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...deferral of one’s duty to pay federal income tax is one of the holy grails of tax planning. And nowhere has income deferral been better achieved than in the context of income earned from off-shore hedge funds by United States managers.
- October 2008 Tax Alert by Greenberg Traurig

There's been a flurry of talk about Sankaty High Yield Asset Investors Ltd, a Cayman Islands corporations owned by Mitt and Anne Romney.  When Mittens's return was first released, I thought I had a decent idea what that corp was and why he had it; in the wake of the increasing interest on the company, I thought I'd throw out my edumacated guess.

First, let's talk about the compensation structure of investment funds, including both hedge funds and private equity funds.  Investment fund managers are typically compensated with the "two and twenty": they get a management fee, which is usually 2% of the value of the assets of the fund, and the carried interest or "carry," which is commonly 20% of the gains that the fund produces (and there's usually some hurdle rate: for example, once the fund grows 10%, then subsequent gains are subject to the carry).

Next, let's talk about the taxation of these things.  The carried interest is actually a partnership interest for tax purposes.  Partnerships, in tax, are "pass through" entities: the tax attributes of the partnership are passed through to the partners as if the income and expense were earned by the partners in proportion to their ownership interests.  Sounds complicated, but it's actually pretty straight forward.  Here's an example:

Mr. X and Y start an investment partnership; X contributes $40 and Y contributes $60.  The next year, the partnership makes $10 in long term capital gains and $10 in ordinary income.  Because the income passes through to the partners, X reports $4 of long-term capital gain and $4 of ordinary income on her individual income tax return, and Y reports $6 of long-term capital gain and $6 of ordinary income on her individual income tax return.  The partnership reports the income on its partnership income but, as a pass-through entity, it pays no tax itself.
There are two key things to note here: first, the character of the income passes through to the partner; second, the partner recognizes and and pays tax on the income in the year that the partnership earns it.

Let's say we don't need the cash, so we'd be better off deferring receipt of the income and recognition of the associated tax liability.  What could we do?  Well, rather than take the carried interest as a partnership interest, the manager could instead opt to be paid by a fee in the same amount that the carried interest would be.  This is called the "incentive fee."  There are some tax problems here; the tax code won't let you voluntarily defer income like that, since once there's no longer a "substantial risk of forfeiture" it's considered taxable income.  So what can our manager do?  Well, what if the fund promised to pay the fee to another corporation?  If the corp is on accrual basis of taxation, then it has to pay tax when the fee is earned regardless of when it's paid, and there will also be another layer of taxation before it gets paid out to the manager.  The answer to that tax quandry is to set up a corporation in a no-tax offshore jurisdiction and elect to use cash-basis accounting.  And voila!  The manager can now defer the fee until she wants to take the cash, and in the interim can get tax-free growth inside of the fund.1  Pretty neat trick, and one that Congress banned in 2008 with the passage of section 457A of the code, although they gave a 9-year grace period for these entities to be wound down and the deferred income to be paid out.

A downside is that, unlike income from a partnership interest, fee income is always treated as ordinary income and taxed at the top marginal rate.  For a private equity manager, it will never make sense to take the 20% as a fee rather than a partnership carried interest, since that would entail transforming long-term capital gains into ordinary income, more than doubling the tax rate on the income.  Even if they can get the benefit of deferral, it doesn't make sense.  Another way to put this is that a manager can get deferral or capital gains treatment, but not both.  Only one tax pony may be picked.  What this tells us is that Mittens was telling the truth about his partnership interests: his offshore funds were treated just like US partnerships would be; in fact, they had to be in order for him to the get the benefit of the lower rates.

Sankaty, on the other hand, is a different animal altogether from the rest of the Bain portfolio.  As they explain, the Sankaty funds invest in debt.  Debt investments and the funds that own them typically throw off most of their income in the form of interest income which, like wage income, is taxed as ordinary income and subject to tax at the top marginal rate.  

There's no doubt it would have been in Mittens's interest to structure his 20% as a fee, rather than a carried interest in a partnership.  And, if he did so, he would have set up a corporation in an offshore tax haven and that corp would've been the general partner of the underlying investment funds (and SEC disclosures confirm that Sankaty Ltd was the GP of the Sankaty High Yield fund through a chain of intermediaries).

Maybe the foregoing is accurate, maybe not, but if Romney deferred his income through the use of an offshore vehicle, this is exactly how he would've done it and the circumstances in which it would've made sense.

All of that tells me that, if the press should ask one tax-related question of Romney, it's this: "Mr. Romney, did you use the Sankaty Cayman Islands corporation in order to defer taxation of your incentive fee income?"

1 The government loses out on tax from the deferral, of course, but the biggest loser in all this is probably the other limited partner investors that are paying the fee.  Investment management fees are considered miscellaneous itemized deductions, and can only be deducted to the extent they exceed 2% of adjusted gross income.  Most people that invest in hedge funds have AGIs that are so high that they'll never be able to deduct those fees.  In the rare times they can, they're often in AMT, and miscellaneous itemized deductions are "preference items" that can't be deducted in AMT.  So one way to think of the incentive fee structure is as a shift in tax liability from the fund manager to the fund investor.

2 This is lighter on links to technical explanations than I'd like; my thinking is that I'll add more and republish in a week or so.

Originally posted to johnny wurster on Wed Jul 04, 2012 at 01:34 PM PDT.

Also republished by Community Spotlight.

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