IRS Proposed Regulations Curtail Management Fee Waivers and Impact Taxation of Profits Interests

On July 22, 2015, the Treasury Department and the Internal Revenue Service (IRS) released proposed regulations that would, if adopted, substantially curtail the use of management fee waivers.  The scope of the proposed regulations is quite broad, however, and could affect the taxation of certain grants of profits interests more generally.

It is common practice for an investment manager (service provider) of a private equity, venture capital, real estate or other investment fund to contractually waive all or a portion of its management fee for the provision of services to the fund in exchange for a special allocation of the fund's future profits. This is advantageous to the investment manager because it converts ordinary income (the management fee) into long term-capital gain (the fund's future profits), which is taxed at preferential rates. This future allocation of profits is a type of "profits interest" which is payable only out of future profits of the fund. Typically, the investment manager is entitled to a priority allocation of the first long-term capital gain earned by the fund. 

Proposed Regulations Look First to the Arrangement's Entrepreneurial Risk

The proposed regulations adopt a facts and circumstances analysis to determine whether to respect the fee waiver or whether to treat payments received by a fund's investment manager as ordinary income for services rendered. The proposed regulations regard the existence of "significant entrepreneurial risk" as the most important factor in determining the appropriate treatment of amounts received by the fund's investment manager. Under the proposed regulations, an arrangement that lacks significant entrepreneurial risk will be treated as a fee under Section 707(a)(2)(A) of the Internal Revenue Code (Code) and, thus, will be taxable as ordinary income to the investment manager.

Secondary Determinations

Additional factors that are of secondary importance in determining whether an arrangement between an investment manager and a fund constitutes fee income include whether:

• 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 that a non-partner service provider would typically receive payment;
• the service provider became a partner primarily to obtain tax benefits which 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 is small in relation to the allocation and distribution; and
• the arrangement provides for different allocations or distributions with respect to different services received, where the services are provided either by a single person or by related persons (as defined under Code Sections 707(b) and 267(b)), and the terms of the differing allocations or distributions are subject to levels of entrepreneurial risk that vary significantly.

Examples of Significant Entrepreneurial Risk

The proposed regulations would, if finalized, affect advance fee waiver arrangements that involve limited entrepreneurial risk as to amount and payment.  For example, a special allocation to an investment manager of a fund's future profits is presumed, under the proposed regulations, to lack significant entrepreneurial risk if the special allocation amount is capped at the amount of the waived management fee and the cap is reasonably expected to apply in most years. Similarly, if the special allocation is made out of the fund's gross income, the arrangement would be presumed to lack significant entrepreneurial risk.  The proposed regulations highlight other arrangements, including an allocation of a share of income that is reasonably certain, that are presumed to lack significant entrepreneurial risk.  In such arrangements, the allocation and distribution would be treated as a fee and the investment manager would recognize ordinary income.

The proposed regulations also provide examples that illustrate arrangements which would provide the service provider with significant entrepreneurial risk, including arrangements where the investment manager's allocation is based on net profits, the allocation is subject to a clawback obligation of the investment manager over the life of the fund, the investment manager is reasonably likely to comply fully with any repayment responsibilities and the allocation's amount is not certain to be available nor reasonably determinable at the time the arrangement is entered into.

Proposed Elimination of Safe Harbor for Certain Profits Interest Recipients

Under Revenue Procedure 93-27, if a person receives a profits interest in exchange for services rendered to or for the benefit of a partnership in a partner capacity or in anticipation of becoming a partner, and the arrangement falls within the safe harbor, the IRS will not treat the receipt of the partnership interest as a taxable event for the service provider or the partnership. Rev. Proc. 93-27 contains several exceptions to this favorable tax treatment of profits interests, including the disposition of the profits interest within two years of receipt. The notice that accompanied the proposed regulations noted that Treasury and the IRS are planning to issue new guidance with respect to the application of Rev. Proc. 93-27 to the grant of profits interests.

This new guidance will likely remove from the safe harbor all profits interest arrangements where one party provides services and a related party receives the profits interest. According to the preamble to the proposed regulations, Rev. Proc. 93-27 does not apply to a transaction in which one party provides services to a fund and another party receives an associated allocation and distribution of partnership income or gain for two reasons: (1) the transaction would not satisfy the requirement that the receipt of the profits interest be for services for the benefit of the partnership in a partner capacity or in anticipation of being a partner and (2) the investment manager's deemed transfer to the general partner would constitute a disposition within two years. Such new guidance will presumably affect not just management fee waivers, but other common arrangements seen in private equity, venture capital, real estate and other private investment funds (including hedge funds), such as when a general partner (or managing member) provides services to a partnership (or limited liability company) but a carried interest or other profits interest is allocated to a special limited partner (or special member). The tax implications of these arrangements in cases where the special limited partner makes a capital contribution and an affiliate provides services is unclear. Moreover, the IRS seems to suggest in the preamble to the proposed regulations that it plans to amend Rev. Proc. 93-27 to not apply to any management fee waiver, including one that is not recharacterized as a fee under the proposed regulations.

Next Steps

Funds and investment managers should review their existing management fee and management fee waiver arrangements to determine the tax impact to them of these proposed regulations. The tax treatment of management fee arrangements with no true entrepreneurial risk, such as capped service fees and gross income allocations, must be reconsidered to determine whether any amounts should be recharacterized as disguised services payments and subject to ordinary income tax as well as the deferred compensation rules of Code Sections 409A and 457A. Fund and investment managers should also anticipate further developments on the taxation of profits interests.

Joel Deuth contributed to this advisory. He is a graduate of the Catholic University of America, Columbus School of Law, and is employed at Arnold & Porter LLP. Mr. Deuth is not admitted to the bar.