(Bloomberg) -- Late last year, some hedge fund managers raced to protect their personal fortunes from being carved up by the Republican tax law.
David Tepper, who runs Appaloosa Management and may soon own the Carolina Panthers, and Ross Margolies, founder of Stelliam Investment Management, were among the managers who took action, according to regulatory filings and people familiar with their moves. They collectively shifted billions of dollars before Jan. 1, when a provision took effect requiring a longer holding period to qualify for the tax break on carried interest profits.
Their concern? That the vague language of the new rule makes it possible that profits that had already been paid to them, taxed and reinvested back into the fund would be lumped in with other untaxed carried interest -- and all subject to the new three-year holding period. So they rushed to separate out those distributed gains.
“The whole statute is an epic screw up and so poorly done,” said Michael Spiro, who chairs the tax group at Finn Dixon & Herling. “Nobody thought through these various policy decisions.”
Spiro said he thinks the lack of clarity in the law spurred dozens of hedge fund managers to split their taxed and untaxed profits up to avoid having it all potentially taxed at a higher rate.
Under the old tax regime, carried interest profits had to be held for one year to be eligible for a rate of just 23.8 percent, instead of facing ordinary income tax rates -- which now top out at 37 percent.
It’s a complicated benefit enjoyed by few, but President Donald Trump turned carried interest into a battle cry during his populist presidential campaign. He’s called some hedge fund managers “paper pushers” who are “getting away with murder,” since they often pay tax rates that are so much lower than employees who face ordinary income tax rates. Money managers have argued that treating carried interest as long-term capital gains is sound tax policy that encourages entrepreneurial risk taking.
Most activist and long-short equity funds, which tend to hold onto investments for more than one but less than three years, “did something” to protect at least part of their carried interest profits because they stood to lose the most under the new law, said Jeffrey Chazen, a tax partner at EisnerAmper. Those that didn’t may pay more tax, he said.
Carried interest is typically 20 percent of a fund’s profits paid to money managers and makes up the bulk of their compensation -- when the funds are profitable. The payouts accumulated by managers over the years generally consist of realized gains that have been reinvested in the fund, unrealized gains that exist as paper profits and the right to a share of future profits. The profits are located in what’s called a general partner’s capital account, which may also include additional money kicked in by the manager.
The legislation says capital contributions -- meaning money or assets put in by the manager -- are exempt from the three-year holding period, but it’s unclear whether profits that have been reinvested in the fund can be considered a capital contribution.
Senate Finance Committee Chairman Orrin Hatch is continuing to meet with members, taxpayers and other stakeholders to address any concerns with the new law and examine potential technical corrections, should be they be needed, said Julia Lawless, a spokeswoman for the panel.
In a Jan. 18 note, KPMG said that it was “difficult to determine” the exact effect of the law’s carve out for capital contributions.
In early December, Tepper along with other Appaloosa insiders created a new fund called Azteca Partners LLC that they have full ownership of, filings show. The purpose was to put the realized gains in a separate vehicle, according to a person familiar with the manager’s thinking who asked not to be named because the matter is private.
Tepper’s ownership of one of the Appaloosa funds -- Appaloosa Investment LP I -- declined to zero from 80 percent by the end of December, and its assets dropped to $2.1 billion as of Dec. 31, from $9.3 billion a year earlier, as he shifted the realized gains out. Azteca had $9.6 billion as of Dec. 31.
A spokesman for Appaloosa declined to comment.
Margolies took a similar approach and also shifted some of his realized gains into a new entity, according to a person familiar with the move who asked not to be named because the matter is private.
A spokesman for Stelliam declined to comment.
David Logan, the financial services industry tax practice leader at accounting firm CohnReznick, said he worked with clients to divvy up carried interest profits last year, but declined to name them.
Some managers may have pursued a more aggressive move to exempt a portion of their unrealized, untaxed gains from the three-year requirement. The strategy involved shifting those gains out of the general partner’s account, sometimes into a new entity, theoretically recasting them as a capital contribution from a limited partner.
A Feb. 21 presentation from Morgan, Lewis & Bockius advised managers to consider preserving unrealized gains by having the funds distribute underlying securities or financial instruments to the manager, who would recontribute them to the fund. The move would effectively render the manager a limited partner with an exempt capital contribution. “It depends on the taxpayer’s risk tolerance,” said Jason Traue, a Morgan Lewis tax lawyer. He added that moving realized gains was a safer approach because unlike unrealized gains, they’ve already been taxed.
“The changes to the taxation of carried interests is a huge development for the taxation of hedge fund managers,” wrote Kleinberg, Kaplan, Wolff & Cohen PC, a boutique law firm that works with hedge fund clients, in a note on Dec. 21 -- the day before Trump signed the tax bill. The firm highlighted how the new law could cause the investment returns on money in the general partner’s entity to be subject to the three-year holding period.
A “minimum action” to take would be converting part of the GP interest in the fund to an LP interest, according to KKWC. It didn’t specify whether it was referring to shifting the realized gains or untaxed gains out of the GP interest. Jeffrey Bortnick, a partner at KKWC, declined to comment.
Maneuvers involving carried interest would have been relatively easy to do, Spiro said, given that many fund agreements allow for the automatic re-designation of partnership interests and sales of securities. And the moves generally didn’t affect a fund’s trading strategy.
Setting a three-year holding period was supposed to save the federal government $1.1 billion over a decade, but workarounds to avoid the three-year holding period could chip away at that number.
Rafael Kariyev, a tax partner at Debevoise & Plimpton, warns that “any structure designed to avoid the carried interest provision is likely to be attacked by the IRS in regulations or other guidance.”
Marisol Garibay, a Treasury spokeswoman, didn’t respond to requests for comment about IRS guidance on carried interest profits.
The agency has already said it will close a carried interest loophole after Bloomberg News reported that hedge funds were rushing to take advantage of a potential workaround for the new three-year holding period by setting up thousands of limited liability companies for managers entitled to the payouts.
“People will be creative in trying to structure around the three-year holding period, but folks will need to be mindful,” said David Sussman, a lawyer who chairs the private investment funds practice at Duane Morris.
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