By: Anthony Tuths, JD, LLM Partner – WithumSmith+Brown, PC
For more than a year now tax practitioners and industry insiders have been waiting for the IRS to clamp down on a compensation strategy common in the private equity arena known as a “management fee waiver.” Generally speaking, a management fee waiver is where the investment manager will waive its right to receive all or a portion of its management fee in exchange for a priority profits interest (in addition to its normal carry, if any). The IRS has stated on numerous occasions that it felt the practice was, at times, being abused and guidance was being developed. On July 22, 2015, the IRS and Treasury released proposed regulations under Section 707 of the Internal Revenue Code that are intended to provide guidance on when a compensation arrangement between a partnership and a partner will be treated as a disguised payment for services to a partner not acting in a partner capacity. The proposal is not limited to private equity but would reach any partnership arrangement including hedge fund and real estate funds. As a general matter, the proposed regulations do not target standard incentive allocations or carried interest provisions common to asset management funds. Rather, the proposal is aimed squarely at management fee waivers.
Treatment as a disguised payment for services would cause the payment to be treated as compensation for all purposes of the Code which would have the effect of subjecting the partner to tax at ordinary income rates, potentially subject such payments to compliance with the deferred compensation regimes of Sections 409A and 457A of the Code, and cause such payments to be subject to the applicable capitalization and deduction rules. This differs greatly from the treatment accorded to a “profits interest” which typically permits tax deferral and conversion from ordinary income to long-term capital gains in many instances.
The proposed regulations take a facts and circumstances approach to determining which fee waivers should be recharacterized as disguised compensation. The most important factor is “significant entrepreneurial risk.” That is, the waiver will not be respected as a partnership allocation unless the service provider partner bears real risk that the partnership will have income to satisfy the related allocation to the partner. Several facts the IRS will take into account in determining if significant entrepreneurial risk exists include, (i) the existence and scope of a “clawback” provision; (ii) whether or not the service provider (or related party) can control the timing of asset dispositions of the fund; (iii) how profits are determined for purposes of the partnership allocations and distributions to the service provider (e.g., on a gross or net basis); and (iv) the timing of the waiver, whether the waiver is legally binding and whether the partnership and its partners are notified of the waiver in a timely manner.
Additionally, the preamble to the proposed regulations make clear that the IRS believes that Revenue Procedure 93-27 (the legal authority for the tax-free transfer of a profits interest in a partnership), was never applicable to the fact pattern where a service provider partnership (e.g., management company) waives management fees in exchange for a related partnership (e.g., general partner) receiving a priority partnership allocation. Thus, for New York City based funds that are routinely formed with a separate GP and management company, the management fee waiver in exchange for the GP receiving an additional allocation will not be respected. In fact, the IRS my challenge past waivers of this sort. Funds of this variety should amend their documents immediately to come within compliance.
In addition, the proposed regulations modify an example in existing Treasury Regulations related to guaranteed payments that many taxpayers have relied on in order to attain favorable character benefits. The modification recharacterizes a portion of an allocation to a partner as a guaranteed payment in circumstances where a partner is allocated a percentage of partnership profits subject to a guaranteed floor, regardless of whether such allocation actually exceeds the floor in a given period.
For more information on management fee waivers or other tax issues, please contact a member of the WithumSmith+Brown financial services practice.