Happy Friday, funds family!

Today we’re going to discuss a fancy way to structure 🛠️ GP compensation in investment funds and syndications. If you’re not familiar with fund fees and carried interest, please review the linked article above to get a quick primer before continuing.

Previously, we discussed the 💰️ taxation of compensation typically earned by investment fund principals. Here, you’ll learn about a special mechanism referred to as a “fee waiver” 🚀 to turbo-charge the tax efficiency GP compensation.

⚠️ Note that even when structured carefully, fee waivers are not free from tax risk and could be successfully challenged by the IRS given certain grey areas of the tax law. Tread carefully and work with a competent tax lawyer.

Note that we’re going to say “GP” here for simplicity, but technically the fee is often waived by the fund’s management company.

💼 What is a fee waiver?

A fee waiver is…a waiver of a fee. 👋 Typically the fee being waived is either a fund’s asset management fee or an acquisition fee. Basically, the GP foregoes a fee it’s otherwise entitled to and, in exchange, it gets additional equity in the fund or syndication.

Fee waivers have two principal goals:

1. Defer taxation. Defer taxation of fee income. Instead of paying taxes on fee income now, you get taxed later.

2. Tax character. Convert ordinary income from fees into dividends or capital gains taxed at preferential rates.

👔 How is GP compensation taxed without using a fee waiver?

On the one hand, management fees (and other fees, such as acquisition fees) are normally taxed as ordinary income 💸 at the time the fund pays the fee (e.g. quarterly after the fund’s initial close).

On the other hand, carried interest is taxed at the time it is earned – typically after the fund earns enough income to return capital to LPs (plus, potentially, a 🛠️ preferred return).

The tax character of the carried interest (i.e., whether it’s ordinary income or capital gains) depends on the tax character of the income or gain earned by the fund. For many funds, the carried interest is taxed at lower rates than ordinary income (e.g., capital gains or dividends).

⚙️ How does the fee waiver work?

In a typical fee waiver, the GP agrees to irrevocably (no take-backs!) waive all or a portion of the applicable fee.  This election should be made on the 🛠️ initial closing date of the fund or syndication.

In exchange, the GP is treated as having contributed the amount of the fee waived as a “deemed” capital contribution to the fund. In other words, they get a type of equity in the fund intended to be a “profits interest” for U.S. federal income tax purposes.

⚠️ The risks and nitty-gritty of fee waivers

The GP does NOT get its “deemed” capital contribution (the amount of waived fee) returned alongside other LPs pari passu. Instead, they get the deemed contribution amount back on a priority basis from the fund’s profits after the return of capital to LPs. Note that the GP takes true economic risk here, which is the basis for the “profits interest” tax position.  If the fund is not profitable, the GP waives the fee but does not get the benefit of the deemed contribution. They waived the fee for nothing (and can’t take it back).

After the priority return of the deemed contribution amount to the GP (after the fund is profitable), the GP receives a return on the deemed contribution as if it were a normal capital contribution.  This is in addition to the carried interest it would otherwise earn or any return on the GP’s actual cash capital contribution.

Like the carry, amounts earned through the fee waiver are taxed based on the characterization of the underlying income generating the return. For a fund like a venture fund, the character is typically long-term capital gains or QSBS, both of which are taxed preferentially compared to ordinary income (as with the carry, special holding period rules apply).

🤔 Should GPs use fee waivers?

As you’ve seen, waiving fees can be a tantalizing proposition. In addition to the exciting tax benefits, waiving fees can help GPs with cash flow. Instead of coming up with a cash GP commitment now, they can use the fee waiver.

However, in addition to the tax risks and economic risk that the fund might not generate enough profit to earn back the waived fees, there are a few drawbacks to using fee waivers. For example, some LPs might prefer that you fund your GP commitment with cash. In addition, the fee waiver mechanism is complex and your 🛠️ service providers (lawyer, administrator, CPA) might not understand it. Finally, you might actually need the full management/acquisition fees to keep the lights on at the GP. 💡

As always, talk to your lawyer!

⚠️ Note: This newsletter is for informational purposes only and nothing should be considered legal advice. For that, hire a lawyer! I am a lawyer, but not your lawyer (unless I actually am your lawyer because you’ve signed an engagement letter and we’re working together). This newsletter may be considered attorney advertising.