How hedge and private equity fund owners can structure employee compensation to keep their superstars

As any astute business owner knows, superstar employees don’t come cheap. But without them, profits and that edge over competitors can be elusive. In the highly competitive world of hedge and private equity funds, how best to compensate premier talent can be both a daunting and complex balancing act.

Two types of revenue streams

In most cases, hedge and private equity funds have two revenue streams.

1. A fee based on the net assets under management (generally, each investor’s capital) is usually charged on a quarterly basis and not tied to profits. Many funds charge 2 percent and call this the management fee. Founder classes or seed money to get funds going are usually charged less. This income is generally sourced to the state of its activity, considered Unrelated Business Taxable Income (UBTI) if received by tax-exempt or pension plan / individual retirement account entities, subject to self-employment tax, and, if received in New York City by a non-corporate entity, subject to the Unincorporated Business Tax. As it is taxed at the highest rate, its cash flow is typically earmarked to pay rent, utilities, payroll, software services and fixed assets such as computers and desks of the fund.
2. A cut of the profits is variously called the carry, incentive reallocation or carve-out. Many funds charge 20 percent and sometimes hurdle rates (such as a fixed percentage or exceeding the federal LIBOR rate) and/or high-water marks (a partner’s historical losses must be recouped first) are used. There are distinct advantages of receiving this incentive reallocation from a partnership entity to a partner. If classified as a share of a partnership’s income as opposed to a payment to an outside consultant, the profit attributable to unrealized taxable gains is not taxed currently and the partner is able to take advantage of the lower tax rates associated with capital gains and qualifying dividends (currently taxed at a highest federal tax rate of 20%). One downside if the fund is classified as an investor fund as opposed to a trader, the expenses of the fund (such as professional fees) will be classified as a portfolio deduction only deductible to the extent they exceed 2 percent of an individual’s Adjusted Gross Income (AGI) and generally are not deductible for those who end up paying Alternative Minimum Tax (AMT) – so pass-through of those expenses could have no benefit to the carry vehicle partner. Most states have a “trading for your own account exception” for purposes of sourcing so, with exceptions pertaining to sourced income such as loan origination fees, real estate or oil and gas royalties, this income is sourced to wherever the partner resides. Generally, this second stream of income would also not be considered UBTI unless the fund has sourced income or uses leverage. This second stream and its advantageous tax treatment under current law is one area constantly under threat of tax reform, albeit that threat has been looming for decades without actually materializing. In recent years, high performers and senior personnel are getting a cut of this stream, where in the past it was usually kept solely with the fund’s founders.

Employee vs. partner

Paying an employee a compensation bonus at year-end through a Form W-2 from the profits of the management company partnership would be the most effective way to reduce profits of the company that are subject to the self-employment tax (though, through structuring options, there are ways to minimize the amount of income subject to that tax) and, if New York City based, the Unincorporated Business Tax. Doing so would reduce the taxable income of the existing partners. If the management company uses the accrual method of accounting, the company could accrue these bonuses at year end and not actually pay out the cash for up to 75 days into the following year. This delay would not only help with cash flow but also in pinning down the actual profitability of the company. In the past, these management companies were typically on the cash basis method of accounting to take advantage of the pre-2009 deferred compensation rules as they pertained to income from foreign investors indifferent to the current deductibility of either stream of fees, a benefit that has largely been eliminated with the implementation of Internal Revenue Code (IRC) §409A and 457A which will be discussed later. Keep in mind that an accrual-based entity cannot take an accrued expense if a cash basis related entity does not pick up the income at the same time under IRC §267. This is often overlooked when a fund pays its management fee at the end of the quarter as the management company must pick up the income even if it is not yet paid for the fund investors to be able to take the expense currently. If the employee is already a junior partner of the management company, they could also be paid a guaranteed payment bonus that would act the same way in that it would be deductible to the remaining partners when the junior partner recognizes the income.

