United States: Proposed Regulations Issued On Management Fee Waivers

On July 22, 2015, the U.S. Department of the Treasury and U.S. Internal Revenue Service issued proposed Treasury Regulations under Section 707(a)(2)(A) of the Internal Revenue Code of 1986, as amended, addressing management fee waiver arrangements.[1]Under the Proposed Regulations, certain management fee waiver arrangements will be treated as disguised payments for services for U.S. federal income tax purposes, resulting in ordinary income treatment (and possibly significant penalties under deferred compensation rules). The Proposed Regulations also cover additional matters that are beyond the scope of this client alert.     

While the Proposed Regulations are not technically effective unless and until the date final regulations are published, the Treasury Department and IRS believe that the Proposed Regulations generally reflect current law. In other words, the government's position is that the core principles outlined in the Proposed Regulations apply under current law.[2]

Management Fee Waiver Arrangements

In a typical management fee waiver arrangement, the general partner of a private investment fund (owned by the fund managers) is permitted to satisfy all or a portion of its capital commitment to the fund with "deemed" capital contributions, and the fund managers similarly are deemed to satisfy all or a portion of their capital contribution obligations to the general partner. In connection with the deemed contribution, there is a reduction in the management fee payable by the fund (where the fee is payable either to the general partner or to a management company owned by one or more of the owners of the general partner of the fund).  

The general partner is entitled to a priority allocation of subsequent net profits of the fund, if and when they occur, equal to the amount of its deemed capital contributions to the fund. If such priority profit allocation includes net long-term capital gain or qualified dividend income, the fund's general partner (and its partners) would be subject to tax at the lower U.S. federal capital gains tax rate as compared to the higher ordinary income tax rate that otherwise would have applied to the waived management fee. The priority allocation may also result in deferral of the tax that would have been due if management fees had not been waived. 

Analysis of Management Fee Waiver Arrangements Under Proposed Regulations

The Proposed Regulations provide that whether an arrangement between a partner and a partnership constitutes a payment for services depends on all of the facts and circumstances, and identifies six non-exclusive factors to consider. The most important factor is the entrepreneurial risk of the arrangement -- an arrangement that lacks significant entrepreneurial risk is treated as a payment for services without regard to any other factor.[3] The five other factors identified by the Proposed Regulations that are indicative of a disguised payment for services:

  1. the service provider holds, or is expected to hold, a transitory partnership interest or a partnership interest for only a short duration;
  2. the service provider receives an allocation and distribution in a time frame comparable to the time frame that a non-partner service provider would typically receive payment;
  3. the service provider became a partner primarily to obtain tax benefits that would not have been available if the services were rendered to the partnership in a third party capacity;
  4. the value of the service provider's interest in general and continuing partnership profits is small in relation to the allocation and distribution; and
  5. the arrangement provides for different allocations or distributions with respect to different services received, the services are provided either by one person or by persons that are related under Sections 707(b) or 267(b) of the Internal Revenue Code, and the terms of the differing allocations or distributions are subject to levels of entrepreneurial risk that vary significantly.[4]

Significant Entrepreneurial Risk

As noted above, the Proposed Regulations treat a management fee waiver arrangement that lacks significant entrepreneurial risk as a payment for services. An arrangement that has significant entrepreneurial risk generally will not constitute a payment for services, unless other factors establish otherwise. Whether an arrangement lacks significant entrepreneurial risk is based on the service provider's entrepreneurial risk relative to the overall entrepreneurial risk of the fund. [5]

Under the Proposed Regulations, each of the following facts and circumstances creates a presumption that an arrangement lacks significant entrepreneurial risk and will be treated as a disguised payment for services unless other facts and circumstances establish the presence of significant entrepreneurial risk by clear and convincing evidence: 

  1.    capped allocations of partnership income if the cap is reasonably expected to apply in most years;
  2.   an allocation for one or more years under which the service provider's share of income is reasonably certain;
  3.  an allocation of gross income;
  4.  an allocation (under a formula or otherwise) that is predominantly fixed in amount, is reasonably determinable under all the facts and circumstances, or is designed to assure that sufficient net profits are highly likely to be available to make the allocation to the service provider (e.g., if the partnership agreement provides for an allocation of net profits from specific transactions or accounting periods and this allocation does not depend on the long-term future success of the enterprise); or
  5. an arrangement in which a service provider waives its right to receive payment for the future performance of services in a manner that is non-binding or fails to timely notify the partnership and its partners of the waiver and its terms.[6]

Examples in Proposed Regulations

The Proposed Regulations include examples of management fee waiver arrangements that presumptively lack significant entrepreneurial risk and those that do have significant entrepreneurial risk.

