IRS fee waiver challenges ‘unlikely’

As the Internal Revenue Service (IRS) and New York's attorney general probe private equity firms' management fee waiver tax strategies, it appears “unlikely” that their investigations will produce any major changes in industry practice, according to legal sources.  

A management fee waiver involves effectively giving up fees in exchange for a priority allocation of future profits – one benefit of which is that the proceeds are taxed at the federal capital gains tax rate of 23.8 percent (like carried interest) rather than the ordinary income rate, which currently can be as high as 39.6 percent.

According to industry lawyers, determining whether a management fee waiver violates the tax code depends heavily on circumstance, making it unlikely the IRS will issue general guidance or regulations on the issue.

Instead the IRS may look to apply pressure via the audit process, reckons law firm Kirkland & Ellis in a client memo. Tax authorities will look to “the extent to which the arrangement subjects the general partner’s special profit allocation to genuine economic risk”. Only when the arrangement is perceived as “aggressive” would the IRS challenge the strategy, the memo said. 

Legal sources warn that strategies which permit managers to “cherry pick” which investments the waiver is applied to – including for example investments made before the waiver date which already have built-in gain – will be under the most scrutiny.