Instead of paying an employee a compensation bonus, they could also receive a partnership interest in either stream. Tax consequences of receiving a profits partnership interest or a capital partnership interest differ in that the fair market value of a capital interest is taxable as consideration upon its reward (that is, if the partnership liquidated the next minute, what would the new partner get), whereas a profits interest would generally not be taxable until a share of taxable income is earned. To prevent future disputes, partnerships should consider having a valuation done to quantify the value of the capital interest being awarded and signed off by both the giver and the recipient. How much say, if any, in partnership management should be considered and clearly delineated in any such grant of interest to a new partner? If structured as a profits interest, sometimes “catch-up” provisions are used so that an interest granted a couple of years into the life of the fund will end up getting a fixed percentage of the profits of the life of the fund even though they didn’t participate at first. This generally would be used in the private equity world more than hedge funds. When receiving a profits interest, the recipient should make a protective IRC 83(b) election in the event that it is later determined that the interest is actually partially or completely a capital interest. This would give the recipient capital gain treatment forward from the time of the election (with the exception of any sale proceeds being allocated to hot assets as defined under IRC §751 – unrealized receivables and inventory) and not have any later sale be classified as all compensation. To help the argument that it is a profits interest and not disguised compensation, the partner should get some sort of voting rights (the more significant the better).

In either case, the cost and sometimes years of frustration caused by litigation can be tremendous so it’s in the best interest of everyone in either case to properly document what is on offer and how future disputes are to be settled. Valuation upon someone leaving either voluntarily or involuntarily, for instance, can be especially contentious when thinly-traded, Level 3 assets or the value of a company’s goodwill / brand name are involved, so exit clauses are essential.

Commonly overlooked issues with partnership interest grants by the employee

Despite the obvious cachet of being named partner, transitioning from employee to partner can have consequences the employee should consider before making that jump. New partners will now be receiving a Schedule K-1 and not a Form W-2 and, therefore, they will become responsible for payment of their own Social Security and Medicare taxes as well as any federal or state income taxes. Their tax returns are likely to become much more complex and may necessitate filing in multiple states and being responsible for making estimated tax payments to multiple jurisdictions – additional accounting fees to prepare their returns may not be anticipated especially if they are receiving a rather minor limited partnership interest. Receiving a partnership interest in either the entity receiving the carry or the management fee can both trigger additional state compliance as states grow more and more aggressive in seeking fees from management fee vehicles through the implementation of market-based sourcing rules and economic nexus. If foreign entities are used, additional forms may need to be filed that failing to do so could incur hefty fines – though there is often relief if certain size thresholds are not met.

Partnership distributions may not mirror taxable income – whether tax distributions are made should be considered as cash flow, especially in the private equity world, can be a real concern. Also, coverage for medical insurance and retirement plans is likely to change as the rules differ for partners versus employees.

As a limited partner, a partner is generally only liable to the extent of his or her capital account (acceptance to a general partnership suddenly exposes the new partner to all liabilities of the partnership), but any capital the limited partner contributes is now an asset of the partnership and could be liable in any lawsuit brought forth, possibly from an event that transpired before the limited partner was even part of the company. Oftentimes, a new limited partner is not required to contribute any capital but that can have its own consequences. To strengthen the argument that both the carry entity itself in the fund and each partner of the carry entity are indeed partners and not paid as outside consultants or advisors, most attorneys and accountants advise partners to have capital at risk. Classification as an outside consultant would lose all the beneficial attributes of being taxed as a partner – not paying tax on the unrealized gain and lower tax rate for long term capital gains and qualifying dividends mentioned above. From the fund standpoint, having partners put their own money in the fund obviously is more encouragement for the fund to do well. However, from a risk standpoint, many fund managers take money from the carry vehicle which is usually classified as the general partner and move it to limited partner interests if they want to keep the money in the fund and not diversify their holdings. Possibly this move will prevent loss of their investment as limited partners if one member/partner of the general partner carry entity commits malfeasance.

