For hedge fund managers who hold pre-2009 fees in deferred compensation programs offshore, the tax-clock is ticking. When the clock strikes midnight on December 31, 2017, any pre-2009 deferred incentive and management fees held offshore will be subject to tax at the owner's top marginal rate. This deadline, which was created in 2008 under Sec. 457A of the Internal Revenue Code, is fast approaching and many hedge fund managers are turning to their advisors for a fast and efficient solution that will offset some of the tax impact this year.
For many individuals affected by the tax, their best strategy may include a charitable gift. By making a charitable gift before the end of 2017, hedge fund managers will receive a charitable income tax deduction that they can use to offset a significant portion of their tax liability. Additionally, they will be able to make a positive impact by supporting the charitable causes that matter most to them. The type of charitable gift will depend on the client's individual needs and can be crafted to accomplish financial, personal and family goals.
This article will begin by explaining Sec. 457A and its ramifications for the client. The article will proceed by presenting four possible charitable solutions for advisors to present to clients who may be looking for a way to soften this year's tax bite. These solutionsoutright major gifts, donor advised funds, charitable remainder unitrusts and charitable lead annuity trustswill enable the client to claim a charitable income tax deduction on his or her 2017 tax return and will instill a sense of fulfillment due to the positive impact that the charitable gift will have on the lives of others.
In 2008, Sec. 457A was added to the Internal Revenue Code (IRC) as part of the Emergency Economic Stabilization Act of 2008 (H.R. 1424). Prior to its enactment, hedge fund managers could defer income recognition of management and incentive fees due from offshore funds until that income was actually received. Section 457(A) not only put an end to this practice but required that hedge fund managers with offshore deferred income arrangements repatriate the pre-2009 funds by December 31, 2017.
The deferred fees are subject to ordinary income tax at the taxpayer's highest marginal rates. Depending on the taxpayer's level of income and where he or she lives (and, therefore, if state income tax will be due), the deferred income could be subject to a nearly 50% tax. According to 2008 tax estimates by the Joint Committee on Taxation, the tax revenue could total more than $25 billion. Failure to recognize the fees as income prior to the deadline will result in a 20% penalty tax plus an interest charge in addition to the taxes due.
Henry Smith is a hedge fund manager at ABC Asset Management LLC (ABC). ABC is a $1.5 billion hedge fund and splits its assets between onshore and offshore funds. Because of Sec. 457, Henry is required to repatriate the $14 million in pre-2009 management and incentive fees that he is currently holding offshore before the end of 2017. Between federal and state taxes, Henry will be facing a tax of 50% and will have to report the entire $14 million on his 2017 income tax return. Unless he finds a way to offset this tax, he will have to hand over approximately $7 million to the government.
While Congress gave hedge fund managers a decade to recognize income from deferred fees earned prior to the enactment, many have not acted and have been holding out hope that changes in tax law could reduce or completely eliminate the provisions of Sec. 457A prior to the December 31, 2017 deadline. However, with the end of 2017 fast approaching, the deadline is looming and the likelihood of substantial tax reform prior to year's end is shrinking with each passing day. As such, hedge fund managers who have not yet repatriated their fees are looking for ways to soften the tax blow before year's end.
One planning technique that advisors are discussing with their clients as the deadline approaches is charitable giving. By making gifts to charities, hedge fund managers can secure immediate tax deductions this year to reduce, or potentially eliminate, the taxes that will be due on their deferred fees. For charitably minded clients, putting those dollars in the hands of their favorite charities, rather then turning them over to Uncle Sam, may be an attractive solution. The charitable gift can be crafted to meet the particular needs of the client and provide the client with the opportunity to pass value to family and to charity. Outright gifts, donor advised funds, charitable remainder unitrusts and charitable lead annuity lead trusts are four potential charitable solutions for clients looking to offset taxes due this year.
