Vedder Thinking | Articles Private Equity Fee Waivers: The IRS Waives the Yellow Flag
July 29, 2015
On July 22, 2015, U.S. Department of the Treasury and the IRS issued proposed regulations addressing disguised payments for services and announced proposed modifications to current guidance addressing profits interests in partnerships. As discussed below, the guidance will impact a wide variety of fee waiver structures utilized by sponsors of private equity funds. The guidance is also potentially relevant to other compensatory partnership equity arrangements.
In a typical fee waiver structure, a fund sponsor entity (such as the general partner or management company) receives an increased equity interest in the fund as a consequence of waiving management fees that otherwise would be paid. The interest is designed to correlate with the amount of fees waived, but only if the fund has sufficient profits. If the fund does not have sufficient profits, the holder of the interest is not made whole for the fees waived.
From a tax perspective, the primary goals are that: (a) the increased equity interest in the fund will qualify as a “profits interest” that can be received without triggering an up-front tax, and (b) after the interest is received, the holder will be entitled to flow-through allocations of income, such as capital gains, in respect of the interest.
The proposed guidance takes aim at both goals. First, the IRS announced that it will modify its current pronouncements to limit the safe harbor that allows profits interests to be received on a tax-free basis. Second, the IRS proposed regulations that can apply to convert a purported allocation of partnership income (capital gains, for example) into a payment for services (and thus ordinary income). This guidance is discussed in more detail below.
Proposed Modifications to the Profits Interest Safe Harbor
A primary tax objective of a fee waiver structure is that the general partner (or management company) will receive the additional equity interest without triggering an up-front tax. To achieve this result, the additional equity typically is designed to qualify as a “profits interest;” that is, an interest that entitles its holder only to future profits, but not any current value. In Revenue Procedure 93-27, the IRS established a safe harbor providing that, if certain requirements are met, the IRS will not treat the grant of a profits interest as taxable to the recipient or the partnership.
In connection with the new guidance, the IRS announced that it will remove safe harbor protection for equity interests issued in conjunction with a partner forgoing a “substantially fixed” payment for services. This includes a substantially fixed amount determined by a formula, such as a fee based on a percentage of partner capital commitments.
Assuming the safe harbor is modified as proposed, fund managers will be exposed to IRS arguments that the equity received on account of an elective fee waiver should be taxed at its “fair market value”—historically an uncertain inquiry. Given the risk of paying tax on value that may never be converted to cash, the removal of the safe harbor will likely have a chilling effect on elective fee waiver structures.
The IRS also stated that it believes the current safe harbor does not apply to “bifurcated” waiver structures; for example, structures in which a management company elects to waive its fee, but the general partner separately receives the additional equity. Funds utilizing this mechanism should carefully consider the impact of this guidance on their structures.
Proposed Disguised Services Regulations
Another goal of receiving a partnership interest for services, including through a fee waiver mechanism, is that the holder will be entitled to “flow through” allocations of income—such as capital gains—on account of its interest. However, the Internal Revenue Code (Code) contains an anti-abuse rule that can convert a flow-through allocation and distribution of income (such as capital gains) into a disguised payment for services (and thus ordinary income). Although this rule was enacted in 1984, no regulations have been proposed under this provision until now.
Summary of Operative Provisions
The proposed regulations treat an arrangement as a disguised payment for services if a person provides services to a partnership, receives a related allocation and distribution, and the foregoing is “properly characterized” as a transaction in which the service provider acts in a third-party, rather than partner, capacity. If an arrangement is recast, amounts paid to the service provider are treated as payments for services (and thus ordinary income), and may be subject to sections 409A and 457A of the Code. The partnership must treat the payments consistently with this characterization. For example, in a typical private equity fund the payments would likely be treated as investment expenses, which individual investors may not be able to fully deduct due to limitations that apply to miscellaneous itemized deductions.
Under the proposed regulations, whether an arrangement is a disguised payment for services depends on all the facts and circumstances. The most important factor is “significant entrepreneurial risk” as to the amount and fact of payment. The presence of any of the following factors creates 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 a fixed number of years in which the service provider’s share of income is reasonably certain.
An allocation of gross (rather than net) income.
An allocation that is predominantly fixed in amount, is reasonably determinable, or is designed to ensure that sufficient net profits are highly likely to be available to make the allocation in question (such as allocations of net profits from specific transactions or accounting periods).
