Profits interests, fee waivers and similar arrangements typically held by general partners and management companies may be recharacterized as ordinary service income under newly issued Proposed Regulations.  


On July 22, 2015, the Internal Revenue Service (the IRS) and the Treasury Department (Treasury) (i) issued proposed regulations (the proposed regulations) regarding disguised payments for services from partnerships and (ii) announced the upcoming modification of existing guidance on the tax treatment of profits interests.  

Any partner who receives a contingent profits interest in lieu of fees in an effort to defer recognition of income and potentially obtain capital gain from disposition proceeds needs to be sure that the arrangement qualifies as a profits interest under the proposed regulations (meeting the new “significant entrepreneurial risk” requirements). Typical carried interests should not be impacted by the proposed regulations; however each such arrangement should be given additional scrutiny when forming partnerships going forward. In addition, given the proposed changes, it is more important than ever that timely protective section 83(b) elections be made with respect to interests in a partnership within 30 days after the grant of such interests (if those interests are subject to a “substantial risk of forfeiture”).  

Please contact us to set up a call to discuss the impact of these proposed regulations on your business planning. A detailed technical explanation follows below for your reference.  

Effective Date

  • The regulations are proposed to be effective on the publication date of the final regulations. However, in the preamble to the proposed regulations, the IRS states its position that the regulations generally reflect Congressional intent with respect to existing law.


  • The proposed regulations address when a partnership allocation and distribution in exchange for services will be re-characterized as a disguised fee and pay particular attention to fee waiver arrangements.
  • The proposed regulations provide that an arrangement will be treated as a disguised payment for services if:
    • a person performs services to or for the benefit of a partnership;
    • there is a related direct or indirect allocation and distribution from the partnership to the service provider; and
    • when viewed together, the services, allocation, and distribution are properly characterized as a transaction occurring between the partnership and a non-partner.
    • An arrangement that is treated as a payment for services under the proposed regulations is treated as a payment for services for all purposes of the Internal Revenue Code, including, for example, Sections 61, 409A, and 457A of the Internal Revenue Code of 1986, as amended (the Code).
      • Further, if an arrangement is subject to section 707(a), the proposed regulations suggest that taxpayers should look to relevant authorities to determine the status of the service provider as an independent contractor or employee.
      • The proposed regulations generally should not apply to an arrangement that the partnership has reasonably characterized as a guaranteed payment under Code Section 707(c).

Significant Entrepreneurial Risk

  • Under the proposed regulations, the key factor is determining whether the allocation and distribution subject the service provider to “significant entrepreneurial risk,” which is a necessary condition for an arrangement to be recognized as a distributive share rather than as a disguised fee.
    • The proposed regulations measure a service provider’s entrepreneurial risk relative to the overall entrepreneurial risk of the particular partnership. For example, the preamble notes, a service provider who receives a percentage of net profits in each of a partnership that invests in high-quality debt instruments and a partnership that invests in volatile or unproven businesses may have significant entrepreneurial risk with respect to both interests.
  • The proposed regulations list the following arrangements as creating a presumption against significant entrepreneurial risk:
    • Capped allocations of partnership income if the cap would reasonably be expected to apply in most years;
    • Allocations for a fixed number of years under which the service provider’s distributive share of income is reasonably certain;
    • Allocations of gross income items;
    • 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
    • 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.

Secondary Factors

  • Following the determination of significant entrepreneurial risk, the proposed regulations list the following secondary factors to consider in determining the proper characterization of an arrangement:
    • whether the service provider holds, or is expected to hold, a transitory partnership interest or a partnership interest for only a short duration;
    • whether 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;
    • whether the service provider became a partner primarily to obtain tax benefits which would not have been available if the services were rendered to the partnership in a third party capacity;
    • whether the value of the service provider’s interest in general and continuing partnership profits is small in relation to the allocation and distribution; and
    • whether the arrangement provides for different allocations or distributions with respect to different services received, where the services are provided either by a single person or by related persons, and the terms of the differing allocations or distributions are subject to levels of entrepreneurial risk that vary significantly.
      • A fact pattern that fits the description in the fifth factor, which supports treating the management company’s allocation and distribution as a disguised fee for services, would be a situation in which a general partner and a related management company both provide services to a partnership in exchange for a share of future net profits. The general partner agrees to a clawback obligation that requires the general partner to repay distributions that exceed the general partner’s percentage share of net profits over the life of the partnership, but the management company does not agree to any such clawback.
      • The proposed regulations state that terms of the allocations and distributions to the management company create a significantly lower level of economic risk than the terms for the general partner.
      • As a general matter, the presence of a clawback on distributions to service providers will support the existence of “significant economic risk” and special attention should be paid to the nature and terms of such clawbacks going forward.

