This week, the IRS issued proposed regulations addressing so-called “management fee waiver” arrangements. While the regulations accept that many of the more conservative forms of those arrangements are partnership interests, the IRS goes on to assert that they generally will not qualify under the safe harbor for the tax-advantaged profits interest treatment.
Management Fee Waivers
In traditional private equity funds, the principals typically get a management fee and a carried interest in the fund. As a way to defer the income associated with the management fee and convert its character from ordinary income to capital gain, many funds have adopted “management fee waiver” mechanisms. These arrangements generally involve the principals giving up some or all of their management fees in exchange for an interest in the fund (a “Waiver Interest”) that is similar to what they would have received if they had invested the foregone fees in the fund. The main difference between the Waiver Interest and the interest the outside investors receive for their invested capital is that the Waiver Interest is designed to qualify as a “profits interest” that only entitles the holder to distributions out of the profits of the fund after the time it is granted.
The proposed regulations would create a framework for determining whether partnership interests issued to service providers are to be respected as partnership interests or instead treated as disguised payments for services. To the extent Waiver Interests are treated as disguised payments for services under these rules, they would essentially result in current ordinary income to the principals, much the same as the management fees.
Under the proposed regulations, an “arrangement [that] lacks significant entrepreneurial risk” will be treated as a payment for services. This determination is based on all of the facts and circumstances of the arrangement. The IRS specifically identifies the following as indicating that there is a lack of significant entrepreneurial risk:
- capped allocations of partnership income that are reasonably expected to apply in most years;
- an allocation under which the service provider’s share of income is reasonably certain;
- an allocation of gross income;
- an allocation that is predominantly fixed or is designed to ensure that sufficient profits are highly likely to be available to make the allocation;
- an arrangement in which the service provider waives its right to receive payment for the future performance of services in a manner that is nonbinding or untimely.
But, even if the arrangement does not lack significant entrepreneurial risk, it will be treated as a payment for services if other facts and circumstances so indicate. For example, factors such as a transitory partnership interest, allocations and distributions that correspond to payments service providers would typically receive, an intent to obtain tax benefits as a partner that are not available to non-partner service providers, a small interest in continuing profits compared to the allocation and distribution rights, and differing interests for different services with significantly different levels of entrepreneurial risk indicate an arrangement is a payment for services.
Application to Waiver Interests
The proposed regulations indicate that while some of the more aggressive Waiver Interests will be treated as payments for services, many will be respected as partnership interests. The examples generally bless these arrangements where the Waiver Interest is entitled to a share of net profits (as opposed to gross profits) over the remaining life of the fund (as opposed to just the years in which there is a net profit) and is issued as a result of an irrevocable waiver of management fees made prior to the taxable year in which the Waiver Interest first shares in such net profits. However, they also indicate that Waiver Interest arrangements that lack any of these essential characteristics are likely to be treated as payments for services.
Waiver Interests as Profits Interests
While the IRS appears to sanction Waiver Interests in one breath, it immediately rebukes them in the next. In the preamble to the proposed regulations, the IRS goes on to describe two reasons why Waiver Interests do not qualify as “safe harbor” profits interests under existing IRS guidance.
First, it announces that it will issue guidance that will carve out from the profits interest safe harbor under existing guidance profits interests “issued in conjunction with a partner forgoing payment of an amount that is substantially fixed (including a substantially fixed amount determined by formula, such as a fee based on a percentage of partner capital commitments) . . . .” There is no doubt that this is specifically intended to exclude Waiver Interests from the safe harbor. However, the broad language appears to also capture situations in which an employee agrees to a reduction in his fixed salary in exchange for a traditional profits interest that shares in the overall growth of an operating business—a rather surprising result. It is also not clear how it would apply in the case of “hard-wired” Waiver Interests, where the Waiver Interest is included as part of the initial fund documentation instead of a typical management fee, in contrast to a Waiver Interest received upon a later elective waiver of preset fees.
Second, the IRS attacks Waiver Interests issued to an entity other than the entity providing the management services. In an effort to insulate the economic rights related to the Waiver Interest from liabilities arising from the management services activities, fund promoters will typically have the Waiver Interest issued to a different entity from the one providing the management services and collecting the management fee. The IRS takes the position that where the Waiver Interest is issued to that other entity, it is not a safe harbor profits interest because it fails the requirements that (i) the interest be received for the provision of services to or for the benefit of the partnership in a partner capacity or in anticipation of being a partner and (ii) it not be disposed of within two years of receipt (because of a constructive transfer to the related party).
But, in neither case does the IRS take the next step of affirmatively declaring that those kinds of interests are not profits interests. Rather, by eliminating them from the safe harbor guidance, it relegates those arrangements to the uncertain case law addressing the taxation of the receipt of profits interests. So, while these assertions are disappointing, fund promoters can take solace in the fact that many arguments remain under that case law that these kinds of arrangements would still qualify as profits interests. See Afshin Beyzaee, “Practical Considerations for Issuing Profits Interests” (143 Tax Notes 1157 (June 9, 2014) & 143 Tax Notes 1277 (June 16, 2014)).
Moreover, even if a Waiver Interest fail to qualify as profits interests, the result is probably not that all of the income allocations and distributions would be taxable as ordinary income to the holder. Rather, it likely means that the Waiver Interest needs to be valued at the time of receipt, with only that value treated as ordinary income; future gains would likely still qualify for capital gain treatment under the principals above.
While the IRS states that the proposed regulations apply to arrangements entered into after the date of publication of the final regulations, it also makes clear that its position is that these regulations reflect existing law. Accordingly, taxpayers should be aware that even existing arrangements would likely be viewed by the IRS through the lens of these proposed regulations.
For a more detailed discussion of management fee waivers, see Afshin Beyzaee, "Current Tax Structuring Techniques for Private Equity Funds," Journal of Taxation and Regulation of Financial Institutions (May/June 2007), pp. 18-20.
For a more detailed discussion of profits interests, see Afshin Beyzaee, "What is a Profits Interest?" Table Talk (August 19, 2014).