In a June 2 article in the publication Tax Notes, Gregg D. Polsky, professor of law at the University of North Carolina School of Law and a critic of private-equity tax practices, writes that “recharacterization of monitoring fees as dividends has very little, if any, positive collateral tax effect” on sponsors or their investors.
Sponsors today often use most or all of their monitoring fees to offset the management fee paid to them by investors. Were monitoring fees re-characterized as dividends, then the private equity fund, as a primary shareholder, would use the dividends it receives from the portfolio company to pay management fees to the firm. So the tax consequences for the sponsor “are unchanged,” Polsky writes. Either way, the firm recognizes ordinary income: monitoring fees paid by the portfolio company or management fees paid by the fund. At the same time, many investors in private equity funds would be unaffected because they are exempt from paying U.S. taxes. (Some individual investors might benefit, however.)
Polsky, who is co-counsel for someone who has filed a whistleblower claim related to the tax treatment of monitoring fees, made the case in a February article that portfolio companies should not be able to deduct monitoring fees paid to sponsors on their tax returns. Such fees, he argued, are really dividends in disguise, rather than fees for service, and should be characterized as such on portfolio-company tax returns. ”For instance,” he wrote, ”in nearly all cases, the fee agreements provide for large periodic fees over lengthy periods for future services described only in nebulous terms.” He added that “the amount of fees are set well before it is known whether there will be any need for those services…”
A number of publications weighed in on the debate in the wake of that February article, including the Wall Street Journal, New York Times Dealbook and CNNMoney. Polksy wrote in his June article that in all of those responses, “there has been no articulated defense against my central points…” However, he noted that some have “pushed back” by suggesting that sponsors would benefit by seeing monitoring fee income (taxed as ordinary income) converted to dividend income taxed at a lower rate. That, in turn, could even mean less revenue for the government. Polsky provided his latest analysis to show “why that analysis is critically flawed.”