In this recently-released Ropes & Gray podcast, asset management partner, Isabel Dische, tax partner, Brett Robbins, and private client partner, Cameron Casey, discuss the effect of Section 457A on pre-2009 hedge fund management and incentive fees and charitable planning strategies that can be implemented this year to reduce 2017’s tax burden.

Illustration: Charitable Lead Annuity Trust


Hello everyone, I am Isabel Dische, a partner in Ropes & Gray’s asset management practice. Today, I am joined by two of my colleagues, Brett Robbins and Cameron Casey. Brett is a partner within the firm’s tax group, and Cameron is a partner within our private client group.

In today’s podcast, we are going to answer some questions hedge fund managers may have about a looming tax liability on management and incentive fees that they earned prior to 2009, but on which they have not yet paid any income taxes. Brett, can you tell us more about this tax and whom it will affect?

Brett: Yes, for many of the hedge fund managers with whom we work, really those who have been in the industry for at least ten years, 2017 has been seen as a pay the piper year. Taking a brief step back, without getting too deep into the Code, the tax laws changed in 2008 and a hedge fund manager’s ability to defer recognition of management fees, including fees based on performance, from certain entities as taxable income was, in general, eliminated except to the extent the right to receive such fees was conditioned on continued performance of services. With the new law, management fees would, in general, be taxable immediately to the hedge fund manager in the year earned. Section 457A generally applies to any management fees attributable to services performed on or after January 1, 2009. Fees earned and deferred prior to 2009 were in general given a reprieve, until 2017. So, to answer your question, whom does this affect, we’re talking about an income tax that will affect those hedge fund managers with previously untaxed management fees earned prior to January 1, 2009.

I think it is important to note that people have done their best over the past ten years to come up with a creative approach to further defer this tax, such as changing to an accrual method taxpayer. In a chief counsel’s memorandum, the IRS expressed its view that this strategy will not work. Others, maybe jokingly, talk about moving to an income tax-free state, like Florida, to potentially avoid paying state tax on the deferred amount. But if the compensation was earned while the hedge fund manager was a resident of a taxing state, the hedge fund manager’s former domicile may still impose an income tax. A determination of whether this would work would require a review of the laws of the relevant states.

Isabel: So Brett, how will these previously deferred management fees be taxed and when are hedge fund managers going to have to write a check to Uncle Sam?

Brett: Pre-2009 fees will be taxed as ordinary income. So, for a hedge fund manager who accumulated and deferred significant management fees prior to 2009, all of those fees, plus any appreciation, will be taxed in 2017. Since we’re talking about hedge fund incentive fees and not carried interest in a private equity fund, ordinary income tax rates will apply. This is a large tax liability for many seasoned hedge fund managers, and it is not necessarily prudent to wait until April 15, 2018 to pay the tax. We recommend at a minimum to the hedge fund managers with whom we work to speak with their tax adviser to discuss estimated tax payments to mitigate interest charges.

Isabel: Cameron, it’s now 2017, is there anything hedge fund managers can do to mitigate the tax bill?

Cameron: Well, as we suggest in the title of this podcast, hedge fund managers, especially those who are charitably inclined, should consider planning that would allow them to use dollars that would otherwise go to Uncle Sam to realize their philanthropic goals. In some cases, they may even be able to transfer value to their children in the process. Subject to some limitations that we’ll get to in a minute, charitable contributions made in 2017 will generate an income tax deduction that can offset a portion of the income the hedge fund managers will recognize as a result of 457A.

There are a few giving options hedge fund managers might want to consider. First, I’ll briefly describe a few outright giving strategies. For those who are charitably inclined, but who also want to do some tax efficient planning to benefit their families, I’ll also describe a charitable giving strategy involving a trust, called a CLAT.

As far as outright giving goes, one possibility is for the hedge fund manager to make an outright gift to charity. This could be a gift to one or more favorite public charities—his or her alma mater or a local nonprofit doing important work in the community. Or, if the hedge fund manager doesn’t have strong established relationships with specific charities, he or she could make a gift to a donor advised fund. Donor advised funds are sponsored by a charitable organization, like a community fund, and allow the donor to create a separate charitable fund account under the sponsoring charity’s umbrella. The donor no longer controls the assets transferred into the account, but he or she has the power to recommend gifts from the donor advised fund to other public charities. Unless the gift recommendation conflicts with the sponsoring charity’s policies, the sponsoring charity will follow through on the donor’s recommendation.

If you make a gift to a public charity or donor advised fund using cash, you’re entitled to a deduction of up to 50% of your adjusted gross income or AGI. As long as you’ve held them for at least a year, securities can be given to a public charity or donor advised fund and deducted at their fair market value, up to 30% of the donor’s AGI. Any deduction that can’t be used in the year of the gift can be carried forward for up to five years following the gift.

Another option is for the donor to establish and make gifts to a private foundation—that’s the vehicle offering the donor the most ongoing control and perhaps the most flexible platform for developing his or her ongoing philanthropy. Income tax deductions for gifts to private foundations are more limited though—up to 30% of AGI for gifts of cash and up to 20% of AGI for gifts of publicly-traded stock. Note that all these AGI limits are interrelated and can’t be tacked onto one another.