1. Outright Major Gifts
The first, and simplest, option for clients looking to ease the tax burden on their deferred offshore fees is to make an outright major gift of cash or appreciated property to charity. By doing so, the client will receive a charitable income tax deduction in the year of the gift equal to 100% of the amount transferred to charity. However, the client should be aware of the charitable deduction limits described in Sec. 170. For charitable gifts of cash, the client will be able take the deduction up to 50% of his or her adjusted gross income (AGI) in the year of the gift. The remaining deduction amount may be carried forward up to an additional five years. If the client uses appreciated property to fund the charitable gift, then the deduction is limited to 30% of the client's AGI in the year of the gift. He or she may carry-over the remaining portion of the deduction for up to five additional years.
Henry meets with his advisor, Mick, about the upcoming December 31 deadline to recognize income from his offshore fees. Mick suggests making a charitable donation to offset the $7 million that he will have to recognize this year from his deferred offshore funds in addition to the $1 million he will have to report from other income sources. After reviewing his current assets, Mick suggests that Henry consider making a charitable gift of his highly appreciated real estate. By making a charitable gift of the land, he will be able to avoid tax on the gain and also offset his tax bill with the charitable income tax deduction. The real estate's fair market value is $4 million. By gifting the property before the end of 2017, Henry will receive a $4 million charitable income tax deduction to help offset the tax on his deferred overseas income. Note that, because the real estate is an appreciated property gift, he can use the charitable deduction up to 30% of his adjusted gross income in 2017. Therefore, he can deduct $2.4 million this year and carry forward the remaining $1.6 million to use for up to five additional years.
Clients might have one particular cause that is near and dear to their hearts, in which case they can simply make a gift to one specific organization. Clients can also earmark their charitable gifts for specific purposes so long as the restriction does not prevent the recipient organization from freely using the gift for its charitable purposes. For example, perhaps a client wants to make a large charitable gift to his alma mater to help fund construction of a new library at the business school or create a scholarship program in his name. Either option would be perfectly acceptable and would enable the client to make an impact while also offsetting this year's tax bill with a charitable income tax deduction.
2. Donor Advised Funds
Some clients might like the idea of being able to distribute funds to multiple charities for particular purposes, but they do not want to create private foundations and would like the flexibility to be able to choose the charities and distribute the funds over time. For these clients, a potential solution is to set up a donor advised fund (DAF). A DAF is an account that is established at a public charity, often a community foundation. When making contributions to the DAF, the client must give complete control of the donated funds to the public charity. As a result, he or she will receive a current income tax deduction for the full amount of the contribution to the DAF. Despite the fact that the client relinquishes control over the donated funds, the unique aspect of a DAF is that the client can remain involved by making non-binding recommendations to the public charity as to investments and DAF distributions. As a result, the client is able to fulfill his or her philanthropic goals in a flexible, tax-favored and cost-effective way.
For clients who are looking for a last minute solution to offset the tax bill on deferred offshore compensation, a donor advised fund may be preferable to a private foundation due to the simplicity of setting it up. In contrast to a DAF, which is simply created through an existing charitable organization, a private foundation is its own legal entity. As such, along with naming officers and directors and creating the appropriate governing documents, the client would need to submit documents to the IRS and receive IRS approval, which can take months to obtain. Additionally, the deduction limits for charitable gifts from private foundations are less preferable (30% for cash and 20% for appreciated assets) and the cost of setting up a private foundation can be significant. Thus, for clients who want more "bang for their buck" from their charitable contribution and who need the deduction this year, a DAF may be preferable.
Contributions to DAFs can be in the form of cash, stock, bonds, real estate or privately held business interests. Assets within the fund can be invested and the fund can potentially grow over time so that more gifts can be made to charities in the future. Advisors with clients who are interested in creating a DAF should make the client aware that the DAF cannot "more than incidentally" benefit disqualified persons, which includes the donor, advisors to the donor, family members and 35% controlled entities. Sec. 4967(a)(1). If an excess benefit transaction is found, both the disqualified person and the organization's directors or officers who approved the transaction will be subject to a tax penalty.
So long as the DAF functions appropriately in accordance with Sec. 4966, this giving vehicle may be an attractive solution for clientsespecially those who wish to create a philanthropic tradition within a family. The client is able to designate successor donor advisors who will be able to direct and recommend gifts to charities in future years. By designating children or grandchildren, the client could open the doors for future generations to fulfill and continue the client's charitable legacy after he or she passes away.
