In July 2015, the Treasury and the Internal Revenue Service issued proposed regulations that address whether arrangements in which the private equity fund managers receive an interest in the managed partnership’s future profits in exchange for waiving part or all of their management fees (generally a fixed payment for services provided to the partnership) constitute disguised compensation. The proposed regulations attempt to determine whether such arrangements should be characterized as a disguised fee, which would be taxable as ordinary income to the manager, or whether such arrangements should be respected as a legitimate allocation of the partnership’s profits, which would generally be taxable as capital gains to the manager. Under the proposed regulations, any arrangement that is determined to be disguised compensation will be treated as disguised compensation for all tax purposes, meaning it will be taxed as compensation for purposes of all sections of the Internal Revenue Code of 1986, as amended (the “Code”), including section 707. If finalized in their current form, the proposed regulations could adversely affect some fee waiver practices that private equity funds currently utilize.
Management Fee Waivers Generally
Management fee waivers can take many forms, but generally involve a decrease in the fee paid to the manager for managing the partnership (often because the manager has waived the fee) in return for the receipt of a profit interest in the partnership. The specific details of the fee waiver mechanism often vary from partnership to partnership, such as when the manager is allowed to waive its fee, the timing of the profit allocations to the manager, and the type of allocation involved. In some instances, a waiver is not required by the manager; rather, the manager’s fees and profit interests are determined using a formula agreed to at the inception of the partnership.
Operation of the Proposed Regulations
The proposed regulations provide that several factors should be used in determining whether a fee waiver arrangement is treated as a disguised compensation arrangement, though ultimately it is a facts and circumstances determination and the factors are a non-exhaustive list. However, the most significant factor in determining the treatment is whether the arrangement has “significant entrepreneurial risk”. Under the proposed regulations, if an arrangement lacks significant entrepreneurial risk, it is automatically reclassified as disguised compensation and thus subject to ordinary income rates, regardless of the application of the remaining factors to the arrangement. Significant entrepreneurial risk is presumed not to be present when one or more of the following are true:
- sufficient net profits are highly likely to be available to make the allocation to the manager;
- there is a cap on the additional partnership income allocated to the manager as partner (if the cap is reasonably expected to apply in most years);
- the allocation applies to a fixed number of years under which the amount of the manager’s distributive share of income can be determined with reasonable certainty;
- the allocation consists of gross (rather than net) income; and
- the waiver is not binding on the manager, or the manager fails to timely notify the partnership of the waiver and its terms.
The preamble to the propped regulations describes additional factors that may be used to determine whether sufficient net profits are highly likely to be available to make the allocation to the manager: The value of partnership assets is not easily ascertainable and the partnership agreement allows the manager or a related party to control the determination of asset values (or events that impact such values); and the manager or a related party controls the entities in which the partnership invests. The significant entrepreneurial risk factors discussed above attempt to determine whether the manager can expect to receive the allocation of partnership income, and the presence of any of the factors can only be rebutted through the presentation of clear and convincing evidence. For example, if the profit interest is “highly likely” to yield the amount of the waived fee to the manager, the manager is not taking sufficient economic risk for the arrangement to be respected. The proposed regulations provide additional factors of secondary importance to consider in determining whether or not an arrangement is a disguised payment for services:
- the arrangement provides for different allocations for different services provided;
- the differing allocations are subject to different levels of entrepreneurial risk;
- the manager holds, or is expected to hold, the partnership interest for a short period of time, or holds a transitory partnership interest;
- the manager receives an allocation in a time frame that is similar to the time frame that the manager would receive payment for services if the manager were a third party (and not a partner);
- the primary purpose of the manager becoming a partner in the partnership was to obtain tax benefits unavailable to the manager if the services were rendered and the manager was a third party; and
- the manager’s allocation is significantly larger than the manager’s interest in the partnership’s continuing profits.
The proposed regulations provide several examples illustrating the difference between an arrangement that is respected as the right to receive future allocations of partnership income and distributions and an arrangement that is treated as a disguised payment for services. In so doing, those examples illustrate the importance of the following factors:
- the timing of a management fee waiver;
- the existence and scope of a clawback obligation;
- whether allocations of net profits to the manager are reasonably determinable or highly likely to be available based on all facts and circumstances that are available at the time of the waiver;
- whether the manager can control the timing of the realization of gains and losses by the partnership.
Other Potential Changes
In addition, the preamble to the proposed regulations indicates the intention to possibly preclude additional, or possibly all, partnership interest distributions in lieu of waived fees from qualifying for the safe harbor under Revenue Procedure 93-27. Revenue Procedure 93-27 provides that, in some circumstances, if an individual receives an interest in a partnership in exchange for providing services to that partnership in anticipation of becoming a partner, that receipt of that interest will not be a taxable event for either the partnership or the partner.
The proposed regulations provide that traditional “catch-up allocations” typically will not lack significant entrepreneurial risk, and thus typically will not be classified as disguised compensation. However, all of the facts and circumstances need to be taken into account when the determination is made.
The final regulations will apply to fee waiver arrangements entered into or modified on or after the date the final regulations are finalized. It appears that for fee waivers that occur periodically, the regulations will apply to any waiver that occurs after the effective date of the final regulations. The preamble to the proposed regulations indicates that the IRS may seek to apply the principles embodied in the proposed regulations to fee waiver arrangements entered into before the regulations are finalized on the theory the proposed regulations reflect Congressional intent.
Pending further guidance from the IRS regarding management fee waivers, we recommend our private equity clients do the following:
- Review current fee waiver arrangements to determine the best administrative practices for such arrangements given the factors identified in the proposed regulations.
- Consider whether fee waiver arrangements should be utilized moving forward, and, if so, what structural changes should be contemplated in light of the factors outlined in the proposed regulations.