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IRS Wakes Up to Private Equity Scam

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Readers of Naked Capitalism may recall past mention of a common tax practice in the private equity (PE) industry known as a “management fee waiver.” This tax maneuver first got media attention during the Romney presidential campaign. Secret Bain Capital files released on Gawker last summer revealed that Bain had “waived” over a billion dollars of management fees in recent years, resulting in federal tax savings to Bain partners of approximately $250 million in aggregate.

For decades, the IRS has been oblivious to the tax dollars that private equity firms have been stealing from the U.S. Treasury via this abusive fee waiver tax shelter. But NC readers in the tax world have alerted us to recent IRS pronouncements indicating that both the Service, as well as influential tax commentators, have woken up to the scam and don’t like what they see in terms of its compliance with tax law.

The concept behind the management fee waiver tax shelter is quite simple, though the tax maneuvering to implement it is mind-bogglingly complex. As we’ve discussed here before, PE fund managers generally receive two main sources of income from the funds they manage. The first is a “management fee,” typically two percent of the fund’s size committed capital, paid annually to the PE firm for its services. This is ordinary income to PE firm managers, typically taxed at the highest marginal rate (39%). The second revenue stream PE firms receive is so-called “carried interest,” which is typically 20% of the profits generated by funds they manage. Carried interest is taxed as long-term capital gains, currently 20%.

PE managers share a version of Leona Helmsley’s belief that “taxes are for the little people.” The PE guys believe that — at a minimum—ordinary income taxes are for the little people and that they should never have to pay more than the much lower capital gains rate on any dollar of income they receive. As a result, PE managers and their lawyers cooked up a scheme to convert the ordinary income of management fees they receive into capital gains.

PE managers implement this scheme by “waiving” management fees owed to them by their limited partnership investors in exchange for a profits (carried) interest in the fund. Managers are deemed to have made a cashless contribution in the amount of the fee to the fund, which is deemed to earn profits like an investor’s cash contribution. Except that managers have leeway to find profits to cover it. Fund governing documents usually allow the general partner to find profits to cover the waived fee in any accounting period. Sometimes there is a clawback if cumulative profits are insufficent to cover waived fees. In the most aggressive version of this practice, fees are waived shortly before payment is due, so that managers can ensure that profits are available to cover them.

Experts have been questioning the legality of the fee waiver for a while. UNC tax professor Gregg Polsky got the ball rolling with a long article in Tax Notes in 2009, where he stated in the introduction:

A little-known technique used by private equity managers to convert the character of their remaining [management fee] compensation is extremely aggressive and subject to serious challenge by the IRS.

Polsky is no lightweight academic, having served in 2007-2008 as the “Professor in Residence” at the IRS. In the article, Polsky identified myriad of reasons why management fee waivers don’t comply with current federal tax law. Among the most important, he pointed out that giving the PE firm managers first claim on every dollar of revenue until amounts they have waived are “repaid” to them effectively removes the “entrepreneurial risk” that is at the core of the argument why fee waviers should be treated as being at the mercy of fund profits.

Polsky also pointed out that fee waivers need to comply with a long list of hyper-technical requirements to stand a prayer of complying with tax law, and that PE firms regularly flout those requirements. For example, the notional “fee waiver profits interest” that is created when fees are waived cannot be transferred to another party within two years of its creation. However, NYT columnist Floyd Norris pointed out last year, in a column questioning the legality of fee waivers, that Apollo openly acknowledges in SEC filings that it routinely violates the no-transfer restriction.

Earlier this year, Lee Sheppard, a contributing editor at Tax Notes and perhaps the most respected tax commentator in the U.S., wrote a long piece questioning the legality of fee waivers. The article was titled “Why Are Fee Waivers Like Deep-Fried Twinkies?” The title says pretty much everything you need to know about Sheppard’s view of the legality of fee waivers. She argued that waivers should not be respected because managers do not take any real risk that there will be no profits to cover the fees.

Even legal practitioners from big law firms have recently questioned the practice, once out from under the skirts of their corporate masters. For example, Ed Kleinbard, a former senior tax partner at Cleary Gottleib has been quoted as saying:

These are tax issues [management fee waivers] that should have been aggressively audited and litigated by the IRS.

I think we’ve just been let down by the IRS. They just haven’t done a good job at policing these practices, for a decade now.

The good news here is that—in better late than never fashion — the IRS in recent months has made multiple public statements indicating that a crackdown on fee waivers is either imminent or already in progress. In May, Clifford Warren, special counsel in the IRS Office of the Chief Counsel, spoke publicly at a conference about the fee waiver practice and for the first time indicated that it is receiving serious official attention:

There is quite a spectrum in fee waivers, and we don’t like everything we see,” Warren said. He later told Tax Analysts that while the Service believes the structure is being abused in some cases, it’s unlikely that the IRS will make all such arrangements “strictly forbidden.

Most significantly, the Service just recently put the fee waiver topic on its “Guidance Plan” work list for the new fiscal year, meaning that they expect to make a formal pronouncement on the legality of fee waivers in coming months.

