How the IRS Fee Waiver Crackdown Affects PE

In July, the IRS issued a proposed rule change meant to stifle supposed abuses of how private equity fund management fees are claimed for taxes. Vinson & Elkins’ David Peck says it’s a hot topic, and the outcome of the proposal is anyone’s guess.

Starting in July, buzz started building in private equity firms about a proposed rule from the Internal Revenue Service. This scrutiny of PE isn’t new, and the previous bouts of worry about the latest target of the IRS sometimes amounted to nothing, with the proposed rule change lingering and not being enacted. The target this time? Management fees being claimed as capital gains rather than as ordinary income.

This proposed rule change from the IRS is almost all that David Peck, a tax partner at Vinson & Elkins LLP, has been talking about with private equity clients in the latter part of the summer. And the management fee waiver—i.e. the practice of turning the normal 2 percent management fee into carried interest, contingent on the profitability of the fund—dates back at least 15 years, he says.

No one is certain exactly why the IRS suddenly took an interest in the management fee waiver, as the agency has been aware of it for as long as it’s been in play. The Obama administration has made no secret of not being a fan of private equity getting favorable tax breaks, and Peck says that starting in the middle of 2013, he started hearing IRS personnel informally making statements about the management fee waivers and PE using tax rules to convert management fees into capital gains.

Now that the Treasury department has written the proposed rule change for the management fee waiver, there is a period for comments that closes towards the end of October, with a hearing thereafter. Peck says the possible outcome includes “a huge range of things,” including the IRS incorporating acceptable comments and issuing final regulations in short order; taking some time and issuing an amended proposal reflecting comments; or the rule could never be implemented.

“The thing about this that is a little tricky is, the rules don’t say you can’t convert the management fees into capital gains,” says Peck, “the conversion just needs to be done in the right way.” The proposed rules require that the recovery of waived fees be conditioned on the profitability of the fund, with the definition of profitability being relatively narrow, he adds.

“What’s going to happen is, the PE world is going to have to decide ‘Do I take the risk? Do I put my management fee on the table and roll the dice, hoping my fund is profitable—in which case I can get the conversion to capital gain, but risk losing the fees altogether if I don’t achieve profitability— or do I take the lower risk, lower reward position and pay the ordinary income [rate] on my management fee?’ In the past, people were trying to have it both ways.”

Peck says there likely won’t be a lot of immediate action from PE players, and that firms are going to digest how the rule change could impact them, particularly with the threat of carried interest legislation looming. “The carried interest is what makes millionaires into billionaires,” he says. “You have this enormous tax benefit from carried interest that’s on the [legislative] chopping block, and then you have this 2 percent [management fee]. It’s definitely big dollars—but compared to carried interest, it’s relatively small.” Peck also cautions that PE sponsors may not want to rock the boat on the management fee issue if they feel it could ultimately jeopardize their ability to achieve favorable tax treatment on carried interest.