There has been buzz in the tax and private equity communities about the rise in audits of private equity firms by the Internal Revenue Service (“IRS”). This has been fueled by the restructuring of the IRS’ Large Business & International group, a report by the Government Accountability Office analyzing IRS audits of “large” partnerships, and public statements by IRS officials of the IRS’ intent to apply more resources to audits of partnerships, “mid-market” companies and high net worth individuals, rather than large corporations. Most recently, practitioners and journalists have heard reports of an uptick in audits of private equity firms and rumors that the IRS has selected, or will be selecting, 100 private equity firms for audit. 

What to Worry About

Two significant events occurred in 2015 that relate to audits of private equity firms. First, in July 2015, the IRS published proposed regulations on “disguised payments for services” that cover so-called “management fee waiver” arrangements commonly employed by private equity fund managers, although the proposed regulations themselves address a much broader swath of arrangements that could be recharacterized as service payments. For prior coverage on these regulations, see A Sea Change for Waive-rs? - Proposed Regulations Address Tax Treatment of Management Fee WaiversProposed Partnership Treasury Regulations – Consider the Guaranteed Payment, and Tax-Saving Strategies - The Management Fee Waiver.

Management fee waivers are a hot topic, and examination agents in audits of private equity firms are likely to concentrate on them. The recently proposed regulations (which contain statements that Treasury and the IRS believe that the proposed regulations generally embody the intent of the current tax rules) may embolden the IRS to be more aggressive than they have previously been on these arrangements. With the IRS’ shifting focus to partnerships and high net worth individuals, it is likely that the IRS will focus on management fee waivers in an audit of a private equity firm. The management fee waiver is not the only item that is on a short list of “hot topics” for partnerships in an audit. There are a number of issues that an examination agent can be expected to explore on an audit of a private equity firm.

Second, the Bipartisan Budget Act of 2015 amended the current rules governing tax audits of partnership in the U.S. These rules will generally apply to partnership taxable years beginning after December 31, 2017. While these rules will not be relevant for several years (unless a partnership elects to apply them to an earlier year), the enactment of these new rules raise several current issues for private equity firms to consider. For prior coverage on these new rules, see Navigating the New Partnership Audit Rules: Sea Change or Same Course? and Recent Changes to Rules Governing Tax Audits of Partnerships.

What to Do

Audits of private equity firms – including management companies, general partners, and the funds themselves – may be a new frontier for many such firms. There are a number of steps that can be taken in advance of an audit, including having a plan in place on how to respond to an audit or similar inquiry from the IRS (or other taxing authority). Policies around email and document retention should be examined and modified if necessary, and education of key personnel on what information and documentation is confidential and/or privileged is advisable (and how to maintain privilege). In addition, a review of fund documentation to determine whether any significant risks are present should also be considered. While facing an audit will not be a welcome event, taking these actions before an audit begins will result in a more thoughtful and effective strategy for a private equity firm. Private equity firms should consider engaging counsel with expertise on these fund-level and controversy issues to assist the firm and its accountants before and during an audit.