Proposed Regulations on Disguised Payments for Services Issued Last Summer by Treasury Still Attracting Attention and Concern From Service Partners, Including Private Equity and Funds Managers

By Jerald David August

Last Summer the Service issued a set of proposed regulations with respect to Section 707(a)(2)(A). This provision involves an arrangement where: (i) involving a partner who provides services (or transfers property) to a partnership; (ii) there is a related direct or indirect allocation and distribution to that partner; and (iii)  the performance of the services (or transfer of property) and the allocation and distribution, when viewed together, are  in substance compensation for the performance of services (or payment made in exchange for the property) as if the partner was acting other than in his capacity as a party. In such case the distribution will be treated as compensation income to the partner-service provider. The purpose of the disguised services rule is to prevent partners from converting ordinary income into capital gains. As to the partnership, the compensation payments may be required to be capitalized. 

In general Section 707(a), along with Section 707(c), provide limited exceptions to the generally accepted rule that a partner cannot receive compensation from a partnership. The proposed regulations provide additional guidance under Section 707(a)(2)(A) and propose conforming changes to Section 707(c) and changes to the issuance of profits interest to service providers under the established safe harbor guidelines in Rev. Proc. 93-27, 1993-2 C.B. 343, clarified in Rev. Proc. 2001-43, 2001-2 C.B. 191.  Partnership allocations that are determined with regard to partnership income and that are made to a partner for services rendered by the partner in its capacity as a partner are generally treated as distributive shares of partnership income, taxable under the general rules of sections 702, 703, and 704. As to profits interests, the Treasury and Service announced in the notice of the proposed regulations their intent to modify the exceptions in the cited revenue procedures to include an additional exception for profits interests where a partner waives his right to a payment of a substantially fixed amount for the performance of services, including a guaranteed payment under Section 707(c) or a payment in a non-partner capacity under Section 707(a).

As of this date, the proposed regulations have received comments, including a fair amount of criticism, but have not been issued in final form. 

Background

Section 707(a)(1) provides that with respect to transactions between a partnership and a partner, who is not acting in his capacity as a partner in the transaction, such shall be treated as occurring between the partnership and one who is not a partner.  See Pratt v. Comm’r, 550 F.2d 1023 (5th Cir. 1977)(emphasis added). The Pratt case reasoned that Section 707(a) was intended by Congress to reach services performed outside of the scope of the partnership’s activities.

At times, it may be difficult to determine if the services are rendered in consideration for making a capital contribution to the partnership or instead are compensatory in nature.  See Treas. Reg. §1.721-1(b)(2). As an analogue to Section 707(a), Section 707(c) provides that to the extent determined without regard to the income of the partnership, payments made to a partner for services or use of capital are treated as not being paid to a member of the partnership but only for purposes of Section 61(a)(gross income) and, as are further subject to the capitalization rules of Section 263 and 263A as well as the deductibility of reasonable compensation payments under Section 162(a).

The Senate Report and the House Report to the 1954 Code as to Section 704(c) provide that a fixed salary, payable without regard to partnership income, to a partner who renders services to the partnership, constitutes a guaranteed payment. The amount of the payment is includible in the partner's gross income and is not to be considered a distributive share of income or gain. A partner who is guaranteed a minimum annual amount for its services shall be treated as receiving a fixed payment in that amount. Note that Section 707(c) relates to payments made to a partner acting in such capacity. At times, it was uncertain when a partner’s services to a partnership were rendered in a non-partner capacity per Section 707(a) instead of with respect to her partner capacity under Section 707(c). See Rev. 

Rul. 81-300, 1981-2 C.B. 153 (guaranteed payments do not have to be fixed amounts where based on all facts and circumstances, the payment is for compensation and not a share of partnership profits). In Rev. Rul. 81-301, 1981-2 C.B. 144, however, the Service held that a general partner who received 10% of daily gross income to provide management services to the partnership received its gross income allocation in a non-partner capacity under Section 707(a).

