August 12, 2015
The IRS Proposes Strict Limitations on Management Fee Waivers
On July 22, 2015, the Internal Revenue Services issued Proposed Regulations to provide guidance on which allocations or distributions made by a partnership to a partner who provides services to the partnership may be treated as disguised payments for services. The Proposed Regulations are intended to apply to all persons that perform services for a partnership either in partner capacity or in anticipation of becoming a partner; however, an emphasis is placed on management fee waiver arrangements, which are common in private equity.
In a typical management fee waiver scenario, the partnership documents allow the manager to waive all or a portion of the management fee to which it is entitled in exchange for an increased profit interest in the partnership. Some have argued that these arrangements are structured to convert payments for services, which would be taxed at ordinary rates to the manager, to a profit interest in the partnership, which may allow for a capital gain allocation to the manager (to the extent that the partnership has earned such gains) as well as a possible deferment of some of the income to future years. The downside to managers when waiving fees is that the partnership could incur losses, and they may never be able to recover the waived management fees. Consequently, many management fee waivers are designed to minimize the risk to the managers. The IRS issued these Proposed Regulations to attempt to limit apparent abuses in this area.
The Proposed Regulations provide for a non-exclusive list of six factors that should be taken into account to determine whether an arrangement is a disguised payment for services. The first factor, which is a common theme in all the factors and the most important factor according to the Proposed Regulations, is in regards to whether a management fee arrangement lacks significant entrepreneurial risk.
To further define what type of payment arrangement lacks significant entrepreneurial risk (and thus should be treated as a disguised payment for services), the IRS provides the following facts and circumstances as situations lacking significant entrepreneurial risk:
- Capped allocations of partnership income if the cap is reasonably expected to apply in most years.
- Allocation for a fixed number of years under which the manager's distributive share of income is reasonably certain.
- Allocations of gross income.
- Allocations that are predominately fixed in amounts, are reasonably determinable under the given facts and circumstances, or are designed to assure that sufficient net profits are highly likely to be made available to the manager.
- Arrangements in which the manager waives the right to receive payments for future performance of services in a non-binding manner or fails to timely notify the partnership and its partners of the waiver and its terms.
The Proposed Regulations offer six examples, to illustrate the application of the facts and circumstances to management fee waiver arrangements. These examples clarify that certain management fee waiver arrangements will be classified as disguised payments for services (such as those that provide for gross income allocations to a manager). Furthermore, the examples in the Proposed Regulations clarify that the following are a few of the circumstances that seem acceptable from the IRS's perspective as far as having significant entrepreneurial risk. Therefore, these conditions would not be considered disguised payments for services:
- Arrangements that are subject to a clawback provision (meaning the manager would have to repay any amounts allocated and distributed pursuant to their waived interest).
- Arrangements containing allocations out of net income.
- Arrangements that contain a binding and irrevocable waiver of fees that is executed at least 60 days prior to the period in which the relevant services are performed.
These regulations are not final and will not be effective until the date in which they are made final. However, fund managers and general partners should review their management fee arrangements and consider the impact of these Proposed Regulations. Making a business decision to modify a partnership's documents to fall within the framework of these new Proposed Regulations could potentially have a significant tax impact on fund managers and general partners.
Should you have any questions related to this Tax Flash, contact your Marcum tax professional.