Legendary hedge fund manager James Simons 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.
Simons, 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.”