Investment Expenses – What Can Fund Managers Do for Their Investors and Themselves
Investment funds incur various fund level expenses, including management fees, professional fees and other expenses necessary to operate the fund. Prior to the passage of the Tax Cuts & Jobs Act of 2017 (TCJA), individual investors who claimed itemized deductions on their tax returns were able to deduct their allocated portfolio expenses from the fund as “miscellaneous 2% itemized deductions.” The miscellaneous itemized deductions were deductible to the extent they exceed two percent of the taxpayer’s adjusted gross income (AGI) and some other limitations, but were subject to an Alternative Minimum Tax (AMT) addback. As of the 2018 tax year and until the end of 2025, the TCJA has suspended miscellaneous itemized deductions for individual taxpayers.
Investors in funds, who are considered to be in a trade or business (trader), are not impacted by this change in the tax law, since the expenses of a trader fund are considered to be that of a trade or business. Therefore, the expenses are deductible as an ordinary deduction or an above-the-line deduction. However, code section 461(l) created a new limitation for trade or business net losses that exceed $250,000 ($500,000 for joint filers) — the “excess business loss.” If an individual is an investor in a trader fund and has a separate business that together generate a net taxable loss, the amount of loss that exceeds the threshold is considered an excess business loss and is disallowed and carried over to the following year as a net operating loss (NOL).
Individual investors who invest in non-trader hedge funds, trader funds, or private equity funds may be losing deductions that were deductible prior to the TCJA. With the potential limitations or non-deductibility of the management fee charged by fund managers, this has put even more pressure on fund managers to reduce the expenses passed on or charged to their investors. As a result, many managers have chosen to reduce management fee rates, execute a management fee waiver, or both in order to compensate investors for the lost deductions.
Management Fee Waivers
Fees for investment management services provided by fund managers are typically calculated as a percentage of capital commitments or invested capital in the fund (e.g., 2%). Management fees are typically used to support various operating costs of the manager and to seek better market opportunities with higher returns for the fund.
Historically, management fee waivers have been used to convert ordinary management fee income to long-term capital gain. With the new law, waivers may be used to reduce or eliminate the management fee charged to investors, which reduces the amount of non-deductible expenses or potential NOLs created for these investors.
Under a typical management waiver, a general partner (or a related investment manager) of a fund agrees to forgo all or a portion of the management fee payable by the fund, which would be taxed as ordinary income to the recipient. Instead, the manager would receive an interest in the fund’s future profits, which is not taxable immediately. Converting management fees into a profits interests often provides substantial tax benefits to both the investment manager and individual fund investors.
One of the key benefits of a management fee waiver is to avoid both ordinary income recognition for the manager and fund level expense for the investors. To defer income recognition, any membership interest received through the management fee waiver cannot be considered a capital interest. Under Rev. Proc. 93-27, a capital interest is defined as an interest that is entitled to receive a share of proceeds if the fund is liquidated for fair market value on the date of grant. Rather, these interests should only be entitled to a share of profits that occur after the date of grant. Rev. Proc. 93-27 is later clarified by Rev. Proc. 2001-43, which states that the grant of a partnership profit interest is tested at the time the interest is granted, even if the interest at that point is substantially non-vested. As a result, it is important to avoid scenarios that would repay a deemed capital account in advance, or alongside a contributed capital account.
Proposed Reg. section 1.707-2 also provides guidance to partnerships regarding when an arrangement may be treated as “disguised payments for services,” thus subject to tax immediately. In general, whether an arrangement constitutes a disguised payment for services (in whole or in part) depends on all of the facts and circumstances. The proposed regulations provided six non-exclusive factors that may indicate an arrangement to be treated as a disguised payment for services. The factor given the most emphasis is whether the interest lacks “significant entrepreneurial risk.”
The proposed regulation identified five facts and circumstances creating a presumption that an interest lacks significant entrepreneurial risk:
- “Capped allocations of partnership income if the cap is reasonably expected to apply in most years;
- An allocation for one or more years under which the service provider’s share of income is reasonably certain;
- An allocation of gross income;
- An allocation (under a formula or otherwise) that is predominantly fixed in amount, is reasonably determinable under all the facts and circumstances, or is designed to assure that sufficient net profits are highly likely to be available to make the allocation to the service provider (e.g. if the partnership agreement provides for an allocation of net profits from specific transactions or accounting periods and this allocation does not depend on the long-term future success of the enterprise); or
- An arrangement in which a service provider waives its right to receive payment for the future performance of services in a manner that is non-binding or fails to timely notify the partnership and its partners of the waiver and its terms.”
A management fee waiver arrangement that does not comply with the guidance could result in both the grant of additional profits interest as well as the allocation of income deriving from the profits interest being treated as compensation income to the manager and an expense to the fund. This would subject the fund manager to ordinary income tax rates, rather than an allocation of the funds income at (potentially) beneficial tax rates. Therefore, a carefully drafted management fee waiver that includes a real risk of loss is important to establish a successful fee waiver program, and provides benefit to the fund investors and the fund manager.
The Tax Cuts and Jobs Act of 2017 has altered the tax code in ways that have negatively affected both investors and managers of funds in the alternative investment industry. With deductions being eliminated or limited for investors, fund managers are forced to look for new ways to make up for the lost benefit. A management fee waiver is one way a fund manager can make up for the lost income tax deductions to individual investors. Should you have any questions related to this topic, please contact your Marcum professional.