The IRS Will Close This Tax Loophole -- Unless Wall Street Gets Its Way

(Photo: Ray Tsang/Flickr)

For nearly a decade, Democrats from President Obama on down have vowed to close the “carried interest” loophole, which allows investment managers to classify a substantial portion of their income as capital gains, benefiting from reduced tax treatment. But there’s another, even more audacious loophole hedge fund managers routinely use to further reduce their tax burden.

It involves a form of laundering—cycling money through shell companies pretending to sell a specialized form of insurance. Using this technique, the nation’s biggest hedge fund managers have shielded hundreds of millions, if not billions, of dollars.

A couple weeks before a deadline to comment on proposed rules to close this loophole, activists have gotten involved by demanding that the IRS act robustly. They want to highlight this elaborate tax evasion as an example of how hedge funds use whatever strategy they can devise to enrich themselves, to the detriment of ordinary workers and the economy.

To understand the loophole, you must consider how hedge fund managers get paid.  The industry standard is a “2 and 20” setup. For every investment in the hedge fund, managers get 2 percent off the top, and then get the “carry,” which is 20 percent of all profits gained once the fund achieves above a certain threshold. The 2 percent off the top gets taxed at rates equivalent to income; the 20 percent of profits gets taxed, under the carried interest rule, as capital gains. The top capital-gains tax rate is 23.8 percent, a little more than half the top marginal tax rate of 39.6 percent.

However, one massive tax break is apparently not enough. Hedge fund managers still had to deal with the other part—the 2 percent off the top. As hedge funds have increasingly failed to reach the hurdle that unlocks their percentage of the profits, the 2 percent management fee has become a greater share of income. So to lower the tax burden on those earnings, hedge funds decided to transform them into capital gains too.

“It’s like propping up a lawn chair behind Ferrari and claiming it’s a school bus,” says Michael Kink, executive director of the New York-based coalition Strong Economy for All.

Over the past decade, hedge funds owned by John Paulson, David Einhorn, Daniel Loeb, and many more have created shell companies with headquarters in corporate tax havens like the Cayman Islands or Bermuda, which typically have few or no employees and cost next to nothing to operate. These shell companies are allegedly reinsurers, or insurance companies for insurance companies, taking in premiums and backstopping large catastrophic events. When not paying out claims, reinsurers invest their reserves. But in this case, the lion’s share of the reinsurers’ capital comes not from insurance company premiums, but from the hedge funds that created them.

To use one example, in 2012, Paulson & Co. transferred $450 million into its reinsurer, Pacre Ltd., which has no employees. Almost all of Pacre’s assets were invested back into Paulson’s hedge fund. So it’s like a perfect circle: The money goes from the hedge fund to the reinsurer, and back into the hedge fund. This allows John Paulson and his top executives to defer taxation until the investment gets sold. At that point, they pay taxes only on capital gains rather than on income.

The strategy has two purposes, says Dan Pedrotty, director of pension and capital strategies at the American Federation of Teachers. It obviously helps hedge fund managers lower their effective tax rate. But in addition, they keep the hedge fund padded with fresh capital, allowing them to continue aggressively investing.

“It’s been more challenging for them to raise money from public pension funds, because the cost is too high, the returns are terrible, and they’re too complex to monitor,” Pedrotty says. “This gives them a way to use their own money to invest back into their hedge fund.”

Information on how much money hedge fund managers route through this scheme becomes difficult, because so much of the industry is opaque. However, Third Point Reinsurance, Daniel Loeb’s Bermuda-based shell company, went public in 2013, and we know that the company is valued at around $1.55 billion. If all of that money represents capital infusions from Loeb’s hedge fund management fees, the tax benefit is worth at least $225 million at sale. Even if it’s less, hedge fund managers, the top 25 of whom took in $11.62 billion in compensation in 2014 (more than every kindergarten teacher in America combined), clearly benefit handsomely from this laundering tactic.

The IRS could eliminate this or any abusive tax strategy with the stroke of a pen. Instead, the agency has moved with extreme caution. After promising a crackdown in 2003 and making no progress for over a decade, Ron Wyden, ranking Democrat on the Senate Finance Committee, demanded a solution last year. The IRS responded this April with proposed rules that would more strictly define an insurance business as one that actually writes insurance policies and performs underwriting, rather than a vehicle for sheltering hedge fund cash.

The rules would limit the favorable tax treatment if the reinsurer and the hedge fund share executives. The IRS has also said reinsurers might need a certain percentage of their assets to come from insurance premiums, and hold reserves that don’t cover much more than their liabilities, although they kept these numbers open.

The IRS chose not to immediately enact the regulation, instead offering a public comment period for 90 days and seeking guidance on how to handle the issue. Industry trade groups tend to dominate the public comment process, using the time to lobby agencies and weaken the rules. Third Point and other hedge fund–created reinsurers have maintained that they operate legitimate businesses, and that sharing employees does not account for the risk they assume as a reinsurer.

Activists want to insert themselves into the mix. The American Federation of Teachers union, along with progressive groups like MoveOn.org and CREDO, plan to mobilize members to submit thousands of comments before the deadline on July 23, supplementing more formal comment letters. “If the IRS were doing its job, this would be a tax shelter poster child for billionaires paying themselves,” says Pedrotty of the AFT.

In addition, activists with the organization HedgeClippers, which focuses on hedge funds, will protest a $5,000-a-plate dinner for New York Governor Andrew Cuomo that will be held at Daniel Loeb’s beach house in the Hamptons this weekend. “Politicians enable these guys to cheat the public and continue an unfair system of taxes,” says Michael Kink of Strong Economy For All is part of the HedgeClippers coalition. “Cuomo's relationship to Loeb is Exhibit A.”

It’s part of a larger effort to make an example of hedge funds as being the epitome of the age of inequality, using financial-engineering tactics to extract corporate profits for wealthy investors and shortchange workers. “If the smart people that cooked up this rule worked on distributed solar or mass transit improvement, we’d be better off,” says Kink. “There are a lot of opportunities for smart Americans to do productive work. With the hedge fund industry, it just goes into making rich Americans richer.”

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