What’s at Issue in the Private Equity Tax Inquiry

The New York attorney general, Eric T. Schneiderman, is said to be investigating private equity firms’ use of a tax strategy known as management fee waiver programs.

Fee waivers are complicated. The main tax strategy is to turn fees, which are normally taxed as ordinary income, into low-taxed capital gains. But another way to understand the strategy is to look at the overall economic benefit of the deal. At issue is whether, through these Byzantine programs, private equity executives are improperly using pretax dollars, rather than after-tax dollars, to invest in their own funds.

Fee waiver programs are a little different from the basic carried interest loophole, which allows returns from an executive’s profits interest in a partnership to be taxed as if it were investment income rather than labor income. For one thing, reporting carried interest income as a capital gain, while unseemly, is perfectly legal.

Fee waiver programs, by contrast, are legally questionable and might not hold up if challenged in court.

Here’s how such a program works. A private equity executive typically has three source of income: management fees, carried interest and investment income from the executive’s own investment in the fund. The management fee is received through an affiliate of the fund and is taxed to the executive at ordinary income rates — the top federal income tax rate of 35 percent, plus a 3.8 percent Medicaid tax, plus another 10 percent or more of state and local income tax (which is presumably why the state attorney general is interested). Call it a combined rate of 50 percent.

Carried interest is held by the executive through the general partner of the fund, and it is taxed at the 15 percent long-term capital gains rate. The executive is also required to co-invest some amount alongside the limited partner investors in the fund. This general partner co-investment often ranges from 1 percent to 5 percent of the fund, and returns are taxed at capital gains rates.

A fee waiver program is often used to pay for the general partner’s co-investment obligation with waived management fees rather than cash. Each quarter or year, as the management fee comes due, the managers can elect to take the cash, or, if markets are looking good, waive the fee. The waived amount can then be used to satisfy the executive’s investment in one of the fund’s portfolio companies. To make the tax magic (allegedly) work, the waived amount must be eventually be made up from future profits in the fund. If the fund never has additional profits, the limited partners can theoretically try to claw back the cash from the waived fee amounts.

The risk is mostly theoretical because the waived fee amounts are offset from priority allocations from the fund in any accounting period, even if the fund loses money overall.

And while the general partner can be asked to contribute cash when the fund winds down, the individual executives do not typically guarantee the partnership’s obligations on this amount, and the limited partners, who would have paid the management fee in any event, have no reason to pursue a legal claim.

These fee waiver programs are risky from a tax perspective. Because the management company is not a partner in the fund, the usual “safe harbor” for carried interest, I.R.S. Revenue Procedure 93-27, does not seem to apply. Even if it did, a court would probably treat the waived fee amount as ordinary income under section 707(a)(2)(A), which Congress passed in 1984 to deal with exactly this kind of situation where a partner is acting in its capacity as a service provider to the partnership.

To see the value of this strategy, think about investing with pretax versus after-tax dollars. Suppose Jill works at an investment bank, and her employer pays her a year-end bonus of $500,000. The bonus is taxed at a combined state and federal rate of 50 percent, leaving her with $250,000 to invest. She invests that $250,000 in her friend Jack’s private equity fund, and the investment doubles in value over five years. The $250,000 of new gain is taxed at the 15 percent long-term capital gains rate, leaving her with $212,500 and an overall after-tax amount of $462,500.

Now consider Jack, who works at the private equity fund. To satisfy his co-investment obligation, Jack must invest in the fund. Under a fee waiver program, he waives $500,000 of his portion of the management fee and credits his capital account with that amount. After the $500,000 doubles over five years, and is then taxed on the full amount at capital gains rates on the back end, Jack walks away with $850,000 — roughly 84 percent better off than Jill, who invested with after-tax dollars.

(For further reading, see Gregg Polsky’s 2008 paper, “Private Equity Management Fee Conversions.“)