IRS prepares to crack down on private equity execs?


FORTUNE — During the 2012 presidential campaign, there were a number of stories about how certain private equity executives (including Mitt Romney and his former Bain Capital colleagues) had lowered their tax rates by using something called “fee waivers.” Now there is reason to believe that the IRS is preparing to slam this loophole shut.

There are a variety of fee waiver strategies but, in general, it works like this: General partners agree to commit a certain amount of personal capital into a new fund, in order to both increase fund size and tighten the alignment of interests with LPs. Rather than fully funding this out of their own bank accounts, however, they simply funnel a percentage of incoming management fees into fund commitments. Sometimes the specific amounts are set upfront at the time of fundraise, sometimes they are done on a year-to-year (or even quarter-to-quarter) basis.

Why do this? Because private equity execs are required to pay ordinary income tax rates on management fee-related income. But if the management fees are converted into fund commitments, eventual proceeds would be taxed at lower capital gains rates. In other words, they evade double-taxation (you know, the same thing everyone else deals with when making investments with money we earned from our jobs). Here is what I wrote about this in August 2012:

Bain and certain other firms justify this aggressive method by pointing to IRS ruling 93-27. Tax attorneys I’ve spoke to differ on the legitimacy of such reliance, and on the broader validity/fairness/etc. of such tax treatment. What they do agree on, however, is that the IRS has allowed such activity to continue unabated.

Last month, however, the issue of management fee waivers appeared on an IRS and Treasury Department Guidance Plan agenda. Then, IRS special counsel Cliff Warren (a onetime KKR exec) said the following during a tax-planning forum in Chicago (according to Tax Notes):

The rule “is going to cover every kind of fee waived under section 707(a)(2), but obviously we’ll be focusing on managed funds where that activity is common.”

The IRS declined to make Warren available for an interview, but I did speak with Bahar Schippel, a tax attorney who was present for Warren’s comments. She tells me that Warren seemed to favor the idea of narrow guidance rather than prohibiting all fee waivers, but adds that there was significant discussion about how difficult such a ruling would be to write (from both a language and justification point of view). Moreover, another source tells me that this difficulty has caused some within the IRS to favor a blanket ban.

Also not yet known is if the new regulation would be retroactive (read: audits), although it almost certainly would apply to already-raised funds that are doing forward-looking waivers.

Expect that when the rules do come out, that there would be a comment period of several months before they are codified.

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