In July of 2015 the IRS released proposed regulations that address disguised payments for services in the partnership context. The regulations are designed in part to address so-called management fee waivers – a private equity fund manager waives its right to receive a fixed management fee in exchange for additional profits interest. Indeed, the proposed regulations come at a time when the IRS appears to have increased audit activity of private equity firms with a particular focus on management fee waivers. The proposed regulations will not be effective until adopted in final form, but the IRS believes they generally reflect current law. As discussed here, the proposed regulations and the IRS’s enhanced scrutiny may have a significant impact on the feasibility of traditional management fee waivers.
Management fee waivers are pervasive in the private equity industry. In most cases, fee waivers are used to satisfy a portion of the manager’s capital commitment – the manager simply reduces its unfunded capital commitment by the amount of the waived fee (a “cashless contribution”). In exchange for the waived fee, the manager receives a special priority allocation of net profits (the “priority allocation”), generally taxed at long-term capital gains rates. The priority allocation increases the manager’s capital account (and entitles the manager to distributions) in the same amount as if the manager had simply made all cash contributions from the outset. Some management fee waivers are “hardwired,” meaning a prospective fee waiver is made up front when the fund is initially formed, while others are “elective,” meaning the general partner may periodically elect to waive a certain percentage of the management fee.
So long as the additional profits interest received in lieu of the waived fee is subject to real entrepreneurial risk (i.e., receipt of the additional profits interest is subject to the overall profitability of the fund), the general perception has been they would be respected by the IRS. However, recent publicity has focused on potentially abusive management fee waivers that virtually guarantee the manager will earn the priority allocation and receive the corresponding distribution. Some elective fee waivers have been made after the start of the year when it is highly likely the fund will have net income for the year that will support the priority allocation. In some cases allocations of gross income are made so that the manager will receive the priority allocation even if the partnership has an overall net loss, and in other cases the priority allocation is earned based on the fund’s profitability in any single quarter or year, notwithstanding the fund’s overall profitability.
When subject to real entrepreneurial risk, and in particular under hardwired fee waivers, the fee waiver and priority allocation have been generally considered a valid non-taxable issuance of profits interest under Rev. Proc. 93-27 (the “93-27 safe harbor”). Under that revenue procedure, the grant of a true profits interest is a non-taxable event so long as the profits interest does not provide a substantially certain and predictable stream of income and the recipient does not transfer the interest within two years after the date of grant.
The proposed regulations appear to embrace the “significant entrepreneurial risk” concept, but may nonetheless take traditional fee waivers out of the scope of the 93-27 safe harbor and characterize many such arrangements as disguised payments for services, taxed at ordinary income tax rates. Under the proposed regulations, such an arrangement may be characterized as a disguised payment for services depending on all the facts and circumstances. The proposed regulations set forth six non-exclusive factors that may indicate a fee waiver constitutes a disguised payment. The most important factor is whether the priority allocation is subject to significant entrepreneurial risk in relation to the overall risk of the partnership. Other factors include whether allocations are made of gross income, whether the waivers are non-binding to the manager, and whether the allocations essentially provide a reasonably certain income to the manager.
The “significant entrepreneurial risk” test, however, should provide lackluster assurance to managers utilizing traditional fee waivers for the following two reasons. In the preamble to the proposed regulations, the IRS states the 93-27 safe harbor does not apply if the priority allocation is issued to a person related to the manager rather than to the manager itself. Management of a private equity fund is often bifurcated between the management company, which employs the investment professionals and receives the management fee, and a general partner shell entity that receives the traditional carried interest and priority allocation. Thus, the management fee is waived by the management company, while the priority allocation is received by the general partner. The IRS views such an arrangement as failing the safe harbor because, in substance, the manager is transferring the priority allocation to the general partner immediately after its receipt, which violates the safe harbor requirement that the recipient not dispose of the interest within two years.
Second, the IRS states in the preamble it intends to create an additional exception to the 93-27 safe harbor such that it does not apply to a profits interest issued in conjunction with a partner’s foregoing payment for the performance of services of an amount that is substantially fixed. Thus, even if a profits interest issued pursuant to a management fee waiver avoids recharacterization as a disguised payment for services (e.g., because it is subject to the fund’s overall profitability and therefore entails significant entrepreneurial risk), the IRS may apparently seek to tax the receipt of the interest at its fair market value on the grant date.
The IRS will no doubt receive significant comments about the proposed regulations. It is not possible to know the final form of the regulations. The proposed regulations will not be effective until finalized. Nevertheless, at a minimum all fee waiver arrangements should (i) involve allocations of net income rather than gross income, (ii) require a binding election well before the beginning of the applicable year (such as sixty-days’ prior notice), (iii) require that notice of the waiver be given to the investors, and (iv) involve significant risk based on the fund’s overall profitability.
To summarize, an arrangement that provides an allocation to the manager only if the partnership has overall net income for the life of the fund may involve significant entrepreneurial risk. However, it is important to note the IRS may nonetheless take the position that even if such an interest involves significant risk, the manager or general partner will be taxable on the value of the interest upon receipt, and the safe harbor for profits interests will not apply, in situations where the manager provided the services and waived the fee, but the priority allocation was received by the general partner. Even if the management fee and priority allocation are received by the same entity, the IRS may nonetheless utilize a potential new exception to the safe harbor that will exclude a profits interest issued in conjunction with a partner’s foregoing payment for the performance of services of an amount that is substantially fixed.
Kader Crawford is a transactional attorney at Robinson Bradshaw whose primary focus includes fund formation and private investment transactions, alternative investments, joint ventures and various lending transactions.