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Private Equity Fee Waiver Planning Under Scrutiny, But Still Viable

August 20, 2014 Business & Tax Blog Capital Gain Transactions

Private equity firms sometimes waive management fees payable by portfolio investment entities or funds in exchange for new partnership interests in the entities or funds. In theory, the practice is fair because the fee recipients surrender a certain stream of income in exchange for a partnership “profits interest” that may or may not produce future income. The exchange is desirable to the private equity firms or managers because the partnership profits interest may ultimately produce more income than the management fee, because the receipt of the partnership profits interest may not trigger income tax, and because the future income from the partnership profits interest may in some circumstances be taxable at the 20% long-term capital gain tax gain rate rather than the almost-40% ordinary income tax rate.

Critics argue the practice is unfair because the fee waiver often occurs shortly before the fee is earned. They also argue the “profits interests” could be engineered using inside information to be very likely to produce a future income stream, making the perceived risk-reward tradeoff disingenuous. Whether the criticisms are fair or not, the Internal Revenue Service has been studying the practice for a few years but has not issued new guidance.

We believe it is unlikely new Internal Revenue Service guidance will ban fee waivers entirely. It is more likely that new guidance will curb the most aggressive fee waiver transactions. We continue to evaluate fee waiver planning that fits the current tax law.

E. John Wagner, II