Yet another private equity tax swindle has come to light. According to Monday’s Wall Street Journal, a leading tax academic has published a paper arguing that so-called “monitoring fees” that PE firms levy on the companies they’ve bought should actually be recognized as dividends for corporate tax purposes. This is is significant because fees are a tax deductible expense to the companies while the dividends aren’t, so the effect of this ruse is to shortchange Uncle Sam, and hence ordinary taxpayers to the PE funds’ benefit.
Professor Gregg Polsky, professor of tax at UNC Law School and former IRS Professor in Residence, contends that PE firms enter into sham fee-for-service contracts with their portfolio companies in order get a business expense tax deduction for the companies and to hide the reality that the payments are actually dividends. According to Polsky, this scam costs the U.S. Treasury hundreds of millions of dollars annually.
Tax law has long recognized that business owners have an incentive to mischaraterize cash distributions to them as fees for service rather than as dividends. As a result, the IRS relies on a two prong test, where both prongs must be satisfied, to determine whether the deduction is valid.
The first prong is whether the fees paid were reasonable in light of the services received. Polsky is not arguing this prong. He is focused on the second prong, which is whether a company, in making the payments, intends them to be compensation for services. According to Polsky, hundreds of agreements can be found on-file at the SEC between PE firms and their portfolio companies that reveal a complete lack of any intent for the payments to related to the rendering of services. Amazingly, the agreements almost always have an explicit provision disclaiming any requirement that the PE firms actually perform any services whatsoever in order to earn a monitoring fee.
Moreover, many of them provide for the right of the PE firms to stop providing the purported services anytime, at their sole discretion, including as early as one second after executing the contract of a typical 10 to 12 year term, and still receive the net present value of the all the future payments the company would have made for the next decade or as payment for “services.” As the author of a Fortune column put it, “This isn’t like paying a termination fee to your cellphone provider because you don’t want to fulfill the term of your two-year agreement. It’s like your cellphone provider terminating your service after six months, and then demanding the next 18 months of payment anyway.”
According to the Wall Street Journal Article, one of the most egregious examples of monitoring-fees-as-disguised-dividends was the 2006 buyout of the fraud-wracked healthcare company HCA by KKR, Bain, Merrill Lynch, and members of the Frist family, which we reproduce here (you can also view it at Edgar):
Not only did the HCA deal incorporate the “money for nothing” provisions of no-work-required-for-payment and quit-at-anytime-for-no-reason-and-get-paid-the-full-contract-term features, but as a “club deal,” the monitoring fees were allocated to each firm and Frist family member in a fashion apparently strictly pro rata to share ownership. Tax lawyers have literally gasped when told about this common practice of pro rata fee allocation in PE deals, as there is a mountain of court precedent declaring that, “pro rata allocation is the hallmark of disguised dividends.”
Professor Polsky’s paper, published in Tax Notes, lists nine other fee agreements that have ALL THREE of these provisions, any one of which Polsky argues would be fatal to the deductibility of monitoring fees. The other nine are:
Moreover, Wall Street Journal reports that Polsky represents a whistleblower who has turned all of these agreements, and hundreds more, in to the IRS, presumably in the hope of receiving the 10 to 30 percent reward that the IRS has recently been required to begin paying whistleblowers. This demonstrates how whistleblower rewards can produce curb abuses, as the sham monitoring fee situation has been hiding in plain sight for decades, much like PE firms’ unregistered broker-dealer activities that we have also covered.
The Journal left out one argument that Polsky made in his Tax Notes article. In recent years, private equity investors, led by the state and local pension funds that dominate the investor ranks, have increasingly demanded that monitoring fees collected by PE firms be turned over to them as the ultimate owners of the companies. Clearly, the investors are in on this ruse. They recognize that the PE firms aren’t providing real services if they think the monitoring fees should go to them, the fund investors, as the ultimate owners of the portfolio companies. Currently, 80 to 100 percent of such fees are generally credited to investors this way. You can see where this is going, which is that the monitoring fees are being distributed to the economic owners of PE portfolio companies pro rata in a different way. Once again, the deductibility goose is cooked.
Note also that government pension funds are actively involved in the monitoring fee deduction scam. We keep coming back to this theme in our coverage of private equity, which is that the public pension funds are, for the most part, thoroughly captured by the PE industry, to the point of turning a blind eye to tax abuses that benefit them, which this one does by increasing after-tax cash flow.
Finally, this scandal helps debunk private equity firms’ claims of adding value through operational improvement. People interested in doing real work aren’t generally at such pains to create sinecures for themselves, where they are contractually guaranteed payment even when they do literally no work at all.
Now as much as this seems like a clear cut tax abuse that the IRS should welcome pursuing, the flip side is that the White House has seen fit to override IRS enforcement efforts for political reasons, as we’ve documented in the case of REMICs (real estate mortgage investment conduits), where the IRS was keen to pursue flagrant violations but the White House blocked them. The Administration did have a plausible public policy argument, in that exposing the REMIC violations would have exposed the pervasive failure to transfer mortgages to trusts (meaning, as Adam Levitin put it, they were non-mortgage backed securities), and generated the mother of all litigation shitstorms (investors would be hit with massive tax liabilities, and would have sued banks en masse, leading at a minimum to a plunges in their stock prices and potential litigation-loss induced bankruptcies).
By contrast, there’s no excuse for saving the PE fund sponsors and their investors from being caught out on systematic chicanery. The costs are affordable and there are no systemic implications. However, Obama is deeply in the pocket of the private equity industry and continues to curry their favor. Two of the three members of the board of his Presidential library foundation hail from the PE industry, a clear sign he intends to hit them up to support this project. So if the IRS fails to pursue this abuse, you can be pretty sure Obama’s continuing financial needs are the reason.