WSJ: Private Equity Firms Save Millions in Taxes by Treating Dividends as 'Monitoring Fees,' Says Polsky

Wall Street Journal:  Private-Equity Firms' Fees Get a Closer Look: Industry May Be Underpaying Taxes by Misrepresenting Payments, by Mark Maremont:

Gregg D. Polsky, a tax-law professor, has long been a thorn in the side of the private-equity industry. Now he is at it again.

In 2009, Mr. Polsky wrote an article criticizing a strategy that allowed many fund executives to save on taxes by converting ordinary fee income into capital gains taxed at substantially lower rates. [Private Equity Management Fee Conversions, 122 Tax Notes 743 (Feb. 9, 2009).] The IRS later started examining the propriety of the practice, called a management-fee waiver, and recently said it plans to issue new guidance on it.

In a new article published over the weekend, Mr. Polsky takes aim at the tax treatment of another revenue stream for private-equity firms, called monitoring fees. [The Untold Story of Sun Capital: Disguised Dividends, 142 Tax Notes 556 (Feb. 3, 2014)]  He claims the industry may be underpaying federal corporate taxes by hundreds of millions of dollars a year by mischaracterizing these fees.

Monitoring fees are payments made by acquired companies to private-equity managers for what typically is described as ongoing consulting services. The companies paying the fees often deduct them as ordinary business expenses, a move that reduces their taxes.

In his article in the journal Tax Notes, Mr. Polsky argues that monitoring fees often should be treated as dividends, in part because fees sometimes bear little relationship to any services being performed. Rather, like dividends, they often are paid out proportionally to ownership stakes or as a percentage of earnings. Under tax law, payment of a dividend isn't a deductible business expense.

"The fee agreements I've seen are so problematic on their face," Mr. Polsky said in an interview, "it boggles the mind how anybody could think these payments are deductible under the current law."

Mr. Polsky discloses in his article that, as an attorney, he represents a would-be whistleblower who has made a claim to the IRS using similar arguments. An IRS spokesman declined to comment.

Looking at 229 large buyout deals in which information on monitoring fees is available, Mr. Polsky, of the University of North Carolina, and associates tallied more than $3.9 billion in monitoring-fee payments from 2008 to 2012 that he said have one or more features suggesting they were dividend-type payments. ...

John C. Hart, a tax lawyer at Simpson Thacher & Bartlett LLP in New York who represents private-equity firms, said it is a large industry and a few cases might have "weaker fact patterns," but that generally firms provide the services for which tax deductions are taken. He said private-equity firms often add staff to provide services and should be compensated when long-term contracts end early.

Some in the industry question whether overall taxes paid could decline if fees were recast as dividends, in part because those receiving the money might pay tax at lower dividend rates rather than ordinary-income rates. Mr. Polsky disagrees, saying that because of the tax-exempt status of many fund investors and complex fee-offset arrangements between private-equity firms and their investors, the Treasury Department would come out ahead.

• CNN, Private Equity's New Tax Problem
• New York Times, Tax Expert Sees Abuse in a Stream of Private Equity Fees

(Hat Tip: Kathleen Thomas.)