Looking Over the Edge of the Cliff – The Use of Pooled Income Funds for the Repatriation of Offshore Carried Interest
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. 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 of this wealth.
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. 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 PIF is long been considered obsolete and ineffective in the planned giving world. 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?
What is a 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. Seventy five percent of the PIFS had assets of less than $500,000.
A pooled income fund is a trust that is established and maintained by a public charity. I.e. 501(c)(3) organization. The pooled income fund receives contributions from individual donors that are commingled for investment purposes within the fund. Each donor is assigned “units of participation” in the fund that are based on the relationship of their contribution to the overall value of the fund at the time of contribution.
Each year, the fund’s entire net investment income is distributed to fund participants according to their units of participation. Income distributions are made to each participant for their lifetime, after which the portion of the fund assets attributable to the participant is severed from the fund and used by the charity for its charitable purposes. A pooled income fund could, therefore, also be described as a charitable remainder mutual fund.
Contributions to pooled income funds qualify for charitable income, gift, and estate tax deduction purposes. The donor’s deduction is based on the discounted present value of the remainder interest. Donors can also avoid recognition of capital gain on the transfer of appreciated property to the fund.
A cash contribution to a PIF is subject to an income tax deduction threshold of fifty percent of adjusted gross income (AGI). Appreciated assets are subject to the thirty percent of AGI threshold. Excess deductions may be carried forward for an additional five tax years. The taxpayer also receives a charitable deduction for gift tax purposes and the remainder interest is not included in the taxpayer’s taxable estate.
In spite of the commingling aspect of funds or contributions from multiple donors, I can find nothing in the Internal Revenue Code or treasury regulations that would preclude a PIF with a single client. Nevertheless, a more conservative planning posture might dictate a PIF with at least two donors even if the second donor has a small contribution such as $250 to the PIF.
IRC §642(c)(5) defines a pooled income fund as a trust:
- to which each donor transfers property, contributing an irrevocable remainder interest in such property to or for the use of a public charity while retaining an income interest for the life of one or more beneficiaries (living at the time of the transfer,
- in which the property transferred by each donor is commingled with property transferred by other donors who have made or make similar transfers,
- which cannot have investments in securities which are exempt from taxes imposed by this subtitle,
- ,which is maintained by the public charity to which the remainder interest is contributed and of which no donor or beneficiary of an income interest is a trustee, and
- from which each beneficiary of an income interest receives income, for each year for which he is entitled to receive the income interest determined by the rate of return earned by the trust for such year.
The trust instrument of the pooled income fund must require that property transferred to the fund by each donor be commingled with, and invested or reinvested with, other property transferred to the fund by other donors. Charitable organizations are permitted to operate multiple pooled income funds, 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. Such manipulation is, however, highly unlikely because the regulations require the governing instrument of a pooled income fund to (1) prohibit a donor or income beneficiary of a pooled income fund from serving as a trustee of the fund, and (2) include a prohibition against self-dealing.
For tax purposes, pooled income funds are, with one important exception discussed below, taxed as complex trusts. Pooled income funds seldom pay any tax, however, for several reasons. First, pooled income funds receive an unlimited deduction for all amounts of income distributed to fund participants. Because pooled income funds are required to distribute all income earned each year, there remains no income to be taxed.
Second, pooled income funds are permitted a special deduction for long-term capital gains that are set aside permanently for charity. In essence, long-term capital gains produced by a pooled income fund are allocated to principal. Because principal is earmarked for charity, such amounts escape income taxation. For purposes of tracking income and gain attributable to contributed assets, pooled income funds take on the donor’s holding period and adjusted cost basis in the contributed property.
Nevertheless, the trust document for most pooled income funds defines income as that term is defined in IRC Sec 643(b). Under this section, the term income, when not preceded by the words taxable, distributable, undistributed net, or gross, means the amount of income of the trust for the taxable year determined under the terms of the governing instrument and local (state) law.
The Uniform Income and Principal Act or Revised Uniform Income and Principal Act adopted by most states defines income to include interest, dividends, rents, and royalties. Unless otherwise defined, income does not ordinarily include capital gains. Provided that such definition is compatible with state law, however, pooled income funds can expand the definition of income to include capital gains.
Pooled income fund beneficiaries are required to include in their gross income all amounts properly paid, credited, or required to be distributed to them during the taxable year or years of the fund ending within or with their taxable year.
Distributions from pooled income funds are taxed under the conduit theory applicable to IRC Sec 661 and 662. Because pooled income funds distribute all income earned during the taxable year, the tax character of amounts distributed to each income beneficiary is directly proportional to the tax character of investment income earned within the PIF.
The Case for PIFs
You 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? The taxpayer does not recognize gain or loss on the transfer of property to the PIF. 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. 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
|Age||2016 PIF contribution||CRT Contribution with 5% Payout|
- 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
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 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 enormous.
Gerald Nowotny – Osborne & Osborne, PA
266 Lovely Street
Avon, CT 06001