In September, a Treasury official, Craig Gerson, attorney-adviser, Treasury Office of Tax Legislative Counsel, explained that the forthcoming guidance would establish bright lines about what kinds of waivers do and do not achieve the desired tax result of capital gain treatment. He said that the Treasury is concerned that there is no risk of nonpayment when the waiver is made close to the due date of the fee and in the presence of profits.

The good news here is that Warren seemed to indicate that the IRS has some fee waivers in its sights to disallow. On the other hand, he didn’t take the step of condemning the practice in totality, and further, it’s worth noting that his last job before the IRS was as a lawyer in-house at KKR, one of the largest private equity firms.

PE fund investors have woken up to fee waivers and they don’t like them. Their gripe is not the tax scam but the implcation that management fees are far too high, despite being originally intended to cover administrative costs. The best practices of the powerful International Limited Partners Association (http://www.ilpa.org) recommend against fee waivers. ILPA doesn’t like cashless contributions, and maintains that management fees should be justified and reasonably calculated to cover costs.

U.S. public pension funds have not only invested in many hundreds of private equity funds in the last decade that contain the fee waiver feature, they have gone far beyond that in enabling the practice. That is because, in their efforts to dress up the fee waiver maneuver as legal, private equity fund limited partnership agreements (LPAs) require the fund investors to agree to the legal contortions of the cashless contribution described above.

The pension funds, and other investors, take a hear-no-evil-see-no-evil posture, and it’s very common to hear private equity investors rationalize the tax evasion they know is occurring by saying, “It’s between the fund GPs (the private equity firm principals) and the IRS.” I want to be clear here: these people who are turning a blind eye to this dubious practice are people you elected, or their subordinates. They are state treasurers, state controllers, and other elected state and local officials who sit on public pension boards.

There is another element of government pension fund complicity, which is their universal treatment of PE fund limited partnership agreements as the only state and local government contracts not subject to state freedom of information (FOIA) laws. Several states have laws permitting state pension funds to keep these agreements and even the extent of their alternative investments secret.

We’ve made a bit of a fetish, whenever we’ve mentioned private equity LPAs in past posts, of referring to them as “super-secret LPAs.” You can see here why it’s important to understand this reality. Fee waivers are implemented via fund LPAs. Typically a meaningful portion of the LPA document deals with the mechanics of the waiver. It was only around ten years ago that PE firms embarked on their aggressive campaign to change state FOIA laws, a task in which they had massive success, so that the public could no longer examine their LPA contracts with public pension funds. This is a textbook case of finance capturing government officials, and relatively unsophisticated state and local pension officials have been easy prey.

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11 comments

  1. vlade

    While I’m not advocating flat tax, I’d say that the first priciple of any fair system is that ALL income (whatever it’s source) is taken in and then taxed with the same rules. The capital/labour/etc. split in taxes makes nil sense (yes, we want capital to go in – but the world is now way less capital intensive than 100 years ago – Microsoft never needed much capital, so in fact we want more labour to go in. How about taxing capital punitively and labour less so?)

    They say that general always fight the last war. I say the general are only a special case of any people with power.

    1. Stelios Theoharidis

      At the risk of repeating an argument used on Corrente a while back higher effective taxes at the top for income and capital gains seems to provide incentive for business owners and executives to reinvest in their enterprises for quality, production, innovation, labor training, or market share. What we have seen more recently via low effective tax rates is pump and dump through venture backed speculative enterprises ala tech bubble (zynga, twitter, ect), by taking a large productive firm and asset stripping, overleveraging and fee recovery by private equities, glorified accountancy cost cutting, pushing down wages, abstaining from R&D, delaying capital expenditures, tax shelters, special investment vehicles, off shoring, etc to pump the value of a stock up while sacrificing a firms long term sustainability. That gets the executives and owners returns so they can get out before the company does a nose dive due to poor product quality or related falling market share. It sounds like much of American business over the last 20-30 years. Big surprise we aren’t producing much anymore or industrially competitive, no one had any incentive to invest in their own firms if they could pull out of their companies drop it in investors hands and get good returns by the difference in effective tax rates alone.

    2. Stelios Theoharidis

      I guess I should preface that first statement by suggesting that I think that is a component in U.S. post-war economic growth and its reversal is part of our collapse into a speculative, extractive, and predatory economic system. The big part was that the productive capacities of the remaining developed economies of the world were absolutely decimated after WWII. No competition gave us U.S. businesses a license to print money. The U.S. government reinforced that through various programs targeted at Europe and Asia to fund their purchase of U.S. goods. The other component would be cheap resource prices reinforced by U.S. military power. Although the latter component has become such a spectacular drag on the U.S. economy in modern times. Those factors aren’t alone but I think they are pretty big. That allowed for the U.S. economic growth post war and it created a tremendous amount of largesse that was funneled into rural electrification programs, agricultural subsidies, irrigation programs, highways, cheap education, home ownership, decent wages, the space program, scientific research funding, amongst other things. A immense amount of it was also spent reinforcing our military power across the world. We really didn’t know what to do with the immense wealth that was created, hell we performed 1,054 nuclear weapons tests from 1945-92, how much do you think that cost alone.

