These hedge fund trades can escape new carried interest limits

NEW YORK: The Internal Revenue Service knocked down one way for hedge fund managers to dodge restrictions in President Donald Trump’s tax law. But for some managers, there’s still a way out.

New limits on carried interest profits don’t apply to regulated futures contracts or contracts to trade foreign currencies.

For managers who rely heavily on those strategies, a chunk of their assets can continue to be taxed at a much lower rate, even if they don’t hold them for three years as the law requires.

Under the old tax regime, hedge funds and private equity managers had to hold their investments for one year to get the long-term capital gains rate of 20%.

Otherwise, they had to pay individual income tax rates, which now top out at 37%.

But those holding the futures or foreign currency contracts didn’t have to meet any time period – they could elect to have 60% of the trade qualify for the long-term rate.

And despite the new tax law, they’ll still be able to do so, according to half a dozen tax experts.

“For many of these hedge funds, the new law has all the bite of a mosquito on an elephant’s butt,” said Michael Kosnitzky, a tax lawyer at Pillsbury Winthrop Shaw Pittman LLP.

Trump turned carried interest into a battle cry during his populist presidential campaign, declaring that “hedge fund guys are getting away with murder.”

Treasury Secretary Steven Mnuchin, a former hedge fund manager, added during last year’s tax debate that “the president has made it very clear that for hedge funds, they will not have the benefit of carried interest.”

Money managers have argued for years that carried interest, or their slice of investment returns – typically 20% – is a capital gain.

After the new law took effect this year, Bloomberg News reported that hedge funds were rushing to take advantage of a potential workaround for the new three-year holding period by setting up thousands of limited liability companies for managers entitled to the payouts. The IRS said last month that it would issue regulations to close that loophole.

But funds that mostly use so-called 1256 contracts – such as some macro, commodity and foreign currency funds – didn’t even have to bother with the extra paperwork.

Carried interest is typically calculated for each individual asset in a fund and its respective holding period. So while some of a fund’s investments are eligible for the lower rate, others aren’t.

Hedge funds generally don’t publicly disclose their individual holdings, aside from some mandatory regulatory filings showing certain stock positions every quarter, so it’s difficult to figure out the percentage of a fund that’s allocated to 1256 contracts – and what a manager’s tax benefits would be.

Long-short equity fund managers who use futures contracts on broad-based indexes, such as the Standard & Poor’s 500 Index, would also be able to avoid the three-year holding period, said Daniel Nicholas, a tax lawyer at Eversheds Sutherland (US) LLP. — Bloomberg