The Internal Revenue Service ("IRS") and Treasury Department recently released proposed regulations under section 707(a)(2)(A) of the Internal Revenue Code of 1986 (the "Code) addressing the issuance of certain interests in partnerships in exchange for services (the "Proposed Regulations").¹ The Proposed Regulations focus primarily on management fee waivers found in many private equity, real estate and other investment fund agreements, but may also impact partnership profits interests more broadly. Among other things, the Proposed Regulations offer guidance intended to distinguish between situations in which a partnership interest granted in connection with a management fee waiver should be treated as taxable compensation for the performance of services rather than as a non-taxable profits interest in the partnership.

Investment fund sponsors who are in the process of forming new funds, or who are planning to implement future fee waivers under existing fee waiver arrangements, should consult with their tax and legal advisors to determine whether amendments to their fund documentation would be appropriate in light of the Proposed Regulations.

Background

Under a typical management fee waiver arrangement, a fund sponsor may waive its right to receive all or a portion of the management fees to which the sponsor would otherwise be entitled from the fund in exchange for an interest in the future profits of the fund. In some arrangements, the amount received from the profits interest is equal to the reduction in the management fee, to the extent the fund has sufficient profits. In other arrangements, each reduction in the management fee is notionally invested in the fund, effectively permitting the sponsor to satisfy its required capital contributions on a "cashless" basis, and the amount received with respect to the corresponding profits interest will be more than the fee reduction if the fund investments are sold at a net gain, and less than the fee reduction if the fund investments are sold at a net loss. Cash that would have been used by the fund to pay the waived management fees remains available to the fund as if the fund sponsor had made its full contribution.

The details of fee waiver arrangements differ in significant respects from fund to fund, including the timing of waivers and the nature and timing of profits to be allocated and distributed to the fund sponsor. In so-called "hardwired" arrangements, for example, the management fees and the recipient partner's entitlement to allocations and distributions are determined by formulas set out in the partnership agreement at the inception of the fund. Other common variations in fee waiver provisions include whether the profits allocable and distributable to the sponsor in respect of its profits interest will be determined on a gross or net basis, and whether net income is measured for this purpose over the life of the fund or a shorter time period. 

Fee waiver arrangements of this type offer fund sponsors the opportunity in some cases to effectively convert management fees, which otherwise would be subject to ordinary income rates and self-employment taxes, into an allocable share of long-term capital gain from the disposition of fund assets, which is taxable at a significantly lower rate and in many cases may be recognized years after the corresponding fee income would have otherwise been recognized. Click here to see our prior e-Alert discussion of self-employment taxes with respect to investment fund management fees.

Proposed Regulations — Fee Waivers

Significant Entrepreneurial Risk. Under the Proposed Regulations, whether a fee waiver arrangement should be treated as a payment for services or a profits interest depends on all of the facts and circumstances at the time the parties enter into or modify the arrangement. Based in large part on the legislative history of Section 707 of the Code, the Proposed Regulations indicate that the most important factor in making this determination is the presence or absence of significant entrepreneurial risk. An arrangement without significant entrepreneurial risk will be presumed to be a payment for services.² Conversely, an arrangement that has significant entrepreneurial risk will generally not constitute a payment for services unless other factors establish otherwise.

Whether an arrangement has or lacks significant entrepreneurial risk is determined based on the service provider's entrepreneurial risk relative to the overall entrepreneurial risk of the partnership. More specifically, the Proposed Regulations indicate that the following facts and circumstances will create a presumption that an arrangement lacks significant entrepreneurial risk and should be treated as a disguised payment for services:

1. Capped allocations of partnership income if the cap is reasonably expected to apply in most years.
2. An allocation for one or more years under which the service provider's share of income is reasonably certain.
3. An allocation of gross income items to the service provider.
4. An allocation (under a formula or otherwise) that is predominantly fixed in amount, reasonably determinable under all facts and circumstances, or designed to assure sufficient net profits are highly likely to be available to make the allocation (e.g., if the partnership agreement provides for an allocation of net profits from specific transactions or accounting periods and this allocation does not depend on the long-term future success of the enterprise).
5. An arrangement in which a service provider waives its right to receive payment for future performance of services in a manner that is non-binding or fails to notify the partnership and its partners of the waiver and its terms in a timely manner.

If any of the foregoing factors is present, the burden shifts to the taxpayer, who must then establish the presence of significant entrepreneurial risk through other facts and circumstances by clear and convincing evidence.

Additional Factors. The Proposed Regulations also provide a non-exclusive list of additional factors that may, depending on the circumstances, indicate that an arrangement constitutes a disguised payment for services, as follows:

1. The service provider holds a transitory partnership interest or holds a partnership interest for a short duration.
2. The service provider receives an allocation and distribution in the same timeframe that a non-partner service provider would receive payment.
3. The service provider becomes 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 continuing partnership profits is small compared to the allocation and distribution.
5. The arrangement provides for different allocations or distributions for different services received, the services are provided by one person or by related persons and the terms of the allocations or distributions are subject to levels of entrepreneurial risk that vary significantly.

Examples. The Proposed Regulations include six examples to illustrate the application of the facts and circumstances test to management fee waiver arrangements. While leaving a number of unanswered questions, the examples do suggest that the following attributes should bolster the argument that a given fee waiver arrangement should not be treated as a disguised payment for services:

1. Cumulative Net Income. Allocations and distributions in respect of the profits interest are made out of, and only to the extent of, cumulative net income and gain over the life of the partnership.
2. Clawback. The distributions in respect of the profits interest are subject to a clawback. The Proposed Regulations do not provide specific details regarding what the IRS perceives to be an appropriately structured clawback mechanism for this purpose. The regulations do, however, imply that the clawback obligation should be calculated on the basis of net profits over the life of the fund and that it should be reasonable to anticipate that the general partner will be able to comply (and actually will comply) with any clawback obligation.
3. Timing and Notice of Waiver. The waiver of management fees occurs prior to the fund's first investment, the waiver is irrevocable, and advance notice of the waiver is provided to all partners. A waiver made after the fund’s first investment may be viable in certain situations, but additional restrictions and considerations will apply.

