EDUCATION CENTER
Investment Management

After tense moments in the great tax and deficit debates of 2010 and 2011, two important tax breaks for hedge funds and investment managers survived repeal efforts from Democrats in Congress and the White House. Although Democrats tried hard in 2010 to repeal “carried interest” tax breaks for investment managers, along with a related repeal of the S-Corp self-employment (SE) tax reduction breaks for professionals (including investment managers), Republicans saved the day and blocked the tax increases.

After Republicans won majority in the House in the 2010 midterm elections, Congress agreed in the lame-duck session to extend all Bush-era tax cuts for two additional tax years (through Dec. 31, 2012), along with other important “tax extenders” too. There was no time or votes to include repeal of carried-interest and the S-Corp SE tax breaks. With a new Republican-controlled House in 2011 and 2012, it’s unlikely that carried-interest or the S-Corp SE tax break will be repealed during this session of Congress. Proposals to repeal carried interest speak of repealing it for investment managers only and not their investors. In this case, carried interest could still be worthwhile in investment partnerships. It pays to continue using carried-interest in hedge fund documents going forward at this juncture.

PROFIT ALLOCATION
Managers can continue to start up new hedge funds and structure in a “profit allocation” clause, so they receive performance income — it’s not compensation or pay — based on their profit allocation share of each income tax category in the fund. The carried-interest tax break means the manager/partner receives a special allocation of long-term capital gains and qualifying dividends taxed at lower tax rates, futures gains taxed at lower 60/40 tax rates, and short-term capital gains taxed at ordinary income tax rates but not subject to separate SE tax rates.

This is an excerpt from Green’s 2012 Trader Tax Guide • Copyright © 2012