On July 22, 2015, the Treasury Department released proposed regulations under Section 707 of the Internal Revenue Code of 1986, as amended (the “Code”), that are intended to provide guidance on when a compensation arrangement between a partnership and a partner will be treated as a disguised payment for services to a partner not acting in a partner capacity. Treatment as a disguised payment for services would, among other things, cause the partner to be subject to tax at ordinary income rates on such disguised payments, potentially subject such payments to compliance with the deferred compensation regimes of Sections 409A and 457A of the Code, and cause such payments to be subject to the applicable capitalization and deduction rules for the partnership. This differs from “profits interest” treatment, which permits a partnership interest to be valued at zero upon receipt if such interest is not “in the money” when granted.
As a general matter, the proposed regulations do not target standard incentive allocation or carried interest provisions common to hedge funds and private equity funds; rather, the proposal takes aim at management companies (and their partners) who waive their right to receive management fees in exchange for a profits interest in a partnership (commonly referred to as “management fee waivers”).
In addition, the proposed regulations modify an example in existing Treasury Regulations related to guaranteed payments that many taxpayers have relied on in order to attain favorable character benefits. The modification recharacterizes a portion of an allocation to a partner as a guaranteed payment in circumstances where a partner is allocated a percentage of partnership profits subject to a guaranteed floor, regardless of whether such allocation actually exceeds the floor in a given period (see “Guaranteed Payments” below).
The proposed regulations also announce the intent of the Treasury Department and the Internal Revenue Service (IRS) to modify Revenue Procedure 93-27 (and related Revenue Procedure 2001-43 and Notice 2005-43), which generally provides that the receipt of a profits interest for services provided to a partnership is a non-taxable grant of property. The modification would add an exception to the application of the Revenue Procedure for a profits interest issued in connection with a management fee waiver program (see “Profits Interest Safe Harbor: Revenue Procedure 93-27” below).
Factors to Determine Disguised Payments for Services
The proposed regulations offer six non-exclusive factors to determine whether the issuance of a partnership interest to a partner in connection with the performance of services is treated as a taxable payment for services.
The Super-Factor: Significant Entrepreneurial Risk
Of the six factors outlined in the proposed regulations to determine whether a disguised payment for services exists, primary emphasis is placed on the first factor, which is whether the arrangement has “significant entrepreneurial risk” for the service provider relative to the overall entrepreneurial risk of the partnership. Under the proposed regulations, an arrangement that lacks significant entrepreneurial risk is treated as a disguised payment for services made to a person other than in its capacity as a partner. Several facts and circumstances are listed that contribute to the presumption that an arrangement does not have “significant entrepreneurial risk” for the service provider:
- Capped allocations of income (i.e., the allocation is set at a specified maximum amount) if the cap is reasonably expected to apply in most years;
- An allocation for one or more years under which the service provider’s share of income is reasonably certain;
- An allocation of gross income;
- An allocation (under a formula or otherwise) that is predominantly fixed in amount, is reasonably determinable under all facts and circumstances, or is designed to assure that sufficient net profits are highly likely to be available to make the allocation to the service provider; or
- Waiver by a service provider of its right to receive payments 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 examples included in the proposed regulations in which evidence is found of a significant entrepreneurial risk pay close attention to three factors: (1) whether the service provider is entitled to an allocation of net profits as opposed to gross income; (2) whether such allocation lasts during the life of the partnership (such that the allocation depends on the overall success of the enterprise); and (3) whether the allocation is subject to a clawback obligation and it is reasonable to anticipate that the service provider could and would comply with the clawback obligation (i.e., whether the clawback obligation is meaningful). While a clawback obligation is not required under the proposed regulations to evidence significant entrepreneurial risk, most of the examples in which partnership allocation treatment is afforded to a partner contain a clawback.
Another relevant fact to establish significant entrepreneurial risk is that the allocation is neither reasonably determinable nor highly likely to be available. If the service provider or a related entity controls the valuation of the underlying partnership assets or the assets have a readily ascertainable market value and the service provider controls the timing of sale and disposition of the assets, then the allocation may appear more reasonably determinable and/or highly likely to be available (and therefore lacking significant entrepreneurial risk). In an example from the proposed regulations, a partner is deemed not to have significant entrepreneurial risk if it receives a priority allocation of net gain in respect of its waived service fee from the sale of any asset at a gain in a year where the partnership has overall net gain because the general partner could control the disposition of assets in a manner that would make it likely the allocation would be made. In our experience, the Treasury Department’s concern is misguided in a fund context given the fiduciary duties of the general partner and management company to their clients.
In addition to the super-factor of significant entrepreneurial risk, the proposed regulations include a list of five other factors for consideration in determining whether an arrangement constitutes a disguised payment for services. First, the service provider holds a transitory partnership interest or a partnership interest for only a short duration. Second, the service provider receives an allocation and distribution in a time frame comparable to the time frame that a non-partner service provider would typically receive payment for services. Third, the service provider becomes a partner primarily to obtain tax benefits that would not otherwise have been available if the services were rendered to the partnership in a third- party capacity; in other words, the service provider becomes a partner only for this purpose. Fourth, the value of the service provider’s interest in general and continuing partnership profits is small in relation to the allocation and distribution it receives. Finally, the arrangement provides for different allocations or distributions with respect to different services received, the services are provided either by one person or by related persons, and the terms of the differing allocations or distributions are subject to levels of entrepreneurial risk that vary significantly. For example, if a partnership receives services from both its general partner and a separate but related management company, and the terms of the allocations and distributions are different for the management company than for the general partner (creating a significantly lower level of economic risk, such as in the absence of a clawback for allocations made to the management company), then the management company’s arrangement might be treated as a disguised payment for services.
