Fund managers must exercise care in applying proposed fee waiver regulations
This article from the Journal of Passthrough Entities explains recently proposed IRS regulations intended to limit the extent to which partnerships may compensate service providers, including fund managers, with an allocation of specified amounts of future partnership income. The government’s main concern is that certain allocations may involve income items – such as a share of the partnership’s future capital gains or qualified dividends – that will be taxed more favorably in the hands of the service provider than an outright fee or salary payment. In the government’s view, where there is limited entrepreneurial risk to the service provider from accepting such an income allocation in lieu of an outright fee or salary, such amounts should be recast as disguised fees or salaries. That would cause the amounts to be taxed as ordinary income. In addition, certain tax deferral benefits could be lost, inasmuch as the value of the promised future allocation would be taxable when it was agreed to, even if the income to be allocated had not yet arisen.
The most important issue in determining whether a purported income allocation will be respected, or recast as a disguised transfer of property in exchange for services, is whether the service-provider’s right to the allocation is subject to significant entrepreneurial risk. For example, a right to be allocated 20 percent of the firm’s net profits over the expected ten year life of an investment fund with $100 million under management would typically entail significant entrepreneurial risk. It might be worth nothing, and in theory there is no limit on how much it could be worth. In contrast, there might not be significant entrepreneurial risk if the manager of a similar fund were allocated the next $100,000 of capital gains realized in any twelve-month period, inasmuch as it was highly likely that a fund with $100 million under management would experience at least one twelve-month period in which it generated at least $100,000 of capital gains.
This article explains the new proposed regulations, which will generally apply only after they are issued in final form, and other tools the IRS may be expected to apply with immediate or retroactive effect against purported allocations that lack significant entrepreneurial risk.