(Bloomberg) The IRS is seeking to limit private-equity executives’ practice of reducing their tax bills by reclassifying how their management fees are taxed.
Rules proposed by the agency on Wednesday would make it harder for firms to convert high-taxed fees into lower-taxed carried interest and take advantage of a 19.6 percentage-point difference in top tax rates.
The proposal represents one of the government’s most concrete attempts to limit the tax benefits enjoyed by private-equity managers.
The “modest move” by the Internal Revenue Service would stop some of the most abusive maneuvers by private-equity firms, said Victor Fleischer, a tax law professor at the University of San Diego.
“The regulations strike me as more taxpayer-favorable than I would have expected,” he said. “The regulations try to accommodate some arrangements that are common in the industry and that in my view ought to be treated as payments for services,” taxed as ordinary income.
President Barack Obama has been trying to tax carried interest as ordinary income at rates up to 43.4 percent instead of capital gains at rates up to 23.8 percent. That effort fell short when Democrats controlled Congress and isn’t going anywhere with Republicans in charge.
Typically, private-equity firms charge their investors a 2 percent fee on their assets and also keep 20 percent of profits, known as carried interest.
By using waivers, firms can forgo some of their fees and take a bigger share of the profits—along with the tax benefit of doing so.
The rules, aimed at preventing “disguised payments for services,” say each case should be decided on the specific facts at hand, with weight given to whether the fund managers bear risk of losing money.
Fleischer said he was surprised at one example in the rules: Fund managers were deemed to have enough at risk when they choose whether to reclassify their fees as few as 60 days before a tax year starts. By that point, future profits may be relatively certain.
“At the point where the general partner is making the decision whether to waive the fee,” he said, “they’re in a very good position” to know how successful the investments will be and can control the timing of realized gains and losses.
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