IRS Wakes Up to Private Equity Scam
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....MORE
