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IRS Investigating Popular Tax Avoidance Strategy Used by Private Equity Firms

The Internal Revenue Service is investigating a common tax strategy that has been used for years by partners at private equity firms to reduce their tax burden, known as "management-fee waivers" or "fee-waiver conversions."

Typically, private equity firms receive a fee for managing clients' investments. This fee is taxable income to the firm and is taxed at the ordinary income tax rate. Managers are also required by law to invest a portion of their own money in the same funds. A "management-fee waiver" is where the private equity manager waives the fee that they would typically receive, in favor of receiving an interest in the investment that they manage. Once the investments generate profits, the managers are entitled to a preference in the distributions of such profits, until they recover the amount that they would have received under a traditional management fee.

The result is that the same money can potentially be taxed at a lower capital gains rate, which starts at 20% for higher-income taxpayers, as opposed to ordinary income tax rates, which are a maximum of 39.6% for wealthy taxpayers. Another benefit is that it allows the income to be deferred to later years. The requirement that managers invest in the funds that they manage is also satisfied, since the managers receive an interest in the investments in lieu of a management fee.

Opponents of the strategy long argued, among other things, that the managers had constructive receipt of the management fees that they have earned and are entitled to, and they cannot avoid having income by choosing to waive the income that they are entitled to. The strategy has since been changed so that managers waive in advance the right to receive anything in the absence of future profits from investments. However, some variations of the strategy allow the managers to "cherry pick" which investments the waiver is applied to, sometimes even including investments made before the waiver date, which already have built-in gains. This can virtually ensure that the manager receives the amounts that they had waived the right to, and it may ultimately determine whether or not the arrangement can withstand IRS scrutiny.

Clifford Warren, a Special Counsel to the IRS Chief Counsel, said that the IRS is "studying" the legality of this tax strategy, which is already being used by many of the largest private equity firms, such as Bain Capital. The strategy was developed in the mid-1990s and has since grown very popular with fund managers. In September of 2012, New York Attorney General Eric Schneiderman launched an investigation of the practice. As of now, no action has been taken against any of the firms.

To learn more about our corporate tax practice and other tax-related matters, please visit Brown, PC online or contact us at 817-870-0025. 

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