Private equity’s common fee practice of waiving a portion of management fees for a greater slice of the fund’s profits is “unlawful”, according to University of North Carolina law professor Gregg Polsky.
Polsky argues that private equity firms are improperly using management fee waivers to get a tax break by turning ordinary income, in the form of a fund’s management fee into, preferentially taxed, capital gains through priority allocation on future profits.
In a recent paper, A Compendium of Private Equity Tax Games, published earlier this month, Polsky says that the fee waiver practice violates Section 707(a)(2)(A) of the US tax code. This section of the tax code was designed to address artificial partnership transactions that are, in substance, merely fee-for-service transactions.
The paper says that the current management fee waiver practice falls outside of the tax code because it permits GPs to receive the tax break without taking “entrepreneurial risk”. Polsky says management fee waivers see GPs compensated for each individual exit, rather than taking into account all gains and losses of the fund.
“The fund agreements typically give the general partner the unilateral discretion to calculate the amount of available gains/profits and to determine whether and how any limitation on distributions (or clawback of prior distributions) is to be made,” says the paper.
“In addition, the critical terms “available gains” or “available profits” are sometimes completely undefined or so ambiguously or complicatedly defined that general partners can define the terms any way they like.
“In these cases, the available gains/profits condition is effectively an illusory condition because, given the discretion afforded the general partner and the ambiguity of the condition, no limited partner would ever be able to successfully sue to recover fee waiver distributions that were improperly received.”
Polsky says the IRS should issue guidance making management fee waivers available only when carry is paid in line of with the net profits of the fund.
“It would require fund managers who wish to turn water into wine to subject their nonrisky pay to meaningful entrepreneurial risk. Fund managers will typically be loath to do this and therefore the approach should go a long way towards killing off management fee waivers.”