United States: When Is A Payment Arrangement Treated As Disguised Compensation?

Last Updated: March 27 2016
Article by Marc D. Teitelbaum and Irene Kim

The proposed Department of Treasury regulations (REG-115452-14) under IRC section 707(a)(2)(A) set forth standards to determine when a payment arrangement to a partner shall be treated as disguised compensation. Section 707(a) generally governs payments to partners who render services to a partnership other than in a partner capacity. Additionally, the rules will affect standards under section 704(b) to reflect the principle that a payment must be subject to significant entrepreneurial risk in order to be considered a distributive share. Section 704(b) most importantly provides for pass-through treatment of capital gains and other tax-favored items from the partnership to its partners. As a result of the foregoing, the rules include changes to the scope of section 707(c) governing guaranteed payments. The rules would become effective on the date the final regulations are published.

These rules, if finalized, will have a significant effect upon the issuance of interests in private equity (PE) funds and the structure of distributive shares for its general partners and principals. In particular, these rules affect fee waiver arrangements, but also create general uncertainty as to how to treat partners that are receiving payments from a partnership that one otherwise thought would constitute a distributive share. A summary of the effect of these rules on PE funds can be found towards the end of this article.

Alternative tax characterizations

Income that a partner receives from a partnership in exchange for services can be characterized in one of three ways: a distributive share under section 704(b); a guaranteed payment under section 707(c); or a section 707(a) payment for services rendered in a non-partnership capacity, often referred to as "disguised services" income. Allocations made to a partner providing services in a partner capacity where the allocation depends on partnership income is generally a distributive share under section 704(b). The two alternative characterizations under section 707 address arrangements in which either a service partner receives income in the capacity of a partner, but without regard to partnership income (section 707(c)) or engages with a partnership in the capacity of a non-partner (section 707(a)). Tax treatment varies across each category for the service partner as well as for the partnership.

For instance, a distributive share of partnership income under section 704(b), is taxed under the general rules in sections 702, 703 and 704, and benefits from flow-through tax characterization. A distributive share may also qualify as a "profits interest" for the purpose of Rev. Proc. 93-27, which provides safe harbor protection from immediate income inclusion upon receipt.

On the other hand, a partner is taxed on a payment under section 707(a) or (c) as if the payment were made to someone other than a partner for some or all purposes of the Code. If a payment is treated as a guaranteed payment under section 707(c), that is, a payment to a service provider in a partner capacity, but without regard to partnership income, it is considered as having been made to a non-partner under sections 61 and 162(a). Often, this results in the payment being treated as ordinary income for the purposes of those sections. A service partner who receives a section 707(a) payment is treated as having received ordinary services income for all purposes of the Code. In either case, the service partner does not receive the benefits of flow-through characterization as it would in the case of a distributive share.

Disguised payment for services

Section 707(a)(2)(A) is an anti-abuse rule under 707(a) and provides that if a partner performs services for a partnership and receives a related direct or indirect allocation and distribution, and the performance of services, together with the allocation and distribution, are properly characterized as a transaction between the partnership and the partner in a non-partner capacity, the transaction will be governed by section 707(a).

Fee waiver arrangements

In a typical fee waiver arrangement, a fund manager or the management company waives some or all of its management fee (generally two per cent) that would have been taxable as ordinary income. In lieu of the fee, the fund manager, usually the GP of the fund, receives an interest in the fund's future income, sometimes in the form of a "special allocation," which usually takes priority over an ordinary interest in profits. Generally, managers take the position that the income received in this arrangement represents a distributive share of partnership income entitled to flow-through tax characterization. Since PE funds often hold portfolio investments for periods of seven to 10 years, much of the character flowing through would be long-term capital gain.

Even prior to the proposed rules, it was possible for the Internal Revenue Service (IRS) to argue that certain PE fee waiver arrangements were disguised payments for services. The legislative history identified certain factors to consider, the most important being whether an allocation bore "significant entrepreneurial risk." An arrangement in which an allocation and distribution to a service partner is subject to significant entrepreneurial risk as to the amount is generally recognized as a distributive share—this remains true under the proposed rules. Various other factors are also relevant, but secondary.

