IRS issues proposed regulations on disguised payments for services
TAX ALERT |
The proliferation of management fee waivers, in exchange for carried interests, has been a topic of legislative and administrative interest in recent years. Some have argued that these arrangements were being improperly structured to convert payments for services that would otherwise be taxed currently at ordinary rates into income items that are taxed at a later date and afforded capital gains tax treatment. In an attempt to limit perceived abuses, the IRS has issued proposed regulations related to disguised payments for services by a partnership.
The proposed regulations clearly target management fee waivers using a variety of means. However, these regulations, if enacted, will also impact many other transactions of taxpayers who are structured as partnerships. At their core, the regulations provide that if specific criteria are not met, certain income items may be deemed to be a payment for services to a nonpartner and not an allocation of partnership profits.
The criteria used for determining the existence of a disguised payment for services relies heavily on the theory of entrepreneurial risk. These regulations provide a rebuttable presumption that if significant entrepreneurial risk does not exist, the underlying allocation will be deemed to be a disguised payment for services.
In defining substantial economic risk (and the lack thereof) the service specifically targets agreements that provide for:
- Capped allocations of income
- Allocations of gross (and not net) income
- Allocations of net income that are derived from specific transactions or accounting periods and are not based upon the lifetime earnings of the entity
- Arrangements in which a service provider waives its right to receive payment for the future performance of services in a non-binding manner
In addition, the regulations provide for additional factors that may be considered to support or rebut the existence of a disguised payment, but these factors are not given the same weight as the existence of substantial economic risk.
If adopted as final regulations, these proposed rules will have a broad impact on many partnerships and their operations. While the unstated target was management fee waivers used in a specific industry, any partnership that receives services from its partners may be impacted. The imposition of these new rules raises a multitude of issues, including but not limited to the ability of a partner to act as an employee, the taxation of carried and preferred interests and the proper treatment of partnership profits interests.
These regulations are only proposed and will not be effective until the date in which they are made final.