      I think that it is interesting to note that that a sizeable component of our current economic system is dedicating to strip mining the tremendous wealth that was generated by our economic system. That would include the privatization of everything, a financial system that lures retirees and their functionaries in pension funds into ‘fraud’ – lite investments with huge information/loss asymmetries, predatory lending, health insurance rent extraction, 401k rent extraction, etc. We built so much within that period of economic growth and prosperity that we still haven’t been ultimately capable of strip mining it all, but they may well manage one day.

  2. Pearl

    Good Morning Yves!

    If I were to peruse SEC filings for such “arrangements,” do you know in which specific types of SEC filings such arrangements might most-likely be referenced?

    And do you have any suggestions for terms I could search within the SEC filings that might be indicative of such arrangements?

    I searched some larger filings for “management fee waiver,” and “carried interest,” and did not get anything yet, but I have gotten a lot of hits for “management fee” and “incentive fee.”

    (I searched for “LLP” and was able to find out the name of the P.E. firm in the deal. So that made me happy.) :-)

    Btw, if you ever need a handy reference list of various SEC forms:

    http://www.sec.gov/about/forms/secforms.htm

    Thanks so much for the great post. As usual, I will have to read it a few more times for it all to sink in. Your breadth and scope of knowledge is crazy-amazing.

    You must have been a hoot to raise! How old were you when you noticed that you were smarter than your teachers? (And was that scary or frustrating?) :-)

    Bye!
    p.s. If you ever need any free “grunt-work” type of research that’s just time-consuming, but easy–PLEASE let me do that for you. (I hate not having been able to contribute actual money to your fundraising.) Maybe you could have an on-going “grunt-work needed” list posted somewhere on your newly renovated blog?

    1. Yves Smith Post author

      Oh, that is a good suggestion! Let me think about that…..the problem is it also takes time to organize, and I don’t have much time for that! But there might be topics where having someone aggregate news and research so I could look at it when it comes time to do a story would be helpful.

      As to my childhood, I did have some issues early on with school. My parents sent me early to kindergarten and I got myself expelled the first day. The teacher was writing instruction on the blackboard, I think for fingerpainting. I thought “This is stupid. I can’t read and I am sure no one here can read either.” After she was done, I stood up in the back of the classroom, yelled “Charge!” , ran to the front of the room, grabbed the eraser, and oblitherated what she had written. Needless to say, my parents were called pronto.

      1. Pearl

        Okay. That’s a great story; I love it!

        That incident would have catapulted you to “most favored student” status if I had been your teacher. :-)

        (New idea–a recurring segment called “All about Yves!”)

        And I’m glad to hear that you’ll kick around the idea about letting us do some “low-priority crowd-sourced research” for you. (Thanks, Diptherio, for the better description of the idea!)

        You could call it/us: Yves’ Reprieves? Laissez-free Capitalism? Laissez-Share Capitalism? Laissez-Fare Capitalism? Yves’ Pleas? Aided Capitalism? Streaker Capitalism? E-Pawned? Econnedvicts? Yves-Sourced?:-)

        Whatever it’s called–count me IN.

  3. clarenceswinney

    David Degraw you are good. Get on TV.
    REAGAN BOOK BY CHRIS MATTHEWS
    Chris wrote a Whitewash and omitted Reagan economic failures and others.
    I voted twice for him. I loved to hear him speak.
    His negatives are—Increased Spending by 80%–Debt by 189%–initiated our involvement in 5 foreign conflicts—Cut Carter’s creation of 218,000 jobs per month to 175,000—Started redistribution of wealth by giving top a 60% income tax cut.

  4. erichwwk

    mainstream economics has fetishized the use of mathematics, and consideration of fairness aren’t easily integrated into reductivist models.

    However, economists in practice want to have it both ways. While their discipline has scientific aspirations, most economists have a clear point of view on what they think the measure of success of economic policies should be, whether it is narrow commercial terms (growth, GDP, interest rates) or broader social outcomes. But even economists who care about the latter (as in they care not just about the level of growth but also how resources are shared), often think of the problem in a combination of distributive and mechanistic terms.”

    One economist, who saw the downside of mathematics was Kenneth Boulding.

    “Mathematics brought rigor to Economics. Unfortunately, it also brought mortis.”

    He also saw the futility of using metrics such as GDP to measure ecomic system success

  5. readerOfTeaLeaves

    There is another element of government pension fund complicity, which is their universal treatment of PE fund limited partnership agreements as the only state and local government contracts not subject to state freedom of information (FOIA) laws.

    These PE folks are too clever by half.

  6. Nathanael

    AFACIT treating “carried interest” as capital gains isn’t even legal, unless the manager actually put up 20% of the initial funding for the fund.

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