I. Overview
This update discusses a new and interesting development with respect to how certain non-US and US tax-exempt investors can receive a “rebate” of previously paid management fees with respect to their investments in private equity funds. We are encountering this new rebate alternative, usually presented in the subscription booklets of private equity funds, with increased frequency. Below is a high-level summary of this new rebate alternative and the potential tax considerations for investors who wish to select it.
II. Background — Management Fee Offsets and Excess Fee Income
Before discussing the new rebate alternative, it is important to understand the basic mechanics used by private equity funds to apply management fee offsets, potentially resulting in excess fee income remaining upon liquidation of a fund. In private equity funds, the fund manager charges investors a management fee (typically 2% annually of committed capital) to cover operational costs. Additionally, over the life of the fund, the fund manager may receive fees directly from portfolio companies, such as transaction fees for services like deal oversight and execution. The management fee offset mechanism reduces the management fees payable by investors by a portion of these transaction fees, to avoid “double charging.” Any excess transaction fee income that was not used to offset management fees (e.g., due to management fee step-downs in a postinvestment period) over the course of the fund’s life can either be retained by the fund manager or be distributed to the investors in the fund, if not otherwise waived. The receipt of such excess transaction fee income by non-US investors that are ECI-sensitive, or by US tax-exempt investors that are UBTI-sensitive, can be problematic from a tax perspective, as there is a risk that such excess transaction fee income can be characterized as ECI or UBTI.[1] As a result, many ECI-sensitive and UBTI-sensitive investors currently waive their right to receive any excess transaction fees, as described more fully below.
III. Historical Alternatives for Excess Fee Income
Historically, investors in private equity funds faced two options for handling their share of excess transaction fee income upon fund liquidation:
- Receive the excess fee income, risking ECI for non-US investors or UBTI for tax-exempt investors.
- Waive the right to receive the excess fee income, avoiding tax risks but forgoing economic benefits.
This binary choice often forced ECI-sensitive and UBTI-sensitive investors to prioritize tax mitigation over economic returns.
IV. Introduction of a Third Alternative: The Rebate Option
Recently, some large US private equity funds have introduced a third alternative in their subscription documents, allowing investors to elect to receive a rebate of excess fee income up to the amount of management fees actually paid by the fund to the manager with respect to that investor (the “Rebate Option”).[2] This alternative could be particularly relevant in scenarios where early in a fund’s life, investors pay full management fees when transaction fee income is low. Later in the fund’s life, portfolio companies might pay significant transaction fees, resulting in transaction fees exceeding management fees payable by the fund, especially after the investment period when management fees may step down. The Rebate Option allows investors to recover a portion of those earlier management fee payments upon liquidation.
This alternative, possibly prompted by heightened tax scrutiny following cases like YA Global Investments, LP v. Commissioner (2023), aims to provide greater flexibility for ECI-sensitive and UBTI-sensitive investors while also allowing such investors to partially share in the economic benefit of receiving a “rebate” of prior management fees paid, rather than completely waiving that benefit.[3]
V. Potential Benefits for ECI-Sensitive and UBTI-Sensitive Investors
The Rebate Option offers a potential path for ECI-sensitive and UBTI-sensitive investors to recover some excess fee income without triggering significant tax concerns. By capping the rebate at the amount of management fees paid, the payment may be characterized as a refund of any such investor’s share of previously paid management fees rather than income from a US trade or business or an unrelated trade or business, potentially reducing ECI or UBTI exposure and related US tax filing requirements.[4] However, the tax treatment will partially depend on the applicable fund’s reporting position with respect to such “rebate,” and we do not expect that funds will be willing to provide any formal tax opinions or assurances with respect to such tax treatment.
VI. Reporting of Rebate Payments
The tax treatment and reporting of payments under the Rebate Option are critical considerations. Non-US investors will want to confirm that the fund will report the rebate on IRS Form 1042-S as fixed, determinable, annual, or periodical (commonly referred to as FDAP) income, subject to withholding under Section 1441, rather than as ECI.[5] This may suggest that the rebate is not treated as income from a US trade or business (and will not be reported as such), potentially mitigating ECI concerns for non-US investors. Likewise, UBTI-sensitive investors, such as US tax-exempt entities, will want to confirm that the fund will report the rebate on IRS Form 1099-MISC or 1099-NEC as a miscellaneous or nonemployee compensation payment and not as UBTI on Schedule K-1.[6]
We will be monitoring further developments in this area and will provide updates as new information becomes available.
Endnotes
[1] ECI, under Internal Revenue Code Sections 871 and 882, is income effectively connected with a US trade or business, potentially triggering US tax obligations for non-US investors. UBTI, under Section 512, is income from a trade or business unrelated to a tax-exempt entity’s purpose, potentially taxable for US tax-exempt investors. Unless otherwise indicated, “Section” references are to the Internal Revenue Code of 1986, as amended.
[2] The Rebate Option limits the rebate to the amount of management fees paid, which may reduce the risk of ECI or UBTI classification by tying the payment to fees already paid by the investor.
[3] YA Global Investments, LP v. Commissioner, 161 T.C. No. 11 (Nov. 15, 2023), found that fees paid to a fund’s manager for services indicated a US trade or business, possibly prompting funds to offer flexible structures like the Rebate Option to further manage ECI and UBTI risks.
[4] Characterizing the rebate as a refund of management fees may reduce the likelihood of it being treated as ECI or UBTI, though this depends on the fund’s tax reporting and IRS interpretation.
[5] FDAP income, reported on IRS Form 1042-S, is subject to withholding under IRC Section 1441 but is generally not treated as ECI, potentially reducing tax exposure for non-US investors.
[6] If treated as a refund, the rebate may be reported on IRS Form 1099-MISC or 1099-NEC for tax-exempt entities, avoiding UBTI classification under IRC Section 512.