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Tax Planning for the Alternative Fund Manager

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Tax Planning for the Alternative Fund Manager By Anthony J. Tuths, JD, LLM, Partner, [email protected] TAX PLANNING FOR THE ALTERNATIVE FUND MANAGER Being an advisor to the alternative investment industry allows me to observe recurring issues that leaders take into account, such as governmental regulation, investor preferences and idiosyncratic asset problems. There is a constant issue which fund managers are always eager to discuss, and that is the taxation of their own compensation. Within the asset management arena there are several strategies OFF-SHORE REINSURANCE COMPANY that managers employ to limit their global tax burden. In this Many large U.S. based fund managers have created off-shore article I will briefly describe several accepted methods managers reinsurance companies, converting ordinary income into long can employ to legally reduce their U.S. tax costs including: term capital gain in order to gain a tax rate advantage. In order to achieve this, the fund manager will work in tandem with a non-U.S. 1. Affirmatively using the PFIC rules partner, typically a reinsurance company. The non-U.S. party owns 2. Off-shore reinsurance companies a portion of the reinsurance company to ensure it is not treated as 3. Private placement life insurance a controlled foreign corporation (a “CFC”) for U.S. tax purposes. 4. Expatriation The new reinsurance company then begins writing reinsurance policies and collecting premiums. The initial share capital of the AFFIRMATIVE USE OF PFIC RULES company plus the insurance premiums collected are invested into U.S. investors, including U.S taxable fund managers, in alternative the manager’s fund(s). The fact that the company takes on real investment funds, almost universally, invest into a U.S. master fund insurance risk and operates a true reinsurance business means that or a U.S. feeder fund. If such U.S. persons were to invest through the company will not constitute a PFIC and unlimited tax deferral is the foreign feeder fund, they would be treated as holding an permitted. interest in a passive foreign investment company (a “PFIC”). PFIC investments are normally viewed as undesirable for a number U.S. investors are able to buy shares in the reinsurance company of reasons, namely that capital gains from a foreign feeder fund with the ultimate goal of taking the reinsurer public and providing do not flow through to the investor unless a special election is investors liquidity in the market. Once publicly registered, the fund made (QEF, or Qualified Electing Fund, election). Without a is open to retail investor money, not just qualified purchasers. The QEF election, tax is deferred until distributions are received from investors have no tax liabilities (absent any dividend distributions) the fund or the fund units are disposed. Then, all appreciation / until they dispose of their shares. When they finally do exit the distributions are taxed at the highest ordinary income rates and an investment they will have long-term capital gains (assuming a “underpayment” interest charge is applied to the tax amount. minimum one year holding period). The fund manager may also be an investor in the reinsurance company Nevertheless, in the asset management realm there is the possibility of using the PFIC rules in an affirmative posture. A U.S. PRIVATE PLACEMENT LIFE INSURANCE (“PPLI”) fund manager can invest through the off-shore feeder and gain If you’ve ever been introduced to a variable life insurance policy tax deferral for many years. When the manager eventually cashes then you can quickly understand Private Placement Life Insurance out there will be tax at ordinary rates with interest as though (PPLI). With variable life policies the insured pays a premium and the income had been earned ratably over the manager’s holding part of the payment covers a standard death benefit amount while period. Moreover, using a PFIC allows the U.S. investor to avoid the remainder is invested. The policy offers myriad investment limitations on deductions (at both the federal and state level), options - typically mutual funds. The invested amounts are able to interest expense, capital losses, wash sales and straddles. For grow tax deferred inside the insurance policy. PPLI works the same funds that would otherwise produce long term capital gains on a way except that the investment portion goes into selected private regular basis this strategy may not be advisable but for all others investments as opposed to publicly registered mutual funds. These it is worth considering. investment options can range from hedge funds to real estate Continued on next page to art. Moreover, the investment option can be one the insured Partial expatriation is a relatively new concept and involves the creates —an insurance dedicated fund or “IDF.” U.S. fund manager relocating