The Treasury Department and the Internal Revenue Service have issued proposed regulations addressing disguised payment for services of a partner, including the proper tax treatment of fee waiver arrangements commonly used by investment funds.


  • The proposed regulations would:
  1. recharacterize certain fee waiver arrangements that result in the right to future partnership profits as disguised compensation arrangements,
  2. prevent deferral of recognition of the resulting ordinary compensation, and
  3. tax the compensation income at ordinary income rates.
  • Fee waiver arrangements would generally not be subject to the disguised compensation treatment under the proposed regulations if properly structured, such as by providing for a binding, irrevocable waiver prior to the 12-month period in which the relevant services will be rendered and by issuance of a partnership interest with respect to which the service provider bears significant entrepreneurial risk.
  • Even if the proposed regulations do not apply to cause a recognition of income as a result of a fee waiver, the Treasury Department and IRS have clarified that if the services for which a fee is waived are not performed in a partner capacity or in anticipation of being a partner, the zero-value safe harbor that prevents recognition of income when a profits interest is issued in exchange for services contained in Rev. Proc. 93-27 will not apply.
  • Further, the Treasury Department and the IRS have set forth their intention to add an additional exception from the applicability of the Rev. Proc. 93-27 safe harbor where the fee that is waived in exchange for a profits interest is substantially fixed, including an amount determined by a formula. The issuance of a profits interest that is not covered by the safe harbor will cause the recipient to recognize ordinary income equal to the present value of the profits interest received.
  • The applicability of the rules in the proposed regulations and the inapplicability of the zero-value safe harbor present the potential for income recognition without any guarantee of cash distributions, and no guidance is given as to the tax consequences of the failure to receive a distribution equal to the compensation income previously recognized or the computation of the allocation of net profits to the service provider who has reported ordinary income on receipt of the profits interest.

The proposed regulations would apply to any arrangement entered into or modified after the date on which they are finalized and published in the Federal Register. The modifications to the Revenue Procedure would apply on the same date.


In a typical investment fund structure, the fund’s governing documents provide the general partner with a 20-percent interest in future profits of the fund if certain performance benchmarks are met and a manager, usually related to the general partner, with a right to an annual management fee of 2 percent of invested capital or net asset value.

A fee waiver arrangement is an arrangement whereby the 2-percent management fee can be fully or partially waived in exchange for a right to participate in future profits (often in the form of an increase in the general partner’s interest). The additional interest is intended to be a “profits interest” for tax purposes that is nontaxable on receipt and that generates payments whose tax character is based on the character of the income earned by the fund. If respected, the fee waiver arrangement provides two major tax advantages for the management company – the deferral of income recognition and the conversion of services income, taxed at ordinary income rates, into income potentially taxable at long-term capital gain rates. In a typical fee waiver arrangement, a service provider takes a significant entrepreneurial risk because the allocation of net profits is totally dependent on performance, i.e., generation of future profits. If the fund does not have future profits, the service provider loses the fee it otherwise would have earned.

The limited partners in the fund typically derive a benefit from a fee waiver on a pre-tax basis because they avoid paying the fixed management fee in return for a contingent profit allocation. Limited partners in the fund also typically derive a benefit from a fee waiver on an after-tax basis; if they are non-US or tax-exempt limited partners, they likely do not derive a tax benefit from the payment, and if they are US individual investors, it will often be difficult to navigate the limitation of the deduction of investment management fees.

Section 707(a)(2)(A) of the Internal Revenue Code of 1986 (the Code), as amended, enacted more than 30 years ago as part of the Deficit Reduction Act of 1984, is intended to determine whether a service provider that provides services to a partnership in exchange for a partnership interest receives the related allocation and distribution from the partnership as a distributive share or as a payment for services. The statute is ambiguous, as it merely provides that the transaction will be treated as a transaction occurring between the partnership and one who is not a partner if the transaction is “properly characterized” as a transaction with a non-partner. Section 707(a)(2)(A) expressly authorized the IRS to prescribe regulations, but until now, the IRS has not exercised that authority.

