Investment advisors who manage–and recommend–hedge funds need to understand the compensation arrangements of those funds. Hedge fund investment advisors routinely defer a portion of their compensation by entering into deferred compensation arrangements with the offshore hedge funds they advise. These amounts are typically invested in the fund’s offshore investments and have been sheltered from U.S. taxation. But this approach’s days may be numbered, if proposed legislation is passed that would limit income deferrals by hedge fund investment advisors.

We will first address the typical master/feeder hedge fund structure, then the taxation of hedge fund advisors generally, followed by the nature of the income tax deferral by hedge fund advisors, and finally consider proposed legislation on deferrals. We assume throughout that the hedge fund investment advisor is a U.S. entity whose owners are U.S. persons.

The Master/Feeder Structure

A typical structure for an offshore master/feeder hedge fund begins when a hedge fund investment advisor forms a master hedge fund, called the “master fund,” in a foreign jurisdiction. Typically, the master fund elects to be treated as a partnership for U.S. tax purposes. The investment advisor then forms two feeder funds that invest in the master fund and are the master fund’s partners for U.S. income tax purposes. One feeder fund, known as the “domestic feeder,” is formed in the U.S. as a limited partnership or limited liability company. U.S. taxable investors invest in the domestic feeder, which then directs the investments to the master fund. The advisor typically forms a related limited partnership or limited liability company, known as the “investment advisor-related entity,” to serve as the domestic feeder’s general partner or manager, in which case the investment advisor acts as the general partner or manager of the investment advisor-related entity.

The investment advisor also forms a second feeder fund, called the foreign feeder, in a foreign jurisdiction. Foreign investors and U.S. tax-exempt investors invest in that feeder, which then directs such investments to the master fund. The foreign feeder is taxed as a corporation for U.S. income tax purposes. The master fund does the actual investing and allocates any profits to the domestic feeder and foreign feeder, which in turn, allocate such profits to the investors.

Taxation of Hedge Fund Advisors

What is the general tax treatment of hedge fund investment advisors? First, remember that the investment advisor typically earns a management fee of 1% to 2% of the master fund’s net assets under management, also known as the AUM fee, and a carried interest in the profits of the master fund. The AUM fee attributable to the assets under management of the domestic feeder is paid to the investment advisor under an advisory agreement between the advisor and either the master fund or the domestic feeder. The AUM fee is treated as ordinary income to the investment advisor for U.S. income tax purposes. Under the terms of the domestic feeder’s limited partnership agreement or LLC operating agreement, the investment advisor-related entity receives the carried interest attributable to the domestic feeder as a special allocation of the domestic feeder’s profits, known as the “domestic incentive allocation.” The domestic incentive allocation is often 20% of the master fund’s realized and unrealized profits that are allocated to the domestic feeder.

What does this mean in real dollars? If the investment advisor-related entity’s domestic incentive allocation is 20% of the domestic feeder’s profits, and the master fund generates $100 of profit, $60 of which is allocated to the domestic feeder, then the investment advisor-related entity would be entitled to receive $12 as a domestic incentive allocation [($100X60%) X 20%].

Because the domestic incentive allocation is received as an allocation of profits from a partnership, the investment advisor-related entity retains the tax character of those profits. To the extent that the master fund allocates ordinary income to the domestic feeder, the domestic incentive allocation is taxed at ordinary income tax rates. However, since (depending on the investment strategy) a large portion of the income earned by the master fund and allocated to the domestic feeder may be capital gains, the domestic incentive allocation is taxed at capital gains rates to the extent such income is capital gains. As a result, the investment advisor effectively receives a portion of its compensation as capital gains.

The investment advisor receives the AUM fee attributable to the foreign feeder and the carried interest attributable to the foreign feeder through an advisory agreement it enters into directly with the foreign feeder. The AUM fee attributable to the foreign feeder is taxed to the investment advisor as ordinary income, similar to the advisor’s receipt of the AUM fee attributable to the domestic feeder. However, unlike the domestic incentive allocation made to the investment advisor-related entity by the domestic feeder, the advisor receives the carried interest attributable to the profits of the foreign feeder as a fee, known as the “foreign incentive fee.” That fee is taxed as ordinary income to the investment advisor upon receipt, assuming the advisor reports income on the cash method of accounting.

The investment advisor does not receive character retention of the foreign incentive fee because the foreign feeder is taxed in the U.S. as a corporation, not as a partnership.

Income Tax Deferral

Hedge fund investment advisors often defer either a fixed amount or a percentage of the foreign incentive fee under a nonqualified deferred compensation arrangement. The advisor usually defers this fee to reinvest the deferred amount in the same manner that the foreign feeder invests its other assets, all tax-deferred. When the advisor ultimately receives the deferred amount, the advisor’s deferred compensation is taxed at ordinary income tax rates.

The determination of when amounts deferred under a nonqualified deferred compensation arrangement are includible in the gross income of a taxpayer earning the compensation depends on the analysis of a variety of tax principles and IRC provisions, including the doctrine of constructive receipt, the economic benefit doctrine, and the provisions of IRC Section 83 relating generally to transfers of “property” in connection with the performance of services.

