Sophisticated Risk Management and Tax Planning for Hedge Fund Managers
Hedge funds and their principals have amassed great fortunes over the last twenty years. This trend will likely continue as many hedge funds sitting on piles of cash are also becoming private equity firms taking control of well known publicly traded companies.
Hedge funds frequently operate with a small number of highly skilled and compensated employees and staff. As a result, these funds are exposed to large amounts of taxation at the individual rates of the principals (owners) of the hedge fund. In the New York tri-state area (where the majority of hedge funds are located), these rates can approach 40% to 48%.
Virtually all hedge funds are structured as pass-through entities such as Limited Liability Companies or Limited Partnerships. Most hedge fund complexes operate their strategies with a domestic fund and an offshore fund for foreign investors and U.S. tax-exempt investors. The hedge fund investment management firm operates as the fund’s general partner or managing member. The hedge fund’s compensation is structured as an annual management fee of 1% to 2% per year and a performance fee equal to 20% to 30% of the fund’s return.
IRC Sec 409A was added in 2009 limiting the ability of hedge fund managers to structure deferred compensation arrangements for their “carried interest” associated with the offshore fund. These offshore deferrals must be repatriated before December 31, 2017. In the interim, hedge funds no longer have the ability to defer income in either the Fund’s domestic or offshore funds. More importantly, hedge funds no longer have any opportunity to defer management fees and carried interest. Moreover, a qualified retirement plan is of marginal benefit to a high income hedge fund manager.
What are Captive Insurance Companies?
A captive insurance company is an insurance company that insures all or part of the risk of its parent company. The biggest catalyst in the development of captive insurers has been the expense or lack of availability of certain types of insurance in traditional commercial insurance markets.
The hedge fund captive insures risks that are excluded from commercial property and casualty coverage or under-insured. The captive may cover the deductibles on existing property and casualty coverage as well as low risks that are currently self-insured.
Hedge funds generally unlike other businesses have yet to integrate captive insurance arrangements as part of the investment management firm’s risk management program. Recent years have also shown that legal claims against hedge funds can be very substantial.
Mini-captives take in less than $1.2 million of premiums annually. This captive may make an election under Section 831(b). Under that section, the Mini-captive is not taxed on premium income but only the captive’s investment income. This type of captive must have a minimum of at least $350,000 in annual premiums to qualify for these tax benefits.
Differences in Jurisdictions for the Hedge Fund Captive
A captive may be formed in a U.S. state or in an offshore jurisdiction such as Bermuda or the British Virgin Islands (BVI). Issues for “domicile” selection facing the captive include the following:
- Permitted Assets. Different jurisdictions have different standards as to what types of investments may be used for reserves (liabilities). Some jurisdictions recognize 100% of the value of certain investment assets used for reserves while another jurisdiction will only recognize a lower percentage of the same asset class. A hedge fund manager thinking of investing in hedge funds should place significant value on this issue in determining the domicile of the captive. This issue is also a factor in capitalizing the asset with appreciated assets. Even in Delaware it is possible for a captive to invest up to seventy percent of its assets into the hedge fund manager’s funds.
2. Conservatism. Newer jurisdictions are generally expected to be more flexible in regulation in order to attract captive insurance business. A more established jurisdiction may be more inflexible in regard to permitted assets and the type of coverage that the captive may underwrite.
3. Records and Meetings. Some domiciles require the captive to maintain records in the domicile. In the case of an offshore jurisdiction, this type of regulation may actually be favorable for the captive owner to protect the captive’s documents from disclosure and discovery. Some domiciles require annual meetings in the domicile while others do not.
4. Licensing Fees and Premium Taxes. All domiciles charge licensing fees which vary from jurisdiction to jurisdiction as well as renewal fees. Some jurisdictions charge premium taxes. These costs are additional factors to consider.
As far as domestic jurisdictions are concerned, Vermont has traditionally been the domicile of choice. States as Delaware Utah, South Carolina, and Hawaii are competing aggressively for this business. The advantage of an offshore jurisdiction for the captive generally centers on the lower amount of bureaucracy and regulatory flexibility. An offshore jurisdiction provides the captive owner with greater asset protection and greater investment flexibility within the captive. However, Delaware has emerged as an excellent option for captive insurers as it offers the ability to use its series limited liability company statute for captive insurers.
How Does the Hedge Fund Captive Work?
The hedge fund captive is an insurer domiciled in Delaware or offshore jurisdiction such as Bermuda or the British Virgin Islands (BVI). The offshore captive can make an election under Section 953(d) to be treated as a U.S. taxpayer for tax purposes. Depending upon the level of expected premium, the captive will make a Section 831(b) election that will not tax the captive’s premium income under $1.2 million per year.