Proposed rules: multi-factor test

The proposed rules, borrowing heavily from the factors outlined in the legislative history, call for a multi-factor analysis to identify payments under section 707(a). The payment arrangement is tested under these rules at the time at which the parties enter into or modify the arrangement. The primary and weightiest factor is whether, as a result of this alternative payment structure, the general partner has taken on "significant entrepreneurial risk." Under the proposed regulations, arrangements that lack significant entrepreneurial risk will be treated as disguised payments for services regardless of the other factors.

The following characteristics create a presumption that there is a lack of significant entrepreneurial risk:

  • Capped allocations of partnership income (if the cap is reasonably expected to apply in most years)
  • An allocation for one or more years where the service provider's share of income is reasonably certain
  • An allocation of gross income to the service provider
  • An allocation that is predominately fixed in amount, reasonably determinable under all facts and circumstances, or designed to assure sufficient net profits are highly likely to be available to make the allocation (e.g., because the agreement only allocates net profits from certain periods or transactions and does not depend on the long-term success of the enterprise)
  • An arrangement in which a service provider waives its right to receive payment for future performance of services in a manner that is non-binding, or fails to notify the partnership and its partners of the waiver and its terms in a timely manner

The preamble clarifies that catch-up allocations to a service partner generally do not fall under the fourth category. However, priority allocations to a service partner that are measured over an accounting period of one year or less, together with an ability for the service partner (or related party) to control either the determination of asset values in the case of hard-to-value assets, or the entities in which the partnership invests—including the amount and timing of distributions by such entities—create a higher likelihood that net profits will be available for the allocation. The examples further illustrate that a failure to measure profits over the life of the partnership would cause one to examine whether the allocation is a fee for services.

Basically, only waiver arrangements which involve a fund manager taking on significant entrepreneurial risk will be rewarded with the attendant benefits of a distributive share, namely flow-through characterization. Alternatively, in cases where the terms of the purported allocation as a result of the waiver arrangement indicate that the manager is highly likely to receive income regardless of the success of the business, the rules treat the profits interest as disguised compensation under 707(a).

In additional to "significant entrepreneurial risk," there are five secondary factors that must be considered. The weight given to each of these factors depends on the facts and circumstances of each case. The secondary factors that may characterize an arrangement as a payment for services include the following:

  1. Service provider holds a partnership interest for only a short duration
  2. Service provider receives an allocation and distribution in a time frame comparable to when a non-partner service provider would typically receive payment
  3. Service provider became a partner primarily to obtain tax benefits which would not have been otherwise available
  4. The value of the service provider's interest in general and continuing partnership profits is small in relation to the allocation and distribution
  5. An arrangement provides for (i) different allocations or distributions with respect to different services received; (ii) the different services are provided either by a single person or related persons; and (iii) the entrepreneurial risk associated with the different allocations and distributions varies significantly

Elimination of safe harbor protection

Rev. Proc. 93-27 defers taxation upon the receipt of a profits interest for the provision of services to a partnership in a partner capacity. However, the revenue procedure makes clear that the safe harbor does not apply where there is a "substantially certain and predictable stream of income" from partnership assets, or in cases where the interest is disposed of within two years of receipt. If an allocation is not treated as a distributive share, or is excluded from the administrative safe harbor under either of these exceptions, this raises questions of how to tax the interest, and whether the IRS can argue that the service partner must currently include income upon receipt of the purported profits interest.

The IRS has indicated that this administrative safe harbor does not apply to cases where one party provides services and another party is allocated partnership income in association with the provision of those services. This describes the organization of most funds in New York (driven by the local tax law), where the management company is a separate entity (non-partner), delegated management responsibility by the GP via contract. As a result, in addition to arguing that ordinary income treatment applies to such arrangements under section 707(a), the IRS will be able to argue that a profits interest received pursuant to this type of fee waiver arrangement is currently taxable upon receipt. Consistent with this view, Treasury and the IRS plan to issue an additional exception to the profits interest safe harbor for fee waiver arrangements.

Effect on PE funds

The following is a summary of the effect of these rules on partnership arrangements in the context of PE funds.