No Distribution Requirement

  • Whether an arrangement is properly characterized as a payment for services is determined at the time the arrangement is entered into or modified and without regard to whether the terms of the arrangement require the allocation and distribution to occur in the same taxable year.
    • Although Code Section 707(a)(2)(A)(ii) requires both an allocation and a distribution to the service provider, the Treasury Department and the IRS believe that a premise of section 704(b) is that an income allocation correlates with an increased distribution right, justifying the assumption that an arrangement that provides for an income allocation should be treated as also providing for an associated distribution for purposes of applying Code Section 707(a)(2)(A).

Proposed Change To Existing Section 707(c) Regulations

  • The proposed regulations also modify current Example 2 of Treasury Regulation Section 1.707-1(c). Under the existing example, a partner that is entitled to receive the greater of a percentage of partnership income or a specified amount is treated as receiving a guaranteed payment only to the extent the allocated share is less than the minimum amount.
  • For example, if a partner is to receive the greater of $10,000 or 30% of partnership income (determined without regard to any guaranteed payment) and the partnership reports $20,000 of income for the year, the partner would be entitled to $10,000, the larger amount.
  • Under the existing regulations, $6,000 of the payment (30% of $20,000) would be characterized as an allocable share of income and $4,000 would be treated as a guaranteed payment. The proposed regulations modify this example to state that the entire minimum amount ($10,000) is to be treated as a guaranteed payment in light of the fact that the minimum amount is not subject to significant entrepreneurial risk.
  • If the rationale of the conclusion in the example above applied to a liquidation preference of a capital partner rather than a service provider, that would indicate a partnership must allocate gross income or make a guaranteed payment to a partner whose partnership liquidation right increased even though the partnership does not have sufficient income in the relevant tax year to match the partner’s increased liquidation right.
  • Treasury and the IRS note that some taxpayers have expressed uncertainty on this issue. It is not clear that the IRS and Treasury proposed this change in Example 2 of Treasury Regulation Section 1.707-1(c) in order to provide guidance on whether guaranteed payment or distributive share treatment of such an arrangement is the better view, although the preamble does note that existing rules under Treasury Regulation Sections 1.704-1(b)(2)(ii) and 1.707-1(c) address this circumstance by requiring partner capital accounts to reflect the partner’s distribution rights as if the partnership liquidated at the end of the taxable year.
    • Treasury and the IRS request comments on specific issues and examples with respect to which further guidance would be helpful and make clear that no inference is intended as to whether and when targeted capital account agreements could satisfy the economic effect equivalence rule under Treasury Regulation Section 1.704-1(b)(2)(ii)(i).

Fee Waivers

  • In evaluating whether an allocation received in exchange for a fee waiver is a disguised fee for services, the examples focus on the manner in which the service provider forgoes its fees and is entitled to share in future partnership income and gains.
  • Fee waivers that are binding, irrevocable, and clearly communicated to the other partners support the existence of significant entrepreneurial risk.
    • A waiver where a lower management fee is baked in at the time of formation of a partnership in exchange for a priority allocation of partnership income and gains, or an annual waiver provision that allows the service provider to waive some or all of its fees for any year by delivering written notice at least sixty days before the start of the year in which the fee would otherwise be paid should generally be treated as an increased distributive share of partnership income and not as a disguised payment for services, provided the other factors support significant entrepreneurial risk.

Proposed Changes To Existing Revenue Procedures On Profits Interests

  • The preamble to the proposed regulations also discusses modifying Revenue Procedure 93-27 upon finalization of the proposed regulations. The modified revenue procedure would not apply to situations in which a profits interest was issued as a result of a partner forgoing a substantially fixed payment.
  • The preamble also states that the IRS and Treasury have concluded that Revenue Procedure 93-27 does not apply when one taxpayer waives a fee and a related taxpayer receives a future partnership profits interest if the profits interest value approximates the value of the waived fee.
    • The position is that Revenue Procedure 93-27 does not apply to such transactions because they would not satisfy the requirement that receipt of an interest in partnership profits be for the provision of services to or for the benefit of the partnership in a partner capacity or in anticipation of being a partner, and because the service provider would effectively have disposed of the partnership interest (through a constructive transfer to the related party) within two years of receipt.
  • As a result, even if allocations attributable to a profits interest avoid re-characterization under the final regulations once issued, the IRS could still attempt to tax the service provider’s receipt of the profits interest on the ground that the profits interest has a determinable value at the time of grant. A timely filed 83(b) election becomes even more important given the suggestions in the preamble regarding the applicability of Revenue Procedure 93-27.