Overview

The addition of IRC Sec 457A effectively ended the ability of investment managers to defer the tax recognition of the carried interest in the investment manager’s offshore fund. Under IRC Sec 457A, hedge fund managers must repatriate the offshore deferred compensation not later than December 31, 2017. Who knows the total amount of capital that has been growing on a tax deferred basis over the last two decades? $50 billion?  IRC Sec 457A effectively eliminates the ability of investment managers to enter into deferred compensation arrangements with their offshore funds going forward.

Undoubtedly, those hedge fund managers with the deferred offshore carried interest problem have been waiting for a last minute miracle. As on the moment, no tax miracles have seemingly fallen out of the sky. The problem of substantial deferred compensation is an insidious one as the income is taxed as ordinary income and also subject to estate taxation. A New York hedge fund manager could ultimately be looking at the erosion of 70-80 percent or more of this wealth.^[1] When the generation skipping transfer tax is added into the calculation mix for the New York City resident hedge fund manager, that number can exceed 90 percent. IRC Sec 457A really deals with two problems. Problem #1 deals with existing deferrals that must be repatriated and Problem #2 deals with the inability to no longer defer the carried interest.

Big Four accounting firms and the tax departments of the large law firms that represent hedge funds and their principals have been in active pursuit of a tax solution.  In the current interest rate environment, the charitable planning giving solution known as the Pooled Income Fund (PIF) emerges as a powerful solution to address both problems. The Charitable Lead Annuity Trust (CLAT) is a sophisticated solution that has been proposed by some law firms. [2]The CLAT is designed as a grantor trust for a term of years with a payment structure that is back-end loaded over the term with a percentage increase each year over the term of years. The contribution and payout is structured so that the amount of income deduction is equal to the contribution. The deduction threshold is 30 percent of adjusted gross income with the ability to carry forward excess deductions for an additional five tax years subject to the 30 percent of AGI deduction threshold.[3]

The CLAT is designed to that the underlying CLAT investment is within an investment LLC with preferred and common membership interests. The trustee of the CLAT contributes trust corpus in exchange for preferred units in the LLC. The taxpayer’s family trust contributed capital to the investment LLC in exchange for common equity membership units. The preferred units receive a preferred cumulative return. The common equity units receive the investment return in excess of the preferred return. The LLC manager has the option of purchasing private placement life insurance (PPLI) as an investment vehicle to provide tax-advantaged wealth accumulation within the LLC. The manager is able to make tax-free distributions to the trustee of the CLAT in order to make CLAT payments.

The PIF has long been considered obsolete and ineffective in the planned giving world. Most tax exempt organizations cannot seem to liquidate their existing pooled income funds quickly enough. This article addresses certain attributes which make PIF as an ideal solution to address the two problems outlined above- (1) How to repatriate deferred offshore carried interest and (2) How to defer carried interest going forward? The results are surprisingly beneficial when compared to the PIF’s tax cousins, the charitable lead annuity trust (CLAT) and Charitable Remainder Trust.

Section 457A—An End to Deferral for Offshore Carried Interest -

The Emergency Economic Stabilization Act of 2008 ended the not-so-well-kept secret of hedge fund managers’ deferred compensation arrangements with their offshore funds—what the New York Times described as “Big IRAs” for the super-wealthy.^[4

A reporter recently told the author that the estimated amount of offshore carried interest is in excess of $200 billion, based on a review of materials from the Joint Committee of Taxation.^[5] The addition of Section 457A effectively ended the ability of investment managers to defer tax recognition of the carried interest in the investment manager’s offshore fund. As noted above, under Section 457A, hedge fund managers must repatriate the off- shore deferred compensation no later than December 31, 2017.

What is a Pooled Income Fund (PIF)?

