IRS issues proposed rule on “disguised fee for services”

Private equity firms using management fee waivers to convert services income into capital gains will soon face added scrutiny.

On July 22, the IRS proposed a rule regarding the ability of private equity firms to convert management fees into capital contributions if the converted funds are - among other factors - not subject to the risk associated with capital contributions.

The IRS, in its statement supporting the proposed rule, said that fee management waivers may disguise payment for services, which should be taxed as ordinary income under Section 707(a)(2)(A) of the Internal Revenue Code. There is currently a 19.6 percentage-point difference in the rate of taxation for ordinary income in the highest income tax bracket and the capital gains tax. For some private equity firms, the proposed rule could have tax consequences worth millions.

Despite the proposed rule, management fee waivers will remain legal and widely recognized after the implementation of the new regulations. Still, executive-level compensation at private equity firms and hedge funds will have to take into account the proposed rule to ensure compliance. The rule is subject to revision and public comment until October 21. Because the new regulations are a clarification of an existing rule, the IRS is free to begin inspecting books regarding whether fee waivers are compliant with the new rule now.

Six non-exclusive factors considered in deciding "disguised fee for services"

The Internal Revenue Service called the proposed rule a "modest move" to how management fees at private equity firms are taxed. The issue first arose during Mitt Romney's presidential campaign, when it was revealed that a hedge fund he helped to found had saved $200 million on taxes over 10 years by converting management fees.

For years, private equity fund sponsors have waived their management fees in return for a profit allocation, such as additional carried interest, because carried interest is taxed the same as the income earned by the fund, which are usually taxed as long-term capital gains.

Under the new regulations, whether a fee waiver arrangement is treated as a disguised fee for services depends on six enumerated factors, although all circumstances regarding the arrangement can be considered. Under the rule, management fee waivers will be taxed as ordinary income if:

  • The allocation and distribution of the partnership arrangement do not carry a similar level of risk associated with capital investments
  • The service provider only holds a partnership interest for a short time
  • The service provider receives an allocation and distribution of capital income in a similar time to when the service provider would receive payment
  • The service provider entered into the partnership primarily for tax benefits unavailable otherwise
  • The service provider's value contributions are small compared to its distribution amount
  • The fee waiver arrangement allows for different allocations or distributions for different services received.

Questions? Contact an experienced tax law attorney

If you have questions regarding the tax treatment of your income, or if the IRS is conducting a review of your tax claims, contact Robert J. Fedor, Esq., to discuss your situation and legal options.