  1. Whether an arrangement lacks significant entrepreneurial risk is relative to the overall entrepreneurial risk of the partnership with respect to its own activities. For example, entrepreneurial risk can exist with respect to participation in a venture capital fund as well as a fixed income fund.
  2. Partnership allocations, including carried interests determined with respect to a subgroup of assets, may not qualify as a distributive share. The argument would be the same as the reasons for denying favorable tax treatment for an allocation of profits out of a particular tax period—that is, because there is a risk that the allocation could be limited to a subgroup of assets that is expected to be profitable.
  3. Allocations of future income should include a clawback provision in order to be considered a distributive share. A "clawback obligation" is described as an enforceable obligation to repay any amounts distributed pursuant to a profits interest that exceed the partner's allocable share as computed over the life of the partnership, where it is reasonable to anticipate that the general partner can and will comply fully with this obligation. These rules appear to say that significant entrepreneurial risk requires that an allocation be a percentage of net profits over the life of a partnership with respect to all assets of the partnership. In order to achieve this, there would have to be some type of accounting at the end of the relevant period and a possible adjustment pursuant to a clawback obligation.
  4. Section 707(a) has been a looming threat to fee waiver arrangements long before this notice, especially those involving elective quarterly or monthly waivers, where at the time of the election, the fund manager may already have a sense of how profitable the fund will be in the following quarter. The rules appear to draw a line in the sand, permitting only fee waivers that are elected prior to the beginning of the service period, and not in cases where there has been, in effect, constructive receipt. Further, the proposed regulations and the examples applicable to fee waivers appear to support the existence of significant entrepreneurial risk where there is an:
    • Allocation out of net profits (not limited to a particular transaction or accounting period) that is not reasonably determinable or highly likely to be available at the time of the waiver, and service provider undertakes a binding clawback obligation (see Example 5)
    • Execution of a legally binding and irrevocable waiver, clearly communicated to the other partners well in advance (60 days or more) of the services period under the management fee agreement (see Example 6)

Other consequences

First, the proposed regulations do not address timing issues for service payments governed by sections 707(a) (2)(A) and 1.707-2. The issue of when a payment for services should be included in the income of the service provider and when the partnership can take a deduction is determined under existing law.

Next, the preamble to the proposed regulations indicates that an arrangement that is treated as a disguised payment for services under these proposed regulations will be treated as payment for services for all purposes of the Code. It is necessary to consider whether a service partner receiving a payment governed by section 707(a)(2)(A) constitutes an employee or independent contractors.

Finally, the preamble also indicates that if an allocation is re-characterized under section 707(a) as a payment for services, the deferred compensation rules under section 409A and 457A may apply. For example, if the fund manager has "received" income for the purposes of section 409A, that section imposes immediate taxation on any deferred income, assuming no exception applies.

Dentons is the world's first polycentric global law firm. A top 20 firm on the Acritas 2015 Global Elite Brand Index, the Firm is committed to challenging the status quo in delivering consistent and uncompromising quality and value in new and inventive ways. Driven to provide clients a competitive edge, and connected to the communities where its clients want to do business, Dentons knows that understanding local cultures is crucial to successfully completing a deal, resolving a dispute or solving a business challenge. Now the world's largest law firm, Dentons' global team builds agile, tailored solutions to meet the local, national and global needs of private and public clients of any size in more than 125 locations serving 50-plus countries. www.dentons.com.

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.

Events from this Firm
25 Oct 2018, Other, New York, United States

Once again, Dentons is proud to bring together insurance industry leaders, lawyers and regulators for a full-day examination of the most current issues.

26 Oct 2018, Other, New York, United States

Selling your company may be the most important and complicated transaction of your life. To achieve an optimal outcome, you need to get educated.

Similar Articles
Relevancy Powered by MondaqAI
Kramer Levin Naftalis & Frankel LLP
In association with
Related Topics
Similar Articles
Relevancy Powered by MondaqAI
Kramer Levin Naftalis & Frankel LLP
Related Articles
Related Video
Up-coming Events Search
Font Size:
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
Confirm Password
Mondaq Topics -- Select your Interests
 Law Performance
 Law Practice
 Media & IT
 Real Estate
 Wealth Mgt
Asia Pacific
European Union
Latin America
Middle East
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.


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.


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