Congress re-examined the scope of Section 707(a)  in 1984, in part to prevent partners from avoiding the capitalization requirements under Section 263 and 709 through structuring payments for services as allocations of partnership income under Section 704 (citations to legislative history omitted). Congress at that time addressed the holdings in Rev. Rul. 81-300 and Rev. Rul. 81-301, affirming Rev. Rul. 81-301 and concluding that the payment in Rev. Rul. 81-300 should be recharacterized as a Section 707(a) payment.  In the notice of the proposed rule-making last July, the  Treasury Department and the IRS announced it was obsoleting Rev. Rul. 81-300 and requested comments on whether it should be reissued with modified facts.

As part of the 1984 legislation, Congress enacted Section 707(a)(2)(A), which provides that under regulations prescribed by the Treasury (or its delegate), where a partner performs services for or transfers property to a partnership, there is a related direct or indirect allocation and distribution of funds to such partner, and the performance of such services (or such transfer) and the allocation and distribution, when combined are properly characterized as a transaction occurring between the partnership and a partner acting other than in his capacity as a member of the partnership, such allocation and distribution will be treated as a transaction between the partnership and someone who is not a member of the partnership. [1]  This rules has been labeled as an “anti-abuse” rule. The Congressional purpose was that where allocations and distributions from a partnership were, in substance, direct payments for services, the payments should be treated as the payment of fees to a non-partner instead of an allocation and distribution of partnership.  Factors were identified to distinguish between an allocation and distribution of funds as a partner and payment of fees that were properly categorized under Section 707(a).

Factors Distinguishing Section 707(a) Payments From Section 707(c) Payments or Allocations of Income Under Section 704(b)

The most important factor in the eyes of Congress was whether the payment is subject to a sufficient degree of entrepreneurial risk both as to the amount and fact of payment. In this regard, individuals rendering services as non-partners expect to receive payments outside of the business risks of the business. Examples of allocations that presumptively limit a partner's risk, include (i) capped allocations of income, (ii) allocations for a fixed number of years under which the income that will go to the partner is reasonably certain, (iii) continuing arrangements in which purported allocations and distributions are fixed in amount or reasonably determinable under all facts and circumstances, and (iv) allocations of gross income items.

On the other hand, where the allocation and distribution of funds to a service provider are subject to a significant degree of entrepreneurial risk as to amount, such payment will generally be treated as a distributive share. The legislative history to Section 707(a)(2)(A) includes the following examples of factors used in making this determination: (i) whether the partner status of the recipient is transitory; (ii) whether the allocation and distribution are close in time to the partner's performance of services; (iii) whether the facts indicate that the recipient became a partner primarily to obtain tax benefits for itself or the partnership that would not otherwise have been available; and (iv) whether the value of the recipient's interest in general and with respect to participating in partnership profits is small in relation to the allocation in question.

Summary of the Proposed Regulations

Proposed Treas. Reg. §1.707-2(b) starts off by essentially restating Section 707(a)(2)(A).  Where Section 707(a)(2)(A) applies, the proposed regulations require that the partnership must treat the payments as payments for service for all purposes of the Code which again would include consideration of whether the payments were required to be capitalized or alternatively could be expensed in computing taxable income.  Where an allocation does not fall within Section 707(a) or Section 707(c), the preamble to the proposed regulations provides that it will be treated as a distributive share (of income) under Section 704(b).

Consequences of Determining Whether Section 707(a) Applies

The Preamble notes that the proposed regulations may cause a service partner to not be treated as a partner where Section 707(a) applies. In a two person partnership model, the application of Section 707(a) may result in determining that no partnership exists. The nature of the arrangement is determined at the time the agreement is entered into or as may later be allocated. To avoid retroactive recharacterization, the proposed regulations will generally require the characterization of the nature of an arrangement when the arrangement is entered into (or as may be later modified) regardless of when income is allocated and when money or property is distributed. The proposed regulations apply to both one-time transactions and continuing arrangements.

