Fees charged to portfolio companies for ongoing management and advisory services are really just disguised dividends that can be claimed as tax-deductible business expenses, argues an academic in a new opinion piece that may catch the attention of US tax authorities.
There’s been little debate about the tax treatment of monitoring fees, but the article’s author, University of North Carolina law professor Gregg Polsky, said he “endeavors to fill that void”.
In his capacity as a lawyer, Polsky has already represented individuals who have filed IRS whistle-blower claims based in part on the arguments made in the article, which appeared in the Feb. 3 edition of the journal Tax Notes.
His argument boils down to this: monitoring fees are not a legitimate tax deduction because they do not actually represent compensation for services performed – as the law requires.
Under many monitoring fee contracts, GPs are not actually required to perform any services and can terminate agreements but still receive all future fees. In consortium deals, monitoring fees are also paid pro rata when one would expect such fees to be distributed based on services performed by each individual private equity firm, Polsky wrote.
“All of these factors indicate a lack of compensatory intent. A payer with compensatory intent would not allow the service provider to decide unilaterally when and how to provide future services that are only ambiguously described.”
Industry trade body the Private Equity Growth Capital Council (PEGCC) disagreed with that conclusion.
“Monitoring fees incurred are legitimate business expenses for private equity-owned portfolio companies,” PEGCC head Steve Judge said in a statement. “Federal and state revenue authorities have examined and affirmed the deductibility of monitoring fees earned by private equity managers, which are classified as ordinary income and taxed at the highest marginal tax rates.”
In the paper, Polsky said that the IRS and courts “have rightly recognized that pro rata allocations of purported compensation such as these are a key indicator of disguised dividends.”