IRS statistics in 2012 demonstrate the scarcity of pooled income funds on the tax planning landscape. As of 2012, charities filed tax returns for only 1,324 PIFs.^[6] Seventy five percent of the PIFS had assets of less than $500,000.^[7]

A pooled income fund (PIF) is similar in many respects to a charitable remainder trust. Pooled income funds were traditionally the planned giving option for donors making smaller contributions that did not warrant the creation of a charitable remainder trust (“CRT”) due to cost considerations and the complexity of trusts. In many respects, it was the equivalent of the CRT for non-high net worth taxpayers.

In recent years, pooled income funds have fallen out of favor with planned giving professionals and public charities as a result of the promotion and popularity of other planned giving strategies such as the CRT and charitable lead annuity trust (“CLT”).

The planning utility with respect to new pooled income funds escapes the attention of most taxpayers and their advisors. The PIF seeks to exploit the fact that the low interest rate environment with respect to the IRC Sec 7520 rate has dramatically decreased the income tax benefits of CRT arrangements. The CLAT has the disadvantage of the payment of the income interest for a term of years or the taxpayer’s lifetime before the remainder interest reverts to the taxpayer. Furthermore, cash contributions to the CRT or CLAT still face the 30 percent of adjusted gross income (AGI) deduction threshold limitation.^[8]

Under the proposed arrangement in this article, the donor, a hedge fund manager or principal in a hedge fund, contributes his repatriated carried interest to a new PIF receiving a much larger income tax deduction than a CLAT or CRT while providing for investment management for the PIF assets. The investment management function can be further enhanced through the creation of an investment LLC that features common equity and preferred LLC interests. Lastly, private placement life insurance (PPLI) might also be included as an investment asset within the LLC.

In the PIF, the donor receives income for his or her lifetime, with remainder to charity. The unique aspect of the PIF is that it allows investments to be combined or "pooled" with the gifts of other PIF donors. However, as this analysis will support, the Internal Revenue Code and Treasury Regulations do not mandate a specific minimum number of donors within a pooled income fund for qualification at inception or on an ongoing basis. Nevertheless, the PIF arrangement in this article assumes a pool of at least two different taxpayers. As a practical matter, the second donor may be a relative who contributes a nominal amount to the PIF.

There are several basic requirements for a PIF under IRC Sec 642(c)(5). The PIF requires that donors transfer property with the remainder irrevocably committed public charity.^[9] The property transferred to the PIF must be commingled with that of other donors that transfer to the same PIF. The language from IRC Sec 642(c)(5) which defines PIF for tax purposes fails to mandate a minimum number of donors for qualification within a PIF. It only stipulates that funds transferred to a specific pooled fund by multiple donors be commingled.[10]

The trust must be maintained by the public charity that is the remainder recipient of the transferred property. A PIF donor or beneficiary may not be a trustee with management responsibility. Finally, each beneficiary must receive his or her prorated share of the PIF income annually

Nothing the Internal Revenue Code or Treasury Regulations preclude a public charity from maintaining more than one pooled income fund. As a practical matter, a number of mutual fund companies and larger universities maintain multiple pooled income funds in order to implement different investment strategies.

IRC Sec 642(c) (5)

Definition of pooled income fund

For purposes of paragraph (3), a pooled income fund is a trust -

(A) to which each donor transfers property, contributing an irrevocable remainder interest in such property to or for the use of an organization described in section 170(b)(1)(A) (other than in clauses (vii) or (viii)), and retaining an income interest for the life of one or more beneficiaries (living at the time of such transfer),

(B) in which the property transferred by each donor is commingled with property transferred by other donors who have made or make similar transfers,

(C) which cannot have investments in securities which are exempt from the taxes imposed by this subtitle,

(D) which includes only amounts received from transfers which meet the requirements of this paragraph,

(E) which is maintained by the organization to which the remainder interest is contributed and of which no donor or beneficiary of an income interest is a trustee, and

(F) from which each beneficiary of an income interest receives income, for each year for which he is entitled to receive the income interest referred to in subparagraph (A), determined by the rate of return earned by the trust for such year. For purposes of determining the amount of any charitable contribution allowable by reason of a transfer of property to a pooled fund, the value of the income interest shall be determined on the basis of the highest rate of return earned by the fund for any of the (3) taxable years immediately preceding the taxable year of the fund in which the transfer is made. In the case of funds in existence less than 3 taxable years preceding the taxable year of the fund in which a transfer is made the rate of return shall be deemed to be 6 percent per annum, except that the Secretary may prescribe a different rate of return.^[11]

