MANAGEMENT FEE WAIVERS – The Next Area to Scrutinize

A couple of weeks ago I wrote about “carried interest,” the income earned by a private equity or hedge fund that qualifies for long term capital gain treatment and thus taxed currently at the lower capital gains rates of 15%.  Well, now it seems that the New York Attorney General, Eric Schneiderman, has probed into yet another industry practice that is raising some eyebrows, known as “management fee waivers.”

Private equity firms typically charge two fees, a profit percentage (carried interest) and a management fee which is based on the total assets within the fund.  Management fee income is taxed at ordinary tax rates. Some firms have been waiving the management fee, opting to take a larger share of the profits earned by the fund, hence the “carried interest” income.  This tax strategy would enable the owners of the private equity firm to have more of its income taxed at the more favorable capital gains rates.

It seems there are mixed reviews of the legality of this practice.  Some lawyers are saying it is perfectly legal while others believe this is an overly aggressive position and potentially illegal.  Some proponents argue that the private equity firm is actually taking a large risk in converting its otherwise guaranteed income (management fee) to “re-invest” it for future potential capital gains, and therefore should get the tax benefits so associated with this practice.

In an article in yesterday’s Wall Street Journal (WSJ) the ultimate obvious question was raised – Since New York State tax rates are the same whether the income is ordinary or capital gain, why would the Attorney General be so concerned?   The WSJ article stated that some people believe this is politically motivated as the New York AG is a democrat and is continuing the scrutiny against Mitt Romney, since much of his income was derived from a private equity firm he had owned and was taxed as “carried interest.”

I really hope this probe isn’t politically motivated.  I would like to believe that our tax dollars are used wisely to ensure a fair tax system, but what do I know, I still believe in Santa Claus, the Easter Bunny and the Tooth Fairy.

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