For years, regulators have scrutinized the tax practices of private equity firms on several fronts. One relatively recent example occurred in 2012 when the New York Attorney General led an investigation regarding private equity funds’ conversion of certain management fees into investments that are eligible for more favorable tax treatment, also known as fee waiver conversion. ((Reed Albergotti, Mark Maremont, Gregory Zuckerman, New York Probes Private-Equity Tax Practices, Wall St. J. (Sept. 3, 2012, 8:05 PM), http://online.wsj.com/news/articles/SB10000872396390443571904577629831800831466.)) In recent years, fee waiver conversion has been the most high profile critical tax practice of private equity firms, but as of recently, a new argument has come to the forefront. ((William Alden, Tax Expert Sees Abuse in a Stream of Private Equity Fees, N. Y. Times Dealbook (Feb 3, 2014, 6:59 PM), http://dealbook.nytimes.com/2014/02/03/tax-expert-sees-abuse-in-a-stream-of-private-equity-fees/.))
The new argument focuses on monitoring fees, one of the three types of payments a private equity firm receives for managing the fund. ((Gregg D. Polsky, The Untold Story of Sun Capital: Disguised Dividends, 142 Tax Notes 556 (Feb. 3, 2014).)) Monitoring fees consist of payments that companies make to their private equity owners in exchange for what regulatory filings call consulting and advisory services over time. ((Id.)) In addition to monitoring fees received directly from the portfolio companies, the firm also receives an annual management fee. ((Id.)) Third, the general partner receives a percentage of profits realized by the fund. ((Id.)) A tax academic recently launched an attack on monitoring fees, which have always been dubiously viewed, arguing that the tax strategy pertaining to monitoring fees should merit a more skeptical look. ((Alden, supra note 2.))
Gregg D. Polsky, a law professor at the University of North Carolina, argues that these fees are being improperly characterized for tax purposes. ((Polsky, supra note 3.)) The core of this issue is whether or not the payments should be considered business expenses, which are tax deductible, or dividends, which are not. ((Id.)) Polsky’s argument intends to show that the payments more closely resemble dividends, paid to owners regardless of whether services are performed and directly in proportion to the size of the ownership stake. ((Id.)) Private equity firms charge hundreds of millions of dollars for monitoring fees, so if the payments are considered dividends, this would mean massive increases in revenue for the treasury.
There is a two-part test used to determine whether a monitoring fee is a legitimate business expense or a disguised dividend. ((Dan Primack, Private Equity’s New Tax Problem, CNN Money (Feb. 3, 2014, 12:10 PM), http://finance.fortune.cnn.com/2014/02/03/private-equitys-new-tax-problem/.)) There are two conditions that must be satisfied: (1) the payer must have a compensatory purpose; and (2) the amount paid must be reasonable in light of the services purchased. ((Polsky, supra note 3.)) The reasonableness prong may be satisfied in certain circumstances; it is the compensatory intent prong that is much less clear for monitoring fees.
To make his point, Polsky states that monitoring fees are often paid according to the size of a private equity firm’s stake, which suggests that the payments resemble dividends, rather than business expenses. ((Id.)) He writes, “Pro rata allocations belie compensatory intent because compensatory payments would be allocated among service providers based on the respective value of their services, not based on mere share ownership. It would be an incredible coincidence if a private equity firm that controlled, say, 7.2347 percent of shares was also expected to provide 7.2347 percent of the monitoring services.” ((Id.))
Similarly, in many cases, he says, the services expected of the private equity firms are described in vague terms. ((Id.)) Likewise, many of the agreements provide for the private equity firm’s cancellation of the service at any time while still allowing them to receive full monitoring fees. ((Id.)) All of these examples suggest that the requisite compensatory intent is not involved for the fees to be business expenses, rather than dividends. This suggests that monitoring fees are not deductible, a belief funds have relied on for years. Although the IRS has not yet caught on and chosen to delve into this issue, given the presence of this discussion in the media, the tax structure of private equity firms could have serious problems in the near future.
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