Under the new partnership IRS audit rules that begin on years starting after December 31, 2017, partnerships with less than 100 partners and no pass through entities as partners can opt out of the new rules. One of the main benefits of opting out is that new partners could avoid the possible assessment of tax and penalties for previous transgressions that the IRS discovers now. Under the new regulations, the partnership and, therefore, current partners would have to pay the assessed tax for prior years now. If, however, the management company partnership or carry partnership did not opt out, a new limited partner to either entity could end up being penalized for activities that happened before they were partners. Curative allocations could be done to allocate such penalties to partners who were around at the time of the year being adjusted but a new limited partner could possibly have no say in whether those curative allocations had to be done and it might be of a significant enough size that, even if curative allocations were done, it might take a few years to even things out because of cash flow or smaller income in the current year.

Privacy and control of information concerns of existing partners

Even if limited partners are given no voting or governance rights, owners of a partnership interest can gain access to the partnership tax return. Despite using side pockets or tranches to isolate a limited partner’s share to a particular revenue stream, managing partners may not want to give access to overall numbers to a junior partner. Not giving them a copy of the tax return won’t necessarily prevent a junior partner from seeing the partnership’s overall tax situation as, being a partner, they can request a copy of the tax return from the government. Elevating an employee to a partner also elevates their authority to act on behalf and represent the entity – if malfeasance were to occur, it’s the possible the partnership may be more liable when a partner commits the act as opposed to an employee.

If a foreign partner were granted a partnership interest, withholding on the income might be due by a domestic partnership. The same might be true of states, even on a domestic partner who lives in another state. These are items to consider before admitting a partner who may not work or reside in the same area as everyone else.

Also to consider for the founding partners of a fund before admitting anyone new as a partner is the long term goal of the partnership. If they ultimately want to sell the entity, it will be easier and probably more lucrative to not have junior partners to redeem out or receive consent from regarding a sales price. Obviously, in the infancy stages of a fund, cash flow may be a concern and offering a partnership interest as a bonus may be the only way to compensate a high performer.

Entities organized as subchapter S corporations

Subchapter S corporations can be used instead of partnerships to receive either stream of income. If the shareholders receive a wage equal to their market value, the remaining profit has the benefit of not being subject to the self-employment tax.

Many companies, rightly or wrongly, place market value at near to the maximum wage subject to Social Security tax ($127,200 in 2017). Management companies structured as limited partnerships to minimize self-employment tax often do the same by giving a guaranteed payment equal to the same limit and arguing the remaining amount going to limited partners is a share of ownership-type profits and not in lieu of salary.

S corporations are also not subject to the new partnership rules that begin on January 1, 2018 that may have the effect of penalizing current partners for previous partners’ sins (many of these partnerships, however, may have the option to opt out of the new rules because of their small size). But S corporations are restricted on who can hold shares – non-resident aliens, corporations and partnerships cannot. Also, S corporations can only have one type of share and allocations must be done based on shares. Side pockets and benchmarks can be used in a partnership.

Bonus tied to individual performance versus fund overall

To motivate company stability and ensure investor loyalty, generally most funds will want to align the interests of their employees with those of their customers. Whatever form the employee bonus grant takes, funds need to bear in mind the rules and regulations imposed by the Investment Advisers Act of 1940, the Commodity Exchange Act, the Dodd-Frank Wall Street Reform and Consumer Protection Act, as well as various data protection laws.

Tying an employee’s chance for a bonus to solely his or her own portfolio’s performance and not to the fund overall can have some adverse results. It can incentivize high risks, possibly cause disputes over resources (researchers or research information, where to spend money to find deals, marketing, use of limited capital) and possibly cause unhealthy relationships with other employees managing separate portfolios that all fold up into one fund.

Example: Before upper management can become aware of the issue, lack of communication could cause two traders to bet opposite sides of the same position unintentionally, which can cause adverse tax consequences such as deferment of recognizing realized losses on wash sales and straddles as tax law applies to the partnership as a whole and not on each trader’s portfolio.

Example: Two traders could double up on the same positions and put diversification at risk.

On the other hand, a high performer won’t feel bogged down by other’s bad performance and feel like all their successes lead to no accompanying reward. If a fund is employing a variety of portfolios with some used just to manage risk, this might even be a rather unfair approach depending on which side the employee is called on to manage. A middle ground can sometimes be achieved by instead having bonus pools an entire team will participate in. Any of these can be discretionary at the will of the managing partner or be fixed on ascertainable benchmarks.