Delaware with its Series Limited Liability Company legislation has adopted state of the art captive legislation. The ability of the Delaware captive to create Small Business Units (SBU) in separate series of the LLC creates a unique opportunity for a business owner to create multiple captive arrangements. These SBUs provide the hedge fund captive with the ability to bifurcate risks not only on the basis of “low risk” and “high risk” but also from the standpoint of ownership by different Principals within the hedge fund ownership structure as well as the IRC Sec 831(b) limits.
Joe Smith, age 45, is a managing director of a hedge fund, Acme Asset Management. Smith has a personal net worth of $20 million. He has generated most of this wealth over the last ten years due to the success of his funds. Joe is married with two children. Each fund strategy features both a domestic and offshore version of the fund.
He created an irrevocable life insurance trust (ILIT) three years ago for estate planning purposes. The trust has a corpus of approximately $1 million. Joe would like to maximize wealth accumulation and distribute as much of his wealth as tax efficiently as possible to his heirs.
The fund has significant income due to management fees and performance fees. After bonuses to employees, Acme has $3.5 million of taxable income that is taxed at a 47% rate.
Joe would like to minimize the income tax liability associated with his funds and accumulate funds on a more tax-advantaged basis beyond the reach of his personal and corporate creditors.
Joe creates a Delaware captive insurer called Hedge Insurance Company (“Hedge”).
The shares of the captive will be owned by the Smith Family Irrevocable Trust, a Delaware Trust. The shares will not be subject to the claims of Joe’s personal creditors. Furthermore, the value of the shares will not be part of Joe’s taxable estate for federal estate tax purposes.
Joe allocates 33 percent of the shares to his Chief Operating Officer, Chief Financial Officer and General Counsel equally.
Acme Captive Management established the captive and will administer the captive’s administrative operations. Acme performed a feasibility study analyzing First Philly’s current coverage to determine risks that are either self-insured or under-insured. Acme’s feasibility study identified the risks below and designed coverage for the company’s identified risks. The outline below details the coverage and premiums.
Acme Risk Assessment and Coverage Proposal
The description of new coverage is as follows.
a.State or Federal Legislative Changes..
b. Directors and Officers Liability Insurance.
d. Inability of Insured Employee to Work.
e. Business Litigation Matters
f. Detrimental Code.
g. Data Breach Liability..
h. Changes in U.S. Tax Law.
i. Loss of a Significant Investor
Acme structures the captive insurer into three different SBUs. One SBU is designed to provide reinsurance for a Fronting Company insuring some higher risk exposures. A second SBU will be owned by the Smith Family Trust and lastly, a third SBU will be owned by the firm’s COO, CFO and General Counsel. Each SBU will make its own IRC Sec 831(b) election. Under IRC Sec 831(b) up to $1.2 million of premium underwriting income is not subject to corporate taxation. Only the SBU’s investment income will be subject to taxation.
Acme will receive a full tax deduction for its annual premium payments to the captive of $3.6 million to each of the SBU’s.
Acme will allocate 70 percent of each premium payment as a capital contribution to each trust to a Delaware LLC. The captive will own all of the preferred interests which have a preferred return equal to at least the long term applicable federal rate. The common interests in the LLC may be owned by family members or a family trust. The preferred equity holder (the captive) holds voting control, preferred liquidation rights and a preferred cumulative return. The common equity holder is entitled to any excess return above the preferred return.
The LLC structure will allow the hedge fund manager to legally circumvent the conservative regulations regarding permissible investments. The hedge fund manager may allocate 70 percent of each premium payment as a capital contribution to the LLC. The LLC may reinvest these funds back into the hedge fund manager’s funds.
The hedge fund captive strategy delivers a combination of significant tax benefits. The premiums are fully deductible for income tax purposes. The captive will be not be taxed on premium income and only investment income in the event of a Section 831(b) election.
The captive’s surplus may be reinvested in the hedge fund manager’s funds at a lower tax rate than the hedge fund manager’s own tax bracket. The captive and its assets will not be subject to the claims of the hedge fund manager for asset protection purposes. The captive and all of its future growth can be arranged so that it will not be part of the hedge fund manager’s taxable estate. Dividends can be paid as qualified dividends at a preferential rate. The captive can ultimately be sold or liquidated at long term capital gains rates. The captive itself can be owned outside of the taxable estate. Premium payments to the captive are not treated as taxable gifts.
The captive insurance structure is the best integrated risk management and tax planning tool available to hedge fund managers.