“Five Factors” Expanded to Six  in the Proposed Regulations in Determining Whether There is Significant Entrepreneurial Risk

Whether an arrangement constitutes a payment for services (in whole or in part) depends on all  facts and circumstances. The proposed regulations set forth six non-exclusive factors on whether an arrangement constitutes a disguised payment for services. The first five factors generally track the facts and circumstances identified as relevant in the legislative history for purposes of applying section 707(a)(2)(A). The proposed regulations add a sixth factor not specifically identified by Congress. The first of these six factors, the existence of significant entrepreneurial risk, is accorded more weight than the other factors, and arrangements that lack significant entrepreneurial risk are treated as disguised payments for services. The weight given to each of the other five factors depends on the particular case, and the absence of a particular factor (other than significant entrepreneurial risk) is not necessarily determinative of whether an arrangement is treated as a payment for services.

A. Significant Entrepreneurial Risk. Congress has indicated that the most important factor in determining whether or not an arrangement constitutes a payment for services is that the allocation and distribution are subject to significant entrepreneurial risk. Under the proposed regulations, an arrangement that lacks significant entrepreneurial risk constitutes a disguised payment for services. On the other hand, an arrangement in which allocations and distributions to the service provider are subject to significant entrepreneurial risk will generally be characterized as a distributive share of partnership income but the ultimate determination depends on the totality of the facts and circumstances.

Prop. Regs. §§ 1.707-2(c)(1)(i) through (v)  set forth examples of arrangements that presumptively lack significant entrepreneurial risk and are to be treated as a disguised payment for services unless other facts and circumstances can establish the presence of significant entrepreneurial risk by clear and convincing evidence. Examples of a lack of entrepreneurial risk include: (i) capped allocations of partnership income if the cap would reasonably be expected to apply in most years; (ii) allocations for a fixed number of years under which the service provider's distributive share of income is reasonably certain; (iii) allocations of gross income items, (iv) 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 (for example, 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 overall success of the enterprise); and (v) 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.

Congress's emphasis on entrepreneurial risk requires changes to existing regulations under Section 707(c). Specifically, Example 2 of  Treas. Reg. § 1.707-1(c) provides that if a partner is entitled to an allocation of the greater of 30% of partnership income or a minimum guaranteed amount, and the income allocation exceeds the minimum guaranteed amount, the entire income allocation is treated as a distributive share of partnership income under Section 704(b). Example 2 also presently provides that if the income allocation is less than the guaranteed amount, then the partner is treated as receiving a distributive share to the extent of the income allocation and a guaranteed payment to the extent that the minimum guaranteed payment exceeds the income allocation.

The Preamble to the proposed regulations provides that the treatment of the arrangements in Example 2 is inconsistent with the concept that an allocation must be subject to significant entrepreneurial risk to be treated as a distributive share under Section 704(b). As a result, the proposed regulations significantly  modify Example 2 to provide that the entire minimum amount is treated as a guaranteed payment under Section 707(c) regardless of the amount of the income allocation. (emphasis added)  The Preamble next announces that Rev. Rul. 66-95, 1966-1 C.B. 169, and Rev. Rul. 69-180, 1969-1 C.B. 183, are also inconsistent with these proposed regulations and the Service intends to obsolete Rev. Rul. 66-95 and revise Rev. Rul. 69-180, when these regulations are published in final form.

B. Secondary factors. Treas. Regs. §§ 1.707-2(c)(2) through (6) describes additional factors of secondary importance in determining whether or not an arrangement that gives the appearance of significant entrepreneurial risk constitutes a payment for services. The weight given to each of the other factors depends on the particular case, and the absence of a particular factor is not necessarily determinative of whether an arrangement is treated as a payment for services. Four of these factors, described by Congress in the legislative history to Section 707(a)(2)(A), are (i) that the service provider holds, or is expected to hold, a transitory partnership interest or a partnership interest for only a short duration; (ii) that 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; (iii) that the service provider became a partner primarily to obtain tax benefits which would not have been available if the services were rendered to the partnership in a third party capacity; and (iv) that the value of the service provider's interest in general and continuing partnership profits is small in relation to the allocation and distribution. The proposed regulations add a fifth factor. The fifth factor states that significant entrepreneurial risk is present if the arrangement provides for different allocations or distributions with respect to different services received, where the services are provided either by a single 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.

