Hedge Fund Deferred Compensation Targeted in Bailout Bill

The 700 billion dollar bailout bill, formally called "The Emergency Economic Stabilization Act of 2008," signed into law last week contains a tax provision that will dramatically affect hedge fund fee deferral arrangements.

Hedge fund managers often elect to defer performance and/or management fees earned from an offshore hedge fund for a set period of time, typically 5 or 10 years. During that time compensation earned is reinvested in the offshore fund on behalf of the fund manager. Under this type of arrangement, the compensation grows on a tax-deferred basis, with no taxes due until the amount is paid to the manager at the end of the term.

These deferred compensation arrangements were targeted by Congress in the past, but until now no limiting legislation was enacted. Part of the bailout bill, H.R. 1424, Title VIII, Section 801 is a revenue raiser that targets "Non-qualified Deferred Compensation from Certain Tax Indifferent Parties." The new legislation imposes current U.S. income tax on deferred compensation from offshore entities that are not subject to U.S. tax or to a foreign comprehensive income tax. As a result, amounts earned by hedge fund managers and deferred in offshore funds will now be subject to tax when earned, rather than when paid.

The change in law is prospective and includes protection for deferral arrangements currently in place. The law is applicable only to compensation for services performed after December 31, 2008. Moreover, existing deferral arrangements for services rendered prior to December 31, 2008 continue to remain valid for deferral dates through December 31, 2017.

In light of this new legislation, it is recommended that hedge funds and alternative investment funds review their existing deferred fee arrangements to determine whether any modifications are necessary prior to December 31, 2008 and to ensure that fees already deferred are payable before 2018.