In general, the time for inclusion of nonqualified deferred compensation depends on whether the arrangement is funded or unfunded. If funded, then income is included in the tax year in which the taxpayer’s rights are transferable or otherwise not subject to a substantial risk of forfeiture. If unfunded, the deferred compensation is generally includible when it is actually or constructively received. An arrangement is considered “funded” when there has been a transfer of “property” under Section 83. The current tax rules provide that “property” excludes an unfunded and unsecured promise to pay money in the future. A nonqualified deferred arrangement is considered an “unfunded and unsecured promise” in situations when the deferred funds are payable from the general corporate funds that are subject to the claims of general creditors.

In the context of advisors’ deferred compensation, the foreign incentive fee is generally set aside in a subaccount of the foreign feeder. However, because the subaccount assets remain in the possession of the foreign feeder, such assets remain subject to the claims of the feeder’s general creditors. Thus, the interest in the sub-account assets is not deemed to be “property” and is not subject to immediate taxation to the advisor unless it is considered “constructively received” by the advisor.

Under the constructive receipt test, income can be immediately taxable if such income is credited to the taxpayer’s account, set apart for the taxpayer, or otherwise made available so that the income can be drawn upon at any time. However, income is not constructively received if its receipt is subject to substantial limitations. Such a limitation exists with regard to an unfunded deferred compensation arrangement if: (1) the arrangement provides for the election to defer payment only before the beginning of the period of service for which the compensation is payable; (2) the arrangement sets forth substantive forfeiture provisions if elections to defer income, other than the initial election, are allowed after the beginning of the service period; (3) the arrangement defines the time and method for payment of the deferred compensation; (4) the arrangement provides that participants have the status of general unsecured creditor of the service recipient and that the plan constitutes a mere promise to the service recipient to make payments in the future; and (5) the arrangement provides that a participant’s rights to benefits under the plan are not subject in any manner to anticipated alienation, sale, transfer, assignment, pledge, encumbrance, attachment, or garnishment by creditors of the participant. Most deferred compensation arrangements of advisors are carefully structured so that a “substantial limitation” exists and, accordingly, the service provider is not considered to be in constructive receipt of its compensation.

Congress Weighs In

On July 25, 2003, the House Ways and Means Committee introduced the American Jobs Creation Act of 2003 (or AJCA), and on September 17, the Senate Finance Committee passed the National Employee Savings and Trust Guarantee Act (NESTEG). The bills seek to amend or repeal the laws that allow advisors to avoid immediate taxation by entering into nonqualified deferred compensation arrangements.

NESTEG seeks to repeal Section 132 of the Revenue Act of 1978, which placed a moratorium on issuing new guidance on when deferred compensation is considered funded or unfunded and whether a taxpayer should be considered in constructive receipt of deferred compensation. As a result, the IRS has been unable to address many perceived abuses regarding nonqualified deferred compensation. By repealing Section 132, Treasury could address three major issues: defining “substantial limitation” under the constructive receipt doctrine and situations under which an individual’s right to receive compensation is subject to substantial limitations, but in fact is not so limited; arrangements that purport to not be funded, but should be treated as so; and arrangements under which assets appear to be subject to the claims of an employer’s general creditors, but practically speaking are unavailable to creditors.

Second, under both NESTEG and AJCA, all income earned under a deferred compensation arrangement would be “constructively received” unless the arrangement provides that: (1) distributions under the arrangement may not be made earlier than separation from service, disability, death, a time specified under the arrangement as of the date of deferral of such compensation, a change in the ownership or effective control of the corporation, or in the ownership of a substantial portion of the assets of the corporation, or the occurrence of an unforeseeable emergency; (2) there shall be no acceleration of the time or schedule specified in the arrangement for distribution of the deferred amount; (3) the initial deferral election must be made at least prior to the beginning of the taxable year in which the compensation is earned; and (4) additional deferral elections must be made not less than 12 months prior to the date of the first scheduled distribution and the additional deferral must be for a period of not less than 5 years. Failure to include such restrictions would render the arrangement ineffective and subject the deferred compensation to immediate taxation and a 10% penalty.

Finally, recall that an arrangement is considered “unfunded” when a taxpayer has received only an unsecured promise as a result of the transfer of a beneficial interest in assets that are subject to the claims of general creditors of the transferor. Under NESTEG and AJCA, however, “assets set aside (directly or indirectly) in an offshore trust (or other arrangement determined by the Treasury)” would be treated as “property” transferred in connection with the performance of services. The phrase “or other arrangement” would probably include a subaccount in the foreign feeder. As a result, when the foreign feeder sets aside the foreign incentive fee by creating a subaccount for the advisor, the foreign incentive fee would be considered “property” and would be immediately taxable unless such fee were subject to a substantial risk of forfeiture.

These bills could effectively eliminate the tax savings associated with an advisor’s deferral of a foreign incentive fee. The IRS could react to the repeal of Section 132 by issuing guidance that the advisors’ subaccounts in the foreign feeder are funded, that the investment advisors’ receipt of the deferred compensation is not subject to substantial limitations, and that offshore accounts are not subject to the claims of general creditors. If the IRS issues such guidance, advisors will be subject to immediate taxation of deferred compensation under the constructive receipt doctrine. Even if the IRS does not overhaul that doctrine, the proposed changes to Section 83 and the economic benefit doctrine could result in immediate taxation of the foreign incentive fee if the IRS rules that subaccounts in a foreign feeder are similar to a trust arrangement, and, therefore, are “property” transferred in connection with services.