Management Fee Waivers
The proposed regulations mean heightened scrutiny for management fee waiver programs in which a service provider waives its rights to all or a portion of the management fees it would have received from an investment fund in exchange for receiving a profits interest in its capacity as a partner in the fund. The examples included in the proposed regulations describe certain fee waiver structures that successfully establish significant entrepreneurial risk and, as such, are respected as a partnership interest issued to a partner in its capacity as a partner and do not constitute a payment for services.
In the examples, additional partnership interests received by partners as part of a management fee waiver program are viewed favorably if certain facts are present. The fee is irrevocably waived by providing written notice to the limited partners of the partnership at least 60 days prior to the commencement of the taxable year for which the fee is payable. The amounts allocated with respect to the partnership interests represent a percentage of future partnership net income and gains (not gross income) as measured over the life of the fund (not a specific, limited period). The amount of net income and gains to be allocated is neither highly likely to be available nor reasonably determinable based on all facts and circumstances. The allocation is subject to a clawback obligation, and it is reasonable to anticipate that the partner could and would comply fully with such obligation. The partnership agreement satisfies the requirements for economic effect contained in the Treasury Regulations under Section 704(b) of the Code, including requiring liquidating distributions to be made in accordance with the partners’ positive capital account balances. The facts and circumstances do not establish the presence of other factors (as discussed above) that would suggest that the arrangement is properly characterized as a payment for services.
The proposed regulations also modify an example in existing Treasury Regulations to clarify the treatment of an allocation to a partner that is determined based on the greater of: (1) a certain percentage of partnership income; or (2) a minimum guaranteed amount. In the example, a partner is to receive 30 percent of partnership income, but not less than $10,000. The income of the partnership is $60,000, and the partner is entitled to receive $18,000 (30 percent of $60,000). Existing Treasury Regulations provide that no part of the $18,000 is a guaranteed payment and that the entire amount is considered the partner’s distributive share. The preamble to the proposed regulations indicates that such treatment is not consistent with Congress’ emphasis on entrepreneurial risk. The example as modified would treat $10,000 as a guaranteed payment to the partner and the remaining $8,000 as the partner’s distributive share.
Profits Interest Safe Harbor: Revenue Procedure 93-27
Revenue Procedure 93-27 provides that the issuance of a profits interest in certain circumstances to a partner in connection with the performance of services is not a taxable event. The Revenue Procedure does not apply if: (1) the profits interest relates to a substantially certain and predictable stream of income from partnership assets; (2) the partner disposes of the profits interest within two years of receipt; or (3) the profits interest is a limited partnership interest in a “publicly traded partnership.” Moreover, the Treasury Department and the IRS do not believe that Revenue Procedure 93-27 currently applies where a partner who is not the one providing the services receives the profits interest; in the context of a management fee waiver, then, the management company (and not a separate entity) would need to be the one receiving the profits allocation to fall within the existing confines of Revenue Procedure 93-27.
The Treasury Department and the IRS plan to issue a revenue procedure providing an additional exception to the application of Revenue Procedure 93-27 for profits interests issued in connection with a partner forgoing payment of a substantially fixed amount (including an amount determined by formula) for the performance of services (i.e., a fee waiver). The discussion on this point in the preamble to the proposed regulations does not distinguish between fee waiver arrangements that are treated as disguised payments for services and fee waiver arrangements that possess significant entrepreneurial risk and therefore are not recharacterized.
The regulations would apply to all arrangements entered into or modified after the date that final regulations are published in the Federal Register. If an existing arrangement permits a service provider to waive all or a portion of its fee for any period subsequent to the date the arrangement is created, then the arrangement is considered modified for purposes of the effective date on the date that the fee is waived. If a service provider waives a portion of its fee after the effective date, the regulations are ambiguous as to whether they apply to prior waivers in addition to the newly waived fees, because the fee waiver arrangement was modified after the effective date of the regulations. Notwithstanding the fact that final regulations may not apply to an existing fee waiver plan, the Treasury Department has indicated that it may still challenge plans lacking significant entrepreneurial risk using the existing statute and legislative history.
Taxpayers should evaluate their existing arrangements, especially their management fee waiver programs, in light of the proposed regulations.
Management companies that were otherwise planning to elect to waive future management fees may wish to consider making an irrevocable decision to waive such fees prior to the finalization of the regulations. In addition, they should also consider whether any amendments would be advisable to support their contemplated tax treatment of those arrangements, as well as what consents (if any) would be required from their clients or investors to effectuate such amendments.
Moreover, firms that currently contemplate having an entity other than the management company earn the profits allocation relating to the waived management fee may want to instead consider having the management company receive those allocations.