The IRC Section 409A regulation will require hedge fund managers to pay tax on compensation deferred offshore to the extent that they do not comply, along with a 20% penalty and interest. For some funds, deferred fees will fall into this category.
“In the case of some hedge funds, performance fees and management fees are deferred and paid later into an offshore account – particularly in the case of illiquid investments, where fees cannot be charged up front, and instead will be charged when the investment is liquidated, as with side pockets,” says David Simonetti, senior manager in Grant Thornton’s compensation and benefits group. “The management fees on side pockets are often accrued and paid upon the investment’s disposition and, under the new regulation, such a structure could potentially violate the new requirements.”
Simonetti says managers are still unclear as to how to tackle the issue, and in some instances, might not even be aware of the regulation. “At the moment there are rough guidelines as to what will be considered deferred compensation and managers are supposed to be complying with these rules in good faith until the regulations become effective next year. Many smaller hedge funds are concerned about the impact, and don’t have the infrastructure to deal with the regulation.” Simonetti says larger funds should also take heed. “Often, larger funds don’t ask for management fees upfront because they are of the size where it is not essential to have the money straightaway. That could be taxable if not structured to comply with the new rules.”
Simonetti suggests that managers should make investors pay management fees on an annual basis with respect to those fees associated with side pockets in order to avoid being subject to the new regulation. It is still unclear, however, how incentive fees will be affected.
