On July 22, 2015, the U.S. Treasury Department and Internal Revenue Service released proposed regulations under Section 707(a)(2)(A) of the Internal Revenue Code relating to disguised payments for services between partners and partnerships. The proposed regulations focus primarily on management fee waiver structures in investment funds, but also will impact partnership profits interests in a variety of other contexts. In light of the proposed regulations, any profits interest that includes disproportionate or capped allocations or is designed to mimic or replace a fee/salary compensation arrangement should be reviewed.
After summarizing the proposed regulations, we provide several immediate practical steps for fund sponsors to consider.
Overview of the Proposed Regulations
Section 707(a)(2)(A) grants the Treasury Department authority to issue regulations under which a purported allocation and distribution to a service partner are recharacterized as a "disguised" payment for services and consequently treated as ordinary compensation income. Any final regulations that result from the proposed regulations will be issued pursuant to this grant of regulatory authority.
In determining whether an allocation and distribution arrangement will be treated as a disguised payment for services, the proposed regulations focus on whether the allocation and distribution are subject to significant entrepreneurial risk (SER), determined at the time the arrangement is entered into (and re-tested at the time of any subsequent modification). An arrangement that lacks SER will be treated as a disguised payment for services. An arrangement that has SER generally will not be treated as a disguised payment for services, although additional factors must be considered.
The proposed regulations’ focus on SER is consistent with the legislative history of Section 707(a)(2)(A). Nevertheless, in our view the proposed regulations require a level of economic risk substantially beyond that envisioned by the legislative history. In particular, the proposed regulations state that the presence of any one of the following facts and circumstances will create a presumption that an arrangement lacks SER:
(i) Capped allocations of partnership income, if the cap is reasonably expected to apply in most years;
(ii) An allocation for one or more years under which the service provider's share of income is reasonably certain;
(iii) An allocation of gross income;
(iv) An allocation (under a formula or otherwise) that is predominantly fixed in amount, is reasonably determinable under all the facts and circumstances, or is designed to assure that sufficient net profits are highly likely to be available to make the allocation to the service provider (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);
(v) An arrangement in which a service provider waives its right to receive payment for the future performance of services in a manner that is non-binding or fails to timely notify the partnership and its partners of the waiver and its terms.
If any of the foregoing factors is present, then the burden shifts to the taxpayer who must then establish the presence of SER through other facts and circumstances by clear and convincing evidence.
The proposed regulations include several examples. The example that is closest to market practice regarding fee waivers treats the waiver arrangement as disguised compensation. None of the favorable examples reflect typical market practice. That being said, the examples suggest that a waiver containing the following core elements generally should be respected.
- Cumulative Net Income – allocations and distributions in respect of the waiver interest are made out of (and only to the extent of) cumulative net income and gain over the life of the partnership.
- Clawback – the partner receiving allocations and distributions in respect of the waiver interest agrees to return to the partnership any distributions that ultimately are not supported by allocations of cumulative net income and gain, and it is reasonable to believe the partner will be able to (and actually will) satisfy the clawback obligation if applicable.
- Waiver Requirements – 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, if each such waiver is made before the commencement of the partnership taxable year for which the corresponding fee would otherwise be payable, but additional restrictions and considerations will apply.
An arrangement that is recharacterized under the proposed regulations as a disguised payment for services will be treated as a payment for services for all purposes of the Internal Revenue Code. As a result, an arrangement recharacterized as a payment for services under the proposed regulations may spark peripheral issues for the partner and the partnership, including potentially under the deferred compensation rules of Sections 409A and 457A of the Internal Revenue Code and the federal employment tax and withholding rules.
The proposed regulations technically will apply to arrangements entered into or modified after their date of publication as final regulations. For this purpose, a modification will include any new waiver of fees made under a pre-existing arrangement. Existing arrangements that are not modified after the effective date of final regulations will be evaluated based on the pre-existing guidance contained in the Internal Revenue Code, the legislative history to Section 707(a)(2)(A) and general principles of federal income tax law. Although we view certain elements of the proposed regulations as an expansive interpretation of the statute and legislative history, the preamble to the proposed regulations asserts that they generally reflect Congressional intent. Therefore, we expect that the IRS may scrutinize fee waiver and other profits interest arrangements under the rubric of the proposed regulations, without regard to when those arrangements were adopted or modified.
