The Department of the Treasury and the IRS have issued proposed regulations regarding “disguised payments for services” under Section 707(a)(2)(A) of the Internal Revenue Code. The proposed regulations appear to be primarily focused on management fee waivers (and similar arrangements), but could also affect certain aspects of the tax treatment of carried interest.
Management fee waivers are a planning technique seen mostly in the private equity fund industry, where a fund manager waives a share of its management fee in exchange for a share of future profits (that is separate from any carried interest otherwise payable), often in amounts that are intended to replicate the foregone management fees. Management fee waivers are generally intended to achieve certain benefits, including deferring the receipt of taxable income by the fund sponsor, allowing the fund sponsor to meet its capital commitment to a fund on a non-cash basis, and providing for potentially more favorable tax rates applicable to individuals (i.e., if the underlying share of profits is comprised of long-term capital gain). Management fee waivers have been utilized in different forms, over many years, including arrangements which effectively amount to a package of a higher carried interest and a lower management fee, as well as arrangements which are structured as annual elective waivers. Different arrangements vary in the manner and priority in which waived amounts are paid out of future partnership profit.
Under the proposed regulations, a share of partnership income received in exchange for services will be treated as a payment for services (and thus subject to tax as ordinary income), rather than a share of the partnership’s income, if, based on a facts and circumstances analysis, it is more appropriately characterized as a payment for services. The primary factor to be considered is whether the recipient bears significant entrepreneurial risk (relative to the overall entrepreneurial risk of the partnership). The proposed regulations list specific factors relevant to both the presence and absence of entrepreneurial risk as well as other relevant factors, and also contain a series of examples where the intended result becomes more apparent, including examples both (i) where a fee waiver arrangement is determined not to involve significant entrepreneurial risk, and thus is treated as a payment by the partnership to a nonpartner service provider, and (ii) where a fee waiver arrangement is determined to have the requisite entrepreneurial risk, such that its form is respected for tax purposes and the recipient is treated as having a share of the partnership’s income. The examples also consider an ordinary carried interest arrangement (that is subject to a clawback) and conclude that such arrangement should also be respected. Nevertheless, in the examples, the proposed regulations generally conclude that the appropriate level of entrepreneurial risk is present or absent without specifying all of the underlying facts on which the conclusions are based and, therefore, do not provide clear guidance in all circumstances.
Under the proposed regulations (as noted above), the following factors create a presumption of a lack of entrepreneurial risk:
- capped allocations of partnership income if the cap is reasonably expected to apply in most years (although the preamble to the proposed regulations notes that traditional "catch-up" allocations are not considered capped allocations for this purpose);
- 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 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 make the allocation to the service provider (e.g., if the partnership agreement provides for an allocation of net profits from specific transactions or accounting periods, and this allocation does not depend on the long-term future success of the enterprise); and
- an arrangement in which a service provider waives its right to receive payment for the future performance of services in a manner that is non-binding and fails to timely notify the partnership and its partners of the waiver.
In addition to entrepreneurial risk, the proposed regulations also identify the following factors that are to be taken into account in determining whether an arrangement will be treated as a payment for services:
- the service provider holds, or is expected to hold, a transitory partnership interest or a partnership interest for only a short duration;
- 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;
- 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;
- the value of the service provider’s interest in general and continuing partnership profits is small in relation to the allocation and distribution; and
- the arrangement provides for different allocations or distributions with respect to different services received, the services are provided either by one person or by persons that are related under Sections 707(b) or 267(b) of the Code, and the terms of the differing allocations or distributions are subject to levels of entrepreneurial risk that vary significantly.
The proposed regulations specify that the resulting recharacterization of the arrangement as giving rise to a disguised payment for services will apply for all purposes under the Internal Revenue Code, including for purposes of Section 61 (gross income), and Sections 409A and 457A (relating to non-qualified deferred compensation arrangements), and any such recharacterization may affect the classification of the entity as a partnership for tax purposes (e.g., if a partner ceases to be considered to own an interest in a partnership as a result of the proposed regulations, and the partnership has only one other partner, the partnership would generally default to treatment as a “disregarded entity” for US federal income tax purposes).
In conjunction with the proposed regulations, Treasury has indicated that it intends to provide additional guidance and consider related issues. For example, Treasury indicated that it intends to issue a revenue procedure modifying Revenue Procedures 93-27 and 2001-43, which are widely relied upon by the private equity industry with regard to the receipt of carried interest and the making of Section 83(b) elections. The anticipated modifications appear to be similarly directed at circumstances involving a waiver of fees in exchange for a corresponding issuance of an interest in the profits of a partnership, with the apparent result that the IRS could seek to tax the receipt of such interest based on its value, regardless of whether the arrangement satisfies the significant entrepreneurial risk test described above. However, the potential scope of such rules is not clear. Treasury has also indicated that it will (i) amend provisions of existing regulations that are inconsistent with the proposed regulations, including as to the general treatment of certain amounts as guaranteed payments, and (ii) consider other related issues, including certain issues related to “targeted capital accounts.”
The proposed regulations would be effective on the date they are published in final form and would apply to any arrangement entered into, or modified, on or after such effective date. In the case of an arrangement entered into prior to such effective date, the determination of whether the arrangement is a disguised payment for services will be made on the basis of Section 707 of the Internal Revenue Code and guidance provided in relevant legislative history. However, the preamble to the proposed regulations specifies that, pending publication of final regulations, it is the position of Treasury and the IRS that the proposed regulations generally reflect Congressional intent as to arrangements that are appropriately treated as disguised payments for services and, accordingly, existing arrangements will be generally subject to review, and may be treated as disguised payments for services, under such criteria.