06/16/2010

Ahead of Tax Vote, Managers Consider Exits

With Congress on the verge of passing a so-called carried-interest bill, some hedge fund managers are considering selling their businesses in order to avoid sharply higher tax rates.

As early as this week, the Senate could approve the American Jobs and Closing Tax Loopholes Act, which would tax managers' performance-fee revenue as income, at a top rate that is currently 35%, rather than as capital gains, at a rate as low as 15%. Even more worrisome than the performance-fee tax is a provision that would change the tax treatment for the sale of a hedge fund-management firm. Instead of taxing the proceeds as capital gains, as is the case with most businesses, the so-called enterprise-value provision would force managers to pay income taxes on a big chunk of the sale.

While Congress has been debating the carried-interest bill since last year, the hedge fund industry only recently has begun focusing on the enterprise-value provision. At the Managed Funds Association conference in Chicago last week, an accountant said a hedge fund client had been "freaking out" about the legislation because it originally was scheduled to go into effect upon passage of the bill. Under a recent compromise, the changes wouldn't take effect until Jan. 1, 2011.

"They are putting the deal together as we speak," the accountant said of his client.

Dean Rubino, whose Kelly Park Capital of New York is looking to buy fund-of-hedge-funds businesses, said he has been using the Congressional action as a marketing technique, sending news items to prospective sellers. "You're getting the sense that the clock has started ticking," he said. "We were hearing from interested parties that we should call them in September, and now they are asking if we're available next week."

Fund managers paid close attention last week when hedge fund operator ESL Partners completed an unusual transaction. The Greenwich, Conn., firm distributed $829 million of stock in Sears Holdings, AutoNation and AutoZone - the fund's main holdings - to ESL founder Eddie Lampert. Though the firm didn't comment on the move, tax lawyers interpreted it as a defensive maneuver in advance of the pending legislation.

Richard Zarin, a tax lawyer with Morgan Lewis in New York, said he immediately started getting calls from hedge fund clients worried about the carried-interest bill. "You start seeing the emails - 'Should we do this?' " Zarin said. "There is a rush to do the thinking."

Most hedge fund managers have resigned themselves to paying income tax on their performance fees, or carried interest. That's because in most cases, their overall tax bill won't change that much.

Under current law, fund managers that keep their fee revenue invested in a fund for at least a year have to pay tax only on long-term capital gains. But most hedge funds trade too frequently to qualify for the long-term capital-gains rate and instead pay the short-term rate, which is the same as the top income-tax rate. Still, even short-term traders would end up paying more because their performance fees would be subject to employment taxes, which include not only the income tax but also Medicare and other entitlement obligations.

For partners in hedge fund firms, a much bigger threat is the enterprise-value provision. They feel it's unfair that Congress wants to treat their sweat equity differently than other businesses.

Under the House bill, which passed last month, half of the proceeds from the sale of a hedge fund business would be taxed as income and half as long-term capital gains for the first two years - 2011 and 2012. After that, 75% of the sale would be taxed as income. In the Senate bill, there's a two-year phase-in period when the split is 50-50. After that, 65% of the sale proceeds would be taxed as income and 35% as capital gains. If a manager has held his interest for at least seven years, then the income-tax portion would drop to 55%.

"One thing that is so alarming about it is it's very well thought through," Roger Lorence, a lawyer with the firm of Sadis & Goldberg, said of the bill. "You can't escape."

Both the top income tax rate and short-term capital gains rate are scheduled to rise to 39.6% next year, from 35%, while the long-term capital gains rate will go up to 20%, from 15%.

Congress has been considering an enterprise-value tax since 2007, when Blackstone Group held an initial public offering. Some lawmakers were livid that the firm's principals pocketed huge sums of money after paying only 15% in capital gains taxes.

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