Wednesday, February 11, 2009
Because of the uproar over "carried interests," it seems that almost everyone knows that the tax law currently allows private equity managers to pay capital gains taxes on a substantial part of the (often substantial) income generated by their services. While this result raises significant tax policy concerns, the basic tax law governing carried interests is well-settled, and legislative action therefore would be necessary to address these concerns.
In contrast, a little-known technique utilized by private equity managers to convert the character of their remaining compensation income is extremely aggressive and subject to serious challenge by the IRS. Private equity managers regularly attempt to convert their fixed annual two percent management fees into additional carried interest through so-called "management fee conversions." The tax result, if this technique is successful, is the conversion of current ordinary income into deferred capital gains.
Despite the recent spotlight on the taxation of private equity management compensation, surprisingly little attention has been paid to this particular tax minimization strategy. This article attempts to fill that void. Its purpose is twofold. First, it will describe the mechanics of management fee conversions, which are pervasive within the private equity community but not widely appreciated or understood outside of it. Second, it will discuss the tax issues stemming from management fee conversions, focusing on the IRS arguments that could be made to disallow their intended tax results.