IRS shines spotlight on fee waivers

Dechert tax lawyer Adrienne Baker says the number of funds audited will rise in the next few years.

There has been a lot of chatter in the private equity community about the US Internal Revenue Service (IRS) upping its audits of private equity firms, especially on the issue of the fee waiver and whether or not that should be taxed.

The increased scrutiny should result in a more concrete definition of the fee waiver, said Dechert tax partner Adrienne Baker. However, the desire to extract tax from the wealthy, like private fund managers, should be done in a way that doesn't upset the principles of tax law, she said.

The real question on the fee waiver is, is it still a fee, or is it subject to risk just like an investment?” Baker said. “I don't think anyone uses investment in a private fund as a sure bet. A profit share is a profit share; it's not necessarily guaranteed.”

Baker said she expected a rise in the number of partnerships that are audited in the next few years, but questioned the costs and benefits of conducting such examinations.

This issue has been fuelled partly by President Obama's signing of the Bipartisan Budget Agreement into law last November. The bill includes major changes to the partnership federal tax audit rules, which include the IRS' examination of income, gain, loss, deduction and credit, as well as partners' distributive shares for the relevant year, as pfm reported.

The challenge for fund managers is that the regulation addresses the fee waiver issue so broadly that it could capture just about anything, Baker said.

There isn't a clear blueprint on private equity partnership agreements. Fund managers and counsel are careful when drafting to reduce the risk of “being on the wrong side” with the IRS, she said.

A surge in the number of private equity partnerships in the mid-market is prompting the IRS to shift and strengthen its focus on the industry, where US presidential candidates have maintained tax loopholes exist, according to Debevoise & Plimpton partner Matthew Sharonson.

As the US approaches 3 November election day, taxation on fees is a hot topic among the presidential candidates, both Republican and Democratic.