The IRS has issued much-anticipated proposed regulations (REG-115452-14
) under Section 707(a)(2) that would address the tax treatment of certain arrangements between service providers and partnerships. These regulations concern management fee waivers and may significantly affect certain private equity fund arrangements. Taxpayers involved in such structures should carefully evaluate what if any changes to make.
The proposed regulations generally are aimed at arrangements in which people entitled to receive a management fee are able to waive some or all of the management fee they are entitled to receive from a partnership, typically in the context of a private equity fund. A key motivation for service providers to waive management fees is the conversion of management fees, which constitute ordinary income, into a distributive share of the fund partnership’s long-term capital gains (for example, from sales of stock in portfolio companies). Another key motivation is the deferral of income recognition until gain is recognized when the fund partnership sells assets.
Such arrangements are increasingly common in the private equity fund context and have faced scrutiny from lawmakers and the IRS.
Proposed regulations at a glance
The proposed regulations provide guidance about when an arrangement involving the receipt of a partnership interest for services would be treated as a disguised payment for services under Section 707(a)(2)(A), and not as the right to receive a distributive share of partnership income.
Once an arrangement is treated as a disguised payment for services under the proposed regulations, it would be treated as a payment for services for all other purposes of the code, including Sections 409A and 457A. Under the proposed regulations, the determination of whether an arrangement constitutes a disguised payment for services depends on all the facts and circumstances. This determination should be made when the arrangement is entered into or modified.
The proposed regulations specify six nonexclusive factors that may indicate that an arrangement is a disguised payment for services. Those factors are the following:
- The allocation and distribution are subject to significant entrepreneurial risk.
- 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 nonpartner 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 a 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 related to different services received, where the services are provided by a single person or related people, and the terms of the differing allocations or distributions are subject to significantly varying levels of entrepreneurial risk.
The IRS also notes that the first factor is the most important one.
Additionally, the preamble to the proposed regulations states that the Treasury Department and the IRS plan to issue a revenue procedure providing an additional exception to the safe harbor in Rev. Proc. 93-27. The safe harbor provides guidance on when the IRS will not treat the receipt of a profits interest for the provision of services to or for the benefit of a partnership as a taxable event for the partner or the partnership.
The proposed regulations generally have a prospective effective date; they would be effective on the date the final regulations are published and would apply to any arrangement entered into or modified on or after the date of publication of the final regulations. However, the proposed regulations provide that for any arrangement entered into or modified on or before the final regulations are published, the determination of whether the arrangement is a disguised fee for services under Section 707(a)(2)(A) is to be made “on the basis of the statute and the guidance provided regarding that provision in the legislative history of section 73 of the Tax Reform Act of 1984.” Therefore, there may be concern that the IRS will apply the principles reflected in the proposed regulations even before the final regulations are adopted.
The proposed regulations are drafted broadly and therefore may apply to arrangements beyond those involving private equity funds. Additionally, the potential retroactive application needs to be monitored for existing arrangements that involve management fee waivers.
Taxpayers who are operating in a private equity fund or other similar arrangement and are able to waive management fees to which they are normally otherwise legally entitled, should evaluate how the proposed regulations will affect their operations.
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