Most institutional investors, I imagine, are sympathetic to the plight of buyout professionals facing the prospect of paying higher taxes on carried interest. They recognize that a big reason so many bright people have migrated to private equity is that no where else (other than the hedge fund business, perhaps) can they get so wealthy from their investment talents.
But it’s not just buyout professionals that get a nice tax break from the business. For years institutional investors have taken advantage of a technique that allows them to avoid receiving what’s called unrelated business taxable income. UBTI is income generated by a tax-exempt organization through a trade or business that’s unrelated to what the organization itself does. Endowments, foundations and other tax-exempt limited partners must pay taxes on UBTI.
Most investment income generated by buyout firms is not UBTI. But buyout firms generate income in ways other than through profitable exits. Most, for example, charge their portfolio companies a variety of fees—transactions fees for work done to close an initial acquisition, investment banking fees for arranging a refinancing, monitoring fees for providing ongoing advice to managers. In forming new funds, limited partners have negotiated hard to get their fair share of these fees, since, they argue, buyout firms wouldn’t be able to generate them without their money. Today LPs typically take 50 percent, 75 percent, 80 percent or even 100 percent of these fees.
But tax-exempt LPs face a quandary. Since these fees would fall under the UBTI designation, they’d have to pay federal income taxes of as high as 35 percent. In addition, some would have to go to the expense of filing tax forms that they otherwise wouldn’t have to file. In certain cases, organizations could lose their tax-exempt status by accepting UBTI. So instead, buyout firms almost always agree to offset, or reduce the management fees that they charge LPs by the amount of the portfolio company fees that they agree to share.The result? The buyout firm gets its full management fees; the LPs—both tax-exempts and taxable—get their agreed-to share of portfolio company fees without having to pay taxes on them (although some lose a tax deduction to the extent they could deduct management fees on their tax returns); and the Internal Revenue Service arguably loses tax revenue from what has become a substantial stream of income for LPs. Foreign investors, meantime, use a similar management-fee-offset technique to avoid receiving taxable income called effectively connected income, or ECI.
The U.S. Supreme Court has generally held that taxpayers cannot duck taxes by assigning their income to another taxpayer. However, it has made exceptions in cases where there’s some risk that the income won’t materialize. Lawyers often craft offset provisions to preclude LPs from sharing in portfolio-company fees once the management fees needed to offset them have run out. This undermines the certainty of at least a portion of the income, and makes the offset strategy more defensible. Further, any assignment of income looks more suspicious when it’s dollar for dollar, tax attorneys say. In the context of management fee offsets, a 50 percent offset would be more defensible than, say, a 100 percent offset. Finally, attorneys can argue that portfolio company fee income represents compensation for work done by the management company, not the fund; therefore the LPs aren’t really assigning their own income to another party.
Beyond those defenses, tax attorneys say that the practice has been around so long that it’s doubtful that the IRS would challenge it. But as with the management fee-for-carry swaps discussed in my last column, both buyout firms and their LPs have been taking risks by employing tax strategies that could be subject to a successful challenge by the IRS. I doubt LPs take these tax risks into consideration when figuring out the risk-adjusted, after-tax returns of the asset class. They should.
For more on private equity tax issues, contact Stefan R. Boshkov, a partner at Nixon Peabody LLP, at 212-940-3068; Isaac Grossman, partner at Morrison Cohen LLP, at 212-735-8735; or Mary B. Kuusisto, partner at Proskauer Rose LLP, at 617-526-9760.