By GRETCHEN MORGENSON form The New York Times

The Internal Revenue Service on Wednesday proposed a rule aimed at ending a common and lucrative practice among private equityfirms that allows them to artificially lower their partners' personal income tax bills.

The practice targeted by the I.R.S. allows private equity firms to convert management fees they receive from their investors, which would normally be taxed as ordinary income, into capital contributions invested in their funds. Profits generated on such contributions are treated as capital gains or dividend income and subject to a sharply lower tax rate.

Converting a management fee to a capital contribution may be a “disguised payment for services,” the I.R.S. said in its proposed rule making, which it said was intended to provide guidance to partnerships and their overseers that such arrangements will be disallowed if they were done in such a way that no entrepreneurial risk was involved.

Private equity firms earn money from their investor clients in two ways. First is the management fee, which typically amounts to between 1 and 2 percent of the assets under management. Unless converted, such fees are taxed at ordinary income rates to the partners who receive them.

A second profit center for private equity partners comes in the form of so-called carried interest, or the gains that a fund generates at the end of its life.
Such gains, made after a fund has sold its investments for more than it paid for them, are taxed at lower capital gains or dividend income rates. Critics of the industry have sought in recent years to end the special tax treatment of carried interest, but the industry has managed to fend off efforts to change the law.

Management fee waivers have not attracted as much attention, but they made headlines during Mitt Romney's 2012 presidential campaign when documents from Bain Capital, the private equity firm he founded, detailed the practice.

The documents indicated Bain saved $200 million in taxes over 10 years.

“This is a very important step in making sure that private equity, like everybody, pays its fair share of taxes,” said Eileen Appelbaum, senior economist at the Center for Economic and Policy Research and co-author of “Private Equity at Work.” The I.R.S. guidelines are open for public comment until Oct. 21. But because the issuance is a clarification of existing regulations, the I.R.S. is permitted to begin examining private equity firms' books for problematic fee waivers now and to pursue possible violations in a firm's last three years of operations.

Gregg Polsky, a law professor at the University of North Carolina School of Law who is also a co-counsel for whistle-blowers on private equity tax matters, called the I.R.S.'s action “a real win for tax justice.”

The proposed regulations, said Mr. Polsky, who was a professor in residence at the I.R.S.'s office of the chief counsel from September 2007 to June 2008, “take the clearly correct position that the typical fee waiver isn't effective in turning ordinary income into capital gains because fee waivers do not alter the economics of the two and 20 deal in any meaningful way.”

“In order to be effective under the regulations,” he explained, “fee waivers would have to subject managers to significant entrepreneurial risk, which most fund managers will be loath to do with respect to their fee income.”

Private equity firms have used management fee waivers for at least 15 years, Mr. Polsky said. It is unclear how many firms use the fee waivers now, because the documents outlining them are confidential. But he estimated that the government loses hundreds of millions of dollars a year in tax revenue because of the practice.

As the private equity industry became aware of the I.R.S.'s scrutiny of management fee waivers in recent years, some funds moved to reduce their reliance on them, industry experts say.
Still, a fee waiver provision can be found in a limited partnership agreement for a 2014 fund offered by Apollo Global Management, a private equity giant. The firm can “elect to forgo an amount of the management fee in favor of a profits interest in the partnership,” the agreement says.

The agreement notes that the waiver requires the approval of the funds' advisory board, which represents investors.

If it finds violations at a private equity firm, the I.R.S. could extract payment of taxes owed by its partners as well as interest on that money. If it found that the fee-shifting had no reasonable basis, it could also levy penalties.

The I.R.S.' rule making follows a similar ruling issued last March by theBritish government. Ms. Appelbaum said that private equity firms should not be the only ones held accountable for problematic fee-shifting.

“Lawyers and auditors ought to be held responsible as well,” she said. “Every private equity firm that does this, does this with some kind of legal advice. But it clearly has been a violation of law for some time.”