Proposed Regulations Require Significant Entrepreneurial Risk for a Service Partner’s Income to be a Distributive Share
On July 22, 2015, the U.S. Department of the Treasury and the Internal Revenue Service (IRS) released proposed regulations under Section 707(a)(2)(A) (the proposed regulations) which would treat certain partnership distributions as disguised payments for services taxable as ordinary income. Section 707(a)(2)(A), which was added to the Internal Revenue Code (the Code) as part of the Tax Reform Act of 1984 (the 1984 Act), grants the Treasury Department authority to issue regulations identifying the circumstances under which an allocation and corresponding distribution will be treated as a disguised payment for services. The Treasury’s priority guidance plan in the past had indicated that guidance would be forthcoming under Section 707(a)(2)(A) specifically targeted at profits interests granted under management fee waiver programs. As described below, the proposed regulations go well beyond the taxation of management fee waivers.
Management fee waivers. Under a typical management fee waiver program, a general partner (or a related investment manager) of a private equity fund (fund) agrees to forego a portion of the management fee payable by the fund which would be taxed as ordinary income. The election to waive management fees is made either at the outset of the fund, or periodically during the life of the fund. In lieu of the management fee, the general partner (or a related party) receives a special interest in partnership profits (waived fee interest) that the parties treat as a “profits interest” not taxable upon receipt under Rev. Proc. 93-27. The limited partners of the fund are still required to make the capital contribution that would have been used by the fund to pay the waived management fee. Such capital contribution is often applied against the general partner’s capital commitment to the fund. The waived fee interest generally entitles the holder to a priority allocation of profits from the fund in respect of the waived amount, but only to the extent such profits are derived from appreciation in partnership property accruing after the waiver. This income will often be long-term capital gain. The fund will in turn distribute this allocable amount to the holder of the waived fee interest.
Proposed regulations—in general. The proposed regulations provide detailed rules for determining whether or not an arrangement with a service provider (i.e., an allocation and corresponding distribution of partnership profits to the service provider) is treated as a disguised payment for services under Section 707(a)(2)(A). The arrangement is tested as of the time it is entered into or modified, regardless of when the income is allocated and when money or property is distributed. If an arrangement is re-characterized as a disguised payment for services under the proposed regulations, it is treated as a payment for services for all purposes of the Code. Accordingly, the timing, character and deductibility of the disguised payment will be determined under Code provisions that apply to actual payments for services. The proposed regulations specifically reference the potential application of Sections 409A and 457A to the disguised payment.
Facts and circumstances analysis. In general, whether an arrangement constitutes a disguised payment for services (in whole or in part) depends on all of the facts and circumstances. The proposed regulations set forth six non-exclusive factors that may indicate that an arrangement constitutes a disguised payment for services. The factor that is accorded the most weight (and the factor given most emphasis in the 1984 legislative history to Section 707(a)(2)(A)) is whether the interest is subject to significant entrepreneurial risk (SER) in relation to the overall entrepreneurial risk of the partnership. According to the preamble to the proposed regulations (the preamble), an arrangement in which allocations and distributions to the service provider are subject to SER will generally be recognized as a distributive share of partnership income. The proposed regulations identify five facts and circumstances—the presence of which create a presumption that an interest lacks SER:
Capped allocations of partnership income if the cap is reasonably expected to apply in most years
An allocation for one or more years under which the service provider’s share of income is reasonably certain
An allocation of gross income
An allocation under a formula or otherwise that is predominately fixed in amount, is reasonably determinable, or is designed to assure that sufficient net profits are highly likely to be available to make the allocation to the service provider, such as an allocation from specific transactions or accounting periods that are not dependent on the long-term success of the enterprise
An arrangement in which the service provider 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 on a timely basis
An arrangement with one or more of these features is treated as lacking SER and thus will be treated as resulting in a disguised payment for services. This is unless other factors demonstrate that the interest possesses SER by clear and convincing evidence.
The proposed regulations identify the following five factors as having secondary importance in determining whether an arrangement is a disguised payment for services: (1) the service provider holds, or is expected to hold, a transitory partnership interest; (2) 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; (3) the service provider became 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; (4) the value of the service provider’s interest in general and continuing partnership profits is small in relation to the allocation and distribution; and (5) the arrangement provides for different allocations or distributions with respect to different services received; the services are provided by one person or related persons; and the terms of the differing allocations or distributions are subject to significantly varying levels of entrepreneurial risk.