Hurdles and high-marks can be used in calculating bonuses similar to those used in calculating the carry of a fund. Complications to consider, which actually apply to the carry as well, are numerous. If the fund is actually down but clears the hurdle, are employees compensated? And what with if there are no profits – is another revenue stream, possibly the management fee, tapped? Should the bonus payable percentage be carried forward? If instead it is carried forward until there are profits, what if the employee leaves? Does the answer change if the employee dies or becomes disabled?

Also to be considered when deciding what benchmarks or hurdles to use is how often money can be withdrawn from a fund. Many hedge funds allow quarterly or monthly withdrawals which may put undue emphasis on short-term results and not enough on the long term. This may limit what traders or portfolio managers are willing to invest in. Obviously, in the private equity arena, this may be less of a concern because withdrawals may not be allowed for years or until a realized event occurs. But, of course, the opposite could be true – betting on something long-term when investors are impatient for more immediate returns.

Restrictions imposed by Internal Revenue Code §409A and §457A

To defer recognition of taxable income and keep employees invested in the long term health of a fund, many compensation arrangements make use of some sort of deferral element. Some firms designate only high earners or holding certain positions as being able to defer. A floor is usually set below which compensation cannot be deferred. But to do any of it, two Internal Code Sections must be considered.

Until implementation of IRC §409A and IRC §457A, hedge and private equity managers had the ability to defer their share of carry, and sometimes management fee, on foreign investors and/or U.S. tax exempt investors for ten years or more (when using “back to back” arrangements). This also kept managing partners from paying tax currently on this deferred income that was earmarked for future employee bonuses with pre-tax moneys. Employees were sometimes offered this benefit as well on a pre-tax basis, allowing their future compensation to rise as the foreign fund thrived. Beginning after 2008, the form of this deferral was changed and “substantial risk of forfeiture” was then required to continue to defer, meaning if the money was essentially guaranteed it needed to be picked up in taxable income currently. Grandfathered plans were required to bring money back into income by 2017. If income needs to be included under IRC §457A, it is taxed currently and loses its intended deferral. In distinction, violation of IRC §409A also incurs current taxation but adds a 20% penalty and a premium interest charge. One exception to these rules is provided in the case of short-term deferrals – once a bonus or fee is no longer subject to a substantial risk of forfeiture it must be paid within 2 ½ months  of year end (March 15 by calendar year entities). Also, under IRC §457A starting in 2009, offshore funds (and certain onshore) could no longer pay a fee more than 12 months after the close of the year in which the services were performed without incurring the 20% penalty and premium interest charge.

Complicating matters further, not all countries have similar rules to the United States. So if funds have offshore employees, there might be other issues to deal with. Though most states conform to the U.S. laws on these topics, fund managers should check if all the states they receive income from or employee people in do as well.

Vesting: pre-tax dollars versus post-tax dollars

To keep star employees tied to the long term health of a fund and make it harder for them to leave for greener pastures, their compensation is often tied to a vesting schedule.

If the bonus is deferred pre-tax, current management company partners must pay taxes on the compensation not being currently expensed – but they will get a deduction in the year it is paid. Pre-tax deferrals are, however, the easiest way to retract if an employee fails to fully vest or forfeits their compensation for any reason. If the deferred bonus is allowed to grow by tying it to the performance of the fund, the partners may want to make an equal investment in the fund to hedge against significant appreciation. A mismatch of cash flow occurs in such a scenario with the partners. They must invest post-tax funds in the hedge and pay tax currently on the appreciation of such a hedge until the offsetting compensation is paid off. One way to mitigate the impact of this mismatch would be to adjust down the appreciation side of the employee to post-tax, that is if the appreciation is 10 percent and the partners tax rate is 40 percent - give the employee’s deferred bonus only an appreciation of 6 percent (10% * (1 – 40%)).

