United States

Disguised payments for services regulations may impact private equity deals

Private equity management fee waivers are under attack

TAX ALERT  | 

The IRS and Treasury have expressed concern over the past several years that taxpayers have been inappropriately disguising payments to service providers as allocations of partnership income. In an effort to address this concern, the IRS released proposed regulations under section 707(a)(2)(A) (REG-115452-14) on July 22, 2015, that are meant to more clearly define the factors to consider when evaluating whether such a payment is appropriately treated as an allocation of income or a payment for services. See our prior article, IRS issues proposed regulations on disguised payments for services , outlining those factors.

Although these proposed rules would have wide-ranging applicability, they are particularly relevant in the private equity world. Techniques such as fee waivers and priority allocations are common in private equity deals, making these proposals particularly noteworthy.

Background

In the private equity world, managers are often compensated with a fixed management fee based on a percentage of assets under management and a carried interest, which generally provides them with a fixed percentage of certain gains or profits of the fund, often only after achieving a minimum "hurdle" rate. The carried interest, of course, is risky. There may not be sufficient gains to generate any value for the carried interest. On the other hand, a carried interest has the potential to be much larger than a fixed fee and, in many cases, will be taxed to the manager as long-term capital gains.

In some cases, both the fixed fee and the carry are established at the beginning of a deal and not changed. In other cases, managers and funds may agree to modify their arrangements midstream through so-called "fee waivers." As the term implies, these typically involve a manager's agreement to waive all or a portion of an otherwise allocable fixed fee, which would be taxed as ordinary income, for an increased or modified interest in the fund's gains, which will often be taxed as long-term capital gains.

These transactions have attracted the attention of the IRS, which recently issued the proposed regulations referenced above, suggesting that such arrangements will be subject to increased scrutiny. Unfortunately, the guidance is far from clear, both in terms of what the regulations will ultimately provide when finalized and what the effective date will be. Thus, the main guidance we can provide is to be very careful in structuring, restructuring or utilizing fee waivers or similar transactions.

Proposed regulations

The proposed regulations are meant to more clearly identify arrangements, including fee waivers, that should be recast as resulting in disguised payments for services, which would generally be taxable as ordinary income. They do so by identifying six non-exclusive factors that may suggest that an arrangement constitutes a payment for services. As discussed in our above-referenced alert, the key factor relates to entrepreneurial risk. In simplified terms, arrangements where the service provider's allocation is near certain (relative to other partners) are more likely to be treated as disguised payments for services. Allocations that are uncertain or dependent upon the partnership's performance are more likely to be respected as allocations of partnership income.

Key themes

The proposed regulations provide several examples meant to help illustrate the appropriate application of these rules. Although the facts vary among these examples, there are several relevant themes for those in the private equity space.

  1. Be wary of a "sure thing"
    Agreements often are structured to maximize the likelihood that a service provider will receive its allocation. These structures are most at risk. For example, agreements that utilize allocations of gross income, as opposed to net income, to fund an allocation are more likely to be recast as disguised payments. For example, there must be real risk in the fee waiver scenario that a service provider might ultimately have been better off taking the fee as opposed to the additional carry.

  2. Clawbacks are helpful
    Sometimes an agreement will utilize net income (as opposed to gross income) to fund an allocation of income, but for a variety of reasons, it still may be near certain that income will be available to fund that allocation. For example, an agreement might provide for a priority allocation of net gain from the sale of any one or more assets during a 12-month period in which the partnership has overall net gain. Facts and circumstances might indicate in that situation that it is highly likely that gains will be available to fully fund that allocation. If, however, the agreement has a clawback provision, an allocation is less likely to be recast as a disguised payment for services. The clawback provision would allow the other partners to claw back a carry that was paid on a particular investment if subsequent investments incurs losses.

  3. Pay attention to the form
    Management companies that waive fees in favor of an additional carry for a related general partner should consider whether an alternative structure could work. The IRS has made it clear that it does not find this structure-where an entity other than the service provider is receiving the carry-consistent with the guidance in Rev. Proc. 93-27. The revenue procedure provides guidance on the treatment of the receipt of a partnership profits interest for services. It indicates that the IRS will not treat the receipt of a profits interest as a taxable event for the partner. However, the guidance does not apply if the partner disposes of the profits interest within two years. There is significant risk that the general partner's receipt of the additional carry could be treated as a transfer by the management company, which would cause the transaction to fall outside the protection of the revenue procedure.

  4. Certain structures are sanctioned
    Much of the discussion regarding the proposed regulations has focused on the deals that may be at risk. However, the regulations do outline in the examples several structures that work. In addition, there is other helpful guidance that should not be overlooked. For example, the regulations highlight that entrepreneurial risk is measured relative to the overall entrepreneurial risk of the partnership. Thus, a partner who receives a carry in a partnership that invests in high-quality debt instruments could still have entrepreneurial risk, as long as the partner's risk mirrors that of the other partners.

  5. These are proposed regulations but warrant attention now
    Although these proposed regulations are not effective until finalized, the IRS states in the preamble that it believes these rules generally reflect current law based on the legislative history and Congressional intent. This can be contrasted with the recently released proposed regulations that would impact the allocation of partnership debt (the section 752 proposed regulations). Because those proposals would clearly change existing guidance, they have limited relevance until they are published in final form. The disguised payments for services regulations, however, clearly provide taxpayers with a window to observe how the IRS will likely view these types of transactions, even before they finalize the regulations.

As highlighted previously, these proposals would impact existing guidance with respect to profits interests. In particular, the IRS has noted that it must modify Rev. Proc. 93-27 to reflect this guidance. It will be interesting to see how the IRS deals with issues such as timing of income recognition, valuation, etc., in situations where an arrangement is recast as a disguised payment for services. It will also be interesting to see whether the IRS issues this guidance in the near future or waits until after the proposed regulations are finalized. If the IRS waits, those in the private equity world will face significant uncertainty as they decide how to deal with these proposed regulations, particularly given the IRS's assertion that the regulations reflect current law.

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