For example, limited partnership XYZ receives services from X, the sole general partner, and from a management company owned exclusively by X. Both the general partner and the management company receive a share in future partnership net profits in exchange for their services. The general partner, X,  is entitled to receive an allocation of 20% of net profits and undertakes an enforceable obligation to repay any amounts distributed pursuant to its interest (reduced by reasonable allowance for tax payments made on the general partner's allocable shares of partnership income and gain) that exceed 20% of the overall net amount of partnership profits computed over the partnership's life and it is reasonable to anticipate that the general partner can and will comply fully with this obligation. The proposed regulations refer to this type of obligation and similar obligations, as a "clawback obligation." Looks like “20” carried interest in a 2-20 management fee arrangement for a fund.  In contrast, the management company is entitled to a preferred amount of net income that, once paid, is not subject to a clawback obligation. Because X, the general partner, and his management company are service providers that are related parties under Section 707(b), and because the terms of the allocations and distributions to the management company create a significantly lower level of economic risk than the terms for the general partner, the management company's arrangement might properly be treated as a disguised payment for services (depending on all other facts and circumstances, including amount of entrepreneurial risk). This revision certainly has the attention of fund managers and their tax advisers.

III. What About Fee Waivers?  Examples. Prop. Reg. § 1.707-2(d) provides several examples illustrating the application of the factors described in Treas. Reg. § 1.707-2(c) on the presence or absence of entrepreneurial risk.

Several of the examples consider arrangements where a partner agrees to forgo (“waives”) fees for services and also receives a share of future partnership income and gains. The examples consider the application of Section 707(a)(2)(A) based on the manner in which the service provider (i) forgoes (waives) its right to receive fees, and (ii) is entitled to share in future partnership income and gains. In Examples 5 and 6, the service provider forgoes the right to receive fees in a manner that supports the existence of significant entrepreneurial risk by forgoing its right to receive fees before the period begins and by executing a waiver that is binding, irrevocable, and clearly communicated to the other partners. Similarly, the service provider's arrangement in these examples include the following facts and circumstances that taken together support the existence of significant entrepreneurial risk: the allocation to the service provider is determined out of net profits and is neither highly likely to be available nor reasonably determinable based on all facts and circumstances available at the time of the arrangement is agreed upon, and the service provider undertakes a clawback obligation and is reasonably expected to be able to comply with that obligation. The presence of each fact described in these examples is not necessarily required to determine that Section 707(a)(2)(A) does not apply to this type of arrangement. However, the absence of certain facts, such as a failure to measure future profits over at least a 12-month period, may suggest that an arrangement constitutes a fee for services.

The proposed regulations also contain examples that consider similar arrangements to which Section 707(a)(2)(A) applies. Example 1 concludes that an arrangement in which a service provider receives a capped amount of partnership allocations and distributions and the cap is likely to apply is to be treated as a disguised payment for services under Section 707(a)(2)(A). In Example 3(iii), a service provider is entitled to a share of future partnership net profits, the partnership can allocate net profits from specific transactions or accounting periods, those allocations do not depend on the long-term future success of the enterprise, and a party that is related to the service provider controls the timing of purchases, sales, and distributions. The example concludes that under these facts, the arrangement lacks significant entrepreneurial risk and provides for a disguised payment for services.

IV. Safe Harbor Revenue Procedures. Rev. Proc. 93-27, supra, provides, in general, that if a person receives a profits interest for the provision of services to or for the benefit of a partnership in a partner capacity or in anticipation of becoming a partner, the IRS will not treat the receipt of such interest as a taxable event for the partner or the partnership. The revenue procedure does not apply if (1) the profits interest relates to a substantially certain and predictable stream of income from partnership assets, such as income from high-quality debt securities or a high-quality net lease; (2) within two years of receipt, the partner disposes of the profits interest; or (3) the profits interest is a limited partnership interest in a "publicly traded partnership" within the meaning of Section 7704(b).

