The U.S. Treasury Department (“Treasury”) and the Internal Revenue Service (the “IRS”) have issued proposed regulations under Section 707(a)(2)(A) of the Internal Revenue Code of 1986, as amended (the “Code”),1 covering the circumstances when certain arrangements between partnerships and their partners will be re-characterized as disguised payments for services (the “Proposed Regulations”). The transactions covered by the Proposed Regulations include so-called “management fee waiver” arrangements commonly employed by private equity fund managers, although the Proposed Regulations address any transaction involving disguised payments for services under Section 707(a)(2)(A).
In addition, Treasury and the IRS have concluded that safe-harbor relief currently affording tax-free treatment for certain profits interests received for the provision of services to a partnership does not apply to transactions in which one party (for example, a management company) provides services to a partnership and another party (for example, a general partner) receives an associated profits interest. Furthermore, Treasury and the IRS announced their intention to issue future guidance excluding profits interests received as part of a management fee waiver arrangement from this safe harbor.
The Proposed Regulations were issued on July 22, 2015. While they technically would not take effect until published in final form, the preamble to the Proposed Regulations (the “Preamble”) states that Treasury and the IRS view the Proposed Regulations as generally reflecting Congressional intent as to when arrangements are appropriately treated as disguised payments for services.
Management Fee Waiver Arrangements
In a typical management fee waiver arrangement, a fund manager may elect to waive prospectively all or a portion of any management fees to which it otherwise would be entitled, in exchange for an increased interest in future profits. The arrangement may also treat any waived amounts as a deemed contribution by the manager, allowing the manager to participate in profits and losses of the fund in the same manner as if it had contributed cash to the fund in the amount of the waived amounts. These partnership interests are separate from any “carried interest” to which the manager may otherwise be entitled if the fund’s performance exceeds certain thresholds.
The Proposed Regulations
The Proposed Regulations provide guidance as to when an arrangement between a partnership and a partner should be properly treated as a disguised payment for services under Section 707(a)(2)(A). An arrangement that is treated as a disguised payment for services would be treated as a payment for services for all purposes of the Code, including under Sections 409A and 457A (relating to the taxation of deferred compensation).
Observation: The treatment of certain management fee waiver arrangements as disguised payments for services would have obvious negative implications for private equity fund managers, including the acceleration of taxable income and the characterization of such income as ordinary fee income, rather than as a share of fund profits (which may be composed largely of long-term capital gains). Private equity fund investors, although perhaps not the focus of the Proposed Regulations, may also suffer adverse tax consequences. A fee waiver arrangement determined to constitute a disguised payment for services generally would result in the creation of additional gross investment income for the investors, with a related expense for the disguised payment for services. Because individual and other non-corporate investors are subject to stringent limitations on their ability to deduct certain management fees and other investment expenses, treatment of any fee waiver arrangement as a disguised payment for services could therefore reduce the after-tax return to such investors.
The Proposed Regulations provide a general rule that an arrangement would be treated as a disguised payment for services if (i) a service provider, either in a partner capacity or in anticipation of becoming a partner, performs services for a partnership; (ii) there is a related (direct or indirect) allocation and distribution from the partnership to the service provider; and (iii) the performance of such services, when viewed together with the allocation and distribution, are properly characterized as a transaction occurring between the partnership and a person acting other than in that person’s capacity as a partner. Whether the third condition would be satisfied depends on all of the relevant facts and circumstances, and the Proposed Regulations provide a non-exclusive list of six factors that would be relevant to this determination.
Observation: Although Section 707(a)(2)(A) applies disguised fee treatment only if (among other things) the performance of services is accompanied by a “related direct or indirect allocation and distribution” to the service provider, and the Proposed Regulations recite this requirement, a timing rule contained in the Proposed Regulations would effectively eliminate the dual requirement of an allocation and distribution. The Proposed Regulations would require that the proper treatment of an arrangement be determined at the time it is entered into or modified, regardless of the timing and separate risk associated with the receipt of any distributions. Thus, it appears possible under the Proposed Regulations that an allocation would be subject to disguised fee treatment even if the service provider ultimately never receives a distribution with respect to such allocation. The Preamble acknowledges this discrepancy, but explains that Treasury and the IRS believe that recharacterizing an arrangement retroactively is administratively difficult.
