Private equity firms are no strangers to controversy when it comes to their compensation arrangements. In the most recent presidential election, Mitt Romney and the entire private equity industry came under intense scrutiny from both the electorate and politicians for the tax rate paid on carried interest. Carried interest is taxed at the capital gains rate, a rate typically much lower than the ordinary income rate. This begged the question whether private equity firms were being taxed at a fair rate. Similarly, private equity firms are involved in another controversy regarding taxes paid by their members: management fee waivers. Not only do the management fee waivers raise fairness concerns, but legality concerns as well.
Private equity firms are paid in primarily two ways, management fees and carried interest.1 Management fees are paid to the fund by the limited partners and are typically around 2% of assets under management.2 Carried interest on the other hand, is a percentage of profit made from selling the portfolio investments owned by the fund, which is usually around twenty percent (20%).3 One crucial difference between these two forms of compensation is the difference in their tax rates.4 The management fees are taxed at the ordinary income rate, which is around 39.6% for the highest tax bracket, whereas the carried interest is taxed at the long-term capital gains rate, which is around 23.8%.5
A management fee waiver is when the general partner of the PE fund chooses to forego the management fee and instead apply that amount to their carried interest.6
This arguably allows the general partner to convert ordinary income into capital gains.7 In addition, it allows the general partner to defer tax payments at a later time when the carried interest gains are realized.8 This raises the concern whether the management fee waivers are legal under the tax code.9
Determining whether a management fee waiver structure is legally compliant with tax law depends greatly on the facts and circumstances of each case.10 One of the factors that the IRS looks at is the economic risk faced by the general partner.11 The more likely it is that a general partner may not receive payment from the carried interest, the better the argument is for the validity of the fee waiver.12 Another factor that the IRS looks at is the aggressiveness of the fee waiver arrangement.13 It is unclear what the IRS will look to in terms of the aggressiveness of the fee waiver arrangement, but one factor that the IRS may consider is when the waiver was executed.14 If the waiver was executed well before the general partner was aware that they would receive additional carried interest from the fee waiver, then it is much more likely to be upheld.15
Critics of the management fee waiver argue that under Section 707(a)(2)(A) and Section 707(c) of the Internal Revenue Code make management fee waivers illegal.16 Under 707(a)(2)(A) the IRS may argue that the management fee waiver is actually a non-partner transaction.17 Similarly, under Section 707(c) the IRS may argue that the fee waiver is a guaranteed payment.18 If either of those arguments is accepted, then additional carried interest from the management fee waiver will be treated as ordinary income as opposed to capital gain.19
In Mixing Management Fee Waivers with Mayo Professor Grewal argues that management fee waivers are not prohibited under Section 707(a)(2)(A) and Section 707(c).20 He argues that under both of these sections that the IRS and the courts cannot use these sections without implementing further regulations.21 Specifically, he argues that under Section 707(a)(2)(A), “the IRS or a court would have to invoke so called phantom regulations.”22 “Phantom regulations” are congressionally mandated regulations that have not yet been written, but are meant to apply as Congress would have intended.23 Professor Grewal argues that Mayo has essentially overruled case law that recognized phantom regulations.24 In regards to the Section 707(c) argument, Professor Grewal states that since Section 707(c) provides ordinary income treatment only to “[payments] determined without regard to the income of the partnership” which would require a court to resort to a ruling that has been subsequently overruled by Mayo.25
Professor Grewal’s arguments are certainly persuasive, but there are many who disagree, at least partially, with his conclusions.26 Some believe that since it is so difficult to get guidance and additional regulations from the IRS and the Treasury, the courts will have to handle issues involving Section 707(a)(2)(A) and Section 707(c) themselves.27 In addition, since the particular facts and circumstances of each case determine whether a fee waiver arrangement complies with tax law, the IRS is not likely to issue further guidance.28
The law in this area is unquestionably murky, but will hopefully prove to be clearer once rulings on fee waiver arrangements are made. As of now, the safest way to comply with current tax laws would be for private equity funds to simply not utilize a fee waiver arrangement at all. The next safest approach would be to conservatively utilize a fee waiver arrangement by, for example, opting for a fee waiver arrangement early in the fund’s life.
Private Equity Compensation Structure, AskIvy http://www.askivy.net/articles/private-equity/private-equity-explained/private-equity-compensation-structure (Last visited Oct. 12, 2013). ↩
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Id. ↩
See Private Equity Firms’ Use of Management Fee Waivers, V&E Private Equity (Sept. 13, 2012), http://www.velaw.com/resources/PrivateEquityFirmsUseManagementFeeWaivers.aspx. ↩
A Taxpayer’s Guide to 2013, Fidelity Viewpoints (Feb. 27, 2013), https://www.fidelity.com/viewpoints/personal-finance/taxpayers-guide. ↩
Private Equity Firms’ Use of Management Fee Waivers, supra note 4. ↩
Id. ↩
Id. ↩
Id. ↩
IRS Unlikely to Seek to Prohibit PE Fund Management Fee Waivers, Kirklandpen (May 29, 2013), http://www.kirkland.com/siteFiles/Publications/PEN_052913.pdf. ↩
Id. ↩
Id. ↩
Id. ↩
Id. ↩
See id. ↩
IRS Unlikely to Seek to Prohibit PE Fund Management Fee Waivers, supra note 10. ↩
Id. ↩
Id. ↩
Id. ↩
Andy Grewal, Mixing Management Fee Waivers with Mayo, 15 Fla. Tax Rev. (Forthcoming 2014). ↩
Id. ↩
Id. ↩
Phillip Gall, Phantom Tax Regulations: The Curse of Spurned Delegations, 56 Tax Law. 413, 413-14 (2003). ↩
Grewal, supra note 20. ↩
Id. ↩
Monte A. Jackel, Recent Commentary on Partnership Fee Waivers Raises Fundamental Questions, Tax News Analysis & Commentary (Oct. 9, 2013), http://jackeltaxlaw.com/recent-commentary-partnership-fee-waivers-raises-fundamental-questions/. ↩
See id. ↩
IRS Unlikely to Seek to Prohibit PE Fund Management Fee Waivers, supra note 10. ↩