Now, a more advanced approach, which could be used in conjunction with any of the other charitable giving strategies I just mentioned, is for a hedge fund manager to establish a charitable lead annuity trust, fondly known in the estate planning world as a CLAT. This type of trust creates an initial annuity interest payable to a charity or charities of the donor’s choice, including a donor advised fund. The CLAT makes an annual payment of a predetermined amount to the charity over a predetermined number of years. The annuity doesn’t have to be a level annuity—the payment can change over time—as long as the present value of the stream of payments can be measured on the day the trust is funded. When the annuity ends, the remaining trust property can be paid outright to, or held in further trust for, designated non-charitable beneficiaries—usually the donor’s children.

If the trust is structured in a particular way, the donor will be entitled to an immediate, accelerated income tax charitable deduction for the present value of the annuity, subject to a 30% AGI limitation. That 30% limit applies whether the annuity is paid to a named public charity or a donor advised fund and whether the trust is funded with cash or securities. CLATs can be payable to a private foundation, but only with special restrictions that make it a less appealing option than using a donor advised fund.

The present value of the annuity payments that will be made to the charity is determined using a discount rate that’s published monthly by the Internal Revenue Service. Although that rate has ticked up recently—it’s 2.4% for May 2017—it’s still very low by historical standards. Typically, a CLAT is structured so that the entire funding amount is equal to the present value of the charitable annuity stream—this is sometimes called zeroing out the trust because the IRS’s valuation method deems there to be zero value to the trust remainder.

Because a portion of the CLAT may benefit non-charitable beneficiaries, CLAT planning has gift tax consequences and, in some cases, may trigger a taxable gift. But with a zeroed-out CLAT, like the one I just described, the donor will get a dollar-for-dollar charitable deduction against the federal gift tax for entire gift to the trust. And there are no AGI limits in the gift tax deduction context. If appreciation of the assets in the CLAT, net of the annuity payments to charity, is greater than the IRS-prescribed discount rate, there will be assets left in the trust when the annuity period ends. And it’s those remaining assets can benefit the donor’s family free of gift and estate tax, making the CLAT a very efficient way to transfer assets to the next generation. One trade-off for these tax benefits is that the donor has to pay the income tax attributable to the trust assets during the annuity period. The other downside is that, if the donor dies during the annuity period, his or her surviving spouse or estate will have to recognize taxable income equal to a portion of the original income tax deduction on the decedent’s final income tax return.

So, short answer, or maybe not so short, is yes, there is something that can be done in 2017 to mitigate the 457A tax through charitable planning. If a hedge fund manager is interested in these charitable planning techniques, he or she should start planning now to take advantage of the variety of options that are available.

Isabel: Now for both of you, and hopefully, one of you brought your crystal ball today, one of the priorities of the new administration and the Republican-majority Congress is comprehensive tax reform. Within the past few days a few details have come out of the White House, including a proposal for a 15% corporate rate, which may also apply to income earned by partnerships that manage hedge funds, as well as a significant increase in the itemized deduction for individual taxpayers. Brett, is it possible that the 457A tax on pre-2009 management fees could be eliminated by virtue of a change in the law?

Brett: Possible, yes. Likely, I really don’t know. The headlines following the breakdown of health care reform in March were that comprehensive tax reform was the new priority for the administration and for the Republicans in Congress and, we are recording this on April 26th, the President has promised a tax proposal as soon as this week. Even if Washington does get to tax reform this year, I don’t know if hedge fund managers would be palatable beneficiaries of a tax break that extends the deferral of income already deferred for at least 10 years, especially if some middle class tax breaks, such as mortgage interest deductions, may be eliminated—but that is conventional thinking. With this new administration, there is a lot of unpredictability, so making any predictions is very difficult.

Isabel: So, Cameron, assuming benefiting hedge fund managers is not at the top of the tax reform priority list, is it possible that a change in the tax law would make the charitable planning and gift tax planning you just described inadvisable?

Cameron: Like Brett’s, my crystal ball is pretty cloudy. During the election, there were certainly headlines about substantially limiting the charitable deduction as part of comprehensive tax reform. Charities and charitable giving have played a longstanding and significant role in our country’s cultural and economic landscape though. Limitations on the charitable deduction are unlikely to come to pass without a fight. There’s also a lot of uncertainty about the future of the gift and estate taxes, which are relevant to the CLAT planning I described a minute ago. Will the estate and gift taxes be repealed, and repealed for the long haul? What, if anything, might replace them? It’s hard to say at this point. The promise of comprehensive tax reform tends to paralyze clients with respect to their planning, but hedge fund managers with a 457A issue have a reason to forge ahead notwithstanding the uncertainty. It’s worth teeing these gifts up now so you will be ready to go once the contours of comprehensive tax legislation are better defined—and before your December 31st deadline arrives.

Isabel: All right, then we should leave it there so our listeners can start planning. Before we end, I want to mention that Cameron has prepared a user-friendly handout that summarizes the CLAT planning she described. We’ll be sure to include a link to that handout on the webpage where this podcast is posted. Thank you, Brett and Cameron, for joining me in this interesting conversation. Thank you all for listening and please visit for additional news and analysis about noteworthy tax issues.