Tax Expert Sees Abuse in a Stream of Private Equity Fees

The tax practices of private equity firms have come under scrutiny from authorities on several fronts. But there is an additional tax strategy that should merit a skeptical look, an academic argues in a new article.

The argument centers on so-called monitoring fees, payments that companies make to their private equity owners in exchange for what regulatory filings call consulting and advisory services over time.

These fees, however, are being improperly characterized for tax purposes, Gregg D. Polsky, a law professor at the University of North Carolina, argues in the article, which appears in the Feb. 3 edition of the journal Tax Notes. The issue could be costing the federal government hundreds of millions of dollars a year in missed tax revenue, Mr. Polsky writes.

At the heart of the issue is whether the payments should be considered a business expense or a dividend. Business expenses are tax deductible, whereas dividends are not.

In many cases, companies owned by private equity firms consider monitoring fees to be business expenses, allowing them to lower their tax bills. But Mr. Polsky seeks to show that they more closely resemble dividends, paid to owners regardless of whether services are performed and directly in proportion to the size of the ownership stake.

Mr. Polsky has a business interest in this matter. In his capacity as a lawyer, he represents an individual who has filed whistle-blower claims with the Internal Revenue Service using arguments similar to the ones in the article. The contents of his article were first reported online by The Wall Street Journal.

The lobbying group for the private equity industry contests Mr. Polsky’s reasoning.

“Monitoring fees incurred are legitimate business expenses for private equity-owned portfolio companies,” Steve Judge, the president and chief executive of the Private Equity Growth Capital Council, said in a statement. “Federal and state revenue authorities have examined and affirmed the deductibility of monitoring fees earned by private equity managers.”

Mr. Polsky relies on publicly available filings to build his case, without having observed whether private equity firms actually performed consulting services for their companies. Still, the filings reflect the logic underpinning these agreements, shedding some light on the nature of the fees.

One argument Mr. Polsky marshals is that monitoring fees are often paid according to the size of a private equity firm’s stake â€" a feature that becomes apparent when multiple private equity firms buy a company. This would suggest that the payments resemble dividends, he says.

“Pro rata allocations belie compensatory intent because compensatory payments would be allocated among service providers based on the respective value of their services, not based on mere share ownership,” he writes. “It would be an incredible coincidence if a private equity firm that controlled, say, 7.2347 percent of shares was also expected to provide 7.2347 percent of the monitoring services.”

In many of these fee agreements, Mr. Polsky argues, the private equity firms do not actually need to provide any significant services in order to get paid.

He points to language that allows private equity firms to terminate fee arrangements at any time and still get paid the net present value of all the fees they would have received. In many cases, he says, the services expected of the private equity firms are described in vague terms.

One agreement involved HCA Holdings, a hospital company that was bought by Bain Capital, Kohlberg Kravis Roberts and Merrill Lynch’s private equity arm. It provided that “no minimum number of hours is required to be devoted” by the private equity owners “on a weekly, monthly, annual or other basis.”

Despite that provision, HCA promised to pay the owners monitoring fees worth more than $100 million, Mr. Polsky wrote.

In a statement, a spokesman for HCA said: “The parties providing services to the company under the management agreement had relevant business, financial or healthcare industry expertise.”

Monitoring fee agreements are “completely unlike any other arrangement you will ever see,” Mr. Polsky said in an interview. “This is a situation where you get to quit tomorrow and still get paid in full.”