As stipulated in IRC Sec 642(c)(5), tax-free funds may not be transferred to the trust, nor are they a permissible investment for the trust. The trust must be maintained by the public charity that is the remainder recipient.[12] A PIF donor or beneficiary may not be a trustee with management responsibility. Finally, each beneficiary must receive his or her prorated share of the PIF income annually.

Treasury Regulation 1.642-5(b)(3) provides additional clarification of these commingling requirements.

Commingling of property required. The property transferred to the fund by each donor must be commingled with, and invested or reinvested with, other property transferred to the fund by other donors satisfying the requirements of subparagraphs (1) and (2) of this paragraph. The governing instrument of the pooled income fund must contain a provision requiring compliance with the preceding sentence. The public charity to or for the use of which the remainder interest is contributed may maintain more than one pooled income fund, provided that each such fund is maintained by the organization and is not a device to permit a group of donors to create a fund which may be subject to their manipulation.

The fund must not include property transferred under arrangements other than those specified in section 642(c) (5) and this paragraph. However, a fund shall not be disqualified as a pooled income fund under this paragraph because any portion of its properties is invested or reinvested jointly with other properties, not a part of the pooled income fund, which are held by, or for the use of, the public charity which maintains the fund, as for example, with securities in the general endowment fund of the public charity to or for the use of which the remainder interest is contributed.

Where such joint investment or reinvestment of properties occurs, records must be maintained which sufficiently identify the portion of the total fund which is owned by the pooled income fund and the income earned by, and attributable to, such portion. Such a joint investment or reinvestment of properties shall not be treated as an association or partnership for purposes of the Code. A bank which serves as trustee of more than one pooled income fund may maintain a common trust fund to which section 584 applies for the collective investment and reinvestment of moneys of such funds.^[13]

The regulations speak to the requirement that the each pooled income fund must be maintained by the organization and not be subject to manipulation by the donor. Under the proposed arrangement, the public charity involved in the arrangement maintains full legal ownership and control of the funds and may enter into an arms-length investment management agreement with one or more investment managers subject to a specific investment policy statement as the investment mandate for a specific PIF. Under such an arrangement, the donor has no ability to control or manipulate the investments within the pooled income fund whose management will be completely discretionary.

Pooled Income Fund Income Tax Deduction

The PIF donor receives a deduction for the present value of the interest in the pooled fund. Based on the highest rate of return for the prior three years, the PIF factor may be obtained from IRS Pub. 1457. This factor, after interpolation, is then multiplied times the gift amount to determine the present value of the remainder interest. This amount is the charitable income tax deduction.

Pooled income funds must calculate the rate of return each year, in order to determine the highest of the prior three-year rates to use for deduction calculation purposes. If the PIF has not been in existence three taxable years, then the fund must use the calculated rate based on the IRC Sec 7520 rates. The rates for each year are averaged and 1% is subtracted from the average. The averaged number is then rounded to the nearest two-tenths of 1% and the highest rate of the calculated three prior years must then be used for deduction purposes. After the PIF has been in existence for three taxable years, the actual PIF rate of return may then be used.[14] As you know the IRC Sec 7520 rate has hovered between 1.2-2.0 percent over the last several years. The current rate is 2.2 percent for January 2015. The rate for new PIFs in 2016 is 1.2 percent.[15]

PIF Securities Exemption

Before 1980, it was possible for counsel to charities to obtain a "no action" letter from the SEC. In 1980, the SEC determined that it would be preferable to issue a "pooled income funds release" No. 33-6175.[16] This ruling from the SEC exempted pooled income funds from securities regulation. However, the pooled fund was required to be in compliance with IRC Sec 642(c) (5) and must disclose fully the fund's operation to donors.

