IRS Wakes Up to Private Equity Scam

Readers of Naked Capitalism may recall past mention of a common tax practice in the private equity (PE) industry known as a “management fee waiver.” This tax maneuver first got media attention during the Romney presidential campaign. Secret Bain Capital files released on Gawker last summer revealed that Bain had “waived” over a billion dollars of management fees in recent years, resulting in federal tax savings to Bain partners of approximately $250 million in aggregate.

For decades, the IRS has been oblivious to the tax dollars that private equity firms have been stealing from the U.S. Treasury via this abusive fee waiver tax shelter. But NC readers in the tax world have alerted us to recent IRS pronouncements indicating that both the Service, as well as influential tax commentators, have woken up to the scam and don’t like what they see in terms of its compliance with tax law.

The concept behind the management fee waiver tax shelter is quite simple, though the tax maneuvering to implement it is mind-bogglingly complex. As we’ve discussed here before, PE fund managers generally receive two main sources of income from the funds they manage. The first is a “management fee,” typically two percent of the fund’s size committed capital, paid annually to the PE firm for its services. This is ordinary income to PE firm managers, typically taxed at the highest marginal rate (39%). The second revenue stream PE firms receive is so-called “carried interest,” which is typically 20% of the profits generated by funds they manage. Carried interest is taxed as long-term capital gains, currently 20%.

PE managers share a version of Leona Helmsley’s belief that “taxes are for the little people.” The PE guys believe that — at a minimum—ordinary income taxes are for the little people and that they should never have to pay more than the much lower capital gains rate on any dollar of income they receive. As a result, PE managers and their lawyers cooked up a scheme to convert the ordinary income of management fees they receive into capital gains.

PE managers implement this scheme by “waiving” management fees owed to them by their limited partnership investors in exchange for a profits (carried) interest in the fund. Managers are deemed to have made a cashless contribution in the amount of the fee to the fund, which is deemed to earn profits like an investor’s cash contribution. Except that managers have leeway to find profits to cover it. Fund governing documents usually allow the general partner to find profits to cover the waived fee in any accounting period. Sometimes there is a clawback if cumulative profits are insufficent to cover waived fees. In the most aggressive version of this practice, fees are waived shortly before payment is due, so that managers can ensure that profits are available to cover them.

Experts have been questioning the legality of the fee waiver for a while. UNC tax professor Gregg Polsky got the ball rolling with a long article in Tax Notes in 2009, where he stated in the introduction:

A little-known technique used by private equity managers to convert the character of their remaining [management fee] compensation is extremely aggressive and subject to serious challenge by the IRS.

Polsky is no lightweight academic, having served in 2007-2008 as the “Professor in Residence” at the IRS. In the article, Polsky identified myriad of reasons why management fee waivers don’t comply with current federal tax law. Among the most important, he pointed out that giving the PE firm managers first claim on every dollar of revenue until amounts they have waived are “repaid” to them effectively removes the “entrepreneurial risk” that is at the core of the argument why fee waviers should be treated as being at the mercy of fund profits.

Polsky also pointed out that fee waivers need to comply with a long list of hyper-technical requirements to stand a prayer of complying with tax law, and that PE firms regularly flout those requirements. For example, the notional “fee waiver profits interest” that is created when fees are waived cannot be transferred to another party within two years of its creation. However, NYT columnist Floyd Norris pointed out last year, in a column questioning the legality of fee waivers, that Apollo openly acknowledges in SEC filings that it routinely violates the no-transfer restriction.

Earlier this year, Lee Sheppard, a contributing editor at Tax Notes and perhaps the most respected tax commentator in the U.S., wrote a long piece questioning the legality of fee waivers. The article was titled “Why Are Fee Waivers Like Deep-Fried Twinkies?” The title says pretty much everything you need to know about Sheppard’s view of the legality of fee waivers. She argued that waivers should not be respected because managers do not take any real risk that there will be no profits to cover the fees.

Even legal practitioners from big law firms have recently questioned the practice, once out from under the skirts of their corporate masters. For example, Ed Kleinbard, a former senior tax partner at Cleary Gottleib has been quoted as saying:

These are tax issues [management fee waivers] that should have been aggressively audited and litigated by the IRS.

I think we’ve just been let down by the IRS. They just haven’t done a good job at policing these practices, for a decade now.

The good news here is that—in better late than never fashion — the IRS in recent months has made multiple public statements indicating that a crackdown on fee waivers is either imminent or already in progress. In May, Clifford Warren, special counsel in the IRS Office of the Chief Counsel, spoke publicly at a conference about the fee waiver practice and for the first time indicated that it is receiving serious official attention:

There is quite a spectrum in fee waivers, and we don’t like everything we see,” Warren said. He later told Tax Analysts that while the Service believes the structure is being abused in some cases, it’s unlikely that the IRS will make all such arrangements “strictly forbidden.

Most significantly, the Service just recently put the fee waiver topic on its “Guidance Plan” work list for the new fiscal year, meaning that they expect to make a formal pronouncement on the legality of fee waivers in coming months.

In September, a Treasury official, Craig Gerson, attorney-adviser, Treasury Office of Tax Legislative Counsel, explained that the forthcoming guidance would establish bright lines about what kinds of waivers do and do not achieve the desired tax result of capital gain treatment. He said that the Treasury is concerned that there is no risk of nonpayment when the waiver is made close to the due date of the fee and in the presence of profits.

The good news here is that Warren seemed to indicate that the IRS has some fee waivers in its sights to disallow. On the other hand, he didn’t take the step of condemning the practice in totality, and further, it’s worth noting that his last job before the IRS was as a lawyer in-house at KKR, one of the largest private equity firms.

PE fund investors have woken up to fee waivers and they don’t like them. Their gripe is not the tax scam but the implcation that management fees are far too high, despite being originally intended to cover administrative costs. The best practices of the powerful International Limited Partners Association (http://www.ilpa.org) recommend against fee waivers. ILPA doesn’t like cashless contributions, and maintains that management fees should be justified and reasonably calculated to cover costs.

U.S. public pension funds have not only invested in many hundreds of private equity funds in the last decade that contain the fee waiver feature, they have gone far beyond that in enabling the practice. That is because, in their efforts to dress up the fee waiver maneuver as legal, private equity fund limited partnership agreements (LPAs) require the fund investors to agree to the legal contortions of the cashless contribution described above.

The pension funds, and other investors, take a hear-no-evil-see-no-evil posture, and it’s very common to hear private equity investors rationalize the tax evasion they know is occurring by saying, “It’s between the fund GPs (the private equity firm principals) and the IRS.” I want to be clear here: these people who are turning a blind eye to this dubious practice are people you elected, or their subordinates. They are state treasurers, state controllers, and other elected state and local officials who sit on public pension boards.

There is another element of government pension fund complicity, which is their universal treatment of PE fund limited partnership agreements as the only state and local government contracts not subject to state freedom of information (FOIA) laws. Several states have laws permitting state pension funds to keep these agreements and even the extent of their alternative investments secret.

We’ve made a bit of a fetish, whenever we’ve mentioned private equity LPAs in past posts, of referring to them as “super-secret LPAs.” You can see here why it’s important to understand this reality. Fee waivers are implemented via fund LPAs. Typically a meaningful portion of the LPA document deals with the mechanics of the waiver. It was only around ten years ago that PE firms embarked on their aggressive campaign to change state FOIA laws, a task in which they had massive success, so that the public could no longer examine their LPA contracts with public pension funds. This is a textbook case of finance capturing government officials, and relatively unsophisticated state and local pension officials have been easy prey.