United States

Revised safe harbor may not apply to many valid fee waivers


As noted in our July 22, 2015, article, IRS issues proposed regulations on disguised payments for services, the Treasury and the IRS issued proposed regulations to address transactions commonly known as ‘fee waivers.’ The preamble to these proposed regulations also announced the government’s intention to revise the current profits interests safe harbor rule, found in Rev. Proc. 93-27, which allows certain profits interests issued in exchange for the provision of services to be assigned a zero value at issuance if they are deemed to have no liquidation value. The full text of the proposed regulations and the preamble are available here.

Because the proposed regulations made it clear that some fee waiver arrangements were viewed as valid issuances of profits interests, while others were viewed as invalid and recharacterized as disguised payments for services, some observers thought that any corresponding revisions to the existing safe harbor rule would be limited to invalid fee waivers under the proposed regulations, and that the current safe harbor treatment would still be available for fee waivers described in the proposed regulations as valid.

New information strongly suggests that is not necessarily the case. The current intention of the government may be to deny the protection of the revised safe harbor to any arrangement in which an existing contractual right, to receive a fixed amount for services to be performed in the future, is waived in exchange for a profits interest, even if such a waiver is valid under the proposed or final regulations.

If the IRS follows this approach, even if the fee waiver satisfies all of the requirements of the proposed regulations, such as being made by the actual recipient of the profits interest, being irrevocable, being made with sufficient advance notice, and having entrepreneurial risk, any such fee waiver made after the issuance of the revised revenue procedure may not qualify for the automatic zero valuation. That would be true, if the government pursues this approach, even if the profits interest received satisfies all of the current requirements of the safe harbor, such as not being made in exchange for an interest in a determinable revenue stream and not being disposed of within two years.

Without the protection of the safe harbor, valuation would be an issue of fact. However, the IRS may argue that the value of the profits interest is likely very close to the value of the fee given up in exchange.

It is unclear whether the IRS will draw a distinction, in the revised safe harbor, for ‘hard-wire’ arrangements. In such a case, taxpayers may argue and the IRS may agree that there is no actual waiver of a fee to which the service provider is entitled, if future services are performed. An example of such a hard-wired arrangement might be the establishment of a new fund arrangement that involves an agreement of the managers to accept a fixed fee that is below-market for the industry, and even below the manager’s normal practice, in exchange for an additional participation in the potential profits of the fund. However, it is possible that the IRS will deny the availability of the revised safe harbor even for such a transaction.

Finally, taxpayers should also be aware that it now appears that the IRS position may be that, even if a transaction is not subject to the revised safe harbor or the proposed or final regulations, because it occurs before the effective date of those provisions, such a transaction would still be subject to very similar requirements pursuant to the legislative history of the Deficit Reduction Act of 1984. That act was the statute that authorized the regulations that were proposed, for the first time, in 2015. The IRS may take the position that the guidance in that legislative history, indicating what Congress expected the future regulations to provide, is ‘self-effectuating’ all the way back to 1984. If the IRS is successful in taking and sustaining that position, it would make the requirement of entrepreneurial risk applicable to fee waivers in which services were performed at any time after Feb. 29, 1984.


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