Henry knows that the December 31 deadline is looming and he wants to find a way to reduce his 2017 tax bill. Henry likes the idea of setting up a private foundation and wants to encourage his kids to live philanthropic lives. However, he realizes that the time, effort and cost of setting up a private foundation simply does not align with his planning goals this year. His advisor, Mick, suggests creating a donor advised fund with the local community foundation instead. Mick explains that Henry could transfer cash and appreciated property to the DAF and then recommend grants to different organizations without having to go through the lengthy and expensive process of setting up a private foundation. He will receive a charitable income tax deduction for the full value of the assets transferred to the DAF and will be able to avoid capital gains tax on the appreciated property used to fund the DAF. Henry not only likes the tax benefits of this plan, but also sees this as a great way to plant a philanthropic seed in the hearts of his children by naming them successor advisors to the fund.
It is possible that hedge fund managers would like not only to make a charitable gift to offset their taxes this year but also would like to retain an income stream for future years. For these clients, a charitable remainder unitrust is a potential solution.
A charitable remainder unitrust is a tax-exempt irrevocable trust that makes income payments to individual beneficiaries for life, lives or a term of years. After all payments have been made, the remaining trust assets are transferred to one or more designated charities. A unitrust is a popular planned gift because it produces a charitable income tax deduction in the year that the client transfers assets to the trust, allows the client to bypass capital gains tax if the trust is funded with an appreciated asset and also produces an income stream for the client or other selected beneficiaries.
The amount of the deduction will be equal to the present value of the charity's remainder interest in the trust and will depend on the funding amount, the trust's payout percentage and the trust duration. Advisors should be aware that to qualify as a charitable remainder unitrust, the trust's payout percentage must be between 5% and 50% and the present value of the remainder interest must be equal to at least 10% of the trust's funding amount. In addition, the trust must file annual tax returns, submit to annual valuations and be managed by a trustee, which can be an individual, a charity or a corporate trustee, such as a bank or trust company.
Careful considerations should be made when deciding how to structure a unitrust to best fit the client's goals and desires. These considerations include who will receive the unitrust payments (donor or family), which charity or charities will receive the trust remainder, whether to structure it for the lives of the beneficiaries or a term of years, the funding asset (cash, stock, real estate etc.), the payout percentage and the frequency of payments. In addition, the trust payout strategy (i.e., when the trust will begin making distributions) must also be considered as it will cause the trust to be structured in one of three ways: 1) Standard Unitrust; 2) Net Income Plus Make-up Unitrust (NIMCRUT); or 3) Flip Unitrust.
If the trust is structured as Standard Unitrust, it will simply make payments based on the unitrust percentage stated in the trust agreement according to the annual trust valuation. In other words, each year, the trustee will determine the annual payment amount by multiplying the unitrust payout percent by the value of the trust corpus. A NIMCRUT will pay the lesser of the trust's net income or the unitrust percentage, which allows for a certain level of income control and a period of deferred income through selection of growth or income producing assets. If there are excess earnings over the unitrust amount, any shortfall or deficit in the initial years could be paid out. A FLIP Unitrust initially functions as a NIMCRUT in order to avoid making payments from the trust. Then, on January 1 following the occurrence of a specified trigger event (e.g., sale of nonmarketable asset or a set date in the future), the trust switches or "flips" to a Standard Unitrust and begins making payments.
Funding a charitable remainder unitrust before the year is up will enable hedge fund managers to offset taxes that are due on offshore deferred management and incentive fees and also enables them to increase income in future years through the unitrust payments. This plan will allow clients to accomplish family and charitable planning goals through the use of one planned giving vehicle.
Henry knows that he needs an income tax deduction this year to offset the taxes that will be due on his deferred offshore fees. However, he has also been looking into ways to support his favorite charity and receive a stream of income later in life. His advisor, Mick, discussed the possibility of funding a NIMCRUT for the lives of Henry and his wife Sally with some highly appreciated tech stock that Henry purchased many years ago. The stock is currently valued at approximately $5 million. By transferring the stock to the NIMCRUT, Henry and Sally will receive a $1,690,500 income tax deduction and will be able to avoid paying tax on the gain when the trust sells the stock. Because Henry and Sally are both in their mid-60s and are not in need of an income stream at this moment, they plan on investing the trust in growth assets until they reach age 80. At that time, the value of the trust will have increased and their 5% trust payments will be approximately $625,000 with estimated lifetime income from the trust of $9,264,000 over their joint lives.
