On July 23 the IRS issued proposed regulations designed to limit the ability of investment managers to defer the recognition of income from fee waivers. In the typical private equity or venture capital fund structure, the managers are entitled to a management fee from the fund. The management fee is taxable to the managers when paid. When fee waivers are exercised, managers receive an additional interest in the fund’s future profits in lieu of receiving the management fee. Under the proposed regulations, the managers’ use of a fee waiver generally would result in taxable income.
Although the proposed regulations were issued to address concerns related to fee waivers by investment managers, their impact is significantly broader, and the regulations will need to be considered in all situations in which a profits interest is exchanged for services.
Under existing IRS guidance, a service provider’s receipt of a profits interest does not result in taxable income to the service provider. A fee waiver is, in essence, the receipt of a profits interest for management services that historically would qualify for the exclusion. The proposed regulations would limit tax-free profits interests to situations in which the service provider has significant entrepreneurial risk with respect to the profits interest. If the service provider does not have significant entrepreneurial risk with respect to the profits interest, the value of the interest received for services will be taxable upon receipt.
The proposed regulations indicate partnership interests with any of the following characteristics will create a rebuttable presumption that entrepreneurial risk does not exist:
- Capped allocations of partnership income if the cap would reasonably be expected to apply in most years
- Allocations for a fixed number of years under which the service provider’s distributive share of income is reasonably certain
- Allocations of gross income items
- An allocation (under a formula or otherwise) that predominantly is fixed in amount, is reasonably determinable in light of 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 (for example, 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 overall success of the enterprise)
- Arrangements in which a service provider either waives its right to receive payment for the future performance of services in a manner that is nonbinding or fails to timely notify the partnership and its partners of the waiver and its terms
A partnership interest that does not fail any of these presumptions would still need to be tested for entrepreneurial risk on a facts-and-circumstances basis using the following factors:
- The service provider holds, or is expected to hold, a transitory partnership interest or a partnership interest for only a short duration.
- The service provider receives an allocation and distribution in a time frame comparable to the time frame in which a nonpartner service provider typically would receive payment.
- 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.
- The value of the service provider’s interest in general and continuing partnership profits is small in relation to the allocation and distribution.
- The arrangement provides for different allocations or distributions with respect to different services received, the services are provided either by one person or by persons who are related under sections 707(b) or 267(b), and the terms of the differing allocations or distributions are subject to levels of entrepreneurial risk that vary significantly.
The preamble to the proposed regulations provides an example to illustrate the final factor: The fund’s general partner and a related management company provide services to the fund. Both the general partner and the management company receive a share in future partnership net profits in exchange for their services. Only the general partner’s share of profits is subject to a clawback provision. Because the management company and the general partner are related, and the management company’s share of income is not subject to a clawback provision, the management company’s share of income from the fund will not be viewed as having significant entrepreneurial risk and will be taxable when received in the fee waiver.
Curiously, the proposed regulations do not address the timing of the income recognized by the investment manager exercising the fee waiver. Presumably, the investment manager would recognize ordinary income in an amount equal to the foregone cash management fee at the time the fee waiver is exercised. However, the IRS could take a different approach, perhaps by treating allocations of partnership income as ordinary income when allocated. It is anticipated that the Treasury Department will provide additional clarification on the timing and amount of income recognition in the future.
The proposed regulations will apply to arrangements modified or entered into after the date the regulations become final. However, the proposed regulations treat the exercise of a fee waiver as a modification of an arrangement, making the regulations effective to fee waivers exercised pursuant to arrangements entered into prior to the date the regulations become final. The preamble to the regulations also indicates that the proposed regulations reflect congressional intent. As a result, the IRS may attempt to challenge existing fee waiver arrangements under the principles of the proposed regulations.