Determination of Significant Entrepreneurial Risk
A critical factor to consider under the Proposed Regulations is whether the arrangement subjects the service provider to significant entrepreneurial risk. If the service provider is not subject to significant entrepreneurial risk, the arrangement would be deemed to be a disguised payment for services, whereas the presence of significant entrepreneurial risk generally (although not always) indicates that the arrangement is not a disguised payment. The presence of five specific factors would create a rebuttable presumption that an arrangement lacks significant entrepreneurial risk, which could only be overcome if the taxpayer showed facts and circumstances that established significant entrepreneurial risk by clear and convincing evidence. The five factors are (i) capped allocations of partnership income if the cap would reasonably be expected to apply in most years; (ii) allocations for a fixed number of years under which the service provider’s distributive share of income is reasonably certain; (iii) allocation of gross income items; (iv) an allocation that is predominantly fixed in amount, is reasonably determinable under all the facts and circumstances, or is designed to assure that sufficient net profits are highly likely to be available to satisfy the allocation; and (v) arrangements in which a service provider waives its right to receive payment for the future performance of services in a manner that is non-binding or fails to timely notify the partnership and its partners of the waiver and its terms. The Proposed Regulations also provide that whether a service provider bears significant entrepreneurial risk will be considered in relation to the level of entrepreneurial risk in the activities undertaken by the partnership generally.
Observation: This focus on entrepreneurial risk extends beyond the disguised payments for services addressed by Section 707(a)(2)(A). The Proposed Regulations would also modify an example in the existing regulations underlying Section 707(c) (relating to guaranteed payments). The example currently provides that an allocation of the greater of 30% of partnership income or a minimum fixed amount is treated as a distributive share of partnership income to the extent of the income allocation, and a guaranteed payment if, and to the extent that, the minimum fixed amount exceeds the income allocation. The Proposed Regulations would modify the example to provide that the entire minimum fixed amount is a guaranteed payment, regardless of the amount of the income allocation, because of the absence of significant entrepreneurial risk.
Even if an arrangement is found to have significant entrepreneurial risk, then the arrangement could still be treated as a disguised payment for services in light of five secondary factors. Under the Proposed Regulations, an arrangement would be presumptively treated as a disguised payment for services depending on (i) whether the service provider holds, or is expected to hold, a transitory partnership interest or a partnership interest for only a short duration; (ii) whether the service provider receives an allocation and distribution in a time frame comparable to the time frame in which a non-partner service provider would typically receive payment; (iii) whether the service provider became a partner primarily to obtain tax benefits which would have been unavailable if the service provider had provided services to the partnership in a third-party capacity; (iv) whether the value of the service provider’s interest in general and continuing partnership profits is small in relation to the allocation and distribution being evaluated; and (v) whether (A) services are provided either by one person or by persons that are related under Sections 707(b) or 267(b) (such as a general partner and management company that are under common ownership), (B) the arrangement provides for different allocations or distributions with respect to different services (such as general management and oversight by a general partner and investment advice or other management services by a related management company) and (C) the terms of the differing allocations or distributions are subject to levels of entrepreneurial risk that vary significantly.
Examples Addressing Management Fee Waivers
Four of the six examples in the Proposed Regulations specifically address management fee waivers, and these examples illustrate certain factors which, in the view of Treasury and the IRS, are indicative that such arrangements should (or should not) be recast. In describing two examples which involve fee waiver arrangements that Treasury and the IRS do not regard as disguised payments for services, the Preamble highlights as supporting factors (i) the execution by the service provider of a waiver in advance of the period to which the waived fees relate, in a manner that is binding, irrevocable and clearly communicated to other partners, (ii) the receipt by the service provider of a profits interest based on net profits that are neither highly likely to be available nor reasonably determinable at the time of entering into the arrangement, and (iii) the presence of a clawback obligation with which the service provider is reasonably expected to be able to comply. The Preamble further states that, although the presence of each fact described in these examples is not necessarily required to reach the same conclusion, the absence of certain facts (such as a failure to measure future profits over at least a 12-month period) may suggest a fee for services arrangement. Accordingly, it should be noted that, once it is concluded that significant entrepreneurial risk is present, any given arrangement may still pass muster even under the Proposed Regulations. Unfortunately, neither the text of the Proposed Regulations nor the Preamble provide guidance as to what specifically is an effective clawback or otherwise constitutes significant entrepreneurial risk. Additional clarity in the examples would have been helpful.