Proposed Regulations – Profits Interest Safe Harbor

IRS Revenue Procedures currently provide a safe harbor under which the receipt of a profits interest in a partnership for the performance of services to or for the benefit of the partnership is generally a non-taxable event.³ In the preamble to the Proposed Regulations, the IRS and Treasury Department offer further guidance with respect to this safe harbor and announce their intention to further narrow the scope of the safe harbor through the issuance of a new revenue procedure.

A grant of a profits interest that falls outside the safe harbor would be governed by a body of case law that does not currently provide clear rules as to the proper treatment and valuation of profits interests, subjecting the service provider to the risk that the IRS might assert that the service provider should have recognized taxable compensation income at the time the profits interest was granted or became vested.

Proper Recipient; Constructive Transfers. The preamble to the Proposed Regulations indicates that the Treasury Department and IRS have determined that the safe harbor described in Revenue Procedures 93-27 and 2001-43 should not apply to the issuance of a profits interest for services to a person other than the actual service provider.

This new guidance may impact not only management fee waivers but also other common practices of private equity fund sponsors. For example, in one potentially impacted structure, a fund's general partner causes the fund to issue the carried interest to a special limited partner affiliated with the general partner rather than to the general partner itself. Under the new guidance, such an arrangement would potentially be treated as a constructive transfer of the profits interest from the general partner to the special limited partner within two years of receipt, which would render the safe harbor unavailable.

Another potentially impacted structure involves the bifurcation of the management fee and carried interest such that the carried interest is issued to the general partner and the management fee is payable to a separate management company affiliated with the general partner.⁴ Under such a structure, the waiver of a management fee by the management company and corresponding grant of a profits interest to the general partner could also be treated as a constructive transfer of the profits interest within two years of receipt, again rendering the safe harbor unavailable. The preamble does not indicate whether the safe harbor would continue to apply if the related party transferee is also providing services to the fund.

Possible Future Modifications. The preamble to the Proposed Regulations indicates that the IRS and Treasury Department plan to issue a revenue procedure modifying the profits interest safe harbor to exclude profits interests that are received in conjunction with a partner forgoing payment of an amount that is substantially fixed, including fees based on a percentage of partner capital commitments. It appears that this proposed exclusion would apply in the context of certain fee waivers even if the arrangement included substantial economic risk and therefore was not treated as a disguised payment for services under the Proposed Regulations. This exclusion may also call into question profits interest treatment in other contexts for certain interests received in tax-free rollovers of compensation obligations. Until the new revenue procedure is issued, there will likely remain significant unanswered questions as to the scope and application of the contemplated exclusion from the profits interest safe harbor.

Effective Date

While the Proposed Regulations technically will apply only to arrangements entered into or modified on or after the date final regulations are published, the preamble to the Proposed Regulations takes the position that the Proposed Regulations generally reflect Congressional intent. Therefore, the Treasury Department and IRS may challenge existing fee waiver arrangements on the basis of the Proposed Regulations without regard to when those arrangements were adopted or modified and prior to the Proposed Regulations being finalized. Moreover, if an existing arrangement permits a service provider to waive all or a portion of its fee at a later date, the arrangement would be considered to be modified on such date and would consequently become subject to any final regulations published prior thereto.

Conclusion

Investment fund sponsors who are in the process of forming new funds, or who are planning to implement future fee waivers under existing fee waiver arrangements, should consult with their tax and legal advisors to determine whether amendments to their fund documentation would be appropriate in light of the Proposed Regulations. In considering any such amendment, fund sponsors will have to weigh the potential tax benefits of any changes against the potentially negative impact of subjecting their interests to additional economic risk, as may be required in many cases to comply with the Proposed Regulations. Additionally, fund sponsors should take into consideration the likelihood that the Proposed Regulations will be widely commented on and possibly refined before being finalized, as well as the possibility that future legislation and regulatory action might impact the nature of profits interest taxation more generally.

¹Section 707(a)(2)(A) of the Code grants the Treasury Department authority to issue regulations under which a purported allocation and distribution by a partnership to a service partner would be treated as a transaction occurring between the partnership and a partner acting other than in its capacity as a member of the partnership, which would result in such an allocation and distribution being treated as ordinary compensation income.

²An arrangement that is treated as a disguised payment for services will be treated as a payment for services for all tax purposes, with the result that the payment will be taxed as ordinary compensation income and will potentially be subject to sections 409A and 457A of the Code.

³Revenue Procedure 93-27 provides that, if a person receives a "profits interest" (i.e., an interest in future profits and appreciation and not in existing capital) for the provision of services to or for the benefit of a partnership in a partner capacity or in anticipation of being a partner, the IRS will not treat the receipt of such interest as a taxable event for the partner or the partnership. This safe harbor does not apply if, among other things: (i) the profits interest relates to a substantially certain and predictable stream of income from partnership assets, such as income from high-quality debt securities or a high-quality net lease, or (ii) within two years of receipt, the partner disposes of the profits interest. The IRS issued additional guidance in Revenue Procedure 2001-43.

⁴The bifurcation of the management fee and carried interest is a common practice for fund managers who are subject to the New York unincorporated business tax or the Texas margin tax, for example.