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.
Capital Contributions
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.