Observation: The facts included in the favorable examples, coupled with the corresponding discussion in the Preamble, appear to confirm, at least implicitly, that the Proposed Regulations are not intended to disrupt customary “carried interest” arrangements, including typical priority “catch-up” arrangements that are intended to equalize a service provider’s return with priority returns already received by the investors over the life of the partnership. In the case of management fee waivers, however, the Proposed Regulations leave many questions unanswered.
Amendment to Profits Interests Safe Harbor
Rev. Proc. 93-27 (as later clarified by Rev. Proc. 2001-43) provides that the receipt of a profits interest for services to a partnership in a partner capacity, or in anticipation of becoming a partner, will not be treated as a taxable event to the partnership or the partners, provided that certain conditions are met. One such condition requires that the partner not dispose of its partnership interest within two years of receipt.
The Preamble provides that Treasury and the IRS have determined that the Rev. Proc. 93-27 safe harbor does not apply to arrangements where one party provides services to a partnership and another party receives a related partnership allocation and distribution. More specifically, Treasury and the IRS do not view a management fee waiver by a management company, and the receipt by a related party of a future profits interest approximating the amount of the waived fee, as falling within the safe harbor. In the view of Treasury and the IRS, such an arrangement does not satisfy either the requirement that the profits interest be received for the provision of services to the partnership in a partner capacity (or in anticipation of becoming a partner), or the requirement that the service provider not dispose of its profits interest within two years of receipt.
The Preamble further announces the intention of Treasury and the IRS to issue a revenue procedure containing an additional exception to the Rev. Proc. 93-27 safe harbor. The exception would apply to a profits interest issued in conjunction with a partner waiving fees of a substantially fixed amount (including as determined by formula, such as a percentage of partner capital commitments) for the performance of services.2 Treasury and the IRS intend to issue this revenue procedure together with the publication of the Proposed Regulations in final form.
Observation: Although Rev. Proc. 93-27 has always been somewhat unclear in both its rationale and its precise application, it provides some certainty in an area that has proven difficult for taxpayers and courts alike. The absence of any safe harbor relief would deny all management fee waiver arrangements the relative comfort that the Rev. Proc. 93-27 safe harbor provides in situations involving the grant of a profits interest for the provision of services to a partnership.
The Proposed Regulations would apply to arrangements entered into or modified after the publication of final regulations, including the waiver of any fee under a pre-existing arrangement where such waiver takes place after the publication of the final regulations. Prior to the publication of final regulations, the determination of whether a management fee waiver is a disguised payment for services under Section 707(a)(2)(A) will be made on the basis of the statute and relevant legislative history. The position of Treasury and the IRS, however, is that the Proposed Regulations generally embody the relevant existing legislative history.
While the Proposed Regulations would clarify the relevant factors to be considered in analyzing management fee waiver arrangements, the facts-and-circumstances approach adopted by the Proposed Regulations may be difficult to apply in practice. While somewhat helpful, the examples also leave significant gaps. This uncertainty, coupled with the added uncertainty as to the value of a profits interest grant absent safe harbor relief, may cause some managers to reconsider these arrangements. Notably, however, the Proposed Regulations do not recast all management fee waiver arrangements. Thus, one could view the Proposed Regulations as confirming the treatment of those situations that might generally be viewed as overly aggressive or overly conservative, while leaving in place a certain amount of uncertainty for all remaining arrangements. Given the position of Treasury and the IRS that the Proposed Regulations generally reflect Congressional intent regarding current law, due care should be given to the guidelines set forth in the Proposed Regulations in reviewing existing management fee waiver arrangements and structuring such arrangements in the future.