EM Pro Tips: Structuring Closing Fees

Unlike traditional private equity (PE) funds, where closing fees typically offset management fees, often at 100%, independent sponsors often rely on closing fees as a meaningful part of their direct compensation for sourcing and executing transactions. However, if not carefully structured, these fees can create avoidable tax consequences or trigger regulatory concerns. Early planning, supported by experienced legal counsel, is essential to avoid pitfalls and preserve flexibility. Here is how independent sponsors can approach closing fees with clarity, efficiency, and compliance in mind.

1. Clearly Allocate the Closing Fee

The starting point for any independent sponsor transaction should be clearly documenting who earns the closing fee. Ideally, this should be outlined in the initial term sheet to align investor expectations from the outset. For tax and regulatory reasons, the sponsor entity, not the individual sponsor, should be designated as the recipient of the closing fee. Importantly, the closing fee should not be paid to the investment vehicle unless expressly agreed, otherwise it could imply that all investors will benefit from the fee. Lack of clarity can lead to confusion at closing, disputes over entitlements and concerns from investors who may view the fee as either an asset of the fund or an indirect charge against their investment.

2. Understand the Tax Default: Ordinary Income

By default, a closing fee is treated as ordinary income when earned. Even if the sponsor chooses to immediately reinvest the fee into the investment vehicle as equity, this roll-in does not recharacterize the amount as capital gain. Instead, it merely converts after-tax cash into an equity contribution, leaving the sponsor with an immediate and often significant tax liability. Sponsors should recognize that, without proactive structuring, closing fees will be taxed at ordinary income rates and should plan accordingly. 

Ordinary income can be taxed at rates as high as 37 percent federally, compared to long-term capital gains rates that generally top out at 20 percent, making the distinction highly significant from a net economics perspective.

3. Consider More Tax-Efficient Alternatives

Profits Interests.  Some sponsors seek to improve the after-tax economics of closing fees through alternative structures. One common approach is to waive the closing fee in exchange for a profits interest in the investment entity. If properly structured, a profits interest can be granted without current tax and can ultimately be taxed at capital gains rates upon exit. However, profits interests only participate in the future appreciation of the investment and do not share in contributed capital or preferred returns. Therefore, they may not fully replicate the economics of an upfront cash fee.

Capital Interest.  Another approach is to avoid charging a closing fee altogether and instead receive a capital interest in exchange for contributing a valuable intangible asset, such as a letter of intent, deal rights, or a developed business plan. If carefully documented and credibly valued, this structure can allow the sponsor to receive equity alongside other investors without recognizing immediate taxable income. However, pursuing a capital interest strategy generally involves greater risk, as the contribution must be properly substantiated and structured to withstand IRS scrutiny. With appropriate foresight, documentation and valuation support, this approach can still be executed successfully and deliver significant tax advantages. It is critical that the contribution be classified as property rather than services; otherwise, the IRS will treat the value as ordinary income.

Each of these alternatives offers different benefits and trade-offs. The right choice will depend on the sponsor’s priorities, including immediate cash needs, risk tolerance and long-term tax planning goals.

4. Structure Fees to Avoid Broker-Dealer Issues

Sponsors must also be mindful of securities laws when structuring fees. If a fee is contingent solely on the successful closing of a deal, and the sponsor lacks a meaningful ownership stake or post-closing governance role, the U.S. Securities and Exchange Commission (SEC) may view the activity as unlicensed brokerage. This could expose the sponsor to significant regulatory penalties, including potential enforcement actions and civil liability. In some cases, investors may also have rescission rights, allowing them to unwind their investment and recover their funds if a violation is found, creating additional financial and reputational risk for the sponsor.

To mitigate this risk, sponsors should tie their compensation to broader deal services, including diligence, structuring, financing and ongoing operational involvement. Maintaining a continuing role post-closing, such as a board seat or management oversight, also strengthens the case that the sponsor is acting as a principal and not as a broker. Purely success-based, transaction-only compensation models should be avoided unless the sponsor has proper broker-dealer licensing.

Conclusion: Plan Early and Execute Thoughtfully

Closing fees are a vital source of compensation for independent sponsors, but they require careful structuring to avoid immediate tax burdens and regulatory pitfalls. Exploring alternatives such as profits interests or contributions of property can deliver more tax-efficient outcomes if implemented early in the deal process, ideally before the letter of intent is signed.  Sponsors who engage legal advisors early preserve flexibility, optimize their economics, and position themselves for long-term success. Waiting until closing often leaves few, if any, viable alternatives. 

At AnchorPoint, we draw on our significant funds experience to help sponsors structure closing fees, mitigate regulatory risks and design flexible options tailored to their business objectives.

Disclaimer: This content is for informational purposes only and does not constitute legal or tax advice. Independent sponsors should consult with qualified legal and tax advisors regarding their specific circumstances.