Forgone Fees Bode Well for PE

Management fee waivers have garnered considerable scrutiny from the Internal Revenue Service (IRS) and the New York Attorney General. However, the IRS recently indicated it likely will not take a formal position regarding the waivers but will reserve the right to examine a waiver structure during an audit. (Watch the video below.)

The typical management fee waiver permits the general partner (GP) of a private investment fund to forgo management fees in exchange for a special profits allocation in the fund. If structured properly, the foregone management fee is not recognized in the year it otherwise would be payable, but instead the GP recognizes income when profits are ultimately allocated to it. Also, under current law, the profits allocated to the GP typically are taxable as long-term capital gain, and the deemed contribution satisfies a portion of the GP's capital commitment to the fund with pre-tax dollars.

The management fee waiver controversy is about whether the special profits allocations are subject to genuine economic risk and appropriately treated as profits interests under the law. If they are not profits interests, the special allocations received with the management fee waivers should result in ordinary income tax recognition. For fund management companies in New York City, the re-characterization of the special profits allocations should also subject the allocations to the New York City unincorporated business tax.

The IRS is concerned about whether the resulting special profits allocation is subject to genuine economic risk. A fund is particularly vulnerable in an arrangement where the GP has discretion to (1) waive the management fee shortly before it is to be paid and (2) share in an allocation of profits from an immediately succeeding investment realization that at the time of the waiver had existing appreciation to ensure the waived management fee would be paid. To alleviate the risk, my advice is to eliminate such discretion and have the fund partnership agreement mandate that each GP capital call will be partially fulfilled with management fee waivers and include a mechanism to recover any related overdistributions.

If legislation to tax carried interest as ordinary income is passed, the special profits allocation resulting from management fee waivers will no longer be afforded any capital gain treatment and the strategy will become less attractive to funds. Under a management fee waiver arrangement, the GP is forgoing a guaranteed management fee to receive a special profits allocation in the fund. So if the fund does not perform and there are no profits, it is possible that the GP will have forfeited a management fee that it otherwise would have received. For more, watch the video on www.themiddlemarket.com/video.