Most members of the great unwashed public, when they hear about unfair results of the tax code, like Warren Buffet’s secretary facing a higher tax rate than he does, or private equity and hedge fund barons paying capital gains tax rates on labor income, assume that those outcomes are the result of a combination of the rich getting the tax code changed over time or succeeding in preserving the exploitation of loopholes that should have been closed ages ago.
But there is another category of tax games that are not discussed much in polite company, that of outright abuses. What is disturbing about that behavior is that it has not only become increasingly common, but members of the bar, including those at white shoe firms, are enablers.
A new paper by Gregg Polsky, A Compendium of Private Equity Tax Games, focuses on two private equity tax dodges involving monitoring fees and management fee waivers. It’s important to recognize that Polsky is no ordinary critic. Not only is he a professor of law at University of North Carolina, but he was Professor in Residence in the IRS Office of Chief Counsel.
It is critical to stress that these ploys are not in the same category as the widely-criticized way in which private equity firms and hedge funds exploit the carried interest loophole. These two abuses fall well outside any grey area. Yet the fact that top law firms have signed off on these strategies marks a serious deterioration from the role that attorneys are supposed to play. As Frank Partnoy, former derivatives salesman, now law professor, wrote in the Financial Times in 2012 (emphasis ours):
As recent debacles at Barclays, HSBC and now Standard Chartered demonstrate, employees of big global banks increasingly lack a moral compass. Some general counsels and compliance officers do provide ethical guidance. But many are facilitators or loophole instructors, there to show employees the best way to avoid the law. Not even mafia lawyers go that far; unlike many bankers, mobsters understand the value of an impartial consigliere who will tell them when to stop.
Similarly, the job that tax attorneys are supposed to play is to tell them where the lines are and how to stay on the right side of them. But since the IRS is thin on enforcement staff, one of the areas it does not police much is complex partnerships. Private equity firms and their advisors have taken advantage of this opportunity. As Polsky says:
More generally, the two abusive practices described here highlight the corrosive combination of IRS enforcement passivity in the subchapter K [partnership] arena with the intellectual capture of the elite tax professionals who practice in the area. These practices raise the question of whether fundamental partnership tax reform that does not radically simplify subchapter K can be successfully implemented without significantly ramped-up IRS enforcement and much more admirable behavior by elite tax professionals.
The monitoring fee abuse is so crass that unlike pretty much anything related to tax, it is easy to explain. You may recall that once a private equity firm buys a company, it typically makes the company sign an agreement to hire the private equity firm or an affiliate* to provide various services to it for a flat fee per year for a long period of time, typically ten to twelve years. That means that the payment to the private equity firm is tax deductible to the portfolio company.
Well, you might say, what’s wrong with that? The wee problem is that when you look at these agreements, it’s clear no business would enter into this arrangement. While the portfolio company has an unambiguous obligation to make payments to the private equity firm, the private equity firm is under no obligation to do anything to justify getting these fees. I’m not making this up, as this highly engaging video called “Money for Nothing” by Professor Ludovic Phalippou of Oxford attests. The entire video is worth watching, and the critical section starts at 8:00
Here is his translation of the services agreement:
I may do some work from time to time
I do some work, only if I feel like it. Subjective translation: I won’t do anything.
I’ll get [in this case] at least $30 million a year irrespective of how much I decide to work. Subjective translation: I won’t do anything and get $30 million a year for it.
If I do decide to do something, I’ll charge you extra
I can stop charing when I get out (or not), but if I do I get all the money I was supposed to receive from that point up until 2018.
This payment for non-services doesn’t wash with the IRS. For an expense to be deductible, the payment must have compensatory intent, as it is supposed to pay for something and that payment has to be reasonable in terms of what was received. The “Money for Nothing” scheme that Phalippou describes should be a non-starter, yet it’s widespread and the IRS has failed to intervene.
The second big abuse that Polksy describes, management fee waivers, is more technical, but one the IRS is apparently on the verge of halting. Polksy underscores that this one requires the cooperation of investors, who play along because they are for the most part tax exempt. The tax code is well enough designed that normally, what is called a character swap, say managing to recharacterize income as capital gains, isn’t a free lunch. While capital gains are taxed at more favorable rates than ordinary income, capital losses are less valuable than ordinary losses. But with private equity firms as tax-paying entities and most investors (particularly the big ones, the public and private pension funds and sovereign wealth funds) as tax exempt, that offers lots of rope for tax games to wring maximum advantage from the situation. We wrote about this in 2013:
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…
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 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 waivers 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.
Back to the current article. The attached article provides a more detailed but very accessible description of the management fee waiver scam, starting on page 11, and why it does not pass muster. Polsky concludes:
Fee waivers, therefore, do not work under current law….Management fee waivers have been pervasive over at least the past 15 years. A well-traveled Wilson Sonsini powerpoint from back in 2001 describes fee waivers in detail…When the IRS finally enforces the law, it will generally be able to recover taxes (plus penalties and interest) for the past three years of fee waiver activity, a small fraction of the taxes that have been avoided since the dawn of fee waivers.
Even though the IRS is finally about to show some muscle in the face of a clear, long-standing abuse, we can expect less rather than more of this sort of thing going forward. The IRS enforcement budget was cut under Cromnibus. So the willingness of the elite tax bar to overstep the IRS code on behalf of private equity kingpins is likely to continue.
*Yes, KKR Capstone is an affiliate.