Proposed IRS Regulations Threaten Management Fee Waivers

Heather Stone, Partner and Co-Section leader of the Locke Lord Investment Adviser and Alternative Funds group will discuss details of the long-awaited proposed regulations issued by the Internal Revenue Service on the taxation of management fee arrangements commonly used by private equity funds and their management as well as the latest developments in the SEC’s ongoing close scrutiny of fees and expenses and how they are allocated to and among funds and portfolio companies.

The proposed IRS regulations, issued on July 23, 2015, address the tax treatment of “disguised” payments for services under Section 707(a)(2)(A) of the Internal Revenue Code, where a partner has rendered services to a partnership in a capacity other than partner. By specifically classifying certain fee arrangements, including particular carried interest mechanisms, as disguised payments for services, the proposed regulations target purportedly abusive situations where private equity funds use management fee waivers to convert services income, taxable at the ordinary rates, into income items meriting capital gain treatment.

The proposed regulations provide a series of factors and illustrative examples to be evaluated in determining whether an arrangement constitutes a disguised payment for services. Our presentation will walk through these factors and their application to certain management fee features, including clawback provisions, control over allocations and distributions by a related party, as illustrated by the examples provided in the proposed regulations. The proposed regulations also contain a surprising development (pursuant to long-standing guidance in Rev. Proc. 93-27) concerning the issuance of “profits interests” (also known as “carried interests”) to service providers. We will include in our presentation a discussion of the implications of this new position regarding the Rev. Proc. 93-27 safe harbor method for valuing of profits interests, as well as several other potential consequences of the proposed regulations.

The SEC continues to have a particular regulatory interest in and focus on the fees and expenses private equity professionals charge the funds that they manage and the portfolio companies that they invest in. We will discuss the latest developments in this area, including recent enforcement actions and best practices.