A management fee waiver arrangement was determined to presumptively lack significant entrepreneurial risk where the priority allocation in respect of the management fee waiver arrangement was an allocation of net profit from any 12-month accounting period in which the partnership had net gain (as a result, the allocation did not depend on the overall success of the enterprise). In this example, the sale of assets by the partnership (and hence the timing of recognition of gains and losses) was controlled by the general partner of the partnership, a company related to the service provider receiving the priority allocation of profit in respect of the management fee waiver arrangement.[7]

By contrast, a management fee waiver arrangement was determined to have significant entrepreneurial risk where the interest consisted of future partnership net income and gains, the allocation was subject to a clawback obligation to the extent that, over the life of the fund, the share of future partnership net income and gain was in excess of the fund's net profit, it was reasonably anticipated that the clawback obligation could and would be complied with, and the allocation was neither reasonably determinable nor highly likely to be available. There were no additional facts and circumstances suggesting that the arrangement was properly characterized as a payment for services.[8]

Certain Transactions Not Within IRS Revenue Procedure 93-27

The receipt of a "profits interest" that is covered by IRS Revenue Procedure 93-27 is not a taxable event.  The preamble to the Proposed Regulations includes a statement that the Treasury Department and IRS have determined certain transactions in which one party provides services and another party receives an associated allocation and distribution of partnership income or gain are not treated as the grant of a "profits interest" that satisfies the requirements of IRS Revenue Procedure 93-27.[9] For example, the IRS Revenue Procedure would not apply where a management company that provides services to a fund in exchange for a fee waives that fee, and a party related to the management company receives an interest in future partnership profits the value of which approximates the amount of the waived fee.[10] This determination by the Treasury Department and IRS leaves open the possibility of challenging the valuation and taxation of the receipt of such a partnership interest.

Next Steps

Fund managers should review any potential or existing management fee waiver arrangements in light of the Proposed Regulations. The Proposed Regulations mandate no gross income allocations and the examples strongly suggest that the management fee waiver arrangement should be economically at risk – and supported by an enforceable return obligation – to the extent amounts received by reason of the fee waiver exceeds the cumulative net profits over the life of the fund. Accordingly, fund managers should consider structuring their arrangements to conform with these guidelines.    

Footnotes

[1] The Proposed Regulations can be found here.

[2] See Preamble to Proposed Regulations. 

[3] Proposed Treasury Regulation Section 1.707-2(c).

[4] Proposed Treasury Regulation Section 1.707-2(c)(2)-(6).

[5] Proposed Treasury Regulation Section 1.707-2(c)(1). 

[6] Proposed Treasury Regulation Section 1.707-2(c)(1)(i)-(v).

[7] Proposed Treasury Regulation Section 1.707-2(d), Example 3.

[8] Proposed Treasury Regulation Section 1.707-2(d), Example 5.

[9] See Preamble to Proposed Regulations.

[10] Id.

Proposed Regulations Issued On Management Fee Waivers

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

To print this article, all you need is to be registered on Mondaq.com.

Click to Login as an existing user or Register so you can print this article.

Authors
Similar Articles
Relevancy Powered by MondaqAI
 
In association with
Related Topics
 
Similar Articles
Relevancy Powered by MondaqAI
Related Articles
 
Related Video
Up-coming Events Search
Tools
Print
Font Size:
Translation
Channels
Mondaq on Twitter
 
Register for Access and our Free Biweekly Alert for
This service is completely free. Access 250,000 archived articles from 100+ countries and get a personalised email twice a week covering developments (and yes, our lawyers like to think you’ve read our Disclaimer).
 
