New Tax Salvo Fired at Hedge Fund Managers

Montana Democrat Max Baucus, and Iowa Republican Charles Grassley,  senior Senators and members of the Senate Finance Committee are at it again.  This time their guns are trained at publicly traded hedge funds.  The catalyst for pulling the trigger is the proposed IPO (initial public offering) of hedge fund operator Blackstone Group.

The Senators wrote a letter yesterday to Henry Paulson, the Secretary of the Treasury, critical of the tax treatment of incentive compensation received by hedge fund managers.  This income is currently often received as a dividend or capital gain and taxed at favorable 15% rates, as opposed to the 35% rates, or so, paid on ordinary income.  Moreover, the entities in which the business are conducted are almost invariably treated as private partnerships for tax purposes for which, unlike in a corporation, there is no entity level taxation.

The essence of the letter is that IPOs of hedge fund operators come under the rules for publicly traded partnerships (PTP) under section 7704  of the Internal Revenue Code.  Under this section, a PTP is taxed as a corporation unless 90% of its income is  "passive".

Grassley and Bacchus argue that since these funds are primarily engaged in the business of providing asset management and financial advisory services that their income is "active".  Hence, their incentive fees should be taxed as corporate income at corporate income tax rates of up to 38%.  Of course, if these fees were paid out currently as salary the corporation would receive a deduction but the income would be taxed as salary at the 35%  ordinary income rates to the individual recipient - not the favorable 15% rate for capital gains or dividends.

There is broader concern that this principle may be extended to try to convert incentive fees of all hedge fund and private equity managers to ordinary income.  However, since very few hedge funds or private equity funds (in fact only about 2 or 3 so far) are publicly traded partnerships some means other than that cited in the Grassley Baucus letter will need to be found.