Mixing Management Fee Waivers with Mayo

Abstract

The 2012 presidential election cycle brought national attention to a strategy used by private equity firms, like the one founded by Mitt Romney, to convert ordinary income into long-term capital gains. Under the strategy, a private equity firm waives its right to a fixed fee from a managed fund. Instead of the fixed fee, which would be taxed at high rates, the firm receives an additional profits interest (or “waiver interest”) in the fund. If this strategy has its intended effect, income allocated to the waiver interest qualifies as low-taxed long-term capital gain.This apparent conversion of ordinary income to long-term capital gain has drawn withering criticism from several respected commentators. Private equity firms, many of which already enjoy spectacular income, have allegedly engaged in aggressive or illegal behavior by taking a waiver interest rather than a fixed fee payment. According to the commentators, the Internal Revenue Service (IRS) could successfully challenge the fee waiver strategy because (1) section 707(a)(2)(A) allows the IRS to recharacterize the transaction as one between strangers (and thus generating ordinary income), (2) a distribution regarding income allocated to the waiver interest may qualify as a “guaranteed payment” under section 707(c) and would again give rise to ordinary income, and (3) the receipt of the waiver interest qualifies as a recognition event under the common law authorities related to profits interests.