U.S. Aims to Halt Tax Dodge by Private Equity ; Internal Revenue Service Plans Accounting Rule on Management Fees

By Morgenson, Gretchen | International New York Times, July 24, 2015 | Go to article overview

U.S. Aims to Halt Tax Dodge by Private Equity ; Internal Revenue Service Plans Accounting Rule on Management Fees


Morgenson, Gretchen, International New York Times


Converting a management fee to a capital contribution may be a "disguised payment for services," the Internal Revenue Service said.

The United States Internal Revenue Service has proposed a rule aimed at ending a common and lucrative practice among private equity firms that allows them to artificially lower their partners' personal income tax bills.

The practice targeted on Wednesday by the I.R.S. allows private equity firms to convert management fees they receive from their investors, which would normally be taxed as ordinary income, into capital contributions invested in their funds. Profits generated on such contributions are treated as capital gains or dividend income and subject to a sharply lower tax rate.

Converting a management fee to a capital contribution may be a "disguised payment for services," the I.R.S. said in its proposed rule making, which it said was intended to provide guidance to partnerships and their overseers that such arrangements will be disallowed if they were done in such a way that no entrepreneurial risk was involved.

Private equity firms earn money from their investor clients in two ways. First is the management fee, which typically amounts to 1 to 2 percent of the assets under management. Unless converted, such fees are taxed at ordinary income rates to the partners who receive them.

A second profit center for private equity partners comes in the form of so-called carried interest, or the gains that a fund generates at the end of its life.

Such gains, made after a fund has sold its investments for more than it paid for them, are taxed at lower capital gains or dividend income rates. Critics of the industry have sought in recent years to end the special tax treatment of carried interest, but the industry has managed to fend off efforts to change the law.

Management fee waivers have not attracted as much attention, but they made headlines during Mitt Romney's 2012 presidential campaign when documents from Bain Capital, the private equity firm he founded, detailed the practice.

The documents indicated Bain saved $200 million in taxes over 10 years.

"This is a very important step in making sure that private equity, like everybody, pays its fair share of taxes," said Eileen Appelbaum, the senior economist at the Center for Economic and Policy Research and co-author of "Private Equity at Work." The I.R.S. guidelines are open for public comment until Oct. 21. But because the issuance is a clarification of existing regulations, the I.R.S. is permitted to begin examining private equity firms' books for problematic fee waivers now and to pursue possible violations in a firm's last three years of operations. …

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