Email Address
Company Name
Password
Confirm Password
Position
Mondaq Topics -- Select your Interests
 Accounting
 Anti-trust
 Commercial
 Compliance
 Consumer
 Criminal
 Employment
 Energy
 Environment
 Family
 Finance
 Government
 Healthcare
 Immigration
 Insolvency
 Insurance
 International
 IP
 Law Performance
 Law Practice
 Litigation
 Media & IT
 Privacy
 Real Estate
 Strategy
 Tax
 Technology
 Transport
 Wealth Mgt
Regions
Africa
Asia
Asia Pacific
Australasia
Canada
Caribbean
Europe
European Union
Latin America
Middle East
U.K.
United States
Worldwide Updates
Registration (you must scroll down to set your data preferences)

Mondaq Ltd requires you to register and provide information that personally identifies you, including your content preferences, for three primary purposes (full details of Mondaq’s use of your personal data can be found in our Privacy and Cookies Notice):

  • To allow you to personalize the Mondaq websites you are visiting to show content ("Content") relevant to your interests.
  • To enable features such as password reminder, news alerts, email a colleague, and linking from Mondaq (and its affiliate sites) to your website.
  • To produce demographic feedback for our content providers ("Contributors") who contribute Content for free for your use.

Mondaq hopes that our registered users will support us in maintaining our free to view business model by consenting to our use of your personal data as described below.

Mondaq has a "free to view" business model. Our services are paid for by Contributors in exchange for Mondaq providing them with access to information about who accesses their content. Once personal data is transferred to our Contributors they become a data controller of this personal data. They use it to measure the response that their articles are receiving, as a form of market research. They may also use it to provide Mondaq users with information about their products and services.

Details of each Contributor to which your personal data will be transferred is clearly stated within the Content that you access. For full details of how this Contributor will use your personal data, you should review the Contributor’s own Privacy Notice.

Please indicate your preference below:

Yes, I am happy to support Mondaq in maintaining its free to view business model by agreeing to allow Mondaq to share my personal data with Contributors whose Content I access
No, I do not want Mondaq to share my personal data with Contributors

Also please let us know whether you are happy to receive communications promoting products and services offered by Mondaq:

Yes, I am happy to received promotional communications from Mondaq
No, please do not send me promotional communications from Mondaq
Terms & Conditions

Mondaq.com (the Website) is owned and managed by Mondaq Ltd (Mondaq). Mondaq grants you a non-exclusive, revocable licence to access the Website and associated services, such as the Mondaq News Alerts (Services), subject to and in consideration of your compliance with the following terms and conditions of use (Terms). Your use of the Website and/or Services constitutes your agreement to the Terms. Mondaq may terminate your use of the Website and Services if you are in breach of these Terms or if Mondaq decides to terminate the licence granted hereunder for any reason whatsoever.

Use of www.mondaq.com

To Use Mondaq.com you must be: eighteen (18) years old or over; legally capable of entering into binding contracts; and not in any way prohibited by the applicable law to enter into these Terms in the jurisdiction which you are currently located.

You may use the Website as an unregistered user, however, you are required to register as a user if you wish to read the full text of the Content or to receive the Services.

You may not modify, publish, transmit, transfer or sell, reproduce, create derivative works from, distribute, perform, link, display, or in any way exploit any of the Content, in whole or in part, except as expressly permitted in these Terms or with the prior written consent of Mondaq. You may not use electronic or other means to extract details or information from the Content. Nor shall you extract information about users or Contributors in order to offer them any services or products.

In your use of the Website and/or Services you shall: comply with all applicable laws, regulations, directives and legislations which apply to your Use of the Website and/or Services in whatever country you are physically located including without limitation any and all consumer law, export control laws and regulations; provide to us true, correct and accurate information and promptly inform us in the event that any information that you have provided to us changes or becomes inaccurate; notify Mondaq immediately of any circumstances where you have reason to believe that any Intellectual Property Rights or any other rights of any third party may have been infringed; co-operate with reasonable security or other checks or requests for information made by Mondaq from time to time; and at all times be fully liable for the breach of any of these Terms by a third party using your login details to access the Website and/or Services

however, you shall not: do anything likely to impair, interfere with or damage or cause harm or distress to any persons, or the network; do anything that will infringe any Intellectual Property Rights or other rights of Mondaq or any third party; or use the Website, Services and/or Content otherwise than in accordance with these Terms; use any trade marks or service marks of Mondaq or the Contributors, or do anything which may be seen to take unfair advantage of the reputation and goodwill of Mondaq or the Contributors, or the Website, Services and/or Content.

