The U.S. Treasury Department has proposed new regulations under IRC Section 707(a)(2)(A) that apply to fee waiver arrangements commonly used by private equity funds involving payments to fund managers.
In a typical private equity fund structure, the general partner is provided an interest (typically 20 percent) in future profits of the fund if certain performance benchmarks are met. A fund manager affiliated with the general partner providing services to the fund usually receives an annual management fee from the fund. Typically, such arrangements are pegged to a percentage of the fund’s invested capital or net asset value. In lieu of quarterly or annual receipt of the management fee, the fund and its managers may enter into a fee waiver agreement.
Upon execution by the fund and the manager, the management fee is fully or partially waived in exchange for a profits interest. The receipt of the profits interest is intended to be tax deferred and taxable upon a future liquidity event or sale of the fund’s assets. Under such arrangements, managers generally have deferred income recognition until the later sale or liquidity event. Furthermore, upon receipt of an allocation of partnership profit or payment, the character of the income received is intended to be treated as capital gain generally taxable at favorable capital gains rates.
If finalized in its current proposed form, the regulations would seek to treat such payments as disguised compensation for services rendered by fund managers that would be included as ordinary income in the year received notwithstanding the right to such payment is waived.
The proposed regulations apply a facts-and-circumstances test to determine whether a management fee waiver arrangement will be viewed as a disguised payment for services. As enumerated within the regulations, the absence (or presence) of significant entrepreneurial risk (SER) is the most important factor.
An arrangement that lacks SER constitutes a disguised payment for services, irrespective of the presence of any other mitigating factor. Conversely, an arrangement that has SER generally will be recognized as a partnership interest as intended (in other words, a profits interest), unless the totality of the facts and circumstances dictate otherwise. Whether an arrangement lacks SER is based on the manager’s entrepreneurial risk relative to the overall entrepreneurial risk of the partnership.
The following five nonexclusive factors in the proposed regulations may indicate that an arrangement lacks SER:
- “Capped” allocations of partnership income if the cap is reasonably expected to apply in most years
- An allocation for one or more years under which the service provider’s share of income is reasonably certain
- An allocation of gross income
- An allocation (under a formula or otherwise) that predominantly is 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 (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 long-term future 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
The preamble to the proposed regulations states that the IRS intends to issue guidance that the zero-value safe harbor in Revenue Procedure 93-27 does not apply to profits interest granted in exchange for a fee waiver. Revenue Procedure 93-27 provides that the receipt of a profits interest for the provision of services to or for the benefit of a partnership is not a taxable event for the partner or the partnership. Consequently, the IRS may begin to assert that even if a waived-fee interest is not disguised compensation, the receipt of the interest is a taxable event that would be a significant change from current practice.
The proposed regulations are not effective until finalized and would apply to any arrangement entered into or modified on or after the date the final regulations are published. Note that the proposed regulations state that the IRS and Treasury Department view these regulations as reflecting current law under the legislative history of Section 707(a)(2)(A) and, therefore, there may be some concern that the IRS will apply the principles of the proposed regulations to arrangements entered into before the regulations are adopted.
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