Elevate the comparison to $130 million, the minimum take-home pay needed to make it on Alpha magazine’s list of the 25 highest-paid hedge fund managers: the first manager receives $136.1 million; the second $115.8 million.  This closely guarded arrangement is completely legal; similar, but 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 that hedge fund managers earn may be far outpacing even the compensation of 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. And that does not count what might have been taken out already. Citadel declined to comment.  “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, the founder of the Vanguard Group. “It’s a very well-gilded lily to allow these tax deferrals.”  This tax advantage is now coming under scrutiny in Washington, where Congress is looking for ways to reduce the budget deficit, to pay for the Iraq war and to help cover the exploding retirement and health care costs of aging baby boomers.  For now, many hedge fund managers are enjoying not only extraordinary profits but the extra benefit of a system almost encouraging them to set up offshore accounts.  Most hedge funds are private partnerships; managers are usually paid 2 percent of the money they manage plus 20 percent of the profits the partnership earns. If the fund operates in the United States, any deferral of the pay of the managers means investors lose the tax deduction associated with the compensation expense. As a result, deferred compensation in domestic funds is very uncommon.  By setting up an offshore fund, though, hedge fund managers avoid socking their investors with extra taxes. At the same time, it serves to attract tax-exempt investors like pension funds and endowments, as well as foreign investors, two of the most active groups investing in hedge funds today.  Once the offshore fund is established, managers can elect to have much of their compensation earned from the offshore fund deferred back into the fund, allowing it to grow tax-free until it is taken out. Managers have to decide ahead of time how much they will defer and they are required to follow a set formula for receiving the money. At the end of the deferral period, they pay ordinary income taxes.  There are downsides to this arrangement. For one, the money cannot be spent right away, which can be unfortunate for those looking to add to, say, their antique car collection. Moreover, the money is at risk.  Unlike 401(k)s and other so-called qualified plans, deferred compensation is not set aside for the individual but becomes a corporate liability. If the fund goes belly up, the deferred compensation is subject to claims from creditors.  “When someone defers money, the reason it’s not taxable to them is it’s not their money,” said Michael G. Tannenbaum, a lawyer with Tannenbaum Helpern Syracuse & Hirschtritt. “It represents a debt in favor of that employee by the company.”  Many forces have worked to make hedge funds, as well as private equity funds — both called alternative investments — the darlings of the investment world. Pension funds are drawn to the promise of greater returns with supposedly fewer risks. Low interest rates and widely available financing have fueled a buyout boom largely run on demand from hedge funds for the debt issued to make the buyouts work.  But perhaps most notable about the spectacular growth is the huge compensation successful managers receive. Consider a relatively modest fund with $500 million in assets that posts a 16 percent return — on par with the market in 2006. The typical handful or fewer of professionals running the fund would share a management fee of $10 million, plus $16 million in “incentive compensation.”  A result is a new class of financial giants. The vast sums of money flowing to a relatively small number of individuals have inspired a vast interest in minimizing taxes.  “As long as you stay on the right side of the bright line, all forms of tax avoidance are very smart,” said Mark Yusko, president of Morgan Creek Capital Management, an investment advisory firm. “People pay good money for that.”  Offshore deferral arrangements have been around for decades. But in 2004, Congress passed the American Jobs Creation Act, and while a provision known as 409(a) restricted some practices, it also served to highlight their advantages.  “I don’t think 409(a) increased the number of deferrals, but it probably made more comfortable the arrangement because it codified what was going on,” Mr. Tannenbaum said.  Indeed, deferred-compensation agreements have continued to thrive under the new regulations. Mr. Massey, the consultant, estimates that 100 percent of managers do it; other investors err on the side of “most.”  The rationale for doing so is evident, especially as the funds and the compensation get bigger. An increase in the use of leverage — borrowed money to increase bets — has translated to outsize returns, and whopping pay packages, much of them comfortably multiplying in value offshore.  “These plans are used more and more in this market, especially with leveraged hedge funds because the more leveraged the fund, the bigger the profit component and the more valuable the deferral of the compensation,” said Mark J. Weinstein, a partner at Hogan & Hartson.  Now, Congress is taking a closer look. An amendment limiting deferred compensation to no more than $1 million or the average of the previous five years’ income was added to the Senate version of the minimum wage bill. Lawmakers from both the House and Senate are meeting to work out the differences.  Other tax advantages are under the microscope. For example, incentive income at private equity funds, called “the carry,” is taxed at a lower capital gains rate, which is often less than half the rates on ordinary income — a benefit being discussed.  To be sure, those who defer taxes face the risk that Congress will raise tax rates on the rich at some future date. But that does not seem to worry most hedge fund managers.  “My clients who have quantified the value of the deferral have never factored in the risk of a tax rate increase,” said Mr. Weinstein from Hogan & Hartson. The advantage of tax-free compounding is so strong, he said that “it doesn’t matter because the after-tax yield is still that much better.”  A version of this article appears in print on , on Page A1 of the New York edition with the headline: Managers Use Hedge Funds As Big I.R.A.’s. Order Reprints| Today's Paper|Subscribe
Some hedge fund managers have discovered a way to avoid paying taxes on their huge fees for up to 10 years.