Rev. Proc. 2001-43, supra,  in clarifying Rev. Proc. 93-27, supra, provides that where a partnership grants a substantially nonvested profits interest in the partnership to a service provider, the service provider will be treated as receiving the interest on the date of its grant, provided that: (i) the partnership and the service provider treat the service provider as the owner of the partnership interest from the date of its grant, and the service provider takes into account his or its distributive share of partnership income, gain, loss, deduction and credit associated with that interest in computing the service provider's income tax liability for the entire period during which the service provider has the interest; (ii) upon the grant of the interest or at the time that the interest becomes substantially vested, neither the partnership nor any of the partners deducts any amount (as wages, compensation, or otherwise) for the fair market value of the interest; and (iii) all other conditions of Rev. Proc. 93-27, supra, are satisfied.

The proposed regulations address a problem associated with a waiver of fees for profits interests. More specifically, the Preamble states that the Treasury Department and the IRS are aware of transactions in which one party provides services and another party receives a seemingly associated allocation and distribution of partnership income or gain. For example, a management company that provides services to a fund in exchange for a fee may waive that fee while a party related to the management company receives an interest in future partnership profits the value of which approximates the amount of the waived fee. The Treasury Department and the IRS have determined that Rev. Proc. 93-27 does not apply to such transactions because they would not satisfy the requirement that receipt of an interest in partnership profits be for the provision of services to or for the benefit of the partnership in a partner capacity or in anticipation of being a partner, and because the service provider would effectively have disposed of the partnership interest (through a constructive transfer to the related party) within two years of receipt. (emphasis in italics added).

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 in conjunction with the publication of these regulations in final form. The additional exception will apply to a profits interest issued in conjunction with a partner forgoing payment of an amount that is substantially fixed (including a substantially fixed amount determined by formula, such as a fee based on a percentage of partner capital commitments) for the performance of services, including a guaranteed payment under section 707(c) or a payment in a non-partner capacity under Section 707(a).

In conjunction with the issuance of proposed regulations (REG-105346-03; 70 FR 29675-01; 2005-1 C.B. 1244) relating to the tax treatment of certain transfers of partnership equity in connection with the performance of services, the Treasury Department and the IRS issued Notice 2005-43, 2005-24 I.R.B. 1221. Notice 2005-43 includes a proposed revenue procedure regarding partnership interests transferred in connection with the performance of services. In the event that the proposed revenue procedure provided for in Notice 2005-43 is finalized, it will include the additional exception referenced.

Effective Dates.  The proposed regulations will be effective on publication in the Federal Register and would apply to any arrangement entered into or modified on or after such date. As to any arrangement entered into or modified before the final regulations are published in the Federal Register, the determination of whether an arrangement is a disguised payment for services under Section 707(a)(2)(A) is made on the basis of the statute and the guidance provided regarding that provision in the legislative history of Section 707(a)(2)(A). Pending the publication of final regulations, the  Preamble announces that the position of the Treasury Department and the IRS is that the proposed regulations generally reflect Congressional intent as to which arrangements are appropriately treated as disguised payments for services.

Chevron Deference Notice. The proposed regulations take the position that the rule-making is not a significant regulatory action and is not subject to the notice-and-comment requirements under 5 U.S.C. Section 553(b).  Comments were still requested on certain items.  In particular, the Treasury Department and the IRS request comments on, and examples of, whether arrangements could exist that should be treated as a distributive share under Section 704(b) despite the absence of significant entrepreneurial risk. In addition, the Treasury Department and the IRS request comments on sufficient notification requirements to effectively render a fee waiver binding upon the service provider and the partnership.

