Private-Equity Firms’ Fees Get a Closer Look; Industry May Be Underpaying Taxes by Misrepresenting Payments

Private-Equity Firms’ Fees Get a Closer Look

Industry May Be Underpaying Taxes by Misrepresenting Payments

MARK MAREMONT

Feb. 2, 2014 4:48 p.m. ET

Gregg D. Polsky, a tax-law professor, has long been a thorn in the side of the private-equity industry. Now he is at it again.

In 2009, Mr. Polsky wrote an article criticizing a strategy that allowed many fund executives to save on taxes by converting ordinary fee income into capital gains taxed at substantially lower rates. The Internal Revenue Service later started examining the propriety of the practice, called a management-fee waiver, and recently said it plans to issue new guidance on it.

In a new article published over the weekend, Mr. Polsky takes aim at the tax treatment of another revenue stream for private-equity firms, called monitoring fees. He claims the industry may be underpaying federal corporate taxes by hundreds of millions of dollars a year by mischaracterizing these fees.

Monitoring fees are payments made by acquired companies to private-equity managers for what typically is described as ongoing consulting services. The companies paying the fees often deduct them as ordinary business expenses, a move that reduces their taxes.

In his article in the journal Tax Notes, Mr. Polsky argues that monitoring fees often should be treated as dividends, in part because fees sometimes bear little relationship to any services being performed. Rather, like dividends, they often are paid out proportionally to ownership stakes or as a percentage of earnings. Under tax law, payment of a dividend isn’t a deductible business expense.

“The fee agreements I’ve seen are so problematic on their face,” Mr. Polsky said in an interview, “it boggles the mind how anybody could think these payments are deductible under the current law.”

Mr. Polsky discloses in his article that, as an attorney, he represents a would-be whistleblower who has made a claim to the IRS using similar arguments. An IRS spokesman declined to comment.

Looking at 229 large buyout deals in which information on monitoring fees is available, Mr. Polsky, of the University of North Carolina, and associates tallied more than $3.9 billion in monitoring-fee payments from 2008 to 2012 that he said have one or more features suggesting they were dividend-type payments.

Several large private-equity firms declined to comment or deferred questions to the Private Equity Growth Capital Council, an industry trade group.

Steve Judge, the council’s chief executive, said in a statement that monitoring services help fund managers expand and strengthen their portfolio companies, and the “fees incurred are legitimate business expenses for these companies. Federal and state revenue authorities have examined and affirmed the deductibility of monitoring fees earned by private equity managers.”

Others in the industry said some large private-equity firms have many employees on staff to provide these consulting services, adding to the legitimacy of the payments.

Linda M. Beale, a tax-law professor at Wayne State University in Detroit who also has explored the general topic of monitoring fees, said she thinks there could be a significant tax issue because in some cases the fees “appear more like a regular dividend paid from earnings and profits rather than a means of providing for actual management needs.”

One of the strongest arguments that the fees are actually dividends, said Mr. Polsky, is that in cases in which more than one buyout firm purchases a company, the fees often are paid based on ownership percentage.

One example is HCA Holdings Inc., HCA +1.58% the hospital chain bought in 2006 by Bain Capital LLC, KKR KKR -1.39% & Co. and Merrill Lynch, now part of Bank of AmericaCorp. BAC -1.06% When HCA went public in 2011, it had paid its owners or their affiliates more than $245 million in monitoring fees, filings show. The original agreement called for the fees to be paid in a ratio that closely mirrored the parties’ control percentage, with each of three buyout firms initially getting 26.6667%, and the other 20% going to the founding Frist family, which retained about one-fifth of the stock.

One of those entitled to be paid for “management, consulting and advisory” services was Patricia F. Elcan, a daughter of Thomas F. Frist Jr. , who has described herself as a homemaker in Federal Election Commission filings. Her share of the overall fees was set at 4.1948018%, the eventual equivalent of about $10 million.

The only reasonable interpretation of these facts, Mr. Polsky writes, is that these are dividend-type payments. Ms. Elcan declined to say whether she had performed any services for HCA. Earlier in life she was a health-care consultant, she said, but now, “I’m a mom with lots of kids running around.”

An HCA spokesman said: “The parties providing services to the company under the management agreement had relevant business, financial or health-care industry expertise.”

Fees paid proportional to shareholding ownership is “fairly strong evidence” that they are dividends, said Martin J. McMahon Jr., a tax-law professor at the University of Florida. He cautioned, however, that any case would rest on specific facts.

Private-equity firms often justify monitoring fees by saying they are in lieu of the portfolio companies having to hire consulting firms to perform similar services. Mr. Polsky argues that, unlike a typical consulting arrangement, monitoring-fee contracts are between related parties, typically last a decade or longer, and originate when the private-equity firm takes control, not when services are needed.

In the 2011 acquisition of retailer J. Crew Group Inc. led by TPG, the contract states that the buyout firms could decide how much work they wanted to perform for their annual monitoring fee, set at a minimum of $8 million, and were required to devote “no minimum number of hours” to the task. TPG could cancel the decadelong contract at any time, and J. Crew still would be required to pay the net present value of the remaining years of unpaid fees.

“It can’t be compensation for services if you have the choice of performing the services or not and still get paid in full,” said Mr. Polsky, who reviewed the specific situation.

John C. Hart, a tax lawyer at Simpson Thacher & Bartlett LLP in New York who represents private-equity firms, said it is a large industry and a few cases might have “weaker fact patterns,” but that generally firms provide the services for which tax deductions are taken. He said private-equity firms often add staff to provide services and should be compensated when long-term contracts end early.

Some in the industry question whether overall taxes paid could decline if fees were recast as dividends, in part because those receiving the money might pay tax at lower dividend rates rather than ordinary-income rates. Mr. Polsky disagrees, saying that because of the tax-exempt status of many fund investors and complex fee-offset arrangements between private-equity firms and their investors, the Treasury Department would come out ahead.