April 22, 2014
Interviewed by: David Snow
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Are Monitoring Fees Actually Dividends?

The IRS is looking at whether monitoring fees paid to private equity sponsors should be treated as dividends, not fees for service. A change would not necessarily be good news for private equity taxpayers, say experts from New Mountain Capital and RSM.

The IRS is looking at whether monitoring fees paid to private equity sponsors should be treated as dividends, not fees for service. A change would not necessarily be good news for private equity taxpayers, say experts from New Mountain Capital and RSM.

Are Monitoring Fees Actually Dividends?
Taxes and Private Equity

David Snow, Privcap: Today, we’re joined by Adam Weinstein of New Mountain Capital and Rick Bailine of RSM. Gentlemen, welcome to Privcap today. Thanks for being here.   

All: Thank you, David.

Snow: You both spend a lot of time thinking about tax and practicing best practices in tax. Adam, you at a private equity and Rick, working for clients at RSM, many of them private equity firms.   

I’d like to dive deeply into some important trends in the world of tax and private equity. Let’s start with one where people predict there may be some movement. It has to do with the treatment of the advisory fees GPs charge to their portfolios, often called “monitoring fees,” and how that gets treated at the portfolio level and at the GP level.

Adam, you can set the stage and talk about what the practice is now by way of taxes and these monitoring fees?   

Adam Weinstein, New Mountain Capital: Today, the way it works is often, during a negotiation, you’re buying a company—there are minority shareholders sometimes coming in; sometimes it’s going to be 100% owned by the private equity fund. You negotiate to have some type of advisory or monitoring fee that’s paid on a quarterly or annual basis to the private equity firm. This is intended to help mitigate some of the costs that go into just overseeing a portfolio company. Some private equity firms don’t charge any travel back to their funds, so this would help offset travel. Others are viewing it as, effectively,afeeforhelpingtooverseethecompany.

In the grand scheme of transaction fees and the dollar amounts you’re talking about, these are usually relatively smaller fees, from as low as $100,000 for a $100-­‐million-­‐sized company to $1 million a year. There are outliers in both directions.

From a GP perspective, it’s getting captured. It’s coming in as ordinary income, as fee income, and then flows to the partners if it’s a partnership. Usually, it comes into the management company itself. The GP is then offsetting this and reducing their LP’s management fees in the next drawdown that they do customarily with transaction fees and other things. Whenever the fee offset we’ve talked about a lot in the industry, 50%, 65% or 100%—it actually just gets credited back to the LPs effectively through that.

LPs are less focused on it these days because many firms have gone to 80% or 100% fee offset. From their perspective, it’s helpful to get advisory fees from the company because it reduces their management fee burden. That’s the practice today.

Snow: From a tax perspective at the portfolio level, how are these fees treated?

Rick Bailine, RSM: That’s what’s truly causing the controversy. If a portfolio company—typically a C corporation—pays a fee to someone for providing management services, that’s simply an ordinary and necessary business expense to the portfolio company, which is fully deducted. The rumblings we have heard coming from Capitol Hill—that’s what has started the focus.

There has been a great deal of focus by the IRS and Congress for many years, on any flow of cash from a C corporation to a shareholder. Probably the most litigated issue in the history of our internal revenue code is called “debt equity.” It is a corporation making a payment of interest, which would be deductible to the corporation and income to the recipient. Or, they are paying a dividend, which would be nondeductible to the corporation and taxable to the recipient.

The difference is, the way our code stands today, it’s not an even balance in the sense that if the portfolio company is paying a fee, the portfolio company gets a deduction but then, as Adam said, the recipient has income. If it were to be reclassified as a dividend, in fact, the portfolio company would not have a deduction but the recipient would also have a 20% or a 23.8% tax rate, not the typical 39.6%.

It’s interesting that Congress is choosing to look at this at a time when changing the characteristic might benefit the shareholder, the management company by giving them a lower tax rate.

Weinstein: The specific area they focused on is where monitoring or advisory fees are going to the private equity firm and/or others in proportion to their ownership, as Rick said. When you have a private equity firm that owns 80% of a business and a minority shareholder that owns 20% and there’s a $100 fee getting paid annually, with $80 going to the private equity firm and $20 going to this minority shareholder, they believe it’s simply a dividend.

Ironically, there is a different argument if you are an 80% owner and you’re getting the monitoring fee all to you and none is going to the minority shareholder. Actually, in this case, that is helpful to the argument and fact pattern.

They’re focused on it and you said it exactly right that, on the face of it today, it would cause a rate reduction for private equity. But obviously, in the long term, if you are the majority owner of a business, less  tax  deductibility is  ultimately  going  to hurt  your outcome to the business. If you do it in a way that is proportional, that is the thing most susceptible to be changed.

Bailine: That’s exactly right. The focus on cash flows from a C corporation to a shareholder always have been scrutinized closely and typically, for anything that was distributed to a shareholder on a pro-­‐rata basis, in proportion to their shareholdings, the government’s initial reaction almost uniformly will be, “If you’re paying this to your shareholders based on their ownership of the stock, why is that not a dividend? It appears to us that you’re simply making distributions to shareholders with regard to the stock that they own, not with regard to the services that someone is providing.”

Importantly, and Adam said it exactly correctly, if you are providing services, why would management fees be going to others if you are the provider of the services? That’s exactly the type of thing the government has looked at almost since the inception of the code.

Typically, distributions to shareholders on a pro-­‐rata basis are viewed, at least by the government, as dividends. They will look closely at whether or not the payments are, in fact, for services. Are you actually  rendering the services?  Are the payments commensurate with the services you are rendering or is something extraordinary going on here?

Weinstein: What is interesting is, if you’re at 100% offset and you get $1 from this type of monitoring fee and you reduce your management fees

by $1 in the next year, to the point Rick made, you now have a tax rate of 23.8% on income and you are reducing management fee income, which is always at the 39.6% rate, presumably if you’re in the highest tax bracket on the management fee. So there’s a windfall for the firm if this type of thing happens.

Snow: There could be an interesting scenario where, in an effort to go after a private equity and these unusual fees they pay themselves, the government could have an unintended consequence of possibly creating a windfall by changing what was income and more into something of a dividend.

Bailine: Which brings us to the next question. I don’t think Capitol Hill is that foolish. It’s one thing for us to say if they were to change the rule and say, “This should be a dividend because it’s being paid pro rata with regard to your shareholders, therefore it’s nondeductible to your portfolio company.” It’s not going to take them long to realize the point that Adam illustrated, that you’re now having a benefit to the private equity group. Maybe it would surprise no one if their solution were that it’s nondeductible to the portfolio company and we still believe it should be taxed at 39.6% to the recipient.

Weinstein: That is the entire argument on carried interest, which is why legislative action is needed for it because it is a conversation. The three of us are in the partnership, the two of us are LPs and David, you’re the GP. I would only pay capital gains rate on the income that comes to me from that partnership. Nobody’s disputing that. It’s the piece of the capital gains that now goes to you, which today is taxed at the same rate, and an argument is being made that it should be taxed at a higher rate. Does that make those you look at important in making the contextual argument of what tax rate to charge them?

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