Management fee waivers are prevalent in the private equity industry, but in recent months the IRS has focused on the use of management fee waivers to generate beneficial tax treatment for fund management. The IRS recently proposed tax adjustments and penalties for a private equity firm that used management fee waivers over a two-year period. This action represents an initial attempt to curb what the IRS views in some circumstances as a potentially abusive tax strategy.
Management fee waivers typically are used to satisfy a portion of the fund sponsor’s capital commitment to the fund – the sponsor reduces its unfunded capital commitment by the amount of the waived fee (a “cashless contribution”). Generally, a fund sponsor would be required to fund its capital commitment with after-tax dollars. But, in exchange for the waived fee, the sponsor receives a special priority allocation of net profits (the “priority allocation”), often taxed at long-term capital gains rates. The priority allocation increases the sponsor’s capital account (and entitles it to distributions) as if the sponsor had contributed cash to the fund in the amount of the waived fee. Some management fee waivers are hardwired, meaning a prospective fee waiver is built into the fund agreement and permanently exercised at the time the fund is closed, while others are elective, meaning the sponsor may periodically elect to waive a portion of its management fees throughout the life of the fund.
In the past, many believed this practice was acceptable to the IRS so long as the profits interest received in exchange for the waived fee was subject to real entrepreneurial risk (i.e., the corresponding special allocation of income was subject to the fund’s overall profitability). However, recent criticism has focused on potentially abusive management fee waivers that nearly guarantee a priority income allocation and corresponding distribution. For example, some elective fee waivers are made late in a tax year when it is known the fund will have sufficient net income to support the priority allocation. In some cases, allocations of gross income are made in respect of the profits interest even when the fund has an overall net loss. Further, in other instances the priority allocation is earned based on the fund’s profitability in any single quarter or year, regardless of the fund’s overall profitability.
In July 2015, the IRS released proposed regulations that not only prohibit potentially abusive management fee waivers, but may also prohibit what many consider to be conservative fee waivers subject to real entrepreneurial risk. Read more about the proposed regulations here. The current case reported by BNA suggests the IRS is not limiting its enforcement to the proposed regulations, but rather is targeting existing management fee waivers under existing law.
Kader Crawford is a transactional attorney at Robinson Bradshaw whose primary focus includes fund formation and private investment transactions, alternative investments, joint ventures and various lending transactions.