In addition, the individuals promoting the fund must be employees of the charity and must not be receiving percentage or commission compensation. The 1995 Philanthropy Act added an additional measure exempting charitable organizations from registration under the Investment Advisors Act of 1940 as broker-dealer requirements.[17] The federal law also had the effect or eliminating any registration requirements at the state level.

The Case for PIFs

The reader may still be asking why consider the PIF as a tax planning solution if it is obsolete in the minds of most public charities.  What’s the point? First, the taxpayer does not recognize gain or loss on the transfer of property to the PIF. More importantly, If a pooled income fund has existed for less than three taxable years, the charity is able to use an interest rate in calculating the charitable deduction by first calculating the average annual Applicable Federal Midterm Rate (as described in IRC §75200 for each of the three taxable years preceding the year of the transfer. The highest annual rate is then reduced by one percent to produce the applicable rate. The rate for the 2016 tax year is 1.2 percent.

In practice, this feature makes pooled income funds ideal for use by persons who desire to dispose of highly appreciated, low yielding property free of capital gains tax exposure in favor of assets that will produce higher amounts of cash flow. It is important to note the double tax leverage that can be accomplished by avoiding recognition of capital gain and creating an immediate charitable income tax deduction.

This interest rate provides a significantly larger deduction than a comparable contribution to a CRT.  The following chart compares the percentage of deduction based upon a charitable deduction of $100,000.[18] The CRT assumes the minimum CRT payout of five percent for the taxpayer’s lifetime. Deductions for cash contributions is subject to the fifty percent of adjusted gross income threshold. Deductions of appreciated property are subject to the thirty percent of AGI threshold. The taxpayer may carryover excess deductions for an additional five tax years beyond the current year.

While a PIF may not have a unitrust payout in a manner similar to charitable reminder trusts, the trustee of a PIF may allocate a portion of long term short term capital gains to trust accounting income while taking a charitable set aside deduction for long term capital gains that are not paid out to the income beneficiary of the PIF, but permanently allocated to PIF principal. In effect, the trustee’s power to adjust creates a total return for the PIF.

Comparison of Charitable Remainder Trust vs. Pooled Income Fund Deduction Levels

Strategy Example

1. The Facts

Joe Smith, age 60, is the managing member of Acme Funds, a hedge fund.  Acme is a $1 billion fund with assets equally split between the onshore and offshore funds. Joe’s deferred offshore carried interest is $25 million. Joe would like minimize income and future estate taxation while maintaining an income for the joint lifetime of Joe and his wife. Joe would also like for Acme to continue managing the funds and accrue the investment gains on a tax deferred basis. Additionally, he would like to cap the upside of the PIF and allow his family’s dynasty trust.

2. Solution

Good Samaritan Charities is a 501(c)(3) organization that sponsors donations to pooled income funds. The charity creates a new pooled income fund. Joe contributes $20 million to the new PIF. Joe’s brother Sam contributes $250 to the PIF. Joe’s donor advised fund is the remainderman of the PIF. The tax deduction is 78 percent of the PIF contribution or $15.6 million.

The PIF will be managed by Acme Funds. The trustee of the PIF invests the funds into a new LLC that is capitalized with non-voting preferred shares (Class B) and voting common shares (Class A). The preferred units constitute 90 percent of the units. The common units represent 10 percent of the units.  Joe’s family investment company will serve as the managing member of the new LLC.

The preferred units provide a cumulative return of five percent and a par value of one dollar per unit. The Class B units will have a liquidation preference. The Class A common units will receive an investment return equal to the excess amount above the preferred return. The projected income for Joe and his wife is $1 million per year for their joint lifetime. The full value of the PIF contribution is outside of their taxable estates. 

As an additional planning strategy, the manager purchases life insurance so that a portion of the LLC income will enjoy the tax-advantaged benefits of life insurance –(1) Tax-free build up (2) Tax-free withdrawals and loans that pass through to the Class B members (3) An income tax-free death benefit. If the entire amount is invested in life insurance, the trustee will utilize tax-free loans in order to make the preferred return payments. Joe and his wife will receive tax-free treatment for their joint lifetime. The death benefit will receive tax-free treatment.