Rev. Proc. 93-27 contains a safe harbor that provides, in certain circumstances, that if a person receives an interest in partnership profits in exchange for providing services to or for the benefit of a partnership and in a partner capacity or in anticipation of becoming a partner, then the receipt of such interest will not be treated as taxable event.

Proposed Regulations

The proposed regulations, which were issued on July 22, 2015, provide a mechanism for determining whether an arrangement is treated as a disguised payment for services under Section 707(a)(2)(A). If an arrangement is treated as a payment for services, a determination that is made at the time that the arrangement is entered into or modified, it is treated as a payment for services for all purposes of the Internal Revenue Code, including for example, sections 61, 409A and 457A. Accordingly, the partnership must treat the payments as payments to a non-partner in determining the tax consequences of the service provider and remaining partners’ shares of taxable income or loss. Where appropriate, the partnership must capitalize the payments or otherwise treat them in a manner consistent with the recharacterization.

Reflecting the rule of Section 707(a)(2)(A), Proposed Regulation Section 1.707-2(b) provides a three-prong test to identify when a fee waiver arrangement is recast as a disguised compensation arrangement. An arrangement will be treated as a disguised payment for services if (i) a person (the service provider), either in its capacity as a partner or in anticipation of being a partner, performs services (directly or through its delegate) to or for the benefit of a partnership; (ii) there is a related direct or indirect partnership allocation and distribution to the service provider; and (iii) the performance of those services and the allocation and distribution, when viewed together, are properly characterized as a transaction occurring between the partnership and a person acting other than in that person’s capacity as a partner.

A “facts and circumstances” analysis is required to determine whether the third prong is satisfied. Proposed Regulations Section 1.707-2(c) provides six nonexclusive factors to consider in making the determination. The paramount factor is whether the arrangement is subject to “significant entrepreneurial risk.” While an arrangement that has significant entrepreneurial risk will generally be recognized as a distributive share, the analysis must also consider the following five secondary factors:

  1. whether the service provider holds, or is expected to hold, a transitory partnership interest or a partnership interest for only a short duration;
  2. whether the service provider receives an allocation and distribution in a time frame comparable to the time frame in which a non-partner service provider would typically receive payment;
  3. whether the service provider became a partner primarily to obtain tax benefits which would have been unavailable if the service provider had rendered services to the partnership in a third-party capacity;
  4. 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
  5. whether (i) services are provided either by one person or by persons that are related under Sections 707(b) or 267(b); (ii) the arrangement provides for different allocations or distribution with respect to different services; and (iii) the terms of the differing allocations or distributions are subject to levels of entrepreneurial risk that vary significantly.

The first four secondary factors above track the legislative history to Section 707(a)(2)(A), while the last factor is new. Furthermore, the preamble suggests that the fact that a partner’s distribution rights are subject to a clawback obligation based on the fund’s overall profitability is a fact in support of the existence of significant entrepreneurial risk.

In conjunction with publishing final regulations, the IRS plans to issue a revenue procedure providing an exception to the profits interest zero-value safe harbor in Rev. Proc. 93-27, which will exclude profits interests issued in conjunction with a partner foregoing payment of an amount that is substantially fixed for the performance of services.


While the proposed regulations aim to curtail fee waiver arrangements, they are broadly drafted and it is unclear to what extent they may affect other common partnership structures. As discussed above, the exclusion of fee waiver profits interests from the Rev. Proc. 93-27 zero-value safe harbor creates additional uncertainty as to the feasibility of fee waiver arrangements, because even if an allocation and distribution attributable to a profits interest avoids being recast as a disguised payment, the IRS could still attempt to tax the service provider’s receipt of the profits interest since the profits interest will no longer be covered by the zero-value safe harbor. Comments to the proposed regulations must be received by October 21, 2015, and until then, it is difficult to predict in which form the proposed regulations will be finalized. Although final regulations will be prospective only, taxpayers should adjust existing transactions where appropriate.

Click here to view the proposed regulations.

Click here to view Rev. Proc. 93-27.