IRS Issues Proposed Regulations Targeting Management Fee Waiver Arrangements

07/29/2015

On July 22, 2015, the Treasury Department and the Internal Revenue Service (“IRS”) released proposed regulations (the “Proposed Regulations”) providing that in certain circumstances a service provider’s allocations of a partnership’s income may be treated as compensatory payments for services under the Internal Revenue Code of 1986, as amended (the “Code”). In particular, the Proposed Regulations are targeting arrangements in which a partnership’s manager has the ability to waive all or a portion of a management fee that the manager is otherwise entitled to receive in exchange for the manager (or the general partner) receiving a profits interest equal to the amount of the waived fee.

The Proposed Regulations utilize a facts and circumstances test and provide a list of non-exclusive factors that will be analyzed to determine whether an arrangement should be treated as a disguised payment for services. Under the Proposed Regulations, the most important factor is whether an arrangement lacks significant entrepreneurial risk. The following factors generally create a presumption that an arrangement lacks significant entrepreneurial risk: (i) capped allocations of partnership income in lieu of the management fee; (ii) an allocation for one or more years under which the service provider’s income is reasonably certain; (iii) an allocation of gross income; (iv) an allocation that is reasonably determinable based upon facts or circumstances or is designed to assure that there are sufficient net profits available to make a profits interest allocation to the service provider; and (v) a waiver that is non-binding or can be made without notifying the partnership.

The Proposed Regulations contain a number of examples illustrating circumstances under which a management fee waiver will be deemed to lack significant entrepreneurial risk. These examples indicate that arrangements with the following terms may be viewed as lacking significant entrepreneurial risk: (i) there are profit allocations from specific accounting periods or specific transactions that do not depend on the partnership’s long-term success; (ii) the service provider or a related party has the discretion to determine the value of partnership assets or controls the timing and amount of distributions from entities in which the partnership invests; and (iii) the allocation is not subject to a clawback obligation over the life of the partnership.

The Proposed Regulations provide the following secondary factors which also may indicate that a partnership allocation should properly be characterized as a compensatory payment:

  • The service provider holds a transitory partnership interest.
  • The service provider receives an allocation and distribution in the same time frame in which a non-partner service provider would typically receive such payment.
  • The service provider became a partner primarily to obtain tax benefits.
  • The value of the service provider’s capital interest is small in relation to its profits interest.
  • The arrangement provides for different allocations or distributions with respect to different services provided by the same or related persons (such as related investment managers and general partners) and the terms of the respective allocations or distributions are subject to different levels of entrepreneurial risk.

An arrangement that is recharacterized as a disguised payment for services under the Proposed Regulations will be treated as such for all purposes of the Code, including Sections 409A and 457A of the Code. Such payments will be subject to tax at ordinary income tax rates, and if such payments are not structured properly, may be subject to additional taxes under Sections 409A and 457A of the Code.

Application of Profits Interest Safe Harbor to Management Fee Waivers

The preamble to the Proposed Regulations notes that the Treasury Department and the IRS have determined that existing IRS safe harbors providing for circumstances in which a service partner may receive a profits interest without being subject to current tax will not apply to an arrangement in which one party waives a management fee and another party receives a profits interest. Thus, even if an income allocation pursuant to a profits interest issued in connection with a management fee waiver arrangement is not recharacterized as a compensatory payment for services, the recipient of such a profits interest may be subject to tax upon receipt of the profits interest if it is determined to have an ascertainable value. In addition, the Treasury Department and the IRS plan to issue new guidance providing that a profits interest received in connection with a service partner foregoing a fixed payment will be a taxable event and will not qualify for the safe harbor set forth in existing IRS revenue procedures.

Effective Dates and Transition Rules

The Proposed Regulations will only be effective on the publication date of the final regulations. However, the preamble to the Proposed Regulations states that it is the IRS’s position that the Proposed Regulations reflect congressional intent as to which arrangements should be treated as disguised payments for services. Accordingly, the IRS may seek to apply the substance of the Proposed Regulations to arrangements entered into prior to the publication of final regulations.

If you have any questions about this topic, please contact one of the following lawyers.

Kenneth K. Bezozo
212.659.4999
kenneth.bezozo@haynesboone.com

Sam Lichtman
212.659.4971
sam.lichtman@haynesboone.com

Vicki Martin-Odette
214.651.5674
vicki.martin-odette@haynesboone.com

Don Shiman
212.835.4852
don.shiman@haynesboone.com


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