Elizabeth Warren Adds Ammunition To Private Equity Tax Battles

Private equity is feeling the squeeze. A week after President Barack Obama and GOP presidential hopefuls Jeb Bush and Donald Trump backed the closing of a prominent tax loophole employed by investment managers, Sen. Elizabeth Warren, D-Mass., is blasting a related maneuver.

The group of senators, which also includes Al Franken, D-Minn., Tammy Baldwin, D-Wis., and Sheldon Whitehouse, D-R.I., sent a letter calling on the IRS and the Treasury Department to enforce new rules around the so-called management fee waivers used widely by private equity managers.

The issue comes down to how fees charged to private equity investors are treated come tax season. It has become common practice for some private equity managers to waive the annual management fees they charge partners in the fund, instead lumping those payments in with capital contributions.

The arrangement allows the managers avoid steep income tax rates that would ordinarily be charged on management fees in favor of the significantly lower capital gains tax, saving private equity firms what some have estimated to be in the range of hundreds of millions of dollars a year.

“Fund managers should not be allowed to alter the character of their salary income simply by inserting into their fee arrangements a few magic words that lack meaningful economic effect,” the senators wrote.

In proposed rules issued in July, the IRS dubbed the arrangement a “disguised payment for services” and indicated that management fee waivers contradicted existing tax law. But the proposed guidelines, which merely clarify existing rules, have not yet been finalized.

“The abuse of fee waivers has been ongoing for years at the expense of middle-class taxpayers who do not use similar gimmicks,” the senators wrote, urging the IRS and Treasury Department to complete the process.

A 2012 analysis of tax returns from Bain Capital, founded by former Republican presidential contender Mitt Romney, showed that management fee waivers allowed the private equity firm to avoid some $200 million in taxes over 10 years.

Private equity firms generally operate on the so-called two-and-20 model. Investors pay a management fee between 1 and 2 percent on committed capital -- which is taxed as income -- as well as a 20 percent incentive fee on whatever profits the fund earns over a benchmark.

Both revenue streams present opportunities for nifty tax workarounds. The other loophole, around carried interest payments, allows private equity firms, hedge funds and similar investment vehicles to classify their 20-percent incentive fees as carried interest, which gets taxed as capital gains rather than income from services rendered.

The carried interest loophole has long been a target of Democrats, yet the private equity industry has managed to fend off regulations designed to curb the practice.

But in theory, no new regulations need to be passed for the IRS to begin sanctioning private equity firms over use of management fee waivers, which have also attracted the attention of New York Attorney General Eric Schneiderman.

“We expect this to be a high priority for the agency,” the senators wrote.