as long as the money is held
offshore, and not related to the conduct of a trade or business, the returns on the¹²
investment can compound tax-free — resulting in a substantial tax advantage. The
advantage is such that the New York Times reported that a single hedge fund, Citadel, has¹³
deferred at least $1.7 billion since it was founded in 1990. H.R. 3996, H.R. 4351, and
H.R. 6049, all introduced by Chairman Rangel, would include compensation deferred
through foreign-chartered funds in the gross income of the hedge fund manager. As
mentioned above, H.R. 3996 was passed by both the House of Representatives and the
Senate, though the Senate amended the bill to remove this provision. H.R. 4351, was
passed by the House of Representatives and referred to the Senate Committee on Finance
on January 22, 2008. H.R. 6049 was passed by the House of Representatives on May 21,

2008.

¹⁰ Sen. Max Baucus, “Statement of Introduction on Publicly Traded Partnership Bill,” June 13,

2007.

¹¹ Brett Ferguson, “Paulson Objects to Senate Bill on Private Equity Firms,” BNA Daily Tax
Report, June 28, 2007, p. G9.
¹² Deferred compensation arrangements are significantly less common in U.S. chartered funds,
because they result in investors losing the deduction associated with compensation and facing
higher tax liabilities.
¹³ Jenny Anderson, “Managers Use Hedge Funds as Big IRAs,” New York Times, April 17, 2007,
p. A1.