How Bain Capital execs lower their taxesAugust 28, 2012: 12:00 PM ET
FORTUNE -- There has been lots of talk over the past few days about how Bain Capital executives have used management fee waivers to effectively lower their tax payments (a tactic that is not unique to Bain). Some academics have argued that such waivers are an illegal dodge, while private equity tax attorneys I've spoken with call it "aggressive but accepted by the IRS."
Here is the basic structure: Bain officially charges 2% management fees to investors in its private equity funds. The idea is to cover overhead, such as salaries, office leases, electric bills, etc. But Bain has lots of other business lines (venture capital funds, hedge funds, etc.) that generate sufficient cash flow, so it "waives" the PE fund management fees. Well, sort of. Limited partners still pay the 2%, only it flows directly into the fund, as part of Bain's general partner commitment (which is between 10% and 15% of Bain's total PE fund capital, an unusually high percentage).
By doing so, Bain partners don't pay ordinary income taxes on their management fees. Instead, they pay at capital gains rates if/when the deals generate profit (because it's now considered carried interest). It appears that the partners irrevocably waive their rights to the returns if the deal returns less than par, although I don't have access to the LPAs that would spell it out more exactly. That said, sources do tell me that Bain partners cannot take waiver-related capital loss on failed transactions.
Sources sympathetic to such structures cite an IRS ruling (93-27) that specifically seems to allow such waivers, under a notion of partnership risk. Critics say that rule is being perverted, because the risk of loss is so low.
I'm not well-versed enough in IRS minutia to render legal judgment, but do feel that such structures should be banned going forward. Management fees are a fee for service. As such, they should be taxed as ordinary income. If Bain wants to eliminate management fees altogether, then move to a 0-and-32 structure.
To be sure, I have no problem with fund managers pushing some of their fees into funds. I think it's a good thing, as it's a tighter alignment of interests. But I don't see why their capital should be cheaper than that of the high-net-worth investors in their funds (who paid taxes on their pre-commitment monies). Doing so, in fact, depresses that alignment.
Tax law is a funny thing, because certain strategies aren't black and white. They're subject to interpretation. When I asked a PE tax attorney if what Bain is doing is allowed, she told me that "allowed" and "not allowed" isn't always the right way to think about it. Okay, understood. But some things are explicitly permitted (treating carried interest as capital gains, for example) and other things are explicitly prohibited (taking deductions for work expenses for which I was reimbursed). So let's just add this one to the latter list.
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