Tax treatment of management fee waivers has been a hot topic of conversation at the Treasury for years. But, the conversation escalated last July when new proposed regulations were issued—treating the fee waiver interest as a taxable event, and significantly increasing the amount of risk required for fee waivers to qualify for the LTCG tax treatment. The IRS has been crystal clear that their proposed regulations are intended to clarify the interpretation of what is already existing law.
While the Treasury remains officially in the comment period, the general expectation is that the regulations may become final by Summer 2016. This has become such a high priority for the IRS that they went one step further the first week of March 2016—announcing a highly targeted program in which they intend to audit 100 VC and PE firms across the country. This surprise move leaves us to ponder whether the IRS is close to finalizing the new regulations—or are they gathering more information to determine how to most effectively shut down management fee waivers?
The answer to that question remains to be seen. But CPA firms and law firms serving the venture and private equity communities have wasted no time in alerting clients about the proposed changes and developing and implementing strategies to address compliance concerns should the regulations become final.
Can the Management Fee Waiver Strategy Still Work?
For existing funds and new funds raised before finalization of the code, the industry generally believes the strategy can still work. We are seeing some firms choose to discontinue the practice altogether, and a rare few taking no action. But many are amending their current strategy to demonstrate Significant Entrepreneurial Risk (SER) by:
- Integrating clawback language into the fee waiver. Until now, fees have been waived in exchange for a first priority interest in the gains of a portfolio. The IRS is taking the position that if the fund is not cumulatively profitable throughout its lifecycle, the General Partners (GP) should not be entitled to any early gains of the fund.
- Declaring the waived amount for the life of the fund at the start of the fund. With no visibility into how that fund will perform, the argument will be made that the GPs are assuming SER.
More Questions than Answers
If the regulations are finalized, management fee waivers will effectively disappear. Along with the finalization of the proposed regulations, the IRS has been clear that it also intends to amend a key revenue procedure—asserting that each time a fee waiver is made, a partnership interest has been received, which will constitute a taxable event and be treated as Ordinary Income. This effectively eliminates the economic benefits associated with the fee waiver strategy.
The three primary benefits of fee waivers are a pre-tax benefit of contributions, deferral of taxation, and long-term capital gain tax treatment. If this trio of benefits disappears, there are two primary questions the investment community may want to address:
- What options are available for meeting the large capital commitments typically required of the GP?
- What other strategies are available to gain tax efficiency?
Solutions for Accessing Liquidity to Meet GP Commits
In addition to using cash reserves, there are several alternatives to solve the liquidity requirements to meet capital call commitments. If applied correctly, there could be some tax benefits. For example, if a loan is used specifically to meet the GP commits, the interest could potentially be written off as an investment interest expense to the extent there is investment interest income.
We are seeing firms use GP Capital Call Lines in a variety of different ways such as:
- Full-recourse loans to each GP based on their individual financial capacity.
- Full-recourse loans to GPs accompanied by the guaranty of the management company, which can typically allow for greater consistency and flexibility in terms and pricing across all investing partners.
- Financing to the management company, which can in turn lend directly to its investing team—while more cumbersome for the management company, it could be an attractive option because it may negate the need for each GP to provide full financial reporting.
Other alternatives might include:
- Accessing real estate equity with a home equity line of credit, which can provide a long-term revolving line of credit with no annual reporting.
- Leveraging an investment portfolio with a securities-based loan, which can prevent disruption of the portfolio and the need to pay the tax on gains.
Considerations for Tax-Efficient Planning
In spite of the new regulations, time-tested strategies for tax-efficient planning remain unchanged. GPs, in consultation with a tax professional or a legal adviser, may want to consider the following:
- Employ estate planning strategies to address large tax payments on potential future gains, for example gifting zero- or low-cost-basis carried interest. As the values increase, gains are generated outside of the estate—which could be ideal for those inclined towards charitable gifting or funding a child's trust.
- Protect income by maximizing contributions to their retirement plans. One strategy we see is making after-tax IRA contributions, converting traditional IRAs to Roth IRAs, then investing the Roth in assets that are expected to appreciate. If there is an opportunity to purchase company stock directly, one might consider purchasing the stock in the Roth—protecting it from taxes and making future withdrawals tax-free.
- Reduce taxable income by timing a large charitable gift to occur in a year when taxable income is unusually high. The use of a Donor Advised Fund (DAF) allows investors to pre-gift multiple years of charitable giving and receive the tax benefit in the year the gift was made to the DAF. Gifts to DAFs can be allocated to selected charities over several years, and gifting securities with large embedded gains can help maximize the value of this strategy.
- Increase deductibility of mortgage interest associated with mortgages of $1.1 million or more by tracing mortgage proceeds above that amount to investment strategies that are expected to earn investment income.
- Implement liquid portfolio strategies such as holding tax-exempt bonds in a liquid portfolio and taxable bonds in IRAs or retirement accounts.
Some early indicators suggest the industry might see a shift to a different model of economics. One alternative we noted is taking a lower management fee in exchange for a higher level of carry since carried interest under current tax code can still be treated as LTCG for taxation purposes—another hot topic of conversation at the Treasury. While this may be easier for larger, well-established funds, it could be more challenging for first-time and smaller funds that are more reliant on the fees to cover expenses.
If the proposed regulations become the new normal later this year or beyond, we expect to see more alternative strategies and solutions emerge. After all, as innovators of the technologies and trends of tomorrow, the VC and PE communities, as well as their CPA and legal partners, thrive on creative problem solving—no matter what the challenges may be.
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