Application to Targeted Allocations. The Treasury Department and the IRS have become aware that some partnerships that assert reliance on  Treas. Reg. § 1.704-1(b)(2)(ii)(i) (the economic effect equivalence rule) have expressed uncertainty on the proper treatment of partners who receive an increased right to share in partnership property upon a partnership liquidation without respect to the partnership's net income. These partnerships typically set forth each partner's distribution rights upon a liquidation of the partnership and require the partnership to allocate net income annually in a manner that causes partners' capital accounts to match partnership distribution rights to the extent possible. Such agreements are commonly referred to as "targeted capital account agreements." Some taxpayers have expressed uncertainty whether a partnership with a targeted capital account agreement must allocate income or a guaranteed payment to a partner who has an increased right to partnership assets determined as if the partnership liquidated at the end of the year even in the event that the partnership recognizes no, or insufficient, net income. The Treasury Department and the IRS generally believe that existing rules under §§ 1.704-1(b)(2)(ii) and 1.707-1(c) address this circumstance by requiring partner capital accounts to reflect the partner's distribution rights as if the partnership liquidated at the end of the taxable year, but request comments on specific issues and examples with respect to which further guidance would be helpful. No inference is intended as to whether and when targeted capital account agreements could satisfy the economic effect equivalence rule.

Impact on Publicly Traded Partnerships of the Fee Waiver Provisions in the Proposed Regulations

Under Section 7704(a), a publicly traded partnership (“PTP”) is treated as a corporation. Section 7704(c)(1) provides, however, that Section 7704(a) does not apply in a tax year where the PTP meets the gross income requirements of Section 7704(c)(2). The gross income requirement is that 90% or more of the PTP’s gross income for such year constitute “qualifying income” as defined in Section 7704(d). Qualifying income includes interest, dividends, rents and gains from the sale of real property.

The proposed regulations change Example 2 to Treas. Reg. §1.707-1(c) in the guaranteed payment rules would adversely affect PTPs which receive preferred returns from lower-tier partnerships.  The problem would be that the payments may not be “qualifying income” for purposes of Section 7704(d). The proposed change to example 2 creates uncertainty regarding the guaranteed payments for the use of capital (“GPUCs”) rule. See also Section 7704(c)(2). Section 7704(d) does not specifically provide for the treatment of a guaranteed payment received by a partner for the use of the partner’s capital contributed to the partnership. If such payments are viewed as a substitute for rent or interest, it should constitute qualifying income (and not income for services).  

Example 2 in Treas. Reg. §1.701-1(c) provides:

“Partner C in the CD partnership is to receive 30% of partnership income as determined before taking into account any guaranteed payments, but not less than $10,000. The income of the partnership is $60,000, and C is entitled to $18,000 (30% of $60,000) as his distributive share. No part of this amount is a guaranteed payment. However, if the partnership had an income of $20,000 instead of $60,000, $6,000 (30% of $20,000) would be partner C's distributive share, and the remaining $4,000 payable to C would be a guaranteed payment.”

The distinguishing factor under the current regulations is that guaranteed payment treatment arise to the extent that the partner’s distributive share of partnership income is insufficient to meet the partner’s contractual right to the $10,000.

The Proposed Regulations revise Treas. Reg. §1.701-1(c)  as follows:

“Partner C in the CD partnership is to receive 30% of partnership income, but not less than $10,000. The income of the partnership is $60,000, and C is entitled to $18,000 (30% of $60,000). Of this amount, $10,000 is a guaranteed payment to C. The $10,000 guaranteed payment reduces the partnership's net income to $50,000 of which C receives $8,000 as C's distributive share.

The Proposed Regulations treat the minimum payment as a guaranteed payment regardless of whether the distributive share times the percentage interest exceeds the threshold.

In written comments made by the Master Limited Partnership Association submitted to the Treasury and IRS in April, it recommended the adoption of a rule that either -- (i) provides that the determination of whether a GPUC is qualifying income is made by treating the GPUC as a distributive share of the payor partnership's income, such that the GPUC is qualifying income to the extent the activities of the payor partnership generate qualifying income; or (ii) treats a GPUC as the equivalent of the type of income that it essentially "replaces" (i.e., as interest if it is paid with the respect to cash, rent if paid with respect to use of real property, etc.). See Rev. Proc. 2012-28, 2012-2 C.B. 4 (COD income and qualifying income; safe harbor where IRS won't challenge a determination by a PTP that COD income is qualifying under section 7704(d) as long as it's attributable to debt incurred in direct connection with activities of the PTP that generate qualifying income).

