One major tax planning strategy for hedge funds is to use carried interest from a hedge fund to the general partners for performance fees paid to hedge fund managers. A newer tax strategy many funds are using is to enter the reinsurance business with a company based in Bermuda. These two methods allow hedge funds to reduce their tax liabilities substantially. In this article, we look at how both strategies work, along with how hedge funds are compensated.
Key Takeaways
- Hedge funds are alternative investments that are available to accredited investors on the private market.
- Managers are compensated through a flat 2% management fee and a 20% performance fee.
- Hedge funds have been able to avoid taxation by using carried interest, which allows funds to be treated as partnerships.
- Funds are also able to avoid paying taxes by sending profits to reinsurers offshore to Bermuda, where they grow tax-free and are later reinvested back in the fund.
What Is a Hedge Fund?
A hedge fund is an alternative investment class that try to earn active returns for their investors by taking advantage of different market opportunities. They are often set up as private investment partnerships. Because of their large minimum investment requirements, they are usually cut off to the average investor. Instead, they cater to accredited investors—those who have a high net worth, high income, and whose asset size is fairly large. Hedge funds are generally considered illiquid, which means investors need to have a long-term horizon and can't capitalize on short-term gains.
Compensation Structures
Most hedge funds are managed under the two and twenty compensation structure or some other variation. This structure normally comprises of a management fee and a performance fee. These fees depend on and can vary between funds.
The hedge fund manager charges a flat 2% fee management fee based on the value of the total amount of assets in the fund. These management fees cover the operating costs for the fund including trading costs.
The performance fee is a percentage of the profits realized under the hedge fund's management. The most common performance fee is 20% of profits. This number may be higher or lower depending on the individual fund. Many funds also utilize high-water marks to ensure the manager is not paid for subpar performance.
Carried Interest
Many hedge funds are structured to take advantage of carried interest. Under this structure, a fund is treated as a partnership. The founders and fund managers are considered general partners, while the investors are referred to as limited partners. The founders also own the management company that runs the hedge fund. The managers earn the 20% performance fee of the carried interest as the general partner of the fund.
Hedge fund managers are compensated with this carried interest. The income they receive from the fund is taxed as a return on investment as opposed to a salary or compensation for services rendered. The incentive fee is taxed at the long-term capital gains rate of 23.8%—20% on net capital gains and another 3.8% for the net income tax on investments—as opposed to ordinary income tax rates, where the top rate is 37%. This represents significant tax savings for hedge fund managers.
This business arrangement has its critics, who say that the structure is a loophole that allows hedge funds to avoid paying taxes. The Tax Cuts and Jobs Act made some changes to the carried interest rule. Under the law, funds must hold assets for more than three years for gains to be considered long-term. Any gains held for less than three years are considered to be short-term, and are taxed at a rate of 40.8%. But this change rarely applies to most hedge funds, which generally hold assets for more than five years.
Under the Tax Cuts and Jobs Act, funds must hold assets for longer than three years or face taxation.
Bermuda Reinsurance Business
Many prominent hedge funds use the reinsurance businesses in Bermuda to reduce their tax liabilities. Bermuda does not charge a corporate income tax, so hedge funds set up their own reinsurance companies in Bermuda. Remember, a reinsurance company is a type of insurer that provides protection to insurance companies. They handle risks that are considered to be too large for insurance companies to take on on their own. Therefore, insurance companies can share the risk with reinsurers, and keep less capital on the books to cover any potential losses.
Hedge funds send money to the reinsurance companies in Bermuda. These reinsurers, in turn, invest those funds back into the hedge funds. Any profits from the hedge funds go to the reinsurers in Bermuda, where they owe no corporate income tax. The profits from the hedge fund investments grow without any tax liability. Capital gains taxes are only owed once the investors sell their stakes in the reinsurers.
The business in Bermuda must be an insurance business. Any other type of business would likely incur penalties from the Internal Revenue Service (IRS) in the United States for passive foreign investment companies. The IRS defines insurance as an active business.
To qualify as an active business, the reinsurance company cannot have a pool of capital much larger than what it needs to back the insurance it sells. Although many reinsurance companies do engage in business, it appears to be fairly minor when compared to the pool of money from the hedge fund used to form the companies.
FAQs
Key Takeaways. Hedge funds are alternative investments that are available to accredited investors on the private market. Funds are also able to avoid paying taxes by sending profits to reinsurers offshore to Bermuda, where they grow tax-free and are later reinvested back in the fund.
