Waive the fee, not the risk

The Internal Revenue Service (IRS) announced a few years ago that they were actively investigating the use of management fee waivers and sure enough, on July 22 of this year, the US tax authority issued a series of proposed regulations that would seem to jeopardize many current waivers. Beyond the proposed reforms, the announcement made it clear that the government was skeptical about their current use.

“Of current relevance, even beyond how the proposed regulations are eventually implemented, is the government’s statement that they don’t believe that many common waiver structures work as contemplated under existing rules,” says Richard Shapiro of the accounting firm EisnerAmper. The announcement suggests that the waivers may already be in conflict with existing regulations, because they’re disguised fees for services, implemented to earn a lower tax rate. And while the new regulations are just proposed at this point, most industry observers expect them to be approved with minimal changes.

The proposed regulations impact private equity in two key ways. First, the IRS announced that situations where one entity waives a fee, and another entity receives a related profits interest, might be viewed as disguised fees, subject to a higher tax rate. The second concerns how the IRS views “entrepreneurial risk” and other factors that allow this profits interest to remain a non-taxable event. While every private equity firm should consult their advisors about their own structures, there are some general guidelines for vetting any current waivers. Most of them are rooted in establishing “entrepreneurial risk” by the timing of the waiver, basing it on net, not gross income, and ensuring clawback provisions are in place. The truth is that many waiver structures already have these terms, but in light of the recent announcement, they’re critical to maintaining viability in the eyes of the IRS.

Currently, private equity firms have been waiving their fees to earn profits interest instead, which is taxed less than ordinary income. In July’s announcement, the IRS warned that when one entity performs a service and waives a fee, while another entity receives a similar payment in profits interest, that profits interest might be viewed as disguised fees and subject to a higher tax rate. Since fund managers waive fees and the GP receives the profits interest, there’s a good chance the IRS had private equity in mind. Presently, the IRS allows fee waivers so long as the fee being waived is charged by a member of the partnership for the partnership, and that the profits interest awarded to the partner for the services performed is not sold for at least two years. But some managers have been able to game the system, and convert income into more tax favorable capital gains without taking any risk of loss, according to some legal sources.

The IRS has taken note, and proposes that any fee waiver exhibiting the following three characteristics (described here in the private equity context) will be pegged disguised income: 1) the management company provides the partnership advisory services through a GP fund entity – which virtually all private equity and real estate firms do; 2) the management company collects a profits interest (carry rights) for their work; and 3) the entire transaction seems like it was only made for the benefit of the management company (and not the GP fund).

While that may seem to outlaw most fee waivers, the reality is that the regulations are not finalized yet, and the IRS has shared some guidance as to how they’ll be evaluating waivers. The IRS defined six factors that will contribute to the decision whether a profits interest is actually a disguised payment.

But the factor that carries the most weight according to the IRS is whether a given arrangement has “substantial entrepreneurial risk,” or rather, if there’s a chance the private equity firm will lose the fees they’re waiving.

Proving your entrepreneurial spirit

“The gist of the proposed regulations as applied to fee waivers is a focus on entrepreneurial risk and the standard for defining that risk for this purpose is higher than what most people view the current laws as requiring,” says Bruce Ettelson of the law firm Kirkland & Ellis.

Given the variation of structures for waivers today, the amount of risk can differ by a large margin. In particular, structures that allow the private equity firm to decide on the waiver annually or more often than that, appear to trouble the IRS. Maybe the firm waives fees one year, but has the option to keep those fees in 2016. That discretion is seen as taking some risk out of the equation.

However, if that waiver is consistent throughout the life of the fund, the IRS may look more favorably on that. This means there’s a fixed percentage in the LPA so that every time an investment is made, LPs will contribute say, 1 percent, as an incentive capital contribution for the benefit of the GP and that reduces the fee automatically.

Here, the manager can’t pick or choose how much is waived and when. “We feel that a hardwired mechanism, though not explicitly blessed by the IRS, is less susceptible to challenge because it’s fixed up front,” says Peter Furci of Debevoise & Plimpton.

Our legal sources note that not many waivers are currently structured in such a way, and there’s a view it ceases to be waiver in the sense that they exist now. A few lawyers argue that even if there is an option to elect a waiver year to year, firms should at least choose to waive fees at the start of the year, again, to add some risk to the situation.

Lawyers also stressed that any fee waivers should be based on net, not gross income, and ideally, should be impacted by a loss of that particular investment, not just the fund as a whole. “Our view is that it’s about the risk of loss. If that particular investment goes down in value, a portion of the fees can’t be recouped by the performance of the entire fund,” says Furci.

The other facet of any fee waiver structure to be included is a clawback mechanism that would require that any profits interest would be repaid in the event that long-term net income doesn’t warrant those payments. “Documentation is very important in terms of the clawback,” says Avi Reshtick of the law firm Bracewell & Giuliani. “But there needs to be a sense that the provisions will be enforced.” So any fee waiver shouldn’t include terms that would make that mechanism overly difficult to employ. This includes that fine print of the LPA listing the many situations where the clawback isn’t applicable.

“What’s driving this idea of a clawback here is the sense by the IRS that certain arrangements currently make it very easy to earn back those waived fees, by calculating profits for this purpose on a calendar year basis rather than on the long term performance of the fund,” says Ettelson. Again, it goes back to the point of ensuring these waiver arrangements have adequate chance of loss to warrant the preferential tax treatment.

While the IRS made a point of suggesting current waivers don’t meet regulatory requirements, lawyers suggest it’s unlikely they’ll go after any prior arrangements, or waivers that have already been applied. But going forward, if the proposed regulations are enacted, there’s a real chance waivers will be challenged. So it appears all of today’s fee waivers come with risks, entrepreneurial or not.