It's well-known that private equity managers often pay capital gain rates on their "carried interest" - typically, a 20 percent profit allocation for their performance enhancing services. It's less well-known that they often also pay capital gain rates on their fixed annual fee - typically, 2 percent of the capital commitments for their management services.
The conversion of ordinary annual fee income to capital gain is accomplished through a common practice of fee waivers. While set up in a variety of ways, the basic approach is that the manager elects to waive the annual 2 percent fee in exchange for a right to an allocation of additional profits. The fee waiver can be a one-time event at the outset or on an annual elective basis. Unlike fee income, the manager's additional allocation of profits tends to be capital gains.
On July 23, 2015, the IRS issued proposed regulations intended to stop the fee waiver practice. REG-115452-14. The regulations apply various factors to determine whether there is an allocation of profits to a service provider that is properly characterized as a transaction with someone acting other than in the capacity of a partner. If so, the profit allocation is treated instead as a disguised payment for services - i.e., ordinary income.
The primary theme running through the regulations is a significant entrepreneurial risk. The more likely the service provider will receive the allocation regardless of the overall success of the business, the more likely it will be a disguised payment for services. Whether there is a disguised payment depends on the facts and circumstances based on a variety of nonexclusive factors. This means that discretion will be involved in their application, and it makes advanced planning difficult.
Some examples of factors showing insufficient entrepreneurial risk include (i) capped allocations where the cap is reasonably expected to apply, (ii) allocations for fixed years during which the service provider's share is reasonably certain, (iii) allocations of gross (not net) income, (iv) holding a partnership interest for a short duration, and (iv) nonbinding fee waivers.
The proposed regulations also disrupt another tax principle relied on by private equity managers. Tax practitioners often cite a 1993 Revenue Procedure to find that the receipt of an allocation of future profits is tax free. See Rev. Proc. 93-27. In a fee waiver scenario, the fund manager typically waives the fee, but it is the general partner who receives the additional profit allocation. The preamble to the proposed regulations states that Rev. Proc. 93-27 will not apply in these situations because the service provider is not the one receiving the allocation. This suggests that under the practice as it stands today, most all fee waivers will fall outside of the safe harbor in Rev. Proc. 93-27 and will therefore risk being taxable on receipt by the general partner.
The proposed regulations are not effective until they are finalized. Meanwhile, the IRS has invited public comments.