4. Charitable Lead Annuity Trust
A more advanced strategy for hedge fund managers looking to reduce the tax impact of Sec. 457A is to set up a super grantor lead annuity trust (CLAT) to benefit charity and transfer wealth to family members. By setting up a super CLAT, sometimes referred to as a "defective grantor lead trust," the client will receive a deduction upfront and be able to transfer the trust's remainder value to family members after the trust makes fixed distributions to charity for a specified period of time.
A super grantor lead trust can be conceptualized as the inverse of a charitable remainder trust because the trust makes annual gifts to charity for a period of time and then, after the trust term is completed, the trust assets are distributed to family members. By structuring the trust as a super lead trust, the client will receive an immediate income tax deduction for the present value of the CLAT's payments to charity. This deduction will reduce the hedge fund manager's potentially large 2017 tax bill and will pass on assets to family members at a reduced gift or estate tax cost.
Note that, unlike tax-exempt charitable remainder trusts, a super lead trust that passes the remainder to family will be taxable to the grantor. As such, the trust investment strategy for a super grantor lead trust should be designed to minimize recognition of income during the term of the trust. The drafter of the trust will also need to include a Sec. 675(4) power that does not cause estate inclusion, but does cause the trust to be classified as a grantor lead trust. The preferred retained power is usually held by a non-adverse party to reacquire trust assets. By including this power in the trust document, the grantor will receive an income tax deduction and the trust will be held outside the donor's estate for tax purposes (so long as the donor does not retain a reversion or control over the distribution of income). Sec. 2036(a).
Charitably inclined hedge fund managers who desire an income tax deduction this year and who also want to distribute wealth to family members in the future may find that a super CLAT could fulfill their long-term goals. If the client is facing the end-of-2017 deadline under Sec. 457A, then the advisor should act quickly, but carefully, to ensure that the trust is established before the clock strikes midnight on December 31.
Henry and his advisor Mick have been discussing various charitable strategies to ease the tax burden he will be facing this year. Henry knows that one of his primary long-term goals is to provide financial security for his two children and asks Mick if there is a charitable plan that would generate an income tax deduction and also enable him to transfer a substantial amount of wealth to his children in the future. Mick suggests that Henry consider funding a super CLAT. If Henry were to transfer the $4 million real estate along with $1 million cash to a CLAT that will make a fixed 5% or $250,000 payment to his favorite charities for a 15-year term, he will receive a $3,164,775 deduction and be able to pass the trust's remainder to his children at reduced gift and estate tax costs. Between the tax savings and the trust's estimated remainder value of $6,163,798, Henry will receive the deduction that he is looking for this year and also meet his goal of transferring valuable assets to his children.
Since 2009, the clock has been ticking for hedge fund managers with deferred management and incentive fees held offshore to repatriate those funds and pay applicable taxes at the federal and state level. Section 457A set December 31, 2017 as the deadline for hedge fund managers to recognize as income any offshore pre-2009 deferred fees. Many hedge fund managers have delayed bringing funds onshore in the hope that changes in tax law would relieve them of some or all of Sec. 457A's tax consequences. However, with December 31 fast approaching, many clients are turning to their advisors for a way to soften the tax blow.
Charitable giving is an effective way for these clients to claim an income tax deduction to offset the taxes that will be due on deferred offshore compensation this year. The charitable gift can be crafted to meet the goals of the particular client, whether those goals are financial, familial, philanthropic or a combination of all three. Making an outright gift, setting up a donor advised fund, creating a unitrust and funding a super lead trust are all possible charitable solutions. While these gifts can be closed fairly quickly, advisors should understand that the charitable gift must be complete prior to the end of the year for the deduction to offset 2017 taxes. By making a charitable gift, the clients will not only be satisfied that they have reduced the tax consequences of Sec. 457A, but they feel good knowing they have made a positive impact through their charitable gifts.