Recent statements by IRS and Treasury representatives signal that, contrary to indications last year, IRS intends to issue formal guidance on management fee waiver arrangements sometime during 2014. The guidance will likely be in the form of proposed regulations and will likely specify examples of both acceptable and unacceptable fee waivers.1

Although there are many possible variations, in a typical management fee waiver arrangement the general partner of a private fund agrees (either at fund formation or periodically during the fund’s life) to forego a portion of the management fees otherwise payable by the fund in exchange for an increased (special) allocation of the fund’s future profits (generally consisting of long-term capital gain). Certain IRS and Treasury representatives have suggested that some of these variations properly convert management fee ordinary income into long-term capital gain, while others do not.

IRS guidance will likely require that the general partner’s special profit allocation be subject to genuine economic risk in order for the fee waiver arrangement to be acceptable. For example, the IRS is more likely to challenge a waiver (1) where the facts suggest that the gain out of which the waived amount is to be paid was already “built-in” at the time the fee waiver was executed (i.e., where the fund assets had already appreciated sufficiently to ensure that the waived amount would be paid) or (2) if the general partner executes the waiver after it has earned the management fee that is being waived.

It is uncertain whether the expected guidance will apply to existing fee waiver arrangements or only to those entered into after guidance is published. We think that the guidance will most likely apply to existing arrangements, as IRS officials have expressed the view that the general legal principles underlying the guidance are already inherent in existing law.

In light of these developments, as well as the complexity of fee waiver strategies generally, fund managers should consult experienced counsel (1) before implementing a new fee waiver strategy and (2) to determine whether existing fee waiver strategies are likely to comply with the expected guidance.