Is There a Future for Management Fee Waivers?
August 17, 2020
For a number of years, the IRS has indicated that it was examining so-called “management fee waiver” strategies. Now it has finally spoken. On July 22, 2015, the IRS issued proposed regulations which, if finalized in substantially their current form (together with a revenue procedure to be released in conjunction with final regulations, discussed below), could force private equity and hedge funds to re-evaluate how they are structured for carry and fee waiver purposes. The proposed regulations would be effective on the date final regulations are published in the Federal Register and would apply to any arrangement entered into or modified on or after the date of publication.
So, what are management fee waivers and why has the IRS shown such concern? Typically, a management fee waiver is part of a fund structure whereby the general partner of a private equity or hedge fund, or a related management company, “waives” the management fee (say 2% of assets or committed capital per annum), typically paid quarterly and taxed as ordinary income for federal income tax purposes. In lieu of that fee, the general partner receives an increased share of profits to qualify as a “profits interest” under an existing IRS revenue procedure, Revenue Procedure 93-27. That allows the general partner and/or management company to potentially take advantage of a deferral of income and the preferential capital gains tax rate.
In Revenue Procedure 93-27, the IRS takes the position that the receipt of a partnership profits interest for services is not a taxable eventso long as the person receives that interest either as a partner or in anticipation of becoming one. However, that tax treatment does not apply if: (i) the profits interest relates to a substantially certain and predictable stream of income from partnership assets; (ii) the partner disposes of the profits interest within two years of receipt; or (iii) the profits interest is a limited partnership interest in a publicly traded partnership.
In the preamble to the proposed regulations, the IRS highlights 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 provides services to a fund in exchange for a fee that it may waive, and a party (usually the general partner entity) related to the management company receives an interest in future partnership profits the value of which approximates the amount of the waived fee. According to the preamble, the IRS and Treasury take the position that Revenue Procedure 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 entity) within two years of receipt.
The proposed regulations provide that an arrangement will be treated as a disguised payment for services, and therefore compensation, and not as the right to receive a distribution of partnership income, if: (i) a person (service provider), either in a partner capacity or in anticipation of being a partner, performs services (directly or indirectly through its delegate) to or for the benefit of the partnership; (ii) there is a related direct or indirect allocation and distribution to the service provider; and (iii) 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. An arrangement that is treated as a disguised payment for services under the proposed regulations would be treated as a payment for services for all purposes of the Internal Revenue Code, including the provisions addressing what is gross income and the tax treatment of nonqualified deferred compensation arrangements.
Whether an arrangement constitutes payment for services (in whole or in part) depends on all of the facts and circumstances. The proposed regulations include six non-exclusive factors that may indicate that the arrangement constitutes a disguised payment for services. One, the existence of “significant entrepreneurial risk,” is given more weight than the others. Under the proposed regulations, an arrangement that lacks significant entrepreneurial risk constitutes a disguised payment for services. Certain facts and circumstances are presumed to result in the absence of significant entrepreneurial risk (and therefore a disguised payment for services): (i) a capped allocation of partnership income if the cap would reasonably be expected to apply in most years; (ii) an allocation for a fixed number of years under which the service provider’s distributive share of income is reasonably certain; (iii) an allocation of gross income items; (iv) an allocation (under a formula or otherwise) that is predominantly fixed in amount, is reasonably determinable under all 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) an arrangement 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 notify the partnership and its partners of the waiver and its terms.
Other factors included in the proposed regulations which indicate that the arrangement should be treated as a payment for services include: (i) the service provider holds an interest for a short duration; (ii) 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) the service provider becomes 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; (iv) the value of the service provider’s interest in general and continuing partnership profits is small in relation to the allocation and distribution; and (v) the arrangement provides for different allocations or distributions with respect to different services received, the services are provided either by one person or by certain related parties, and the terms of the differing allocations or distributions are subject to levels of entrepreneurial risk that vary significantly.
The proposed regulations provide a number of examples that address the difference between an arrangement that is treated as a disguised payment for services and an interest in a partnership that is treated as the right to future allocations of income and gain. These examples demonstrate, in part, that where an allocation of income is reasonably determinable and it is highly likely that profits will be available to allocate to the service provider, the arrangement will lack significant entrepreneurial risk and therefore will generally be viewed as a disguised payment for services. Further, a management fee waiver is likely to be respected when: (i) the management fee waiver is irrevocable and made in advance of the time the fees would be earned; (ii) allocations and distributions in respect of the waiver “profits” interest are made out of cumulative net income and gain over the life of the partnership; (iii) the partner receiving allocations and distributions in respect of the waiver interest undertakes an enforceable obligation (“clawback obligation”) to repay amounts not supported by allocations of cumulative net income and it is reasonable to anticipate that the partner can and will comply fully with this clawback obligation; and (iv) the allocations are neither reasonably determinable nor highly likely to be available.
Also, in the case of private equity funds not subject to a clawback obligation and hedge funds that invest in illiquid securities: Say, for example, the general partner controls the valuation of assets that are difficult to value as well as the timing of asset dispositions (and therefore the timing of recognition of gains and losses). A related management company, in addition to holding an interest in the partnership’s capital and profits, is entitled to a priority allocation and distribution of net gain from the sale of any one or more assets during any 12-month accounting period in which the partnership has overall net gain in an amount intended to approximate the fee that would normally be charged for the services performed by the management company. Based on the examples in the proposed regulations, this arrangement would result in a disguised payment for services unless other facts and circumstances establish otherwise by clear and convincing evidence.
As noted, the proposed regulations would be effective on the date final regulations are published in the Federal Register and would apply to any arrangement entered into or modified on or after the date of publication. Importantly, in conjunction with the issuance of final regulations, the IRS and Treasury have indicated their intention to issue a revenue procedure which would apply an additional exception to the “no taxable event” safe harbor of Revenue Procedure 93-27. Namely, the exception would 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. Without the benefit of the safe harbor, the recipient of a profits interest in connection with a management fee waiver could potentially be viewed by the IRS as receiving taxable compensation income at the time the profits interest is granted or when it subsequently vests, even if there is no disguised payment for services under the proposed regulations.
If you utilize management fee waivers currently or are considering their use in current or future fund ventures, please do not hesitate to contact your tax advisor to discuss the implications of these proposed regulations and related IRS actions.