Management Fee Waivers: Potentials and Pitfalls for Fund Advisors– November 07, 2017 by Jonathan Williamson

Private equity fund advisors earn income in different ways, including via management fees and profits interests. Strategic planning techniques — such as opting to waive the management fee — can help an advisor potentially defer income or take advantage of more preferential income tax rates. The key to success is implementing the technique thoughtfully. Mistakes during implementation could disqualify the transaction or leave the advisor open to unnecessary entrepreneurial risks.
Below are some important considerations to help fund advisors minimize their income tax and mitigate potential pitfalls in the process.

Types of Advisor Income

Management Fees
In most situations, a fund advisor or sponsor is compensated by periodic management fees, which are calculated as a percentage of committed or invested capital. Management fee income is treated as ordinary income to the recipient. Payment of these fees is usually prioritized over the return of fund capital or profits to members, making management fees a safer bet for an advisor than a profits interest. Tax planning surrounding the receipt of management fee income is minimal; it is either taxed upon receipt or when it is earned, depending on the accounting method of the manager.
Profits Interest
In addition to management fees, many fund advisors also hold a profits interest (or carried interest) in the funds they manage. As the name suggests, a profits interest gives the holder a share of future earnings of a fund, but it does not guarantee a return. Holders of a profits interest receive no share of the contributed capital of other members, and generally do not receive a payout until the contributing members of the fund reach certain benchmarks.
For example, it’s common that those holding profits/carried interests may not receive a profit allocation until the contributing members have received a specified, cumulative percentage of the return. At the point of reaching X%, some or all profits are allocated to profits/carried interest members until they reach a similar benchmark. Upon completing this second tier of allocations to profit interest members, profits are split between contributing members at a pre-determined interest rate.

Management Fee Waivers as a Tax-Planning Tool

If permitted in an operating agreement, a fund advisor may have the option annually to waive the management fee they are entitled to, instead receiving a corresponding "deemed capital account."
A deemed capital account works similarly to a profits/carried interest; however, the timing of allocations is more beneficial. When calculating returns allocated to members with contributed capital, a deemed capital account holder is entitled to receive a return on their deemed contribution. That means a deemed capital account is allocated profits alongside those with capital contributions, rather than receiving allocations after other members reach a return benchmark.
Any returns on a deemed capital account (including repayment of the deemed capital account) would be considered income when received. However, this income would mirror the income type earned within the equity fund, and therefore may be converted into capital gain or another tax-beneficial income type, depending on the taxable income types of the fund.

Current Issues and Pitfalls

One of the key benefits to a successful carried interest or management fee waiver is avoiding income recognition when it is granted. To defer income recognition, any membership interest received cannot be considered a capital interest. Under Rev. Proc. 93-27, a capital interest is an interest that is entitled to receive a share of proceeds if the fund liquidated for fair market value on the date of grant. Rather, these interests should only be entitled to a share of profits that occur after the date of grant. As a result, it is important to avoid any scenarios that would repay a deemed capital account in advance, or alongside a contributed capital account.
Another situation to be wary of is an irrevocable over-allocation of cash and profits to profits/carried interest or deemed capital account holders. This situation could occur if a fund incurs early investment gains but ultimately nets to a loss (or does not have enough gains to cover benchmarks discussed earlier). A possible alternative is to consider claw-back conditions to allow a correction of previously over-allocated items.

Future Potential Concerns

The IRS has released proposed regulations that are meant to further restrict the use of both carried interests and management fee waiver agreements. These regulations focus on assuring these interests and waivers are subject to "significant entrepreneurial risks" to avoid being considered current ordinary income. These regulations are especially stringent on items such as timing of waiver agreements, allocation methods, and allocation frequency and timing.
It is important to note that these are proposed regulations that have not been finalized, so they may differ from any permanent regulations that may be issued in the future. However, they give us insight that these interests are a focus area of the IRS and will most likely be a topic of scrutiny in years to come.

The potential opportunities and traps discussed here represent only a small sample of a multitude of planning considerations. The specifics of a carried profits/carried interest can be very complex and should be discussed with a tax advisor knowledgeable on detailed nuances of these arrangements.
Cohen & Company is not rendering legal, accounting or other professional advice. Any action taken based on information in this blog should be taken only after a detailed review of the specific facts and circumstances.