Last week, the press reported on a recent series of investigations undertaken by the New York Attorney General's Office to scrutinize private equity firms' use of "management fee waivers." Starting in July, Attorney General Eric Schneiderman began issuing subpoenas to some of the largest private equity firms with operations in New York in an effort to obtain documents describing the management fee waiver practices utilized by each firm.
What Are the Management Fee Waiver Strategy and its Potential Tax Benefits?
A management fee waiver or conversion is a strategy whereby the general partner or management company of a private equity fund "waives" the management fee (often up to 2 percent of assets or committed capital per annum), which would typically be paid quarterly and treated as ordinary income for tax purposes, in exchange for an increased "carried interest," which often qualifies for long-term capital gain treatment. In many cases, the receipt of an additional carried interest pursuant to a fee waiver can be used to satisfy the general partner's capital contribution obligation. The key to the strategy is to change the management fee, which is unconditionally payable, into a payment that is conditioned upon future profitability of the fund. However, that does not necessarily mean that the fund has to have an overall net profit for the general partner or manager to earn the waived fee. In many variants of the strategy, the additional carried interest obtained as a result of the waiver results in a priority allocation of the fund's profits from certain investments and/or during certain fiscal periods, unlike the basic carried interest. In these cases, the general partner can realize some carried interest (and, effectively, some portion of the "waived" management fee) even if the fund has a net loss at the end of the overall investment lifecycle.
If the structure is upheld, a management fee waiver effectively allows the general partner to largely convert ordinary income (management fee), currently taxed at a maximum federal rate of 35 percent, into capital gain, currently taxed at 15 percent. There also may be a deferral benefit — delaying current taxation on the waived management fee income and pushing the tax to later years when the gains that produce the additional carried interest are realized. Limited partners who are individuals may also avoid limitations that might otherwise apply to management fee deductions. Finally, the waived amount is categorized as a "profits interest," which is not subject to employment taxes, whereas management fee income generally is.
For New York taxation purposes, there is no rate differential between ordinary income and capital gains, although there could be a deferral benefit. In addition, some non-resident general partners who waive their management fees take the position that no New York income or New York City unincorporated business tax is due on the additional carried interest.
What Are the New York Tax Risks?
The potential New York tax benefits of the strategy appear to hinge primarily on the validity of the structures under federal income tax law. The New York attorney general, of course, does not have authority to enforce the federal tax laws but has broad investigative powers. To date, there has been no Internal Revenue Service challenge to these structures, despite an IRS statement in late 2007 identifying such arrangements as warranting study for potential non-compliance. So in the absence of an adverse determination under federal tax law, it is not clear how the New York attorney general would have any basis to challenge the New York tax consequences of the arrangements.
If the IRS were to challenge management fee waiver strategies under existing law, the success of the challenge would most likely depend on the structure utilized and the particular facts. The primary focus in a challenge to a management fee waiver structure is likely to be on the nature and substantiality of the conditions to the general partner's or manager's receipt of the converted carried interest. If the payment of the converted carried interest is conditioned upon the fund having overall net profit in its entire investment lifecycle, the payment is more likely to be respected as an allocation of partnership profits than if the payment is contingent on the recognition of net profits from any individual investment or in any particular year. Generally speaking, the higher the likelihood that the general partner or manager may not eventually receive the payment, the stronger the case is that the conversion will be respected. Additionally, the timing of the election will likely be relevant. In some structures, for example, the general partner makes an upfront "hardwired" election to waive its management fee in exchange for an additional carried interest at the start of the fund that lasts for the duration of the fund's lifecycle. Some commentators have suggested that the hardwired format is the more def ensible position, as the general partner can point to increased risk involved in giving up a guaranteed payment in exchange for a less certain profit share based on the performance of the fund.
There are other potential technical risks under federal partnership tax law principles. For example, general partners in these structures typically characterize the additional carried interest as a mere "profits interest" in a partnership. A profits interest entitles the partner to a share of future profits of the partnership and is not subject to tax upon receipt so long as the interest does not provide a substantially certain or predictable income stream. The IRS might challenge this position, arguing that the additional carried interest does not satisfy the relevant legal standards or satisfy the requirements for the safe harbor provided in IRS Revenue Procedure 97-23. The IRS might also argue either that the management fee waiver is actually a disguised non-partner transaction as described in Section 707(a)(2)(A) of the Internal Revenue Code, or that the arrangement is really a guaranteed payment covered by Section 707(c) — in both cases potentially taxing the additional carried interest as ordinary income rather than capital gain.
We are not aware of any pending IRS challenges to management fee waiver structures. There could be legislative change after the election, however. Indeed, Congress has previously considered legislation that would treat carried interest as ordinary income rather than as capital gain, and the President's 2010 and 2011 Budget Proposals contained similar provisions. Firms with management fee waiver structures should consider how such structures might fare under any such legislation, if enacted.
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