NY Times: IRS Shuts Down Private Equity Management Fee Waiver Tax Game

New York Times:  I.R.S. Targets Tax Dodge by Private Equity Firms, by Gretchen Morgenson:

The Internal Revenue Service on Wednesday proposed a rule aimed at ending a common and lucrative practice among private equity firms that allows them to artificially lower their partners’ personal income tax bills.

The practice targeted by the I.R.S. allows private equity firms to convert management fees they receive from their investors, which would normally be taxed as ordinary income, into capital contributions invested in their funds. Profits generated on such contributions are treated as capital gains or dividend income and subject to a sharply lower tax rate.

Converting a management fee to a capital contribution may be a “disguised payment for services,” the I.R.S. said in its proposed rule making, which it said was intended to provide guidance to partnerships and their overseers that such arrangements will be disallowed if they were done in such a way that no entrepreneurial risk was involved. ...

Gregg Polsky, a law professor at the University of North Carolina School of Law who is also a co-counsel for whistle-blowers on private equity tax matters, called the I.R.S.’s action “a real win for tax justice.”

The proposed regulations, said Mr. Polsky, who was a professor in residence at the I.R.S.’s office of the chief counsel from September 2007 to June 2008, “take the clearly correct position that the typical fee waiver isn’t effective in turning ordinary income into capital gains because fee waivers do not alter the economics of the two and 20 deal in any meaningful way.”

“In order to be effective under the regulations,” he explained, “fee waivers would have to subject managers to significant entrepreneurial risk, which most fund managers will be loath to do with respect to their fee income.”

Private equity firms have used management fee waivers for at least 15 years, Mr. Polsky said. It is unclear how many firms use the fee waivers now, because the documents outlining them are confidential. But he estimated that the government loses hundreds of millions of dollars a year in tax revenue because of the practice.

Bloomberg, IRS Tries to Curb Private Equity’s Fee Waivers With Tax Rule:

The “modest move” by the Internal Revenue Service would stop some of the most abusive maneuvers by private-equity firms, said Victor Fleischer, a tax law professor at the University of San Diego.

“The regulations strike me as more taxpayer-favorable than I would have expected,” he said. “The regulations try to accommodate some arrangements that are common in the industry and that in my view ought to be treated as payments for services,” taxed as ordinary income. ..

Fleischer said he was surprised at one example in the rules: Fund managers were deemed to have enough at risk when they choose whether to reclassify their fees as few as 60 days before a tax year starts. By that time, future profits may be relatively certain.

“At the point where the general partner is making the decision whether to waive the fee,” he said, “they’re in a very good position” to know how successful the investments will be and can control the timing of realized gains and losses.

Prior TaxProf Blog coverage:

• Gregg Polsky, Private Equity Management Fee Conversions (Feb. 11, 2009)
• NY Times, A Tax Tactic That’s Open to Question (Sept. 14, 2012)
• WSJ, IRS Reviews Private Equity Management Fee Waivers (May 13, 2013)
• Andy Grewal, Mixing Management Fee Waivers with Mayo (Oct. 8, 2013)
• WSJ, Private Equity Firms Save Millions in Taxes by Treating Dividends as 'Monitoring Fees,' Says Polsky (Feb. 3, 2014)
• NY Times, Tax Expert Sees Abuse in a Stream of Private Equity Fees (Feb. 3, 2014)
• Gregg Polsky, A Compendium of Private Equity Tax Games (Nov. 24, 2014)
• UK to Kill Private Equity Management Fee Waivers (Mar. 27, 2015)