IRS Eyes a Private-Equity Tax Move

Mark Maremont for the Wall St. Journal writes:  The Internal Revenue Service is examining the propriety of a tax practice used in some parts of the private-equity industry, in which firms convert management fees into investments that receive more favorable tax treatment, a senior IRS official said at a recent legal conference.

The practice, often called a management-fee waiver or fee-waiver conversion, has been used for years by partners at some of the nation's largest private-equity firms to reduce their taxes, and can involve significant sums.

Clifford Warren, a special counsel in the IRS's unit that covers partnerships such as private-equity firms, said during an April 30 panel discussion at a Chicago legal conference that the IRS is "studying" the issue. "We don't like what we see in all cases," he added.

The remarks were first reported by Tax Notes, an industry publication. An IRS spokeswoman confirmed that Mr. Warren made the comments.

The tax strategy came to public attention in the midst of last year's presidential campaign and after New York Attorney General Eric Schneiderman began an investigation into the issue and sent subpoenas to about a dozen firms, including Republican presidential candidate Mitt Romney's former firm, Bain Capital LLC. It is not clear where the investigation stands. A spokeswoman for Mr. Schneiderman declined to comment.

In the main strategy in question, private-equity firms or firm partners voluntarily waive annual or quarterly management fees due to them from investors. Instead, the firms often redirect that fee money to satisfy their own obligations to invest in the funds they manage. That change can turn management fees, currently taxed as ordinary income at federal rates of up to 39.6%, into investments that enjoy capital-gains treatment at lower rates, now starting at 20% for upper-income federal taxpayers.

Tax experts said Mr. Warren's remarks suggest that the agency is seriously considering the legalities of the fee-waiver practice. The IRS Office of Chief Counsel, where Mr. Warren works, doesn't typically get involved in investigations, but studies complex tax issues and often issues legal opinions that guide agency field staff.

It doesn't appear that the agency has actively engaged with the industry on the issue. John C. Hart, a tax attorney at Simpson Thacher & Bartlett LLP in New York, said none of his private-equity clients have been contacted by the agency about the matter. Two other attorneys with large private-equity practices said they weren't aware of any IRS audits or formal requests for information on the topic.

Some of the largest private-equity firms, such as Bain and Apollo Global ManagementLLC, APO -2.85% have taken advantage of this tax strategy, according to filings and documents. Apollo recently terminated a management-fee waiver program and isn't currently engaging in the practice, according to a regulatory filing and a person familiar with the matter. KKR KKR -1.19% & Co. used the strategy from 2007 until 2009, when it became a public company, according to a person familiar with the matter. Still, others, such as Blackstone Group LP, BX -0.23% Carlyle Group, CG -2.42%TPG and Madison Dearborn Partners LLC, never employed the strategy, according to people familiar with the matter.

Proponents have said the strategy is legal, that executives take on risk by redirecting the money into investments and thus should be taxed at lower rates. Some academics have called it aggressive and potentially subject to IRS challenge.

Partly at issue is whether the strategy fits within a 1993 IRS ruling, and whether it potentially triggers a separate law about partnership transactions that would require the income to be taxed at ordinary rates.

Some lawyers say private-equity firms have employed different versions of the tax strategy, along a spectrum ranging from conservative to more aggressive from a tax standpoint.