On July 23, 2015, the US Treasury Department and IRS released proposed regulations (the 'proposed regulations') (REG – 115452-14) under Section 707(a)(2)(A) related to disguised payments for services by a partnership. These regulations are intended to address (among other things) waivers of certain management fees by private equity fund managers in exchange for increased future payments. The proposed regulations treat certain waivers as payments for services by the partnership to the recipient (e.g., a fund manager) for all purposes of the Code and, therefore, subject to ordinary income treatment.
The proposed regulations will apply to arrangements entered into or modified after their date of publication as final regulations. However, the preamble to the proposed regulations asserts that the rules generally reflect Congressional intent. Based on that statement and the general negative publicity regarding the 'conversion' of ordinary income into capital gain in the fund context, it would not be surprising if the IRS uses the proposed regulations to scrutinize current arrangements as well.
Therefore profits interests that may be seen to replace or simulate a salary or fee arrangement should be reviewed, including any arrangements that have already been entered into.
EXPLANATION OF THE PROPOSED REGULATIONS
Section 707(a)(2) grants the Secretary broad regulatory authority to identify transactions involving disguised payments for services under Section 707(a)(2)(A). This grant of regulatory authority stems from Congress' concern that partnerships and service providers may inappropriately treat certain amounts as an allocation of income (and subsequent distribution) to a partner even if the partner was acting in a non-partner capacity.
The proposed regulations provide that an allocation will be treated as a disguised payment if:
- A person (service provider), either in a partner capacity or in anticipation of becoming a partner, performs services (directly or through its delegate) to or for the benefit of a partnership;
- There is a related direct or indirect allocation and distribution to such service provider; and
- The performance of such services and the allocation and distribution, when viewed together, are properly characterized as a transaction occurring between the partnership and a person acting other than in that person's capacity as a partner.
The proposed regulations list six factors that will be used to determine whether a transaction is a disguised payment for services. While the test is an all facts and circumstances analysis, the first factor, significant entrepreneurial risk, is accorded more weight. The proposed regulations explain the emphasis on the significant entrepreneurial risk factor on the basis that (presumably) if the payment is not dependant to a significant extent on entrepreneurial risk, it is more likely the service provider is acting in a non-partner, rather than a partner, capacity.
This emphasis is highlighted by the statement in the proposed regulations that an arrangement that lacks significant entrepreneurial risk constitutes a payment for services, whereas the presence of significant entrepreneurial risk generally will not require recharacterization.
Within the significant entrepreneurial risk factor are a list of five facts and circumstances that create a presumption that an arrangement lacks significant entrepreneurial risk:
- 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 is predominantly 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 (e.g. 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); or
- An arrangement in which a service provider waives its right to receive payment for the future performance of services in a manner that is non-binding or fails to timely notify the partnership and its partners of the waiver and its terms.
The presence of the above five factors will result in the arrangement being treated as a disguised payment unless other facts and circumstances establish the presence of significant entrepreneurial risk by clear and convincing evidence.
The remaining five factors (other than significant entrepreneurial risk) are:
- 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 that 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 in general and continuing partnership profits is small in relation to the allocation and distribution; and
- The arrangement provides for different allocations or distributions with respect to different services received, the services are provided either by one person or by persons that are related under Sections 707(b) or 267(b), and the terms of the differing allocations or distributions are subject to levels of entrepreneurial risk that vary significantly.
The proposed regulations include a number of examples intended to illustrate their application to various facts and circumstances. Several examples consider an arrangement in which the partner/service provider forgoes fees for services in exchange for a share of future partnership income and gains. While all such arrangements should be examined more closely in light of the proposed regulations, three factors indicate an arrangement should be respected:
- The arrangement, i.e. the waiver of management fees, occurs prior to the fund's formation and is irrevocable and binding and notice is given to all partners;
- The allocation is paid out of cumulative net income over the life of the fund as opposed to a yearly allocation; and
- The allocation received is subject to a clawback to account for the cumulative return of the fund. There should also be evidence that the partner will be able to satisfy the clawback if applicable.
IMPACT ON THE PROFITS INTEREST SAFE HARBOR
Importantly, the preamble to the proposed regulations also states that Treasury and the IRS have determined that the Safe Harbor applicable to grants of profits interest to service partners set out in Rev. Proc. 93-27 and clarified by Rev. Proc. 2001-43 does not apply to transactions in which one party provides services and another party receives the associated allocation and distribution of partnership income or gain. An example of this arrangement would be if a management company that provides services to a fund in exchange for a fee waives that fee and a party related to the management company receives an interest in future partnership profits (instead of their share of the fee income), the value of which approximates the amount of the waived fee. The Treasury and the IRS have determined that these arrangements do not satisfy the requirements of Rev. Proc. 93-27 that receipt of a partnership profits interest is for the provision of services to or for the benefit of the partnership in a partner capacity or in anticipation of being a partner. Therefore, the service provider may be viewed as having disposed of the partnership interest (through a constructive transfer to the related party) within two years of receipt, in which case the partner would be subject to tax on the receipt of the interest.
The IRS also announced that they intend to provide an additional exception to the Safe Harbor in connection with finalization of the proposed regulations. This exception will apply to any profits interest issued in conjunction with a partner foregoing payment of a substantially fixed amount (including fixed via formula). Where profits interest do not qualify for the new exception, taxpayers would be required to determine the value of such an interest or argue that the receipt of the interest is not taxable under case law.
The proposed regulations shed additional light on an issue which has concerned the IRS in recent years. Taxpayers should consider all of their existing arrangements and consult their tax advisors before entering into any new management fee waivers or profits interest arrangements as the analysis under the proposed regulations is complex and these arrangements could result in unintended tax consequences.