IRS Proposes Additional Rules Applying to Private Equity Management Fee Waivers

By:
Todd G. Povlich
Published Date:
Sep 1, 2015

On July 23, 2015, the IRS issued proposed regulations that would further limit a private equity firm’s ability to use management fee waiver mechanisms.  It is commonplace to see private equity firms waive current management fees from a sponsored investment fund and, in return, take a profits interest in said fund.  This mechanism has the effect of converting ordinary income (management fees) into capital gains (profit allocation), but only works if the fund has profits to allocate.  The proposed regulations do not constitute the death of the fee waiver, but rather add to existing rules on the books and further restrict how waiver mechanisms can be installed. 

Background

Under Subchapter K of the IRC, allocations or distributions between a partnership and a partner for the provision of services can be treated as: (1) a distributive share under IRC section 704(b); (2) a guaranteed payment under IRC section 707(c); or (3) as a transaction in which a partner has rendered services to the partnership in its capacity as “other than a partner” under IRC section 707(a).   

IRC section 707(a)(2) grants the Treasury Secretary authority to identify transactions involving disguised payments for services under IRC section 707(a)(2)(A). This stems from Congress’ concern that partnerships and service providers were inappropriately treating payments as allocations and distributions to a partner even when the service provider acted in a capacity other than as a partner.  There are five factors examined to determine whether or not an allocation or distribution is a disguised payment for services. 

The first and most important factor is whether the payment is subject to significant entrepreneurial risk as to both the amount and fact of payment.  An arrangement for an allocation and distribution to a service provider that involves limited risk is treated as a fee.  Specific examples include: (1) capped allocations of income; (2) allocations for a fixed number of years under which the income that will go to the partner is reasonably certain; (3) continuing arrangements in which purported allocations and distributions are fixed in amount or reasonably determinable; and (4) allocations of gross income items.

An arrangement in which an allocation and distribution to a service provider is subject to significant entrepreneurial risk as to the amount will generally be recognized as a distributive share, although other factors are also relevant.  The legislative history of IRC section 707(a)(2)(A) includes the following examples of factors that ought to be considered: (1) whether the partner status of the recipient is transitory; (2) whether the allocation and distribution is close in time to the partner's performance of services; (3) whether the facts and circumstances indicate that the recipient became a partner primarily to obtain tax benefits for itself or the partnership that would not otherwise have been available; and (4) whether the value of the recipient's interest in general and in continuing partnership profits is small in relation to the allocation in question.

Proposed Rules

Consistent with the language of IRC section 707(a)(2)(A), section 1.707-2(b) of the proposed regulations provides that an arrangement will be treated as a disguised payment for services if: (1) a person (service provider), either in a partner capacity or in anticipation of being a partner, performs services (directly or through its delegate) to or for the benefit of the partnership; (2) there is a related direct or indirect allocation and distribution to the service provider; and (3) the performance of the 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.

An arrangement that is treated as a disguised payment for services under these proposed regulations will be treated as a payment for services for all purposes of the IRC.  Thus, the partnership must treat the payments as payments to a non-partner in determining the remaining partners' shares of taxable income or loss.  These proposed regulations apply to a service provider who purports to be a partner even if applying the regulations causes the service provider to be treated as a person who is not a partner.  The regulations also apply to a special allocation and distribution received in exchange for services by a service provider who receives other allocations and distributions in a partner capacity under IRC section 704(b).

Whether an arrangement constitutes a payment for services (in whole or in part) depends on all of the facts and circumstances.  The proposed regulations include six non-exclusive factors that may indicate that an arrangement constitutes a disguised payment for services.  Of these factors, the first five factors generally track those identified in legislative history, as summarized previously.  The proposed regulations also add a sixth factor – whether the arrangement provides for different allocations and distributions with respect to different services received, where the services are provided either by a single person or by persons that are related under IRC 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.  This goes straight to the heart of the matter, which is that incentive allocations to the general partner of a private equity fund are subject to clawback, whereas profit allocations in connection with management fee waivers are not typically subject to clawback, and could reasonably be made even if a fund over its term does not generate net profits in the aggregate. In other words, there might be instances of profit generated, but losses in other periods prevent the fund from generating aggregate net profits over its term. 

The examples contained in the proposed rules are helpful in assessing the potential impact.  Example 3 states that allocations and distributions will be treated as disguised payments for services if they can be made in any 12-month accounting period in which the partnership has a net gain, and thus do not depend on the overall success of the fund.  The example claims that the allocations and distributions are reasonably determinable, in part because the general partner controls the fund, and the management company is affiliated with the general partner.  Example 3 goes further, calling out the concept of subjective asset revaluations.  The example states that allocations and distributions that are made from net gains due to the revaluation of fund assets, which is ultimately controlled by the general partner, are to be characterized as disguised payments for services. 

Takeaways

The proposed rules, if adopted, would require certain funds to change their management fee waiver mechanisms to remain in compliance.  Fund managers and their advisors ought to review the proposed rules and the given examples to understand all of the ramifications and to know which arrangements will be recognized as compliant going forward.  While fee waivers may still be allowed, the new rules may make the use of these mechanisms far less attractive than before.  On the other hand, the tax treatment of performance allocations (carried interest allocations) to general partners of private equity funds does not appear to be affected by these rules. 


PovlichTodd G. Povlich, ASA, is a partner at MPI (Management Planning, Inc.) in the firm’s New York City office.  Mr. Povlich oversees the firm’s alternative investment fund and carried interest valuation practice. Mr. Povlich also conducts and oversees business valuation projects for a variety of purposes, including estate and gift tax, income tax, charitable contributions, ESOP administration, shareholder disputes, matrimonial dissolution, and corporate planning.  He is a member of the NYSSCPA.  Mr. Povlich can be reached at 212-390-8310 or tpovlich@mpival.com.

 
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