The use of management fund waivers should be undertaken carefully moving forward.
The IRS has taken a hard look at management fee waivers since Mitt Romney's presidential campaign. It was revealed in 2012 that Bain Capital had saved hundreds of millions of dollars by converting management fees over several years. In July, the IRS issued Proposed Regulations that provide some insight into when management fee waivers will be considered as a disguised fee for services moving forward.
The good news is that the IRS will continue to recognize management fee waivers as legitimate. However, managers at private equity firms and other financial institutions will have to carefully observe the Proposed Regulations issued by the IRS to ensure any management fee waiver transactions are not subject to taxation as a disguised fee for services.
Management fee waiver basics
Management at private equity firms can waive all or a portion of the fees it is owed at the beginning of the year in which the fee is owed. In exchange, the fund manager obtains an increased profit interest in the funds and a priority allocation that are equal to the fee waiver amount. The exact structure of this arrangement is variable, but the upshot is that managers can claim long-term capital gain income in lieu of ordinary income, which has the potential for significant tax benefits.
On July 22, the IRS issued Proposed Regulations governing when management fee waivers can be converted without having to pay ordinary income taxes. While the practice has not been made illegal, the IRS Proposed Regulations have suggested a "facts and circumstances" test to consider when determining whether distributions under a partnership agreement will be treated as a disguised fee for services.
IRS Proposed Regulations
Under the Proposed Regulations, the IRS will consider six non-exclusive factors when considering whether a management fee waiver is a disguised fee for services. The most important factor is the "entrepreneurial risk" associated with the partnership agreement. If the arrangement lacks any risk typically associated with a partnership distribution arrangement, then it is more likely to be categorized as a fee for services. Examples of partnership arrangements which lack significant entrepreneurial risk include distribution based on gross income, rather than net income, and fee waivers that are non-binding.
Despite the Proposed Regulations, there remains significant uncertainty about how management fee waivers will be treated in the future. In addition, the IRS has not provided a safe harbor in which management can be certain that fee waivers will not be challenged.
Help with compliance issues and IRS challenges
At Insight Law, our experienced tax attorneys can help financial institutions and business remain compliant with IRS regulations and rules. For help with compliance matters through the issuance of an option letter or to discuss an IRS investigation, audit or challenge, contact our Seattle office.