Post-tax bonuses that are required to be reinvested in the fund give current partners a deduction, but also tax the employee currently on amounts not yet fully vested. This can be mitigated by tax distributions. Required reinvestment forces an employee to continue to have skin in the game and contribute to the firm’s success. If large enough, the amounts might even have an effect on the fund’s ability to continue to find new deals and perpetuate the fund’s life. Typically, required reinvestment is done through a separate entity that invests in the fund so that later disputes are handled at its level and not at the fund’s to keep investors ignorant of such conflicts – this can also help in meeting the ��accredited investor” and “qualified purchaser” exception thresholds offered by the Securities Act of 1933 and Investment Company Act of 1940, though with the expansion of “knowledgeable employees” by the Securities and Exchange Commission in 2014 this may be less of a concern.  Whether or not these funds are subject to expenses of the fund and redemption restrictions that other investors share should also be considered. By putting these partners in another entity they are also probably not able to participate in the management of the fund and voting.

Pre-tax is generally better for the employee, post-tax perhaps better for the partners but it requires a lot more work with tax distributions and possibly an additional entity to form and file tax returns for. Also pre-tax is usually achieved with a single document whereas post-tax with required reinvestment necessitates vesting schedules and forfeiture conditions addendums to the limited partnership or limited liability company agreement.

Vesting: cliff versus graded

The two types of vesting generally used are cliff and graded (or serial). Cliff has the full amount of compensation vesting all at once on a single future date with forfeiture usually occurring if the employee leaves beforehand through resignation. The more common graded has a percentage vesting on a certain date over a certain time period (for example: one third vesting each December 31 over the next 3 years – up to 5 years is the period used by most in the industry) with the unvested portion usually being forfeit if the employee leaves. However, in both cases, the effect of death, disability or termination without cause should be addressed in the compensation agreement. Typically an employee must be in good standing with the firm when receiving this vesting. Obviously, if a new employer matches or exceeds any lost deferred compensation because it hasn’t vested when he or she leaves, using this tool as a way to retain high performers is less effective.

Incentives to leave on good terms and paying out retiring partners

Despite most employment arrangements being “at will,” to encourage employees or partners who leave a fund to do so on good terms, sometimes severance packages are offered in exchange for those leaving to sign covenants pledging non-competition, non-solicitation of investors or employees, non-disparagement and/or non-disclosure of confidential, proprietary or trade secrets.

To pay out a retiring partner, sunset distributions might be used (which are typically only available for partners who have been with a firm for certain amount of time). Instead of buying out a partner in good standing which would result in no deduction for the remaining partners, the retiring partner could receive a declining interest in net management fees or the carry over a number of years which would give less taxable income to the partners that will remain in each of those years but achieve the same ultimate result. In such an arrangement, the retiring partner is usually given a corresponding lesser share of proceeds from a possible partnership sale with each year. Such sunset distributions can be similar to the severance packages listed above in that they can be a bonus for those leaving who do not compete, solicit employees or investors, etc.

“Faithless servant” doctrine

The term clawbacks generally refers to some sort compensation being taken back that might be unvested or vested and still not paid, but can even apply when payments have been made in certain cases. Any clawbacks implemented must be cognizant of the “faithless servant” doctrine and how it applies. The “faithless servant” doctrine says that if an employee’s material and substantial misconduct violates his or her contract of service or if he or she has engaged in misconduct that constitutes a breach of the duty of loyalty or good faith, the employer can recover compensation already paid. However, not all states follow this and interpretation can vary even in states that do. Connecticut, Florida and Rhode Island have all rejected the doctrine. What can further complicate matters is choice of law issues. What happens when the partnership is organized in Delaware, does most of its business in New York but has a dispute with a trader who lives in Connecticut? What state’s rule presides? When drafting employment contracts and partnership agreements, these issues should be addressed. Recovery of payroll taxes and who’s responsible for that can be especially burdensome in such cases when clawbacks are implemented.

Other clawbacks

How clawbacks work varies dependent on what revenue stream pays them and whether the employee is to receive a partnership interest (and no longer be an employee but now a partner) or just compensation.

Pre-tax clawbacks which would be classified as compensation that has not yet been paid would generally have no issue since neither side has taken the deduction or the income into taxable income.