Mondaq reserves the right, in its sole discretion, to take any action that it deems necessary and appropriate in the event it considers that there is a breach or threatened breach of the Terms.

Mondaq’s Rights and Obligations

Unless otherwise expressly set out to the contrary, nothing in these Terms shall serve to transfer from Mondaq to you, any Intellectual Property Rights owned by and/or licensed to Mondaq and all rights, title and interest in and to such Intellectual Property Rights will remain exclusively with Mondaq and/or its licensors.

Mondaq shall use its reasonable endeavours to make the Website and Services available to you at all times, but we cannot guarantee an uninterrupted and fault free service.

Mondaq reserves the right to make changes to the services and/or the Website or part thereof, from time to time, and we may add, remove, modify and/or vary any elements of features and functionalities of the Website or the services.

Mondaq also reserves the right from time to time to monitor your Use of the Website and/or services.

Disclaimer

The Content is general information only. It is not intended to constitute legal advice or seek to be the complete and comprehensive statement of the law, nor is it intended to address your specific requirements or provide advice on which reliance should be placed. Mondaq and/or its Contributors and other suppliers make no representations about the suitability of the information contained in the Content for any purpose. All Content provided "as is" without warranty of any kind. Mondaq and/or its Contributors and other suppliers hereby exclude and disclaim all representations, warranties or guarantees with regard to the Content, including all implied warranties and conditions of merchantability, fitness for a particular purpose, title and non-infringement. To the maximum extent permitted by law, Mondaq expressly excludes all representations, warranties, obligations, and liabilities arising out of or in connection with all Content. In no event shall Mondaq and/or its respective suppliers be liable for any special, indirect or consequential damages or any damages whatsoever resulting from loss of use, data or profits, whether in an action of contract, negligence or other tortious action, arising out of or in connection with the use of the Content or performance of Mondaq’s Services.

General

Mondaq may alter or amend these Terms by amending them on the Website. By continuing to Use the Services and/or the Website after such amendment, you will be deemed to have accepted any amendment to these Terms.

These Terms shall be governed by and construed in accordance with the laws of England and Wales and you irrevocably submit to the exclusive jurisdiction of the courts of England and Wales to settle any dispute which may arise out of or in connection with these Terms. If you live outside the United Kingdom, English law shall apply only to the extent that English law shall not deprive you of any legal protection accorded in accordance with the law of the place where you are habitually resident ("Local Law"). In the event English law deprives you of any legal protection which is accorded to you under Local Law, then these terms shall be governed by Local Law and any dispute or claim arising out of or in connection with these Terms shall be subject to the non-exclusive jurisdiction of the courts where you are habitually resident.

You may print and keep a copy of these Terms, which form the entire agreement between you and Mondaq and supersede any other communications or advertising in respect of the Service and/or the Website.

No delay in exercising or non-exercise by you and/or Mondaq of any of its rights under or in connection with these Terms shall operate as a waiver or release of each of your or Mondaq’s right. Rather, any such waiver or release must be specifically granted in writing signed by the party granting it.

If any part of these Terms is held unenforceable, that part shall be enforced to the maximum extent permissible so as to give effect to the intent of the parties, and the Terms shall continue in full force and effect.

Mondaq shall not incur any liability to you on account of any loss or damage resulting from any delay or failure to perform all or any part of these Terms if such delay or failure is caused, in whole or in part, by events, occurrences, or causes beyond the control of Mondaq. Such events, occurrences or causes will include, without limitation, acts of God, strikes, lockouts, server and network failure, riots, acts of war, earthquakes, fire and explosions.

By clicking Register you state you have read and agree to our Terms and Conditions