Death by deferral

A looming US tax rule is easy on private equity but hard for hedge funds.

A proposed amendment to the US Internal Revenue Code would impose a stiff tax penalty on many hedge fund professionals who sink their bonuses back into the hedge fund.

The proposed rule change would amend section 409A of the 1986 Code, and is part of broader proposed legislation pushed by the Democrat-controlled Congress to increase America's minimum wage.

The legislation, already approved by the Senate Finance Committee, would limit the amount of income that a taxpayer can defer each year to the lesser of $1 million or the average annual compensation paid to the individual during the preceding five years.

According to Andrew Gaines, a partner in the New York office of law firm Weil, Gotshal & Manges, the proposed changes to deferred compensation tax rules are unlikely to present complications for most private equity professionals. Deferred compensation is defined as severance payment, compensation derived from nonqualified pension plans called SERPs, certain types of equity compensation awards, and any earnings on previously deferred compensation.

?It doesn't look like private equity is going to get hit hard,? says Gaines. ?But for hedge funds, it could end the whole practice of deferring incentive fees.?

Many hedge fund professionals choose to ?leave? their portion of carried interest in the fund, where it continues to be put to work through the fund's investment strategy. There could now be severe consequences for continuing this practice – deferred compensation that crosses the $1 million or five-year average threshold will be subject to an additional 20 percent penalty tax.

The proposed amendment appears to be in response the recent public outcry over what many see as excessive executive severance packages in the US, most notably that of Robert Nardelli, the outgoing CEO of Home Depot, a home improvement retailer, who received a $210 million exit package, despite the fact that the company's shares had suffered under his leadership.

It is unclear what effect the new tax rule, if enacted, will have on the hedge fund industry. The change should hurt most at funds where performance has been consistent and strong. But there are far more hedge funds now that are going out of business due to poor performance, and it is unlikely that these professionals are spending much time thinking about deferring compensation.