US tax change to hit hedge fund compensation

A proposed amendment to the US Internal Revenue Code would impose a stiff tax penalty on many hedge fund professionals who sink their bonuses back into the hedge fund.

A proposed rule change amending section 409A of the 1986 US Internal Revenue Code, part of broader proposed legislation pushed by the Democrat-controlled Congress to increase America’s minimum wage, is expected to have little effect on private equity professionals.

But the change could potentially hit hedge fund professionals hard, according to a report in this month’s issue of sister publication Private Equity Manager.

The legislation, already approved by the Senate Finance Committee, would limit the amount of income that a taxpayer can defer each year to the lesser of $1 million or the average annual compensation paid to the individual during the preceding five years.

According to Andrew Gaines, a partner in the New York office of law firm Weil Gotshal & Manges, the proposed changes to deferred compensation tax rules are unlikely to present complications for most private equity professionals. Deferred compensation is defined as severance payment, compensation derived from nonqualified pension plans called SERPs, certain types of equity compensation awards, and any earnings on previously deferred compensation.

“It doesn’t look like private equity is going to get hit hard,” says Gaines. “But for hedge funds, it could end the whole practice of deferring incentive fees.”

Many hedge fund professionals choose to “leave” their portion of carried interest in the fund, where it continues to be put to work through the fund’s investment strategy. There could now be severe consequences for continuing this practice – deferred compensation that crosses the $1 million or five-year average threshold will be subject to an additional 20 percent penalty tax.

The proposed amendment appears to be in response the recent public outcry over what many see as excessive executive severance packages in the US, most notably that of Robert Nardelli, the outgoing CEO of The Home Depot who received a $210 million exit package, despite the fact that the company’s shares had suffered under his leadership.