Management fee waivers generally are a technique used by private equity funds involving a manager’s waiver of its right to certain management fees in exchange for an increased interest in the profits of the private equity fund.
The objective of the management fee waiver is reducing the taxes payable by the fund’s manager by allowing the manager to forego income that would be taxed as ordinary income in exchange for receiving income that is taxed as long-term capital gains.
The Treasury Department’s Priority Guidance Plan over the past two years has included a project to examine the management fee waiver issue and to propose guidance on that issue. The Internal Revenue Service recently has indicated that proposed regulations relating to management fee waivers likely will be released sometime later this year.
How does a management fee waiver work?
A management fee waiver generally permits a manager of a private equity fund to make an election to waive some or all of its entitlement to management fees in exchange for an enhanced share of the fund’s distributable profits.
For example, in a private equity fund that entitles a manager to an annual management fee of 2% of the investors’ capital contributions to the fund, the manager could waive its right to receive that 2% fee in exchange for receiving an amount equal to that waived fee out of any profits that the fund realizes in the future when it sells its investments.
Amounts paid for management fees typically are taxed as ordinary income, but amounts associated with a disposition of a fund’s investments typically are taxed as long-term capital gains.
What are the possible ramifications of the anticipated management fee guidance?
The anticipated management fee waiver guidance may have consequences for several categories of taxpayers:
- First, the anticipated management fee guidance almost certainly will impact some or all of the private equity fund managers that have used management fee waivers as part of their compensation structure. For such managers, the impact of the guidance will depend both on the specifics of the guidance and the effective date of the guidance. Also, fund managers that have not previously used management fee structures due to the lack of any significant guidance in the area may determine that the guidance will allow managers to structure future compensation arrangements in a manner that passes muster under the guidance.
- Second, investors in private equity funds may be impacted by the management fee waiver guidance as a result of amendments to existing fund documents or the structure of future funds. Many existing private equity funds permit a manager to make certain amendments to the fund’s organizational documents following a change in tax laws such as the issuance of guidance on management fee waivers. For any existing private equity funds that permit such amendments, fund investors should monitor any such amendments to assess whether such amendments will have any impact on them.
- Third, the management fee waiver issue and any guidance relating to that issue potentially could impact any other investment arrangement that is taxed as a partnership where some participants in an arrangement contribute capital to the arrangement and other participants in the arrangement provide services to the arrangement. Any such arrangement with separate capital providers and service providers potentially raises issues as to whether some or all of the income earned by the service providers in connection with the arrangement is taxable as ordinary income or capital gains.
We intend to monitor developments with respect to management fee waivers and assess the impact on our clients of any guidance from the Internal Revenue Service on the treatment of such waivers.