How do investors avoid taxes? ›
Contribute to Your Retirement Accounts
Investing in retirement accounts eliminates capital gains taxes on your portfolio. You can buy and sell stocks, bonds and other assets without triggering capital gains taxes. Withdrawals from Traditional IRA, 401(k) and similar accounts may lead to ordinary income taxes.
How are hedge funds taxed? ›
Private equity and hedge funds are generally structured as pass-through entities, allowing them to pass their entire tax obligation along to their investors or limited partners. Investors report their share of the fund's income (or losses) on their individual tax returns.
How do private equity firms avoid taxes? ›
Private equity firms have devised strategies to capitalize on the advantageous difference between capital gains and ordinary income tax rates. A common practice involves waiving the standard 2 percent annual management fee in exchange for a corresponding equity share of potential investment returns.
What are hedge funds exempt from? ›
Part 3 explains how the exemption of hedge funds from regulation under the Investment Company Act enables the funds' investment advisers to avoid regulation under the Advisers Act but, more importantly, to remain free from the limitations on the fees the advisers may collect.
How do private companies avoid taxes? ›
How do profitable corporations get away with paying no U.S. income tax? Their most lucrative (and perfectly legal) tax avoidance strategies include accelerated depreciation, the offshoring of profits, generous deductions for appreciated employee stock options, and tax credits.
How to pay no income tax? ›
Be Super-Rich. Finally, it's quite easy to pay no income taxes if you're extremely rich. In our tax system, money is only subject to income tax when it is earned or when an asset is sold at a profit. You don't have to pay income taxes on the appreciation of assets like real estate or stocks until you sell them.
How do investors avoid capital gains tax? ›
A few options to legally avoid paying capital gains tax on investment property include buying your property with a retirement account, converting the property from an investment property to a primary residence, utilizing tax harvesting, and using Section 1031 of the IRS code for deferring taxes.
How can you grab a 0% tax rate? ›
For example, if you're filing as an individual, you can earn taxable income of up to $44,625 in 2023 and qualify for the 0 percent rate. For 2024, that threshold for individuals rises to $47,025.
What is the 2 20 rule for hedge funds? ›
The 2 and 20 is a hedge fund compensation structure consisting of a management fee and a performance fee. 2% represents a management fee which is applied to the total assets under management. A 20% performance fee is charged on the profits that the hedge fund generates, beyond a specified minimum threshold.
However, there are also some potential drawbacks to investing in hedge funds, including the potential for high fees, lack of transparency, and limited liquidity. Let's take a closer look at some of the pros and cons of investing in hedge funds.
How do hedge funds pay themselves? ›
Hedge funds make money by charging a management fee and a percentage of profits. The typical fee structure is 2 and 20, meaning a 2% fee on assets under management and 20% of profits, sometimes above a high water mark. For example, let's say a hedge fund manages $1 billion in assets. It will earn $20 million in fees.
How do I avoid taxes on equity? ›
Hold the shares inside an IRA, a 401(k) or other tax-advantaged account. Dividends and capital gains on stock held inside a traditional IRA are tax-deferred, and tax-free if you have a Roth IRA. Dividends and capital gains on stocks in a regular brokerage account typically aren't.
Are hedge fund fees tax deductible? ›
Recently, the Internal Revenue Service issued Revenue Ruling 2008-39, which generally treats advisory fees paid by a fund of hedge funds as “investment expenses” for tax purposes, thereby subjecting their deductibility to the limitations applicable to “miscellaneous itemized deductions.” Under the Ruling, this ...
What is the capital gains loophole? ›
Second, capital gains taxes on accrued capital gains are forgiven if the asset holder dies—the so-called “Angel of Death” loophole. The basis of an asset left to an heir is “stepped up” to the asset's current value.
What is the private equity loophole? ›
The carried interest loophole allows investment managers to pay the lower 23.8 percent capital gains tax rate on income received as compensation, rather than the ordinary income tax rates of up to 40.8 percent that they would pay for the same amount of wage income.
Can hedge funds be ethical? ›
If legality is the chief concern then hedge funds should be just fine. If, however, you define ethical as not causing and/or profiting from situations that have negative financial consequences for people less fortunate than yourself, you might have an issue.
Why are hedge funds only for the rich? ›
A hedge fund investment is often considered a risky, alternative investment choice and usually requires a high minimum investment or net worth. Hedge funds typically target wealthy investors.
