In a long-awaited development that will affect fee waivers utilized by some fund managers and advisers, the Internal Revenue Service on July 23 proposed regulations that emphasize the role of entrepreneurial risk in determining when a partnership allocation and distribution to a partner that provides services to the partnership is considered to be a "disguised payment for services."

In a typical fee waiver arrangement, a fund manager waives its right to a fixed management fee in exchange for a partnership interest that entitles the partner to an allocation of fund profits that typically are intended to closely mirror the waived fee in amount and, to a large extent, timing of payment.

Under IRS Revenue Procedure 93-27, if a partnership interest issued in exchange for services only entitles the partner to share in future profits (a "profits interest"), then the receipt of the partnership interest is not taxable to the service partner, provided certain conditions are met. Instead, the service provider would be taxed on allocations of income to it, which income would have the same character to the partner (i.e., ordinary or capital gain) as the underlying income earned by the fund. As a result, fee waivers could potentially shift payments for management services rendered to the fund from ordinary income into lower-taxed capital gains.

The July 23 proposal was prompted to address this practice due to IRS concerns that some aggressive fee waiver practices may cross the line (such as waivers made after the services are performed or where the income allocation is substantially certain to occur). Should they be adopted in their present form, the regulations would make it more difficult for fund managers to convert high-taxed fees into potentially lower-taxed capital gains, which enjoy a 19.6 percentage-point reduced rate.

Internal Revenue Code Section 707(a)(2)(A) provides that if a partner receives an allocation and distribution that, when viewed together with the provision of services by the partner to the partnership, is properly characterized as a transaction between the partnership and a partner that is not acting in a partner capacity, then the allocation and distribution shall be treated under regulations as a payment to a non-partner. The proposed regulations set forth six factors (the first five of which are taken from the legislative history) to gauge whether or not an allocation and distribution constitutes a disguised payment for services under the statutory rule.

The first and most significant factor is whether the allocation and distribution is "subject to significant entrepreneurial risk," relative to the overall risk inherent in the partnership. The proposed regulations outline specific circumstances in which there is a "high likelihood" the service provider will receive an allocation regardless of the fund's overall success, and therefore lack significant risk, including:

  • Capped allocations of partnership income if the cap would reasonably be expected to apply in most years.
  • Allocations for a fixed number of years under which the service provider's distributive share of income is reasonably certain.
  • Allocations of gross income items.
  • An allocation that is predominantly fixed in amount, is reasonably determinable under all the facts and circumstances, or is designed to ensure that sufficient net profits are highly likely to be available to make the allocation to the service provider.
  • Arrangements in which a service provider either 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 other five factors outlined in the proposed regulations, whose importance is secondary to entrepreneurial risk and depends on the facts of each particular case, are as follows:

  • 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.
  • 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 who are related, and the terms of the differing allocations or distributions are subject to levels of entrepreneurial risk that vary significantly.

While the regulations are proposed to be effective only when finalized (comments and requests for a public hearing on the matter must be received by Oct. 21, 2015), the IRS stated that it will analyze arrangements entered into before that date on the basis of the statute and legislative history and believes that the proposed regulations reflect congressional intent. Thus, taxpayers can expect the IRS to apply the proposed regulations (or similar standards) with respect to pre-existing arrangements.

In addition to the proposed regulations, the IRS indicated that it plans to provide an exception from the application of Revenue Procedure 93-27 for profits interests issued in conjunction with the partner forgoing a substantially fixed payment. Thus, even if a fee waiver is properly designed to satisfy the entrepreneurial risk and other factors set forth above, a fund manager might nonetheless be taxed (at ordinary rates) upon the receipt of a partnership interest issued in connection with a fee waiver.

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