The IRS issued the much anticipated proposed regulations that severely curtail the practice of a fund manager waiving management fees in exchange for a share of future partnership profits. In essence the regulations tighten the necessary “entrepreneurial risk” required of the future profits interest plus list five other negative factors for recasting the profits interest back into a fee. The IRS also noted that Rev. Proc. 93-27, which treats a qualifying profits interest as having a zero value, will be amended to provide an additional exception for profits interests given in exchange for a partner forgoing a substantially fixed right to payment for services. This latter change would mean that even if the fee waiver has the requisite entrepreneurial risk, there would still be a material risk that the IRS will treat the present value of the profits interest as compensation income. This one-two punch has the distinct possibility of knocking out fee waivers altogether plus extending uncertainty beyond fee waivers to other targeted issuances of profits interests. The regulations are to be effective for all arrangements entered into or modified after the regulations are published as final.

The proposed regulations also address other related topics. First, the examples in the proposed regulations that find sufficient entrepreneurial risk involved partnerships that liquidated with positive capital accounts, despite the prevalence of partnerships liquidating instead with a cash waterfall and using “targeted” tax allocations. The Preamble specifically states that there is no inference whether such targeted capital accounts could satisfy the allocation safe harbors and requests comments if taxpayers want more guidance. Second, the proposed regulations modify an important “guaranteed payment” example that currently treats an allocation of profits over a fixed floor amount as always getting the benefit of profits interest treatment to the extent the profit share exceeds the floor amount. The example now always treats the fixed floor amount as a guaranteed payment even if the profits exceed the minimum floor amount. Finally, the Preamble appears to confirm the IRS position in Rev. Rul. 69-184, that a guaranteed payment to a partner cannot be treated as an employee payment (i.e., no W-2).