EM Pro Tips: Structuring Closing Fees

Independent sponsors often rely on closing fees as a meaningful part of their compensation for sourcing and executing deals. But if not carefully structured, these fees can lead to avoidable tax consequences or raise regulatory concerns. Here's how sponsors can approach these fees with clarity, efficiency and compliance in mind.

1. Clearly Allocate the Fee

The first step in any independent sponsor transaction is clearly documenting who earns the closing fee. This should be set forth in the transaction documents, including in the initial term sheet to manage investor expectations. The sponsor entity (not the individual sponsor) should be the recipient of the fee. The fee should not be paid to the investment vehicle unless expressly agreed. Lack of clarity can lead to disputes over who is entitled to the closing fee or surprise investors that a fee is being indirectly assessed against their investments.

2. Recognize the Tax Default: Ordinary Income

By default, a closing fee is treated as ordinary income to the sponsor when earned. Even if the sponsor immediately contributes the fee into the investment vehicle as equity, this does not recharacterize it as capital gain.

Thus, a “roll-in” of the fee does not defer or reduce the tax burden as it merely converts after-tax proceeds into an equity investment.

3. Consider Alternatives to Fee Income

To improve tax efficiency, some sponsors explore alternative structures:

a. Fee Waiver for a Profits Interest

Sponsors may waive the closing fee and receive a profits interest in the investment vehicle instead. This can be tax-efficient, as a properly structured profits interest can be granted tax-free and taxed as capital gain on exit.

However, the key limitation is that a profits interest:

• Only participates in future appreciation, above a return-of-capital hurdle; and

• Does not share in investor capital or preferred returns.

Because of this, profits interests may not replicate the economics of a closing fee, which sponsors often expect to be non-subordinated compensation.

b. Capital Interest in Exchange for Property

A sponsor may avoid the fee structure altogether and instead receive a capital interest in exchange for a contributed intangible asset, such as a letter of intent, business plan or deal rights.

If the contribution is properly documented and credibly valued, this interest may qualify as a tax-free contribution of property to a partnership, allowing the sponsor to receive equity pari passu with investors.

Key conditions:

• The interest must be received in exchange for property, not for services.

• If any portion is deemed compensation for services, it will be taxed as ordinary income.

This approach has been used successfully to replicate sponsor economics without generating current income, but requires careful planning and supportable valuation.

4. Avoid Broker-Dealer Traps

Sponsors must structure fees to avoid triggering broker-dealer registration requirements. If the fee is contingent on a successful closing and the sponsor lacks a capital stake or governance role, the SEC may view this as unregistered brokerage activity.

To mitigate this risk:

• Tie the fee to comprehensive services throughout the transaction lifecycle—not just closing.

• Maintain a meaningful post-closing role (e.g., board rights or operational involvement).

• Avoid purely contingent or success-based structures that resemble banker compensation.

Conclusion

While closing fees can provide critical near-term compensation for independent sponsors, they must be carefully structured to avoid immediate tax burdens and regulatory exposure. In many cases, alternative structures, such as profits interests or contributions of property for equity, can replicate the intended economics more efficiently.

Most importantly, planning must begin at the earliest stages of the deal, ideally before the LOI is signed. Once the deal is ready to close, it may be too late to implement tax-efficient or legally sound alternatives. Sponsors who wait until the eleventh hour may lose opportunities to achieve favorable treatment or mitigate risks.

Early alignment with tax and legal advisors is key to preserving flexibility, optimizing economics and staying compliant.