IRS proposes curbing management fee waivers

  • GPs avoiding income tax on management fees
  • Industry group says IRS doesn’t have power to change rule
  • Four key Democratic senators support IRS move

Private equity firms are lining up to fight a new regulation proposed by the Internal Revenue Service to stem the use of waivers that allow income from management fees to be taxed at a lower rate.

Many GPs pay their GP commitment to a fund by waiving the management fee, instead of straight cash, in exchange for a priority profit allocation once the fund starts to earn income. These profits, as carried interest, are taxed as long-term capital gains, which are taxed at a rate of 20 percent or less. Regular income is taxed at a rate of up to 40 percent.

The measure proposed by the IRS characterizes management fee waivers as a “disguised payment for services” with little or no entrepreneurial risk posed by the income.

The IRS set a deadline of October 21 for written and electronic comments and requests for a public hearing on the rule change, which the agency formally proposed on August 10.

The move by the IRS marks another front in the overall battle over carried interest, which is taxed at the capital gains rate rather than as ordinary income. The issue has picked up steam in the presidential race and on Capitol Hill.

The IRS fee waiver proposal drew support from Senators Al Franken (D-Minnesota), Elizabeth Warren (D-Massachussets), Tammy Baldwin (D-Wisconsin) and Sheldon Whitehouse (D-New York), who wrote a letter to Treasury Secretary Jack Lew and IRS Commissioner John Koskinen.

“Fund managers should not be allowed to alter the character of their salary income simply by inserting into their fee arrangements a few magic words that lack meaningful economic effect,” the senators wrote in the September 21 letter. “The abuse of fee waivers has been ongoing for years at the expense of middle-class taxpayers who do not use similar gimmicks.” The senators said “billions of dollars” of tax revenue have been lost as a result of fee waivers.

James Mahoney, spokesman for the Private Equity Growth Capital Council, said the IRS doesn’t have the power to change the rule without an act of Congress, a view expressed in a 2010 letter from Timothy Geithner to Senator Whitehouse, who had raised the issue at that time.

“Treasury has recognized for quite some time that the characterization of carried interest income cannot be changed without legislation,” Mahoney said.

The PEGCC is preparing a formal comment opposing the measure as well, according to a person familiar with the group.

Industry members who declined to be quoted by name said fee waivers benefit LPs in funds because they may reduce or eliminate management fee payments. For GPs, the waivers help reduce the cost for younger executives to participate in funds. It’s not clear how many private equity firms use fee waivers.

However, the Institutional Limited Partners Association, the trade group for LPs, prefers GPs make their GP commitments with cash rather than through management fee waivers. “GP equity interests in funds primarily made through cash contributions result in higher alignment of interest with LPs compared to those made through the waiver of management fees,” according to ILPA’s Private Equity Principles.

Management fee waivers have been in the spotlight before. New York Statelaunched a probe into the practice back in 2012, but no conclusion was publicized.

Action Item: See the IRS proposal here or the senators’ letter here