An arrangement in which a service provider waives its right to receive payment for future services in a manner that is nonbinding, or the service provider fails to timely notify the partnership and its partners of the waiver and its terms.
The last factor is of particular relevance to waiver structures. If finalized in present form, fund managers would be required to notify all investors (not just the fund) of each decision to waive fees.
The proposed regulations identify secondary factors that may indicate an arrangement is a disguised payment for services. Unlike the above, the presence of these factors does not create an automatic presumption of disguised services. These factors are as follows:
The service provider holds, or is expected to hold, a transitory partnership interest or an 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 receive 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 related persons, and the terms of the differing allocations or distributions are subject to levels of entrepreneurial risk that vary significantly.
The proposed regulations include six examples of “fee replacement” equity arrangements. Five examples address equity granted up front, and one example addresses equity received on account of a fee waiver.
In considering which arrangements pass muster, the examples focus on certain key factors: whether the allocation is determined out of “net” profits that are neither highly likely to be available nor reasonably determinable; whether the relevant partner provides a “clawback” obligation that it is reasonably expected to comply with; and whether the fees are clearly foregone and any waiver is communicated before the applicable period begins. In examples where these and other factors were present, the IRS concluded that the disguised services rule did not apply where:
A general partner in an investment fund became entitled to a priority allocation designed to approximate 1 percent of capital commitments (in addition to its 20 percent carried interest). The management company agreed up front to accept a management fee that was lower than what comparable funds would pay.
A management company could waive its fees at least 60 days before the beginning of the year. In exchange, the company was entitled to a future allocation of net profits, measured above current valuation levels, intended to approximate the fee that was waived.
However, other examples—some of which are briefly summarized below—illustrate situations where the disguised services rule would apply:
A fund manager was entitled to receive priority allocations and distributions of gains, intended to approximate the fee that the manager would normally receive. The allocation could be made in any year in which the fund recognized a gain, regardless of whether the fund had losses in other years. The general partner, who could control asset sales and distributions, was related to the manager.
In a real estate partnership, an architect was entitled to receive, in lieu of its normal $40,000 fee, a gross income allocation capped at $20,000 per year for the first two years of the partnership’s operations. The cap was reasonably expected to apply.
As the above examples show, various forms of fee replacement equity—whether granted up-front or on account of a waiver—can avoid recast under the disguised services rules. However, the precise boundaries (such as allocations limited to specified profits such as capital gains, as well as clawback arrangements) may not always be clear. Moreover, as discussed, fee waiver equity apparently could remain subject to attack as being outside the profits interest safe harbor (once modified), even if the equity runs the gauntlet of the disguised services rules.
The proposed regulations are not effective until finalized. However, they are proposed to apply to any fee waiver made (even for preexisting funds) after the regulations are final. Moreover, until the final regulations are issued, the IRS’s position is that the proposed regulations generally reflect Congressional intent, thus making current structures subject to scrutiny. It is possible the final regulations will vary from the current proposal.
The proposed modifications to the safe harbor revenue procedures are to be issued “in conjunction with” the issuance of the final regulations. Although not expressly stated in the guidance, it appears that these changes will be prospective only.
If adopted in current form, the proposed guidance will adversely impact the intended tax treatment of elective fee waiver structures. However, the guidance is not limited to elective fee waiver structures, and could impact nonstandard carried interest structures, as well as equity issued outside the private equity context. Thus, any partnership issuing equity for services should be cognizant of these developments.
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If you have questions regarding this bulletin, please contact Matthew P. Larvick at +1 (312) 609 7970 or firstname.lastname@example.org or the Vedder Price attorney with whom you regularly work.
 Revenue Procedure 93-27 was a “truce” of sorts; issued in response to prior uncertainty regarding how to value profits interests. Compare Diamond v. Commissioner, 492 F.2d 286 (7th Cir. 1974) (a profits interest sold three weeks after receipt had a “determinable market value” that was properly taxed upon receipt) with Campbell v. Commissioner, 943 F.2d 815 (8th Cir. 1991) (concluding that the profits interests at issue “were without fair market value” and therefore were not properly taxed upon receipt).
 Interestingly, this example addresses an elective waiver of fees. As discussed above, the IRS intends to eliminate the profits interest safe harbor for interests received in connection with forgoing payment of a substantially fixed amount. However, the examples in the proposed regulations do not address “profits interest” characterization, but rather address whether the disguised services rules can recast the nature of payments received on account of the interest.