Profits Interest Safe Harbor
IRS Revenue Procedures currently provide a safe harbor under which the receipt of a partnership profits interest for the performance of services to or for the benefit of the partnership is generally a non-taxable event, provided that the service partner retains the profits interest for at least two years and certain other conditions are satisfied.
The preamble to the proposed regulations states that the Treasury Department and the IRS have determined that the current safe harbor does not apply to a profits interest issued to a person other than the actual service provider. According to the preamble, the safe harbor also would not apply if a partnership interest is issued to the service provider, but the service provider immediately transfers it to a related person. The preamble gives an example of a fund management company waiving its right to management fees, and an affiliate of the management company receiving the related profits interest in the fund. However, the same principle also could be applied by the IRS to other situations, such as grants or transfers to estate planning vehicles or tax-deferred accounts. The preamble does not say whether the current safe harbor would apply if the related party also is providing services to the fund.
The preamble further states that the safe harbor will be modified 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 is not clear under what circumstances a partner would be deemed to forgo such a right to receive substantially fixed amounts of fees for this purpose. For example, it is not clear whether the exclusion would apply if the reduced fee and related partnership interest were embedded in the initial fund agreement and there were no prior contractual right to a management fee to be waived. The preamble’s characterization of certain examples, however, suggests that the IRS may view such an arrangement as falling outside the safe harbor. Importantly, the proposed exclusion would apply even if the arrangement included SER and therefore was not treated as a disguised payment for services under the proposed regulations.
Any grant of a profits interest that falls outside the safe harbor would be governed by case law that does not provide clear rules as to the proper treatment and valuation of profits interests. Thus, the IRS may assert that the recipient of the profits interest recognized taxable compensation income at the time the profits interest is granted or becomes vested.
Fund sponsors and others who have existing funds with fee waivers, or who may be in the process of implementing a fee waiver strategy for a new fund, should consider the following in light of the proposed regulations:
- Sponsors contemplating fee waivers for new funds, or for pending funds that have not had their final closing, should consider a limitation based on cumulative profits coupled with a clawback. As noted above, the proposed regulations are strongly biased in favor of cumulative profits arrangements over arrangements that permit allocations of gain in any single year or without any clawback.
- If a fund’s final closing occurs before the effective date of the final regulations, an upfront waiver is more likely to qualify for the current profits interest safe harbor and would not technically be subject to the final regulations.
- In the case of existing funds that permit future fees to be waived, sponsors should consider amending their partnership agreements to (a) “hardwire” any discretionary waivers for future periods, (b) limit allocations in lieu of new waivers to cumulative profits arising in future periods and (c) implement a cumulative clawback. An amendment along these lines may be permitted in certain cases without limited partner approval, such as in funds that allow the general partner to adopt amendments that do not adversely affect the limited partners.
- If possible, allocations and distributions in lieu of waived fees should be made to the party entitled to receive the fee in the first instance. In a fund structure where more than one party provides services to the partnership (such as, for example, the management company and the general partner in a typical fund), the sponsor may have more flexibility to elect which entity receives the special allocations and distributions by embedding the economic terms in the original fund documentation. As noted above, it may be more difficult in our view for the IRS to assert that the party receiving the allocations and distributions waived receipt of substantially fixed management fees, because the operative documents did not provide for a fee to either party.
- In the case of existing funds in which fees previously were waived, it may be advisable to memorialize the factors that could be helpful in rebutting an IRS claim that the fee waiver arrangement lacked SER. For example, it may be helpful to identify any facts and circumstances indicating, at the time of each waiver, that the potential allocations and distributions in lieu of the waived fees were not highly likely to be available to be allocated to the fund sponsor or were otherwise subject to appreciable entrepreneurial risk, and/or that the general partner had limited control over the determination of asset values, timing of investment dispositions or other events that might influence the likelihood of the allocation being achieved.
Of course, the potential tax benefits of any prospective changes to a fee waiver program must be weighed against other potentially negative considerations, such as the additional economic risk that may result from adding a limitation to cumulative net profits and a clawback. Moreover, it is important to note that changes to a fee waiver program generally must be irrevocable. This could make any such changes undesirable if future changes to tax law were to reduce or eliminate current tax benefits associated with carried interest.
 The term “partnership” is used to refer generically to all entities that are classified as partnerships for federal income tax purposes.
 A fee waiver, in its most basic format, typically involves the general partner of a fund (or an affiliate of the general partner) waiving its right to receive future management fees payable by the fund and, in exchange therefor, receiving an interest in future profits generated by fund investments. The “waiver” may be made at fund formation or via periodic waiver elections.