Upon the death of Joe and his wife, the Class B units will pass to their donor advised fund. Upon liquidation of the LLC, the Class B units will be redeemed at par value plus any portion of the cumulative return. The excess return will be paid to Joe’s dynasty trust.

The Charitable Split Annuity

The split-annuity concept provides you with a guaranteed income stream along with principal preservation. To accomplish this goal, the investors purchases two non-qualified annuity contracts: a fixed period annuity for income and a single premium fixed deferred annuity for growth

The fixed immediate annuity provides the investor with a safe and guaranteed income for a term of years. The term of years can range from five-forty years. The payments can be in monthly, quarterly, semi-annual or annual intervals. The growth portion of the strategy features a single premium fixed deferred annuity. The investment return features tax-deferred growth at a fixed rate of interest. Frequently, the crediting rate can be selected for one-year or greater guarantee period. 

The split annuity concept can be illustrated for an investor who needs a conservative method to supplement retirement income over a ten-year period without exposing a large portfolio to the volatility of the stock market. Assuming the principal is $100,000. The investor allocates $31,935 to a ten year fixed period annuity which produces an annual income of $3,744 per year. In this case, 95 percent of each payment is considered a tax-free return of principal. At the same time, the investor allocates $68,066 to a fixed interest deferred annuity which compounds on a tax-deferred basis at the guaranteed crediting rate of 4.25%.

The charitable split annuity concept is a combination of charitable planning techniques – the charitable lead annuity trust (CLAT) and the pooled income fund (PIF).  The CLAT is designed as a grantor trust. The CLAT provides payment to the taxpayer’s donor advised fund for a term of years. The annuity payout is designed to maximize the charitable deduction which is limited to 30 percent of AGI. The unused deduction may be carried forward for five tax years. The annuity payment scheme may be structured to backload the payments, i.e. small initial payments growing by a fixed percentage each year. This payment scheme allows the CLAT corpus to grow over a term of years back to its original amount or more.

The second part of the charitable split annuity concept is a contribution of assets to a pooled income fund (PIF). The PIF income interest may be designed to provide an income over a single or joint lifetime over multiple generations, concurrently or consecutively.

There are two basic types of living charitable lead trusts. These are the grantor lead trust and the non-grantor, or family lead trust. In the case of a non-grantor type lead trust created during lifetime, no income tax deduction is available. In the case of a grantor lead trust, the grantor retains powers which cause the trust to be treated as though owned by the grantor for income tax purposes. The grantor is allowed a deduction in the year the trust is established for the actuarial value of the annuity or unitrust income stream to be paid to the charity.

A consequence of a CLAT taxed as a grantor trust status allowing for the income tax deduction, is the taxation of CLAT income to the grantor during the lifetime of the trust. Nevertheless, a CLAT is a useful technique that can accelerate a charitable income tax deduction into the year in which the grantor has unusually high income. The CLAT can be designed to produce a deduction equal to the contribution. The deduction (including cash contributions) are limited to 30 percent of adjusted gross income. Excess income tax deductions may be carried forward for five additional tax years.

The CLAT has a high degree of flexibility in selecting the duration for the lead trust. A lead trust may pay to charity for the life of the donor, for a term of years, or even for the lesser of a life or a term of years. The CLAT does not have a limit for a term of years. A CLAT may be created for thirty or thirty five years, with the CLAT remainder going to grandchildren at the expiration of that term.

In the traditionally structured CLAT, there are two primary reasons a CLAT may fail to transfer wealth. First, if the assets of a “zeroed-out” CLAT do not have a total return that exceeds the §7520 rate (currently 1.8 percent), then no assets will remain in the CLAT at the end of the term. The term “zeroed-out” refers to the value of the remainder interest being equal to zero so that there is no value for gift tax purposes on the initial transfer to the CLAT.

