Offshore Fund Managers: Charitable Donations Can Reduce Tax on Long-Deferred Pay
January 30, 2017
Managers of offshore hedge funds and offshore private equity funds may owe billions of dollars in tax this year on incentive and management fees they earned in years past. Various charitable strategies can reduce the income tax due as well as potential estate tax, but the managers need to act before the end of 2017.
Since 2009, Internal Revenue Code Section 457A has impaired the ability of managers to defer tax on incentive fees and management fees earned from managing offshore hedge funds and offshore private equity funds. The law also requires that any of these fees deferred into a non-qualified compensation plan before 2009 must be distributed and subjected to income tax by the end of this year.
The amounts at stake are substantial. One fund manager we consulted will receive a taxable distribution of $50 million from a non-qualified plan this year as a result of Section 457A. The manager asked us how to reduce the nearly $25 million in US and California income taxes due on the distribution.
Further discussion revealed that the manager had two other long-term goals: giving to charity and passing on wealth to his children. We thought the right charitable strategy could achieve all three of his goals; our analysis showed that in his case, a charitable lead annuity trust (CLAT) would work best.
With a CLAT, a donor makes a large gift to a trust, which typically distributes all of its principal plus interest over time to one or more qualified charities that the donor selects. In effect, it pre-funds charitable donations. The IRS requires that the CLAT charitable distributions include interest based on the lowest of three recent Section 7520 rates: from the month the CLAT is established and the previous two months.
The December 2016 Section 7520 rate was 1.8% and remains available through the end of February 2017. Any investment returns that the trust earns above that rate will ultimately go to the remainder beneficiaries (typically children or a trust for their benefit) when the trust expires, free of gift and estate tax. Based on our forecasts of the range of returns for a trust invested in a moderate growth allocation, there is currently a high probability that a 20-year CLAT will leave money to the remainder beneficiaries.
The Display shows how this would work for the fund manager. If he gave half of the distribution, or $25 million, to a 20-year grantor CLAT, he would receive a charitable deduction that would cut the income tax due on the distribution this year to $12.7 million; his family would keep $12.3 million.
After 20 years, the family would owe only $3.7 million in estate tax on the money received in 2017 and invested in a moderate growth portfolio. If he didn’t use a CLAT and invested similarly, estate taxes would consume almost $10 million more.
Over the full 20 years, the charity would receive $23.3 million in inflation-adjusted distributions, leaving $21.7 million (inflation-adjusted) for the family—more than the family would receive after estate tax if a CLAT were not established. We project that the CLAT strategy would generate almost $25 million more in combined charitable and personal wealth, even if the estate tax is abolished.
The analysis assumes that if the client doesn’t use a CLAT, he invested the after-tax proceeds of the distribution in a globally diversified portfolio with a 60% allocation to stocks and a 40% allocation to bonds. It also assumes that the CLAT would make a $176,000 charitable distribution in the first year that increases 20% annually for 20 years, with the taxpayer paying income taxes on behalf of the trust in the interim.
Other strategies to consider include a direct gift to a donor-advised fund, a charitable remainder trust (CRT) or a pooled income fund. The right strategy for any individual depends on that individual’s goals and circumstances.
The Bernstein Wealth Forecasting System seeks to help investors make prudent decisions by estimating the long-term results of potential strategies. It uses the Bernstein Capital Markets Engine to simulate 10,000 plausible paths of return for various combinations of portfolios, and for taxable accounts, it takes the investor’s tax rate into consideration.
Bernstein does not provide tax, legal, or accounting advice. The rules governing gifts to split-interest charitable vehicles are complex. Please consult your professional advisors in those areas prior to implementing any strategies.