The first four of these factors were also drawn from the 1984 Act legislative history. The last factor is new and is aimed at management fee waivers. This factor would appear to apply to an arrangement in which a general partner’s carried interest is subject to a clawback obligation based on overall partnership profits, while a related manager’s waived fee interest is not subject to a clawback. The weight accorded to each of these secondary factors depends on the facts of the particular case, and the absence of any one of these factors is not necessarily determinative of whether an arrangement is a disguised payment for services.
The proposed regulations include six examples illustrating the application of the multi-factor test for distinguishing a distributive share of partnership income from a disguised payment for services. Examples five and six address management fee waivers in a fund context and describe scenarios in which the waived fee interest is subject to sufficient SER in order to avoid re-characterization as a disguised payment. Notably, in both of these examples, the service provider undertook clawback obligations and was reasonably expected to be able to comply with that obligation.
Future narrowing of profits interest safe harbor. The preamble to the proposed regulations states that when the proposed regulations are issued in final form, the IRS intends to issue a revenue procedure that would create an additional exception to the profits interest safe harbor in Rev. Proc. 93-27. Under Rev. Proc. 93-27, the IRS will not treat receipt of a profits interest issued in exchange for service rendered to, or for, the benefit of the partnership as generating current taxable income. Rev. Proc. 93-27 sets forth certain exceptions in which the safe harbor will not apply. The preamble states that future guidance will exclude from the scope of the safe harbor a profits interest issued in conjunction with a partner foregoing 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. Thus, it appears that even if a profits interest issued pursuant to a management fee waiver avoids re-characterization as a disguised payment for services, the IRS would seek to tax the receipt of the interest at its fair-market value on the grant date.
Effective date. The proposed regulations are proposed to be effective on the date final regulations are published in the Federal Register. Final regulations will not apply to any arrangement entered into or modified prior to the date final regulations are published. For this purpose, if an arrangement entered into prior to the effective date allows a subsequent fee waiver, the arrangement will be treated as modified on the date or dates that the fee is waived and, thus, the interest issued in respect of the waived fee will be subject to the regulations. In addition, the preamble states that the Treasury and the IRS intend to apply the general principles of the proposed regulations in evaluating whether an interest granted to a service provider is a disguised payment for services. Thus, existing fee waiver arrangements may be subject to increased audit scrutiny on the question of whether a profits interest issued thereunder has sufficient SER.
According to the preamble, the Treasury and the IRS have determined that the Rev. Proc. 93-27 safe harbor would not apply to a waived fee interest issued to a person related to the investment manager (the service provider) rather than to the investment manager itself. The IRS would view such as an interest as failing the safe harbor for one or both of the following reasons: (i) it fails to meet the safe harbor requirement that the interest be issued to a person for the provision of services to the partnership in a partner capacity or anticipation of becoming a partner; or (ii) if the service provider is deemed to have received the waived fee interest and constructively transferred it to the related holder, the interest fails the requirement that service provider not dispose of the interest within two years after the grant date.
The preamble states that some taxpayers have expressed uncertainty whether a partnership that uses a targeted capital account approach 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. Treasury invites comments on whether further guidance on this situation would be helpful. The preamble states that no inference is intended as to whether and when a target capital account approach can satisfy the economic effect equivalence rule under the section 704 regulations.
The proposed regulations would change the result in example two of Treasury Regulation 1.707-1(c). Under this example, if a partner is entitled to an allocation of the greater of 30 percent of partnership income or a minimum guaranteed amount, and the income allocation exceeds the minimum guaranteed amount, then the entire income allocation is treated as a distributive share under Section 704(b). Example two also 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 Treasury views the arrangements in this example as inconsistent with the concept that an allocation must be subject to SER to be treated as a distributive share under Section 704(b). Accordingly, the proposed regulations modify example two to provide that the entire minimum amount is treated as a guaranteed payment under Section 707(c), and therefore ordinary income to the recipient, regardless of the amount of the income allocation.