Many private fund managers (hedge, private equity, real estate, natural resources) have adopted a practice of waiving all or a portion of their future management fees in exchange for being deemed to have made a cashless investment in the fund, all on a tax-deferred basis. For some time, there has been debate over whether and under what conditions the IRS would respect this tax-deferral technique. Today, the IRS answered that question loud and clear. While the proposed regulations apply broadly without regard to industry, they appear to be driven at least in part by the management fee waiver practice in the alternative investment management sector.
In today’s Federal Register, the IRS published a notice of proposed rulemaking on disguised payments for services under Section 707(a)(2)(A) of the Internal Revenue Code of 1986, as amended. 80 Fed. Reg. 43652 (July 23, 2015). The purpose of these proposed Treasury regulations is to provide guidance to partnerships and their partners regarding when an arrangement will be treated as a disguised payment for services. In addition, the proposed rulemaking provides notice that the IRS intends to modify Rev. Proc. 93-27 that addressed the issuance of profits interests by partnership to service providers.
Under the proposed regulations, a management company that intends to waive its fee for managing a private equity fund’s investment in exchange for a profits interest in the fund must do so long before the fee is earned. The proposed regulations consist of three tests that must be examined to determine if an arrangement will be treated as a disguised payment for services:
1. Does the service provider, either in a partner capacity or in anticipation of being a partner, perform services (directly or through its delegate) to or for the benefit of the partnership?
2. Is there a related direct or indirect allocation and distribution to the service provider?
3. Are the performance of the services and the allocation and distribution when viewed together, properly characterized as a transaction occurring between the partnership and a person acting other than in that person’s capacity as a partner?
If the arrangement is treated as a disguised payment for services, the partnership must treat the payments as payments to a non-partner in determining the partners’ share of taxable income or loss and the service provider must include the payments as ordinary income.
Six Factors (Only One of Which Matters?)
The proposed regulations provide six (6) non-exclusive factors to determine whether an arrangement is properly characterized as a disguised payment for services. The first factor, whether there is significant entrepreneurial risk, is accorded more weight than the remaining five factors. If an arrangement lacks significant entrepreneurial risk the arrangement constitutes a disguised payment for services. An arrangement that has significant entrepreneurial risk will generally not constitute a payment for services unless the other factors establish otherwise.
The IRS states that the weight given to the other five factors will depend on the facts and circumstances of the particular arrangement and “the absence of a particular factor (other than significant entrepreneurial risk) is not necessarily determinative of whether an arrangement is treated as a payment for services.” Preamble to the proposed regulations 80 Fed. Reg. 43654 (July 23, 2015). The remaining five factors are:
1. The service provider holds, or is expected to hold, a transitory partnership interest or a partnership interest for only a short period of time;
2. 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;
3. The service provider became a partner primarily to obtain tax benefits that would not have been available if the services were rendered to the partnership in a third party capacity;
4. 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. The arrangement provides for different allocations or distributions with respect to the different services received, the services are provided either by one person or by persons that are related under sections 707(b) or 267(b), and the terms of the differing allocations or distributions are subject to levels of entrepreneurial risk that vary significantly.
Three Private Equity Examples
Six examples are provided in the proposed regulations. Example 3 addresses a situation where (i) a partnership that will acquire a portfolio of investment assets that are not readily tradable on established securities market and (ii) the manager (which is related to the general partner) is entitled to a priority allocation and distribution of net gain from the sale or any one or more assets during any 12-month accounting period in which the partnership has overall net gain in an amount intended to approximate the fee that would normally be charged for services that the manager performs. The IRS concludes that there is no entrepreneurial risk to the manager because the amount of partnership net income or gains that will be allocated to the manager is highly likely to be available and reasonably determinable based on all facts an circumstance available upon the formation of the partnership. Section 1.707-2(d) of the proposed regulations; 80 Fed. Reg. 43659 (July 23, 2015).
Examples 5 and 6 address situations where the fee waiver by the manager will not result in income for services in a non-partner capacity.
In example 5, the general partner receives an “additional interest in future partnership net income and gains determined by a formula (the ‘Additional Interest’). The parties intend that the estimated present value of the Additional Interest approximately equals the present value of one percent of capital committed by the partners determined annually over the life of the fund.” The amount of net profits allocable under the Additional Interest is neither highly likely to be available nor reasonably determinable and, because of a clawback obligation, it is reasonable to anticipate that the general partner would comply fully with any repayment responsibilities. The proposed regulations conclude that the arrangement with the general partner creates significant entrepreneurial risks and that, therefore, the arrangement does not constitute a payment for services. Section 1.707-2(d) of the proposed regulations; 80 Fed. Reg. 43660 (July 23, 2015).
In example 6, the manager is allowed to waive all or a portion of its management fee for any year if it provides written notice to the limited partners at least 60 days prior to the beginning of the partnership taxable year for which the fee is payable. If the fee is waived the manager receives Additional Interest. The proposed regulations find that the arrangement does not lack entrepreneurial risk and, therefore, does not constitute a payment for services. Section 1.707-2(d) of the proposed regulations; 80 Fed. Reg. 43660 (July 23, 2015).
The proposed regulations will be effective on the date that they are finalized. However, the IRS states that “pending the publication of final regulations, the position of the Treasury Department and the IRS is that the proposed regulations generally reflect Congressional intent as to which arrangement are appropriately treated as disguised payments for services.” The notice does not state when the proposed modification to Rev. Proc. 93-27 will be issued.
These proposed regulations are subject to public comment and could possibly change before becoming final. However, the changes to Rev. Proc. 93-27 when issued will be the IRS’ position going forward and the IRS’s comment about enforcement pending final regulations indicates that it will likely challenge private fund manager fee waivers even before final regulations are issued.