On July 22, 2015, the Treasury Department (Treasury) published proposed regulations concerning the proper tax treatment of certain arrangements between service providers and partnerships (Proposed Regulations). The Proposed Regulations are aimed at perceived abuses in the arrangements between sponsors of private equity funds and their private equity funds in the form of so-called management fee waivers. While the Proposed Regulations acknowledge and confirm that such fee waivers will be respected if properly structured, they are designed to significantly restrict the types of fee waiver arrangements that would withstand scrutiny by the Internal Revenue Service (IRS). The Proposed Regulations will generally apply to fee waiver arrangements entered into after the date on which they are finalized.
In a typical private equity partnership, the fund’s limited partnership agreement provides that the general partner is entitled to a 20% interest in future profits of the fund and an annual management fee of 2%. Often, but not always, the management fee is earned by a separate management company that is not a partner of the fund but is owned by essentially the same persons who own the entity that serves as the fund’s general partner. It has become increasingly common that the funds’ limited partnership agreements provide that the 2% management fee can be partially waived in exchange for a larger share of future profits of the fund. Such "fee waivers" are implemented in different forms.
One key motivation for service providers to waive management fees is to convert management fees, which constitute ordinary income, into a distributable share of the fund partnership’s long-term capital gains (e.g., sales of stock in portfolio companies which are typically held for three to seven years). If respected, the fee waiver delivers two tax advantages to the service provider, namely (a) the deferral of income recognition until gain is recognized upon asset sales by the fund partnership and (b) the conversion of ordinary income into long-term capital gains taxed at much lower tax rates. While most tax practitioners have believed that fee waivers should work, if properly structured, there has been significant uncertainty among practitioners and the IRS as to what exactly properly structured means. In addition, fee waivers have attracted significant attention in the general media (e.g., New York Times) and have often been characterized as an unfair tax advantage to Wall Street.
Against this background, based on a statutory anti-abuse provision, Treasury has now released the Proposed Regulations to provide guidance as to the necessary line drawing. For the Treasury two issues are at stake. First, increasing tax revenues is a significant motivation. Most investors in private equity funds in today’s world are tax-exempt organizations that cannot make use of the corresponding tax deduction for management fees paid because they pay no tax. Accordingly, the tax treatment of the management fees in the hands of the service provider directly affects the amount of tax revenues collectable by the Treasury. Second, perceived fairness is a tax policy goal: if service providers, such as doctors and architects, must pay tax on their fees as ordinary income, then, so the argument goes, service providers that provide asset management services should also be taxed at ordinary income rates.
Summary of Proposed Regulations
Under the Proposed Regulations, an arrangement, including a "fee waiver" arrangement, will be treated as a disguised payment for services (taxable as ordinary income) if (a) a person (the service provider), either in its capacity as a partner or in anticipation of being a partner, performs services (directly or through its delegate) to or for the benefit of the partnership, (b) there is a related direct or indirect partnership income allocation and associated cash or property distribution to the service provider, and (c) the performance of the services on the one hand and the partnership income allocation and associated cash or property distribution on the other hand, when viewed together under substance over form principles, are properly characterized as a transaction occurring between the partnership and an unrelated person that is not a partner in that partnership. An arrangement is tested under this anti-abuse rule at the time at which the parties enter into or modify the arrangement. Whether clause (c) is satisfied is determined based on all the facts and circumstances. However, the most important factor to determine whether an arrangement constitutes a disguised fee payment for services is whether the partnership income allocation and the associated cash or property distribution by the partnership is subject to significant entrepreneurial risk. A lack of significant entrepreneurial risk is indicative of a disguised fee arrangement. Whether an arrangement lacks significant entrepreneurial risk is based on the service provider’s entrepreneurial risk relative to the overall entrepreneurial risk of the partnership. Other aspects that will be taken into account for this purpose are (a) the existence (and scope) of a "clawback obligation" (i.e., will the clawback apply to the additional partnership profits interest created by the fee waiver?), (b) whether or not the service provider can control the timing of asset dispositions of the fund partnership and (c) how "profits" are determined for purposes of the partnership allocations and distributions to the service provider
- Not All Fee Waivers Are Created Equally. Fee waiver arrangements can work, but some fee waiver arrangements currently seen in the market could be challenged under the Proposed Regulations.
- Effects of Recast Clarified. Consistent with the re-characterization of certain fee waivers as disguised fee payments in private equity funds, the Proposed Regulations clarify that if a fee waiver is indeed treated as a disguised fee arrangement, the deferred compensation rules of Section 409A and Section 457A could apply to such disguised fees.
- Timing of Waiver Is Critical. The Proposed Regulations are very focused on the timing of the waiver and its legal form. Generally speaking, the earlier the fee waiver occurs, the better. Also, the fee waiver must be in writing, legally binding, irrevocable and clearly communicated to the investors in the fund partnership offering documents.
- Proposed Regulations May Have Broader Implications. While the Proposed Regulations target fee waiver arrangements, the Proposed Regulations are broadly drafted and, therefore, apply to other arrangements as well (e.g., hedge funds or real estate development partnerships).
- Proposed Regulations Leave Many Questions Unanswered. The Proposed Regulations do not provide comprehensive guidance on all aspects. Accordingly, we expect that the Treasury will receive comments on various technical details of the Proposed Regulations. Accordingly, it is difficult to predict in which form the Proposed Regulations will be finalized.