Photographer: Scott Eells/Bloomberg

IRS Tries to Curb Private Equity’s Fee Waivers With Tax Rule

The IRS is seeking to limit private-equity executives’ practice of reducing their tax bills by reclassifying how their management fees are taxed.

Rules proposed by the agency on Wednesday would make it harder for firms to convert high-taxed fees into lower-taxed carried interest, and by doing so take advantage of a 19.6 percentage-point difference in top tax rates.

The proposal represents one of the U.S. government’s most concrete attempts to limit the tax benefits enjoyed by private-equity managers.

The “modest move” by the Internal Revenue Service would stop some of the most abusive maneuvers by private-equity firms, said Victor Fleischer, a tax law professor at the University of San Diego.

“The regulations strike me as more taxpayer-favorable than I would have expected,” he said. “The regulations try to accommodate some arrangements that are common in the industry and that in my view ought to be treated as payments for services,” and taxed as ordinary income.

President Barack Obama wants to tax carried interest as ordinary income at rates as high as 43.4 percent instead of as capital gains at rates up to 23.8 percent. That effort fell short when Democrats controlled Congress and isn’t going anywhere with Republicans in charge of both chambers.

Typically, private-equity firms charge their investors a 2 percent fee on their assets and also keep 20 percent of profits, known as carried interest.

Profits Share

By using waivers, firms can forgo some of their fees and take a bigger share of the profits -- along with the tax benefit of doing so.

The rules, aimed at preventing “disguised payments for services,” say each case should be decided on the specific facts at hand, with weight given to whether fund managers bear a risk of losing money.

The Private Equity Growth Capital Council, an industry trade group whose members include the Carlyle Group, Silver Lake and TPG Capital, said it was still studying the proposal.

“It is important to remember that management fee waivers are and will remain legal, widely recognized, and part of negotiated agreements between the alternative investment community and investors, including pension funds and endowments,” Steve Judge, the group’s president and chief executive officer, said in a statement.

Capital Pledges

Private equity executives sometimes swap their cut of management fees into investments as a way to satisfy capital pledges they have made to funds managed by their firms.

The strategy surfaced as an issue in Mitt Romney’s 2012 presidential campaign, when documents from Bain Capital, which he co-founded and led, showed Bain used it to shave partners’ taxes by more than $200 million.

Apollo Global Management, another prominent firm, offered waivers to its partners until 2012, it said in a regulatory filing. Blackstone Group, the world’s largest private equity manager, and Carlyle have said they avoid the practice.

Fleischer said he was surprised at one example in the rules: fund managers were deemed to have enough at risk when they choose whether to reclassify their fees as few as 60 days before a tax year starts. By that time, future profits may be relatively certain.

“At the point where the general partner is making the decision whether to waive the fee,” he said, “they’re in a very good position” to know how successful the investments will be and can control the timing of realized gains and losses.

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