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