By Lauren Mack
On July 22, 2015, the IRS issued a notice of proposed rulemaking regarding the classification of management fee waivers in exchange for partnership interests as disguised payment for services. Under the proposed regulations, allocations of income to partners that provide services to the partnership that lack “significant entrepreneurial risk” will be recharacterized by the IRS as payments for services.
In 1984, section 707(a)(2)(A) was added to the Internal Revenue Code (the “Code”), which authorized the Secretary of the Treasury to prescribe regulations that would cause certain partnership allocations and distributions related to transfers of property and performance of services between partners and partnerships to be disregarded and instead treated as “disguised sales” and “disguised payments for services”. Treasury Regulations providing rules applicable to “disguised sales” were implemented in 1992. Since no regulations on “disguised payments for services” had been proposed until this year, some partnerships have taken the stance that arrangements between the partnership and a service-providing partner that provide for substantially fixed allocations of income and distributions, capped allocations of such income and distributions, and a non-binding waiver of fees in exchange for the partnership allocations and distributions cannot be disregarded under the Code.
For example, the limited partnership agreement for an investment fund may allow the manager to waive all or a portion of its management fee in exchange for an increased profit interest in the partnership. The income received by the manger from its profit interest in the partnership, if any, would be considered capital gains, which are taxed at a lower rate (long term capital gains) than income from providing service, and may allow for the possible deferment of some of the income to future years. The risk to the manager is that the partnership might incur losses, and the manager may never earn the value of the waived management fees. Many such management fee waivers are therefore designed to reduce this risk.
If finalized, the proposed regulations would finally implement the disregarding of disguised payments for services provisions under the Code.
The Proposed Regulations
The Proposed Regulations provide several factors to be taken into account when determining whether or not an arrangement related to services provided by a partner or in anticipation of becoming a partner is a disguised payment for services. When making this determination, all the facts and circumstances at the time that the parties enter into, or amend, the arrangement should be considered. The following is a non-exclusive list of factors to determine if an arrangement is a disguised payment for services:
- There is no significant entrepreneurial risk to the service provider, as determined relative to the overall entrepreneurial risk of the partnership;
- The partner status of the service provider is, or is expected to be, transitory;
- The allocation and distribution that are made to the partner are close in time to the partner’s performance of services;
- The facts and circumstances indicate that the service provider became a partner primarily to obtain tax benefits for itself or the partnership that would not otherwise have been available;
- The value of the service provider’s interest in general and continuing partnership profits is small in relation to the allocation and distribution; and
- The arrangement provides for different allocations or distributions with respect to different services received, the services are provided either by one 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.
The most persuasive factor is whether there is significant entrepreneurial risk in the arrangement. The Proposed Regulations go on to provide examples in which there is a high likelihood that an arrangement with a service provider lacks significant entrepreneurial risk:
- Capped allocations of partnership income if the cap would reasonably be expected to apply in most years;
- Allocations for a fixed number of years under which the service provider’s distributive share of income is reasonably certain;
- Allocations of gross income items;
- 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
- 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.
Clear and convincing evidence would be required to rebut the presumption of a lack of significant entrepreneurial risk created by the presence of any of the above facts and circumstances.
If enacted, the Proposed Regulations would apply to all arrangements entered into or modified after the final regulations are promulgated. For arrangements entered into or modified before the promulgation of final regulations, the determination of whether they are a disguised payment for services will be made based on the statute and the guidance provided in the legislative history, implying that the IRS may challenge arrangements based on the statute itself, even without implementation of the Proposed Regulations.
Fund managers and general partners should therefore review their management fee arrangements and consider the potential impact of the Proposed Regulations. However, they should also be aware that the decision to modify a partnership’s agreements to fall within the framework of the Proposed Regulations could come with a significant tax impact.