A partnership interest in the management company that does not end up vesting that is allocated income in years before full vesting presents problems that to date have not been resolved by any authoritative guidance from the IRS. Under Revenue Procedure 2001-43, allocating profits to a profits interest in the first year is necessary even if the partner does not vest until year two to argue that the partnership interest grant is a profits one and not a capital interest. In the year of the forfeit, the remaining partners could have ordinary income for the interest they receive from the partner that did not vest. Presumably the unvested partner would probably receive a capital loss on its lost partnership interest and the remaining partners would receive ordinary income to the extent they receive the unvested partner’s interest in the partnership. However, this result is also an unresolved area of law and taxpayers have been waiting years for the IRS to provide guidance in this area. 

Profits interests in the carry vehicle that vest over a number of years can be more complex. In the private equity world, it may take a number of years to earn a carry and, therefore, if the carry is not earned before an unvested interest is forfeited, there is probably no effect. If the private equity entity is paying carry currently when granting a profits interest that would vest over a couple of years or in a typical hedge fund that is profitable, the answer becomes more difficult. If a graded vesting is used, where the new partner is entitled to 1 percent of profits in year one, 2 percent in year two, etc., the ungraded and unvested profit percentage is simply forfeit. If, however, the new partner would be entitled to a cliff vesting 5 percent of the profits in year one if he or she stays two years, the partner would have to pay tax on the full 5 percent of profits in year one to argue that the interest was a profits interest. If that 5 percent is forfeited, curative allocations can be used as in the management company. However, the character may end up different as carry vehicles often do not generate any ordinary income and losses are sometimes classified as portfolio deductions that must exceed 2 percent of Adjusted Gross Income to be deductible. Partners that remain may not be too concerned about a departing partner and the departing partner may negotiate that their new employer help with the mismatch, but both should be aware of the mismatch when offering multiple year vesting in a carry vehicle generating current profit.

Clawbacks of post-tax compensation with required reinvestment, if done and allowed by local employment law (since payroll taxes will have been paid) should probably be done post tax as well to avoid disputes over recapture of payroll taxes, income tax withholding and tax distributions. Forfeitures in these cases, however, seem ripe for litigation and should probably be avoided.

Options

Options on a partnership profits interest generally have no increase in value prior to exercise and don’t seem to fit the hedge and private equity fund model. Options on a capital interest are treated like a stock option but do not qualify for capital gain treatment. However, private equity companies that operate as LLCs with membership interests cannot sponsor employee stock ownership plans (ESOPs), grant stock options, or provide restricted stock corporations, or otherwise distribute to employees actual shares or rights to shares. Instead of implementing options, most funds choose to issue profits interests.

Other perks

Retirement plans with employer matching, medical insurance, life insurance and other perks such as generous expense accounts or company vehicles can be offered as well to star employees. These have various issues and drawbacks that are outside the scope of this article, but keep in mind that the treatment of items such as retirement plan contributions and medical insurance expense are different for an employee versus a partner and one cannot be both. For instance, often a partnership will continue to pay a partner through compensation on a Form W-2 to make sure the partner withholds enough income taxes each year, but this is not correct and, if audited, the IRS could disallow the partnership a deduction for its share of the payroll taxes and any medical insurance paid on the partner’s behalf.

Conclusion

Losing a superstar employee and having to spend time and resources to replace them, often without a guarantee of their replacement’s equal ability, can be a very costly endeavor. So the incentive to keep them happy and earning for a fund is considerable. Through uses of vesting and clawbacks, there are ways hedge and private equity funds can competitively compensate their top performers while still maintaining some control of the future. Depending on the fund’s trading strategy, type of investments and long term goals, bonus packages can be tailored to satisfy both parties.

For more information on compensation of hedge and private equity fund partners and employees, or to learn how Baker Tilly asset management industry tax specialists can help, contact our team.

The information provided here is of a general nature and is not intended to address the specific circumstances of any individual or entity. In specific circumstances, the services of a professional should be sought. Tax information, if any, contained in this communication was not intended or written to be used by any person for the purpose of avoiding penalties, nor should such information be construed as an opinion upon which any person may rely. The intended recipients of this communication and any attachments are not subject to any limitation on the disclosure of the tax treatment or tax structure of any transaction or matter that is the subject of this communication and any attachments.