Locke Lord QuickStudy: Private Equity and Hedge Fund Managers Take Caution - Proposed Treasury Regulations Threaten Management Fee Waivers

Locke Lord LLP
July 23, 2015

On July 23, 2015, the Internal Revenue Service ("IRS") issued long-awaited proposed regulations discussing the taxation of management fee arrangements commonly used by private equity funds and their management.  The proposed regulations address the tax treatment of “disguised” payments for services under Section 707(a)(2)(A) of the Internal Revenue Code (the "Code") where a partner has rendered services to a partnership in a capacity as other than a 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 that an arrangement will be treated as a disguised payment for services, instead of an allocation of partnership income, if, at the time the parties enter into or modify the arrangement, (i) the service provider, either in its capacity as a partner or in anticipation of becoming a partner, performs services, directly or indirectly through a delegate, to or for the benefit of the partnership, (ii) there is a related direct or indirect allocation and distribution to the service provider, and (iii) when viewed together, the performance of services and the allocation and distribution are “properly characterized” as a transaction occurring between a partnership and a person acting other than in that person’s capacity as a partner.  Once an arrangement is treated as a disguised payment for services under the proposed regulations, the arrangement is treated as a payment for services for all other purposes of the Code.  Under the proposed regulations, the question of whether an arrangement constitutes a disguised payment for services depends on all of the facts and circumstances.  However, the proposed regulations specify six non-exclusive factors that may indicate that an arrangement is a disguised payment for services:

1. The arrangement lacks significant entrepreneurial risk.
2. The service provider holds, or is expected to hold, a transitory partnership interest or a partnership interest for only a short duration.
3. The service provider receives an allocation and distribution in a time frame comparable to the time frame that a non-partner service provider would typically receive payment.
4. The service provider became 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.
5. The value of the service provider’s interest in general and continuing partnership profits is small in relation to the allocation and distribution.
6. The arrangement provides for different allocations or distributions with respect to different services received, the services are provided by related persons (as determined under the Code), and the terms of the differing allocations or distributions are subject to levels of entrepreneurial risk that vary significantly.

Of these six factors, the first factor regarding significant entrepreneurial risk is the most important and often will be determinative. The presence or absence of significant entrepreneurial risk is based on the service provider’s entrepreneurial risk relative to the overall entrepreneurial risk of the partnership. The proposed regulations identify five arrangements that presumptively lack significant entrepreneurial risk: 
(i) capped allocations of partnership income if the cap would reasonably be expected to apply in most years; (ii) allocations for a fixed number of years under which the service provider’s distributive share of income is reasonably certain; (iii) allocations of gross income; (iv) an allocation (under a formula or otherwise) that is predominately fixed in amount, is reasonably determinable under the circumstances, or is designed to assure that net profits are highly likely to be available to make an allocation to the service provider; and (v) arrangements in which the service provider waives its right to receive payment for the future performance of services in a non-binding or untimely manner.

The proposed regulations conclude by applying these factors to a set of management fee arrangements in a series of examples.  The provided examples examine the impact of certain management fee features, including clawback provisions, control over allocations and distributions by a related party and the timing of fee waivers, on the taxation of the arrangements as disguised payments for services.

Safe Harbor Modification
In the preamble to the proposed regulations, the IRS also announced related changes to Rev. Proc. 93-27 concerning the issuance of “profits interests” (also known as “carried interests”) to service providers. This Revenue Procedure contains a safe harbor for holders of carried interests to be treated as partners and achieve capital gain treatment on certain partnership gain allocations. The IRS plans to modify the Revenue Procedure to include an additional exception for “profits interests” issued in connection with a partner forgoing payment of a substantially fixed amount (including a substantially fixed amount determined by a formula, such as a fee based on a percentage of partner capital commitments) for the performance of services, including a guaranteed payment or a payment in a non-partner capacity. The IRS also stated that Rev. Proc. 93-27 does not apply to transactions in which one party provides services and another party receives an associated allocation and distribution of partnership income or gain (for instance, a management company waives the fee for the services it provides to a fund and a party related to the management company receives an interest in future partnership profits that approximates the amount of the waived fee).

Effective Date
The proposed regulations purport to have a prospective effective date on or after the date the final regulations are published.  However, taxpayers should exercise caution as the IRS believes that the proposed regulations generally reflect Congressional intent as to the classification of these arrangements and could be applied retroactively. The IRS is accepting comments and public hearing requests until October 21, 2015. Taxpayers, particularly private equity and hedge fund managers, should carefully review the proposed regulations. We will continue to closely monitor this issue and will provide future client updates before and after the final regulations are published.

For more information on the matters discussed in this Locke Lord QuickStudy or if you are interested in submitting a comment to the IRS, please contact the authors.