The IRS Is Getting Serious About Cracking Down On Another Cherished Hedge Fund Tax Loophole

james simmonsJames Simmons

Legendary hedge fund manager James Simmons has caught the ire of Wall Street’s friends at the IRS by using a tax cutting strategy¬† known as basket options contracts, Bloomberg reports.

Simmons, a Cold War code breaker turned billionaire and founder of quant firm Renaissance Technologies, has been using the strategy on his $10 billion flagship Medallion fund, according to people with knowledge of the situation.

One former Renaissance employee said the IRS contacted him to let him know he may have to pay $90,000 in additional taxes. (Woof)

The employee was then assured, by his former employer, that the practice was perfectly legal and used by a bunch of hedge funds.

Here’s how basket options contracts work: By nature, firms like Renaissance do not hold investments for a long time, but wages and investments held for less than a year are taxed at a rate of 39.6%. Those held for 2 years or more, on the other hand, are charged at the 20% capital gains rate.

So to turn those short term investments in to long term investments, foreign banks like Deutsche Bank and Barclays buy a basket of securities that hedge funds want to sell. Then they hire the hedge funds to oversee that portfolio.

Then the fund (in this case Medallion) buys a two year option linked to the portfolio (from Bloomberg):

Medallion could claim it owned just one asset — the option — which it held for more than a year, allowing any gain to be treated as “long-term” when its investors reported the income on their personal tax returns…

Tax planners started using derivatives to convert hedge funds’ short-term gains to long-term gains in the 1990s, said Alex Raskolnikov, a tax professor at Columbia University Law School. Congress tried to close the loophole in 1999, enacting a law allowing the IRS to disregard the tax effect of some derivatives, such as swaps and forwards, if they were economically akin to owning the fund directly.

The IRS wrote a memo about this practice in 2010, and called it an “end run”.

A Renaissance spokesman declined to comment saying that “the dispute is ongoing and being handled in the appropriate forum.”

For the full story, head to Bloomberg>

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