There is further concern in the PTP community that the proposed regulations could treat certain incentive distribution rights (“IDRs”) held by general partners as preferred return profits interests as possibly falling outside of qualifying income as well as not being a return on contributed property but instead as income for services. Consider also whether an IDR meets the requirements of a profits interests in accordance with Rev. Proc. 93-27, supra.  Another problem is the conversion of IDRs into common units, is such right a compensatory or non-compensatory option.

Cashless Contribution Arrangements

The proposed regulations state that an arrangement will be treated as a disguised payment for services where: (1) an individual, either in a partner capacity or in anticipation of being a partner, performs services to or for the benefit of the partnership; (2) there is a related allocation and distribution to the service provider; and (3) the performance of the 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.

As mentioned previously, under the proposed regulations whether an arrangement lacks significant entrepreneurial risk is based on the service provider's overall entrepreneurial risk relative to the overall entrepreneurial risk of the partnership.  Some believe that where a partner makes an economic contribution to a partnership in the form of services under a cashless contribution arrangement, the determination of the amounts allocable and distributable to that partner exposes the partner to a level of entrepreneurial risk commensurate with the economic risk of a partner who has made an actual  economic contribution to the partnership.  The issue is whether a cashless contribution lacks significant entrepreneurial risk. 

Back to Fee Waivers For Higher Allocations of Partnership Profits

The fee waiver has become a relatively common technique in an investment fund agreement which allows a private equity or venture capital manager to exchange a fixed amount of compensation, e.g., a 2% management fee based on total capital invested in the fund, for a greater share of venture profits but presumably by further agreeing to take on additional risk. It is employed with the added feature of a cashless contribution although in many funds managers are required to contribute some of their funds. Comments submitted to the Treasury and Service feel that the proposed regulations penalize cashless waivers based on the language that there must be a significant risk (of loss) as to both the amount and fact of payment. In other words, the argument is that the “entrepreneurial risk as to the amount distributable to the general partner under a cashless contribution arrangement is the same entrepreneurial risk as the amount distributable to a limited partner that has made cash capital contributions to the partnership. The adverse outcome sought to be avoided is that the cashless contribution will be treated as a disguised payment for services which raises not only characterization issues but timing issues as well.

It has been recently reported in Tax Notes that “at least a dozen and as many as 100 private equity firms, are under audit with respect to management fee waivers”.   The managers waiving their managerial fees for greater profits interests presumably are not reporting the conversion as taxable. Fund managers presumably argue that the priority carried interest qualifies as newly created profits interest in a partnership in exchange for services (for fees waived) and meets the safe harbor of Rev. Proc. 93-27, exempting it from immediate taxation by the IRS as ordinary income.  The best chance of prevailing on this position is where the right to receive payment of the fees has not accrued. The opposite position, one presumably that will be taken by the IRS and possibly reflected in a ruling or other guidance, is that the conversion is taxable as compensation income.

The Service presumably is looking at whether the fee waiver really does not present any additional economic risk to the fund managers.  Some partnership agreements allow managers to waive the fees and convert them into a priority share of the fund's profits. Under some aggressive structures, managers waive their fees in exchange for the first profits the firm accrues from a fund or in exchange for an allocation of gross income. Again, the Preamble to the proposed regulations announced that the IRS plans to add an exception to Rev. Proc. 93-27, supra, to provide that profits issued where a service partner waives a substantially fixed amount won’t automatically qualify for tax-free treatment and will be taxed as compensation. Moreover, if the entity waiving the fee is different from the entity receiving a separate or increased profits interest, the profits interest is outside of the safe-harbor. For a thoughtful review of this subject see Gregg d. Polsky, “Private Equity Management Fee Conversions”, TNT June 10, 2009.

So, we all have to be concerned, of course, of what the final regulations, which are expected to be issued in the near future, is going to treat fee waivers.

 

 


[1] §707(a)(2)(B) provides a similar rule with respect to transfers of money or other property by a partner to a partnership for which there is a related direct or indirect transfer of money or property by the property to such contributing partner or another partner and when viewed together such exchange is properly treated as a sale or exchange then the transaction will be characterized as a sale or exchange of property. 

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