IRS Audits Target Management Fee Waivers

May 2017

According to recent Bloomberg BNA reports, IRS audits are increasingly targeting private investment funds over management fee waiver arrangements that are commonly used by investment managers to convert fee income into carried interest.

Bloomberg BNA reports that, in one of the first such cases, the IRS has proposed adjustments and multi-million dollar penalties in connection with management fee waivers and transaction fee offsets tied to a 2012 fund managed by private equity firm Thoma Bravo. Reportedly, Thoma Bravo issued a letter to investors, in which the firm said the terms of the waivers are standard in the industry. This report should serve as a reminder of the IRS’s antipathy to this strategy, and might lead fund sponsors to discuss their management fee structures with their tax advisors.

Background on Management Fee Waivers

Fees for investment management services provided to a private investment fund are typically calculated as a percentage (e.g., 2%) of capital commitments or invested capital in the fund and paid to a management entity that is usually affiliated with the general partner of the fund. Management fees are taxed as ordinary income to the investment manager and, as a practical matter, are often not deductible when computing the taxable income of individual fund investors.

A standard management fee waiver arrangement lets a manager elect to not receive all or a portion of future management fees throughout the term of the fund. Instead, the manager would receive an interest in the fund’s profits. Converting management fees into profits interests often provides substantial tax benefits to both the investment manager and individual fund investors. If the arrangement is respected by the IRS as a profits interest, all or a portion of the investment manager’s income allocated under the profits interest may qualify for a lower 23.8% long term capital gains tax rate as compared to the highest ordinary income tax rate of 39.6% applicable to management fees. In addition, income allocated under the manager’s profits interest reduces, without limitation, the amount of income allocated to the fund investors, including individual investors.

Proposed IRS Regulations

The IRS enforcement effort cited in Bloomberg BNA follows on the heels of proposed regulations that the IRS issued in 2015 to curb the use of management fee waiver arrangements (REG-115452-14), particularly those that lack “significant entrepreneurial risk.” These proposed regulations outline standards for determining whether an arrangement, including a management fee waiver, is a disguised payment for services (i.e., a management fee) rather than a profits interest.

The proposed regulations will apply to arrangements entered into or modified on or after the date the final regulations are published. The final regulations will not be issued until after the current regulatory freeze on federal agencies has been lifted.

In the meantime, the IRS views the proposed regulations as reflecting the legislative history of the rules addressing profits interests and appears to be following them in audits of existing arrangements. Informal comments by an IRS representative at the Federal Bar Association Tax Law Conference in March provide further insight into the mindset of the IRS on this topic. According to another Bloomberg BNA report, at the conference, a special counsel in the IRS Office of Chief Counsel expressed a strong negative sentiment toward fee waiver structures and warned against engaging “in that type of tax planning at this stage.”

The IRS posture embodied in the proposed regulations and its approach on audits represent a significant erosion of the broad administrative grace that was bestowed by the IRS in its long-standing Revenue Procedures permitting tax-free issuance of compensatory profits interests.

While taxpayers and practitioners have confidently assumed that the tax-free character of such issuances was virtually unassailable, this IRS attitude argues for more care and closer adherence to the safe harbor requirements contained in those Revenue Procedures. In particular, in the wake of the IRS enforcement efforts in this area, investment fund sponsors should consider reviewing existing and prospective management fee waiver arrangements with their tax advisors.

For more information, please contact:

Louis Tuchman at 212.592.1490 or [email protected]

© 2017 Herrick, Feinstein LLP. This alert is provided by Herrick, Feinstein LLP to keep its clients and other interested parties informed of current legal developments that may affect or otherwise be of interest to them. The information is not intended as legal advice or legal opinion and should not be construed as such.