From the December 2007 issue of Investment Advisor • Subscribe!

December 1, 2007

Deadline Looms for AMT Fix

Congress: curbs in hedge funds' deferred comp a revenue remedy

With a deadline to fix the Alternative Minimum Tax (AMT) by year-end fast approaching, Congress is in a mad dash to find alternative sources of revenue to plug the hole that would be created if 25 million taxpayers were saved from the AMT. Besides tax hikes, lawmakers' revenue-boosting targets of choice are deep-pocketed hedge funds.

Two recent bills have been introduced that would curb the ability of high-wage taxpayers to defer unlimited amounts of their offshore compensation--House Ways and Means Chairman Charles Rangel's (D-New York) Tax Reduction and Reform Act of 2007 (H.R. 3970) and Senator John Kerry (D-Massachusetts) and Rep. Rahm Emanuel's (D-Illinois) bill, The Offshore Deferred Compensation Reform Act (S 2199).

Unlike average Americans who are limited to the amounts of income they can defer into 401(k) and other retirement accounts, U.S.-based hedge fund managers who operate offshore investment funds can defer unlimited amounts of their compensation. Reforming the tax code will help ensure that all Americans are on a level playing field when it comes to paying taxes on the money they've earned, Kerry and Emanuel argued when introducing the bill.

As Brian Snarr, a partner at Morrison Cohen in New York attests, U.S. hedge fund managers who manage funds for onshore accounts "typically take an equity position, so they are partners with the [investors] they manage the money for." When it comes to managing money for offshore investors, however, hedge fund managers usually take a fee instead. When hedge fund managers become successful, Snarr says, they defer taking all of their fees at once, and instead treat the money as if it were invested in the hedge fund or in Treasury bills and collect it later--say in five years.

Section 409(A) of the tax code currently governs deferred compensation, and as Snarr notes, it covers all sorts of workers--hedge fund managers, corporate managers, and employees--when it comes to deferred compensation. Post Enron, Congress has taken a keen interest in deferred compensation, since some of the top guys "escaped with their deferred comp and left the stockholders and creditors hanging," Snarr says.

But Snarr questions whether the Kerry/Emanuel bill will apply to all types of workers who have deferred compensation plans. The bill is effectively saying "that if you're managing money for someone, and they're not in the U.S., then you can't defer" your compensation, Snarr says. "Is that just hedge funds? What if you are managing money for someone in England, Japan, or Germany--you can no longer say 'pay me later?'" Deciding which workers to single out, he says, "is going to prove difficult."

The Kerry/Emanuel bill would create a new Section 457A of the IRS code that eliminates the ability of U.S. taxpayers to defer nonqualified deferred compensation in offshore tax havens. According to the bill, "nonqualified deferred compensation paid by a foreign corporation will be taxable income when there is no substantial risk of forfeiture to the compensation."

While Rangel's proposed bill would repeal the AMT, it would also stop private equity managers and venture capitalists from classifying their income as "carried interest" and having it taxed at the capital gains rates instead of the higher, ordinary income tax rate. Carried interest, as described by Milton Ezrati, senior economist and market strategist at Lord Abbett, in his most recent Economic Insights newsletter, is "the share of any profits that the general partners of private equity and hedge funds receive as compensation, despite not contributing any initial funds." But recent reports have said that after hearing Senate Finance Chairman Max Baucus (D-Montana) say there's not enough support for the carried interest provision in the Senate, Rangel said he would consider removing it from his bill as long as Baucus suggests replacement offsets. In fact, Senate Majority Leader Harry Reid (D-Nevada) said November 13 that the Senate is "going to fix the AMT thing before the end of year, but we're going to do it the right way, by paying for it."

Meanwhile, back at the AMT

As for the Alternative Minimum Tax, the U.S. House of Representatives passed November 9 by a vote of 216-193 the Temporary Tax Relief Act of 2007 (H.R. 3996), which would ensure that no additional taxpayers pay the AMT this year. The bill would also extend popular tax credits and deductions such as the deduction for state and local sales tax, tuition, out-of-pocket expenses for teachers, and research and development that would otherwise expire at the end of the year.

Secretary of the Treasury Henry Paulson told Congress in a recent letter that it must enact an AMT patch by early November to save 25 million taxpayers from getting hit with the AMT on their 2007 taxes. "If a patch is not enacted until mid-December, an additional 25 million taxpayers--50 million total--could see delays in up to $75 billion in refunds," Paulson wrote.

Under Rangel's proposal lost revenue from the AMT would be replaced with new revenues derived from raising the maximum income tax rate. At the same time, in addition to letting the Bush income tax cuts expire, "Rangel also would place a surcharge on higher-income households, at 4% for workers who make more than $200,000 a year ($150,000 for single taxpayers) and 4.6% on couples who earn more than $500,000 a year ($250,000 for single taxpayers)," explains Ezrati of Lord Abbett. With this huge tax hike, "Rangel could replace more than 90% of the revenue lost in the repeal of AMT," he says. "Others on the Democratic side, including most of the current bevy of presidential candidates, would simply raise the maximum rate from its present level of 35% to its former level of 39.6%, which, depending on the calculation, is considerably less than Rangel proposes."


Washington Bureau Chief Melanie Waddell can be reached at mwaddell@investmentadvisor.com.

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