It has been a common practice of private equity firms to convert their right to receive management fees from the funds they manage into the right to receive profits and distributions from the funds through management fee waiver arrangements. As a result of these arrangements, the firms achieve a lower tax rate because the profits and distributions they receive in place of the fees usually receive capital gains treatment while the fees would otherwise have generated ordinary income, subject to higher tax rates. In the proposed regulations, the IRS suggests that these arrangements may be disguised payments for services and result in ordinary income anyways.

While the proposed regulations would be effective when final regulations are published, the IRS has indicated that it believes the principles reflected in the proposed regulations generally reflect Congressional intent—signaling that it may apply these principles to existing arrangements even prior to the adoption of final regulations.

Read the proposed rule in the Federal Register HERE.