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Hedge fund managers defer taxes on earnings

Many Americans squirrel away as much as they can into retirement accounts like 401(k)s and IRAs that allow them to compound their earnings tax free. The accounts also lessen what they owe when tax day rolls around. For the average person, however, the government strictly limits the savings to about $20,000 a year.

And then there are people who work at hedge funds.

A lot of the hedge fund managers earning the astronomical paychecks making headlines these days are able to postpone paying taxes on much of that income for 10 years or more.

The key to the hedge fund tax boon is that many managers of these lightly regulated private pools of capital have the ability to earn the bulk of their compensation offshore and invest it in their funds, where it grows tax-free.

"If you could compound your compensation tax free, why wouldn't you?" asked Stewart Massey, founding partner of Massey & Quick, a consulting firm.

Few people know the power of compounding better than hedge fund managers. Consider the following calculation done by Financial Engines, a financial advisory and portfolio management firm: A hedge fund manager makes $10 million in fees and defers it for five years, earning a return of 10 percent a year. When he pays taxes at the end, he walks away with $10.5 million. Another manager who makes the same $10 million pays his taxes immediately. He still earns 10 percent on what's left, but over the same period he accumulates just $8.9 million.

This closely guarded arrangement is completely legal; less generous deferrals have been commonly used by corporate executives for years. But thanks to the peculiarities of the structure of hedge funds and their enormous growth, the tax-deferred sums hedge fund managers earn may be far outpacing even the most well-paid corporate chieftains.

One of the flagship funds at Citadel, a $13.5 billion hedge fund, for example, has deferred at least $1.7 billion since it was founded at the end of 1990. That's not counting what might have been taken out already.

"We pile advantage on advantage for these managers and there doesn't seem to be any economically logical basis for it," said John C. Bogle, founder of the Vanguard Group.