New Hedge-Fund Tax Dodge Triggers Wild Rush Back Into Delaware
(Bloomberg) -- Wall Street’s fast-money crowd is returning to well-trodden ground to elude Trump-era tax laws: Delaware.
Since late 2017, hedge fund managers have created numerous shell companies in the First State, corporate America’s favorite tax jurisdiction. These limited liability companies share a common goal: dodging new tax rules for carried-interest profits through a bit of deft legal paperwork.
Big names appear to be embracing the maneuver, which requires setting up LLCs for managers entitled to share carried-interest payouts. Four LLCs have been created under the name of Elliott Management Corp., the hedge-fund giant run by Paul Singer. More than 70 have been established under the names of executives at Starwood Capital Group Management, the private-equity shop headed by Barry Sternlicht.
President Donald Trump turned carried interest into a rallying cry during his populist presidential campaign, declaring that “hedge fund guys are getting away with murder.” Critics from billionaire Warren Buffett on down essentially agree, saying carried interest is a fee-for-service and should be taxed at the individual rate that today tops out at 37 percent. But money managers are eligible to pay a rate of about 20 percent, having successfully argued for years that carried interest, or their portion of investment returns, is a capital gain.
“Carried interest was a key litmus test of whether the bill can be called tax reform, and it failed,” Steven Rosenthal, a senior fellow at the Urban-Brookings Tax Policy Center in Washington, said of the tax overhaul passed in December. “This legislation was a Swiss cheese.”
It wasn’t supposed be this way. But the LLCs demonstrate, yet again, how determined Wall Street players are to circumvent whatever rules Washington throws at them.
Under pressure from industry lobbyists and exploiting a split among White House advisers, the Republican Congress in December failed to fulfill Trump’s promise to end the tax windfall enjoyed by money managers. And lawmakers may have stumbled in trying to narrow their tax advantage, writing the new carried-interest rule in a way that provides firms an easy escape.
The rule requires hedge funds and private-equity players to hold investments for at least three years to get the lower capital gains rate, rather than one year under the old law. Otherwise, they must pay the higher income tax rate.
The rule, however, exempts carried interest from the longer holding period when it’s paid to a corporation rather than an individual. To the surprise of legal and accounting experts, the law didn’t specify that it applied solely to regular corporations, whose income is subject to double taxation.
Hedge funds are preparing to exploit the wording: Managers are betting that by simply putting their carried interest in a single-member LLC -- and then electing to have it treated as an S corporation -- the profit will qualify for the exemption from the three-year holding period and be taxed at the lower rate. The maneuver by money managers contributed to a 19 percent jump in the number of LLCs incorporated during December in Delaware.
“It’s a total end-run around the statute,” said Anthony Tuths, a tax principal in the alternative investment unit of KPMG’s New York office. The Delaware filings “spiked through the roof because all these fund managers set up single-member LLCs,” said Tuths, adding that he doesn’t endorse the strategy because the government could still close the loophole.
Spokespeople for the firms declined to comment or didn’t return a request for an interview on the purpose of the LLCs.
Thousands of LLCs
Tax attorneys say hedge funds are setting up thousands of LLCs, most of which are difficult to identify. Some include the names or initials of executives at activist hedge funds Corvex Management and Sachem Head Capital Management, Delaware records show. Steadfast Capital Management, Permian Investment Partners and Stelliam Investment Management also created LLCs.
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.
Private-equity firms also formed LLCs in late December, even though their typical five-year holding period means the new law may not be an issue for many of them. Crestview Capital Partners, the private-equity firm co-founded by Barry Volpert and Thomas Murphy, incorporated 28 LLCs in the last month of the year.
By lengthening the holding period for capital gains treatment instead of eliminating it, lawmakers gave up revenue.
The Congressional Joint Committee on Taxation estimated that the longer holding period would raise about $1.1 billion in additional tax revenue through 2027, far less than a 2016 projection of $19.6 billion from ending the capital gains treatment altogether. And the LLCs may prevent the government from even getting the total $1.1 billion.
Tax attorneys and accountants are convinced the loophole resulted from a drafting error in the Republican rush to score a legislative victory before year end. They expect the government to close it by clarifying that the holding period exemption is available only to regular corporations.
The Treasury Department is confident that it has the power to narrow the law so only regular corporations would be included in the exemption, Dana Trier, the department’s deputy assistant secretary for tax policy, said at a conference in San Diego last week.
That could create a quandary for hedge fund managers who set up LLCs in December. They have 75 days to decide whether they want the LLC to convert into an S corporation, a window that would close by mid-March. Those who make the election could face additional taxes and administrative nightmares if the government subsequently knocks down their strategy.
“I am telling everybody, ‘Don’t do anything at this point,’” said Robert Schachter, a tax partner in the financial and investment services group at the New York office of WithumSmith+Brown. “You are going to end up with egg on your face if you run too quickly.”
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