According to a recent BNA news report, the Internal Revenue Service (IRS) has proposed adjustments and penalties to a private fund manager related to its use of management fee waivers and transaction fee offsets. Based on the report, this is one of the first cases to arise in connection with the IRS’s efforts to stop the practice of some participants in the private fund industry (including hedge funds and private equity funds) of reducing the taxes of executives by reclassifying how management fees are treated. Specifically, the IRS is targeting the practice of converting management fees to shares of future profits of a fund (sometimes referred to as “carried interest”) through the waiver of management fees. Unlike the management fees, which are taxed as ordinary income, the shares of future fund profits attributable to long-term capital gains are taxed at the lower maximum rate applicable to long-term capital gains generally.

The IRS started focusing on this practice in 2015 and proposed regulations under Section 707 that would make it more difficult for private fund managers to use management fee waivers. The proposed regulations are primarily directed at limiting the tax benefits of management fee waivers and other fee-waiver arrangements. The proposed regulations adopt rules that recharacterize certain profits interests into payments for services, which could impact the timing and character of payments received by fund managers and impact the deductibility of these payments to the private funds they manage. The IRS is concerned that these arrangements are not true “profits interests” because they lack the essential characteristics of partnership interests. While these proposed regulations did not target carried interest generally, they did raise concerns on whether carried interest will be respected as profits interests where the allocation of profits is based on targeted allocations or permits allocations of gross items of income and gain to the holder of the carried interest.

If the current case is any indication, the IRS does not intend to limit enforcement of what it considers abusive management fee waivers to prospective enforcement of the proposed regulations, but is willing to target these arrangements on audit as well. According to the BNA news report, the penalties in the current case could reach a multimillion-dollar amount if the IRS’s adjustments are upheld. The private fund manager in question plans to protest the adjustments and stated that its practices are common in the private equity industry. Given the prior proposed regulations, private fund managers should take care in the use of these types of management fee waivers and carried interest arrangements, and may want to review their existing arrangements to consider the risks of a potential IRS audit.