New York Attorney General, Eric T. Schneiderman Is Investigating Compensation Received By Large Private Equity Firm Equilty Managers, Including Those At Bain Capital

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Tax Attorney Alvin S. Brown Justifies "Ordinary Income" Taxation Of Management Fees By Equity Managers

On September 1, 2012, the New York Times reported that New York attorney general, Eric T. Schneiderman, is investigating whether some of the nation’s biggest private equity firms have abused a tax strategy in order to slice hundreds of millions of dollars from their tax bills, according to executives with direct knowledge of the inquiry by diverting management fees into investments in their funds. The Wall Street Journal has also reported on this story.

The NY attorney general has subpoenaed documents from Bain Capital, founded by Mitt Romney, seeking documents that would reveal whether it converted certain management fees collected from its investors into fund investments, which are taxed at a far lower rate than ordinary income.

Tne New York Times story observes that the tax strategy came to light last month when hundreds of pages of Bain’s internal financial documents were made available online. The financial statements show that at least $1 billion in accumulated fees that otherwise would have been taxed as ordinary income for Bain executives had been converted into investments producing capital gains, which are subject to a federal tax of 15 percent, versus a top rate of 35 percent for ordinary income. As a retired partner, Mr. Romney continues to receive profits from Bain Capital and has had investments in some of the funds that documents show.The tax strategy used by Bain converts management fees, the compensation normally taxed as ordinary income, into capital gains is known as a “management fee waiver.” The leaked documents show that Bain has in recent years waived management fees in at least eight private equity and other funds, including one formed as early as January 2002. The documents stated that Bain executives had the right to decide either annually or each quarter whether to waive some or all of their management fees; they also had the ability to convert the waived fees into investments in particular companies held by the funds. The Wall Street Journal reports that the fee-waiver conversion program often works this way: The private-equity managers before the start of each year commit to waiving a portion of their management fee for the coming year. In practice the managers do not pay ordinary income taxes on that portion of the fee. Instead, it gets invested in that year's new fund deals, as a form of carried interest, but with higher priority on any payouts. The manager report this income as taxable at the preferential 15% federal capital-gains rate.

Tax attorney Alvin S. Brown, a tax expert on IRS controversies,, states that under the the "economic substance doctrine, codified in § 7701(o) of the IRS Code, the "form" of the "managment fee waiver" will be disregarded. See IRS Notice 2010-62 for more details. Mr. Brown adds that the “economic substance doctrine” is largely applicable to the period before the enactment § 7701(o) under judicial precedent. When the "form" of the "management fee waiver" is disregarded, those fund managers will be taxed at the highest tax rate for the taxation of ordinary income and not at any reduced rate.

Using the "substance" not the "form" analysis, as authorized by § 7701(o) of the IRS Code, tax attorney Brown states that the IRS will disregard the "form" of the "management fee waiver." When the "form" is disregarded, the management fees will be taxable as ordinary income under § 61(a) of the IRS Code. Mr. Brown believes that it is basic tax law, under the reported facts, that profits earned by equity managers for their management services are taxable income when the services are completed under § 61 of the Code which defines gross income. The fees were earned and constructively received by the fund managers, in the same way interest is constructively recieved in a bank account and creditited to bank account of the owner. The management fees became fully taxable as ordinary intiome prior to the "management fee waiver."

Section 61(a) provies that ‘’except as otherwise provided in this subtitle, gross income means all income from whatever source derived, including (but not limited to) the following items: (1) Compensation for services, including fees, commissions, fringe benefits, and similar items.” Tax attorney Brown states that it is beyone dispute that "management fees" are "compensation for services" withing the clear meaning of
§ 61 of the IRS Code.

Tax attorney Brown observes that the substantive effect of the "management fee waiver" is that the transaction if bifurcated into 1) the taxable constructive receipt of the income 2) followed by a transfer which of the funds to an investment account of the fund manager under the codification of the "economic substance doctrine" under § 7701(o) of the IRS Code.

The Wall Street Journal story observes that managers at a typical private equity firm or hedge fund collect from their investors management fees based on the size of the fund. But most of their compensation comes as a share of the profits earned by the fund. The structure of a private-equity fund is that equity managers get paid in two primary ways. Investors pay an annual management fee, typically 2% of the money being managed. This is like salary, and typically is taxed at ordinary income rates, which are 35% at the highest income bracket. Managers also are entitled to management fees equal to a percentage of investing profits they produce for investors, at times as much as 20% of the profits after a certain return threshold is met. This is called a "carried interest" or a profits interest. The taxation of carried interest is controversial, but has long been taxed at capital-gains rates, currently 15% at the federal level. Tax attorney Brown believes that the "economic sutstance doctrine" analysis will likely apply to what is described as "carried interest" transactions.

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