Second, even if the CLAT assets have a total return that exceeds the IRC Sec 7520 rate, the CLAT may fail because of the “path of the returns”. In reality, the investment return is not static (a fixed return in every year), varying in some cases from day-to-day over a period of years. From an investment standpoint, the ability to backload the annuity payments in a CLAT allows the trustee to invest in higher volatility (and, theoretically, higher returning) asset classes and strategies.

Strategy Example #2

1. The Facts

Bob Smith, age 50, is a hedge fund manager. He expects to receive a distribution of his offshore carried interest in December 2016, a full year before the 2017 deadline. His offshore carried interest is expected to be worth $10 million. Bob would like to minimize the impact of income taxation as well as future estate taxes. He would like to retain an income for his lifetime, but also transfer a portion of the funds to future generations. Bob’s fund generates short term capital gain income primarily. Bob’s expected AGI in 2016 is projected to be $14 million.

2. Solution

Bob creates a CLAT with a sixteen year term with a $5 million contribution. The CLAT is structured as a grantor trust. The IRC Sec 7520 rate for April 2016 is 1.8 percent. The projected investment growth rate within the CLAT is 10 percent per year. The CLAT payments are made to Bob’s donor advised fund. The trustee of the CLAT invests the contribution in Class B Preferred interests of a new investment limited partnership, managed by Bob’s investment management firm. The Class A Common interests are owned by a family trust created by Bob’s wife Marilyn. Bob is an income beneficiary of that trust. The Class A interests will be entitled to the investment growth in excess of the Class B preferred return of 4 percent.

The limited partnership purchases a private placement policy on Bob’s brother Sammy that features an insurance dedicated fund managed by Bob. The investment growth within the policy will accrue on a tax-free basis. The policy death benefit will also be income tax-free. The limited partnership may access policy loans and withdrawals on a tax-free basis in order to make CLAT payments to the donor advised fund.

The income tax deduction is equal to the initial contribution and is limited to 30 percent of AGI. The excess deduction may be carried forward for five additional tax years. The CLAT payments will increase by 20 percent each year for twenty years. The projected remainder interest at the end of Year 20 is $11.64 million and will pass to the designated family trust. The initial payment to the donor advised fund in Year 1 is $28,000. The final payment in Year 16 is $435,000. The assets are outside of his taxable estate.

Bob creates a PIF with a contribution of $5 million. The PIF will provide an income for the joint lifetime of Bob and his wife. The income tax deduction is equal to 70 percent of the contribution. The deduction is limited to 50 percent of AGI. The projected income from the PIF is ten percent or $500,000 per year. The assets are outside of his taxable estate.

Bob’s total income tax deduction is $8.5 million; of which $7 million can be used in 2016 based on his AGI. The CLAT assets are projected to be worth $2.9 million when the CLAT terminates in Year 16.  These assets will revert to his family trust for the benefit of his children at that time. The PIF will provide an income for Bob’s lifetime and for the lifetime of his children. The projected income is $80,000 per year. The entire amount of the charitable contribution will be outside of his taxable estate.

Summary

The PIF provides substantially larger income tax deductions in the current interest rate environment when compared to the very well-known and “time-tested” CRT.  Sophisticated law firms have utilized charitable lead annuity (CLAT) trusts in order to minimize current taxation on the repatriation of offshore carried interest. It is an excellent solution, but the hedge fund manager who wants current income from all or part of the repatriated funds has to wait until the expiration of the CLAT term.

The pooled income fund provides a higher deduction threshold while providing the hedge fund manager and his family with current income. The PIF eliminates future estate taxation and provides the manager with the ability to continue managing the assets. Sophisticated PIF planning provides the hedge fund manager to provide a total return that approximates the CRT unitrust payout. Additional planning allows the hedge fund manager to leverage the assets on a tax-advantaged basis and cap the upside passing to charity.

As this article points out, it is time to rescue the PIF from tax obsolesce. The planning potential for hedge fund managers in the repatriation of offshore carried interest is significant.