Management Fee Waivers: Who Should Bear the Compliance Costs?

02.25.2016

Management fee waivers have been an accepted feature in private equity, private real estate and other closed-end funds for many years.  In closed-end funds recently reviewed by Hirschler Fleischer, management fee waivers were expressly permitted almost 50 percent of the time.

Management fee waivers represent the holy grail of tax planning—they arguably provide fund managers with the opportunity not only to convert management fee income taxed at higher ordinary rates into a deemed investment in the fund taxed at lower capital gains rates, but also to defer any taxation of the waived fees for many years, possibly until the end of the fund’s life.

Not surprisingly, management fee waivers have drawn the attention of tax authorities.  In July 2015, the IRS released proposed regulations, and public hearings on these proposed regulations will be held on February 26.  These proposed regulations suggest that many of the traditional techniques used for management fee waivers represent a disguised payment for services and, consequently, that the payments should be treated as ordinary income.  The key factor used by the IRS to determine whether the management fee waiver is a disguised payment for services is whether the arrangement lacks significant entrepreneurial risk, which compares the manager’s risk relative to the other entrepreneurial risks of the fund.

While the proposed regulations would apply only to management fee waiver arrangements entered into or modified after the publication date of final regulations, the Treasury Department and IRS have stated that the proposed regulations generally reflect congressional intent regarding disguised payments for services.  Therefore, the Treasury Department and IRS appear to be reserving the right to challenge existing management fee waiver arrangements even before the final regulations are published.

Although we have noted a trend recently of some fund managers abandoning the practice of management fee waivers, many fund managers are attempting to adopt management fee waiver procedures designed to comply with the proposed regulations.

Institutional investors investing in private funds that make use of management fee waivers may wish to consider the compliance costs associated with management fee waivers that the fund (and, therefore, the investor) may be called to bear.  For example, almost all fund governing documents include provisions requiring the fund to be responsible for the cost of responding to an examination or audit of the fund by a tax authority, without distinguishing between the part of this cost that may relate to the tax authority’s review of management fee waivers undertaken for the benefit of the fund manager versus tax items that apply more generally to all investors.  In addition, the result of an examination or audit of a fund relating to management fee waivers may lead to an amendment of the fund’s tax return, potentially requiring the investor to refile its own return for the affected tax year.  In our experience, the fund manager has never agreed to reimburse this expense.  In addition, many funds include a provision in their limited partnership agreement or other governing documents that allows the manager without investor consent to modify the documents to address the effects of new or proposed tax legislation or regulations. Most fund documents require the fund to bear the costs of these types of amendments, without distinguishing between those that primarily benefit the tax position of the fund manager as opposed to the fund investors generally.  Investors may want to consider in particular whether the costs of amending fund governing documents to allow the fund manager to engage in management fee waivers in compliance with proposed or final regulations on that topic is an expense they should be responsible for.

No one can dispute that compliance with tax laws is of paramount importance to the private fund industry and its investors.  What seems an overreach is if fund managers attempt to shift to their investor base tax compliance costs that are primarily for the manager’s benefit.