Hedge Fund Tax Technique used by James Simons challenged by IRS.
Hedge fund titan James Simons, who became a billionaire when he turned his extraordinary mathematical ability from Cold War code breaking to investing, deployed an unusual strategy at his Renaissance Technologies hedge fund to skirt hundreds of millions of dollars in taxes for himself and other investors, according to Businessweek. The Internal Revenue Service is challenging the technique, which it called “particularly aggressive,” without naming the hedge fund in the dispute. It’s demanding more tax payments from investors in Renaissance’s $10 billion Medallion Fund, said the people, who declined to be identified because the matter hasn’t been made public.
Renaissance’s strategy involved buying an instrument called a basket option contract from Barclays (BCS) and other banks so it could convert profit from Medallion’s rapid trading into long-term capital gains, according to the people. The top federal rate on long-term gains is about half that on short-term gains. IRS lawyers released an 11-page memorandum in 2010 describing the technique and outlining an example, without naming Medallion and Barclays. Jonathan Gasthalter, a spokesman for Renaissance, would say only that “the dispute is ongoing and being handled in the appropriate forum.” Kerrie Cohen, a spokeswoman for Barclays, declined to comment. The IRS also declined to comment, citing confidentiality laws.
As described in the memo and by people with knowledge of the matter, the transaction worked as follows: Barclays bought a portfolio of stocks and other instruments that Renaissance fund managers wanted to trade—then hired Renaissance to manage it, paying a nominal fee. Medallion then bought an option with a term of two years, the value of which was linked to the portfolio’s value. Medallion could say 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. “The profits are just being transmuted, through the alchemy of derivatives, to a preferenced return,” says Steven Rosenthal, a former tax lawyer who is a fellow at the Urban Institute in Washington.
It couldn’t be determined whether Renaissance is still using the strategy or how much the IRS wants investors to pay in back taxes. A former Renaissance employee, who spoke on condition of anonymity, says the firm notified him years after he left that the IRS was challenging the tax technique and told him that he might have to pay more than $90,000 in additional taxes if the firm loses. He says Renaissance assured him the trade was a common and legitimate technique and said the IRS was trying to rewrite the rules retroactively.
Although tax experts say some specifics of Renaissance’s strategy are unusual, figuring out ways to convert a hedge fund’s trading profit into income taxed at the lower, long-term gains rate is the holy grail for tax planners. “It’s been going on since there’s been hedge funds,” says David Weisbach, a tax professor at the University of Chicago Law School.