IRS Issues Proposed Regulations on Management Fee Waivers

The U.S. Internal Revenue Service issued proposed regulations (Proposed Regulations) on July 22 designed to provide guidance on whether an arrangement in which a partnership effects allocations or makes distributions to a partner providing services to the partnership will be treated as a disguised payment for services, as opposed to the receipt of a distributive share of partnership income. These arrangements have been popular in the private funds industry. As a practical matter, and as further discussed below, the waivers can afford significant tax benefits. The Proposed Regulations have broad application to persons who perform services to a partnership, either in a partner capacity or in anticipation of becoming a partner, but particular attention is given to the treatment of management fee waiver arrangements. The Proposed Regulations represent the culmination of the IRS's prolonged saber-rattling against increasingly aggressive management fee waiver arrangements and address some of the uncertainties in the tax law about the treatment of allocations and distributions made in connection with such fee waivers. Although the Proposed Regulations compel fund managers to rethink some of the terms that define recent management fee waiver arrangements, the good news is that, in the same breath, the IRS has implicitly accepted management fee waivers as a legitimate means of structuring private fund cash flows. Ultimately, however, the Proposed Regulations pose more questions than they answer. As such, careful consideration must be given to how any specific management fee waiver arrangement may be subject to IRS scrutiny and potential challenge.

Background on Management Fee Waiver Arrangements

Often fund documents will permit the manager of the fund to waive irrevocably all or a portion of the management fee to which it is entitled (waived amount) before the beginning of the year in which the fee will be earned or accrued for tax purposes. (The timing of the fee waiver is critical to its success: if the fund manager was already entitled to the management fee and attempted to forfeit it, the manager would be deemed in constructive receipt of the fee, notwithstanding the waiver, and taxed accordingly.) In exchange for the waived amount, the fund manager receives an increased profits interest in the fund (waiver interest), typically entitling it to a priority allocation of the fund's profits equal to the waived amount. Fund managers generally take the position that income allocated to the waiver interest is properly characterized as a distributive share of partnership income, thereby converting what otherwise would have been ordinary income (in the absence of a fee waiver) into long-term capital gain (to the extent that the fund has earned such gains.) The downside associated with waiver interests, however, is that the fund manager may lose out on the management fee (that it was virtually assured of receiving) if the fund loses money in future years. Accordingly, many management fee waivers are designed to minimize such risk, for example, by measuring the fund's performance on a quarterly basis for purposes of allocating income to the waiver interest; or by allowing for a carryover into future (profitable) years to compensate for any unfulfilled allocation in a loss year.

Proposed Regulations

Under the Proposed Regulations, certain management fee waiver arrangements will be reclassified as the payment of fees to a fund manager and taxed entirely as ordinary income. In other words, if the arrangement is deemed to constitute a disguised payment for services, the fund manager will recognize ordinary income rather than any capital gains as intended. If amounts under the fee waiver arrangement are recharacterized as a payment for services, the attributable income and deduction (if any) will be determined under all relevant sections of the Internal Revenue Code, including the deferred compensation rules of Sections 409A and 457A. Failure to comply with the rules of Sections 409A and 457A (if applicable) can result in significant excise taxes.

Facts and Circumstances Test

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. The Proposed Regulations describe six factors that are relevant in this determination. 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 by the fund manager, unless the totality of the facts and circumstances dictate otherwise. Whether an arrangement lacks SER is based on the fund manager's entrepreneurial risk relative to the overall entrepreneurial risk of the partnership.

Significant Entrepreneurial Risk

The Proposed Regulations list the following facts and circumstances that create a rebuttable presumption that an arrangement lacks SER (and, therefore, constitutes a disguised payment for services):

1. Capped allocations of partnership income, if the cap would reasonably be expected to apply in most years;
2. Allocations for a fixed number of years under which the fund manager's distributive share of income is reasonably certain;
3. Allocations of gross (as opposed to net) income to the fund manager;
4. Allocations that are predominantly fixed in amount, reasonably determinable under all facts and circumstances, or designed to ensure that sufficient net profits are highly likely to be available for allocation to the fund manager, if, for example, the partnership agreement provides for an allocation of net profits from specific transactions or accounting periods that does not depend on the overall success of the enterprise; and
5. Arrangements in which the fund manager either waives its right to receive payment for the future performance of services in a nonbinding manner or fails to timely notify the partnership and partners of the waiver and its terms.

These facts and circumstances have a common theme: their presence suggests a high likelihood that the fund manager will receive an allocation of the fund's profits in an expected amount regardless of the overall success of the fund's investment returns.

Secondary Factors

If the result of the threshold SER analysis described above is that the arrangement has SER, the Proposed Regulations apply additional factors of secondary importance in determining whether or not the arrangement will be viewed as a disguised payment for services. Of particular note, if the arrangement provides for different allocations or distributions with respect to different services received from a single fund manager (or certain related entities), and the terms of the differing allocations or distributions are subject to levels of entrepreneurial risk that vary significantly, the IRS may recast the arrangement with a significantly lower level of economic risk as a fee for services.

The Proposed Regulations contain examples that illustrate application of these secondary factors. In these examples, the IRS has emphasized the importance of including a clawback obligation in management fee waiver arrangements as a means of strengthening the position that the arrangement does not lack SER. Under such a clawback obligation, the fund manager must be required to repay any distributions it receives from the partnership in connection with the fee waiver arrangement that exceed the overall net amount of partnership profits allocable to the fund manager, as computed over the life of the partnership. The examples suggest that clawback obligations will be respected as a factor supporting the presence of SER where it is "reasonable to anticipate" that the fund manager will likely comply fully with the obligation. The preamble to the Proposed Regulations offers a further scenario in which a clawback obligation applies to a fund manager's carried interest, but not to a related fund manager's waiver interest. In that case, although the absence of a clawback obligation does not control the outcome of the facts and circumstances test, the fund manager's fee waiver arrangement is at risk of being treated as a disguised payment for services rather than a share of fund profits.

Conclusions

The Proposed Regulations will apply to management fee waiver arrangements entered into or modified on or after the date they are finalized. The IRS expressly states, however, that the Proposed Regulations generally reflect Congressional intent as to which arrangements are appropriately treated as disguised payments for services. This suggests that the IRS may begin scrutinizing current fee waiver arrangements for SER before the Proposed Regulations are finalized.

Despite the uncertainty that remains in the wake of these Proposed Regulations, the silver lining that they offer to fund sponsors should not be overlooked: namely, that the IRS has seemingly accepted management fee waivers as a legitimate strategy for converting fixed fees into an additional profits interest. Fund managers would be well advised to analyze the fee waivers employed in their investment funds and determine whether they will pass muster under the Proposed Regulations.