Elizabeth Warren, Al Franken, Tammy Baldwin, and Sheldon Whitehouse wrote a short, forceful letter supporting IRS efforts to end a long-standing private equity tax dodge, management fee waivers. We written about this abuse before, most recently in one of our posts on CalPERS, where Chief Investment Officer Ted Eliopoulos did a “put foot in mouth and chew” by showing he had no clue about how management fee waivers actually worked, and instead parroted general partner Big Lies about the practice.
Despite the mouthful of a name, in concept, management fee waivers not all that complicated. As we wrote earlier this year, when the IRS issued guidance that it had the scam in its crosshairs:
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.
Back to the current post. Recall we criticized CalPERS for attempting to present this scheme as aligning general partners’ interest with those of limited partners like CalPERS. As you can see, that view reflects either a complete misunderstanding of how management fee waivers work, or willful misrepresentation to CalPERS’ board, since the management fees waived aren’t treated in the same manner as the limited partners’ hard dollar contributions.
Worse, the limited partners routinely allow management fees waived to stand in lieu of the monies the limited partners expect the general partners to invest in the fund to show they are willing to eat their own cooking.
The net economic effect is that the limited partners choose to pay excessively high management fees (remember, management fees are intended to cover limited partner essential overhead, so the fact that they have money left over to waive says the management fees should be cut back) to preserve the fiction that general partners have “skin in the game”. And to add insult to injury, taxpayers have come out losers thanks to this dodge. As the International Business Times pointed out, the amounts at issue are significant:
A 2012 analysis of tax returns from Bain Capital, founded by former Republican presidential contender Mitt Romney, showed that management fee waivers allowed the private equity firm to avoid some $200 million in taxes over 10 years.
On a broader basis, both tax experts and Washington insiders report that this move is the beginning of the end of special treatment for private equity in tax land. The big and long criticized tax abuse, that of treating the profit share widely mislabeled as “carried interest” is nearing its sell-by date. It isn’t because The Donald has attacked it, but that not only are right wing populists speaking out against it, but at least as important, banks are also quietly on board. As one well-connected source said, “The banks are going after PE because PE is competition.” Even Jeb Bush’s tax plan, which is a gimmie to the wealthy, not only targets the “carried interest” loophole, but also takes aim at another tax break essential to private equity, that of the tax deductibility of interest payments. As the New York Times’ Andrew Ross Sorkin noted:
Mr. Bush is seeking to destroy an incentive for American companies to borrow money.
His policy could have a profound impact on almost every industry, but would especially affect the private equity and real estate industries, which have long relied on debt — or leverage, in Wall Street parlance — to increase their profits.
You’ll also see that the Senators’ letter applauds the IRS for taking the position that this tax scheme was never kosher. That gives the agency the power to challenge past tax filings. This certainly appears warranted, given the strong position the IRS has taken. But heretofore the agency has been unwilling to confront large tax payers with savvy lawyers. Let’s hope Warren and her fellow Senators make sure the IRS follows through and dings the private equity miscreants for back taxes owed.