to a U.S. territory like Puerto Rico. In this case, the individual is able to keep his or her U.S. passport The tax benefits associated with PPLI are incomparable. The cash and U.S. citizenship. However, the individual will take advantage of investment amount grows tax deferred and invested amounts can special U.S. tax rules for territories. In the case of Puerto Rico this be borrowed at any time with proper arrangements. However, can be compelling for an asset manager. The island’s government there is a fine line between legitimate PPLI and illegal tax evasion. has special tax programs available for asset managers designed to Any manager investigating a PPLI policy should enlist the encourage relocation. Under current law, managers relocating to assistance of tax professional knowledgeable of the issues created Puerto Rico can achieve a zero percent capital gains tax rate and by PPLI. a 4% tax rate on management fees. Moreover, the manager will escape state tax. EXPATRIATION Expatriation means to give up one’s citizenship. In tax terms CONCLUSION expatriation comes in two flavors: full or partial. In full expatriation The fact that asset management is an advisory function which is a fund manager would physically leave the U.S. and give up his or highly mobile creates unique tax planning opportunities. These her U.S. passport. The expatriation would have to be disclosed planning options are valuable and should be used, but never to the U.S. government and there would be an exit tax imposed abused. Shortcuts, slipshod planning and questionable techniques on the individual. The individual’s assets are treated as sold for have no place in tax planning. Always consult with an experienced fair market value on the day before the expatriation and taxed and reputable tax planner before undertaking any tax reduction accordingly. The first $600,000 of gain (adjusted for inflation) strategies. is permitted to escape tax. Thereafter, the individual would be treated as a non-resident for both tax and immigration purposes. HELPING A FRIEND OR ACTING AS AN UNREGISTERED BROKER-DEALER? By Brian Wallace, CPA, Partner, [email protected] Recent crackdowns, by the SEC, have put one about the company they may be investing in —The SEC question at the top of many fund managers’ and will raise their eyebrows. investors’ minds: When are ‘finders’ required to be registered as broker-dealers? Not an easy Now, let’s take it a step further and consider the same question and one that must be approached with scenario but you get compensated for your investor caution and proper education. referral. If you are compensated with a one-time flat fee, regardless of the company’s success: you are probably According to the Securities Exchange Act of okay. However, taking compensation based on the 1934 (“Exchange Act”), any person who effects amount raised or anything contingent on the success securities transactions in the U.S is required to register as a of the transaction without a broker-dealer license can land you in broker dealer, unless that individual is an associated person of a some hot water. Recently the SEC has been quoted as saying that registered broker dealer. That’s a pretty broad definition and one even a single instance of transaction-based compensation may be that has caused some serious headaches to friends of start-ups enough to find that an individual was “engaged in the business” of and private fund managers. a broker activity, and subject to registration or penalities for failing to hold registration. CONSIDER THE FOLLOWING SCENARIO You are a partner in a law firm who works in the areas of trust and Finally, suppose this isn’t the only “friend” you have done this estate law. By nature of your practice your clients are primarily for. In fact every year a “friend” comes to you with a similar high net worth individuals (translation - accredited investors). A opportunity. Guess what? In industry terms, you are what good “friend” of yours is starting a technology company based is commonly referred to as a “finder:” someone who assists around some social media application and he is looking to raise companies and private fund managers in raising capital. And you some capital. He asks for your help and you agree to present this are required to be registered as a broker-dealer. opportunity to some of your clients. The penalties associated with acting as an unregistered broker- From a regulatory perspective, you’ve acted within the law to dealer can be severe. Thus, care must be taken when “helping” this point. (Ethically, the area is grey.) Where things start to get your “friends” find investors. Finder compensation agreements cloudy, and where the SEC, catching on, has taken up recent need to be properly structured and the scope of services needs enforcement actions, is if you go beyond this point. to be clearly defined with activities limited to merely making introductions.
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