IRS Cracks Down on Private Equity Management Fee Waiver Tax Abuse

We wrote in 2013 that the IRS was zeroing in on a flagrant, longstanding private equity tax abuse that was first flagged by University of North Carolina tax professor Gregg Polsky in Tax Notes in 2009. Nearly two years later, the IRS has finally decided to crack down on it, as Gretchen Morgenson describes in today’s New York Times.

The abuse allowed private equity firms to convert income that would otherwise have been taxed at ordinary income rates into lower capital gains rates. That’s the same type of result that has been widely decried in the media as far as so-called “carried interest” loophole is concerned. Recall that “carried interest” which is actually a profit share, is the 20, or 20%, in the prototypical “2 and 20” private equity fee schedule.

What perilously few outsiders understood is that the 2, or usual 2% management fee, which is income that is in no way, shape or form at risk, was also managing to get capital gains treatment through so-clever-it-flouted-law tax scheming. Keep in mind that the management fee is clearly income for services, as in income from labor, not capital. Moreover, the private equity investors had to agree to the tax machinations for this ruse to work. From our 2013 post:

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.

Now even this simplified explanation may still seem a bit dense, but focus on this part: Except that managers have leeway to find profits to cover it. The ploy is that the purported equity investment in the fund (via waiving the management fees and pretending that it is tantamount to a cash contribution) is not at risk like a bona fide equity investment because the private equity general partners have all sorts of wriggle room to create “profits” on their “investment” so as to achieve the desired tax result. As our earlier post elaborated:

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.

And state and local tax officials enabled this gambit, which lowers Federal tax receipts and thus has the effect of shifting the tax burden off the 0.1% of private equity kingpins to small fry like you and me:

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.

Now to Morgenson on the IRS move. Even though the IRS has only proposed a rule and is subject to a comment period, IRS official were making unhappy noises about the management fee waivers in 2013. Moreover, because this rule is a clarification of current IRS regulations, it appears the issue is whether this practice will be disallowed in totality or only curbed substantially. As Morgenson explains, “…the I.R.S. is permitted to begin examining private equity firms’ books for problematic fee waivers now and to pursue possible violations in a firm’s last three years of operations.” The IRS’ hand is also strengthened by the fact that the British tax authorities issued a similar ruling earlier this year.

Morgenson explains that the management fee waiver is not a trivial abuse:

Management fee waivers…made headlines during Mitt Romney’s 2012 presidential campaign when documents from Bain Capital, the private equity firm he founded, detailed the practice.

The documents indicated Bain saved $200 million in taxes over 10 years…

Gregg Polsky, a law professor at the University of North Carolina School of Law who is also a co-counsel for whistle-blowers on private equity tax matters, called the I.R.S.’s action “a real win for tax justice.”

The proposed regulations, said Mr. Polsky, who was a professor in residence at the I.R.S.’s office of the chief counsel from September 2007 to June 2008, “take the clearly correct position that the typical fee waiver isn’t effective in turning ordinary income into capital gains because fee waivers do not alter the economics of the two and 20 deal in any meaningful way.”

“In order to be effective under the regulations,” he explained, “fee waivers would have to subject managers to significant entrepreneurial risk, which most fund managers will be loath to do with respect to their fee income.”

The IRS may also get some significant recoveries:

If it finds violations at a private equity firm, the I.R.S. could extract payment of taxes owed by its partners as well as interest on that money. If it found that the fee-shifting had no reasonable basis, it could also levy penalties.

New York State’s Department of Financial Services has taken the pioneering move of holding professional like lawyers and consultants accountable for enabling regulatory violations. Private equity expert Eileen Appelbaum regards the management fee waiver scam as so egregious as to call for similar sanctions for tax professionals:

Ms. Appelbaum said that private equity firms should not be the only ones held accountable for problematic fee-shifting.

“Lawyers and auditors ought to be held responsible as well,” she said. “Every private equity firm that does this, does this with some kind of legal advice. But it clearly has been a violation of law for some time.”

Let’s hope Appelbaum is right. We won’t see meaningful changes in the financial services industry conduct until the lawyers who get massive fees for providing banksters with liability shields suffer real penalties.

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