(Adds Falcone not party to settlement, comment from Harbert, no comment from Falcone)
By Karen Freifeld
NEW YORK, April 18 (Reuters) - Harbert Management Corporation and its top executives agreed to pay $40 million to settle with New York over a failure to pay state and city income taxes on hundreds of millions of dollars of hedge fund performance fees, according to the New York attorney general.
Alabama-based Harbert Management was the fund sponsor for Philip Falcone's Harbinger Capital Partners, a New York-based hedge fund that once boasted $26 billion in assets.
In 2001, Harbert hired Falcone, who worked out of offices in Manhattan, for the Harbinger Capital Partners Master Fund I Ltd, attorney general Eric Schneiderman said in a statement.
When businesses operate in and out of New York, they must allocate the income they derive from New York for tax purposes.
But Harbinger Capital Partners Offshore Manager LLC, which served as investment manager for the fund, did not apportion any performance fee income to New York, instead allocating it all to Alabama, a lower-tax state. The performance fees were equal to 20 percent of Harbinger Fund's net profits.
The fund, which focused on distressed investments, grew dramatically between 2004 and 2008. At its peak, in 2007, Falcone doubled his investors' money, Schneiderman noted, in good part by shorting the subprime mortgage market.
The accord resolves claims against Harbert and Alabama-based members of the investment manager, including Harbert chairman and CEO Raymond Harbert.
Falcone, who paid lower New York taxes on performance fee income as a result of the allocation, is not party to the deal, according to the settlement.
A spokesman for Falcone and Harbinger Capital Partners declined to comment.
The attorney general's office said the investigation is continuing.
A spokesman for Harbert Management and the individuals involved said they "adamantly deny" any wrongdoing and called the settlement a "commercial decision."
Falcone is winding down Harbinger Capital Partners, where he remains CEO. He also is chairman and CEO of HC2 Holdings Inc , a publicly traded holding company.
In 2013, Falcone agreed to a five-year ban from the financial industry after the government accused him of misconduct, including that he gave himself a $113 million loan from his hedge fund to pay personal taxes.
The latest probe stemmed from an unidentified whistleblower, who will receive 22 percent of the settlement, nearly $9 million. The agreement covers 2004 through 2009.
Schneiderman said it was the largest tax-related recovery by his office and stemmed from a 2010 change in the state's False Claims Act to cover tax claims. (Reporting by Karen Freifeld; Editing by Lisa Shumaker)