Many Americans squirrel away as much as they can into retirement investment accounts like 401(k)s and I.R.A.’s that allow them to compound their earnings tax free. The accounts also reduce what they owe when tax day rolls around. For the average person, however, the government strictly limits the contributions to about $20,000 a year.
And then there are people who work at hedge funds.
A lot of the hedge fund managers earning the astronomical paychecks making headlines these days are able to postpone paying taxes on much of that income for 10 years or more.
The key to the hedge fund tax boon is that many managers of these lightly regulated private pools of capital have the ability to earn the bulk of their compensation offshore and invest it in their funds, where it grows tax-free.
“If you could compound your compensation tax-free, why wouldn’t you?” asked Stewart Massey, founding partner of Massey & Quick, a consulting firm.
Few people know the power of compounding better than hedge fund managers. Consider the following calculation done by Financial Engines, a financial advisory and portfolio management firm: A hedge fund manager makes $10 million in fees and defers it for five years, earning a return of 10 percent a year. When he pays taxes at the end, he walks away with $10.5 million. Another manager who makes the same $10 million pays his taxes immediately. He still earns 10 percent on what’s left, but over the same period he accumulates just $8.9 million.
Elevate the comparison to $130 million, the minimum take-home pay needed to make it on Alpha magazine’s list of the 25 highest-paid hedge fund managers: the first manager receives $136.1 million; the second $115.8 million.
This closely guarded arrangement is completely legal; similar, but less generous deferrals have been commonly used by corporate executives for years. But thanks to the peculiarities of the structure of hedge funds and their enormous growth, the tax-deferred sums that hedge fund managers earn may be far outpacing even the compensation of the most well-paid corporate chieftains.
One of the flagship funds at Citadel, a $13.5 billion hedge fund, for example, has deferred at least $1.7 billion since it was founded at the end of 1990. And that does not count what might have been taken out already. Citadel declined to comment.
“We pile advantage on advantage for these managers and there doesn’t seem to be any economically logical basis for it,” said John C. Bogle, the founder of the Vanguard Group. “It’s a very well-gilded lily to allow these tax deferrals.”
This tax advantage is now coming under scrutiny in Washington, where Congress is looking for ways to reduce the budget deficit, to pay for the Iraq war and to help cover the exploding retirement and health care costs of aging baby boomers.
For now, many hedge fund managers are enjoying not only extraordinary profits but the extra benefit of a system almost encouraging them to set up offshore accounts.
Most hedge funds are private partnerships; managers are usually paid 2 percent of the money they manage plus 20 percent of the profits the partnership earns. If the fund operates in the United States, any deferral of the pay of the managers means investors lose the tax deduction associated with the compensation expense. As a result, deferred compensation in domestic funds is very uncommon.
By setting up an offshore fund, though, hedge fund managers avoid socking their investors with extra taxes. At the same time, it serves to attract tax-exempt investors like pension funds and endowments, as well as foreign investors, two of the most active groups investing in hedge funds today.
Once the offshore fund is established, managers can elect to have much of their compensation earned from the offshore fund deferred back into the fund, allowing it to grow tax-free until it is taken out. Managers have to decide ahead of time how much they will defer and they are required to follow a set formula for receiving the money. At the end of the deferral period, they pay ordinary income taxes.