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September 22, 2015

2015-Issue 31—On July 23, 2015, the Internal Revenue Service issued proposed regulations under Section 707(a)(2)(A) that could have broad implications for how a partnership can structure a valid “profits interest.” The preamble to these proposed regulations indicates that the IRS is particularly concerned with limiting the ability of the general partner in a private equity fund to agree to waive a portion of its annual management fee in exchange for receiving an additional interest in future profits of the fund. (See Internal Revenue Bulletin, 2015-32, August 10, 2015.) However, the proposed regulations are not limited to management fee waivers by private equity managers. Indeed, if finalized in their current form, the new Proposed Regulation Section 1.707-2 may limit the acceptable structure of partnership profits interests in a wide range of industries, not just private equity. Profits interests are commonly used to compensate partners who provide important services to a partnership. Accordingly, taxpayers should be aware of the potential impact of the new proposed regulations on such interests.

Definition of a Profits Interest

A profits interest in a partnership is commonly understood to mean an interest in only the partnership’s future profits or appreciation. If certain conditions are met, Rev. Proc. 93-27 provides that the receipt of a “profits interest for the provision of services to or for the benefit of a partnership in a partner capacity or in anticipation of being a partner” is not a taxable event for either the partner or the partnership. (See Rev. Proc. 93-27, as clarified by Rev. Proc. 2001-43.) The receipt of a profits interest that does not meet the requirements of Rev. Proc. 93-27 is subject to current tax as compensation in an amount equal to the excess of the interest’s fair market value over the amount paid for the interest.

(Indeed, the preamble to Prop. Reg. Section 1.707-2 states that the Internal Revenue Service intends to modify Rev. Proc. 93-27 at the same time it issues final regulations. The preamble states that the IRS would exclude profits interests received in exchange for waiving a management fee from the Rev. Proc. 93-27 safe harbor. This change to the revenue procedure would allow the IRS to also challenge the receipt of a profits interest in a waiver transaction based on the value of that interest.)

A well-known example of a profits interest is the 20 percent “carried interest” portion of the “2 and 20” compensation model commonly used by private equity partnerships. The 20 percent carried interest is often subject to a clawback provision, which ensures that a fund manager receives only 20 percent of the fund’s cumulative profits, if any.

In recent years, a relatively common transaction has been for a management company to waive all or a portion of the annual 2 percent management fee in exchange for an additional profits interest with an expected economic value roughly equal to the foregone fee. As compared to the 20 percent carried interest, it is less common for this additional interest to be subject to a clawback provision. A fund manager would agree to this type of waiver to defer its recognition of taxable income and, depending on the nature of the fund’s future income, to change the character of that recognized income from ordinary income to capital gain.

The preamble to the new Section 707 proposed regulations shows that IRS concerns about these private equity fee waivers were a driving reason behind those proposed regulations. (See I.R.B. 2015-32.)

Disguised Payments for Services

Prop. Reg. Section 1.707-2(b)(1) identifies arrangements that are treated as a disguised payment for services instead of as the grant of a profits interest.

If an arrangement is treated as a disguised payment for services under the new proposed regulations, then the timing of when the service provider recognizes income is determined by other provisions of the Internal Revenue Code. Moreover, any arrangement that constitutes a disguised payment for services is not a partnership interest, even if this means that the partnership itself does not exist for tax purposes because it does not have at least two partners. Finally, treating an arrangement as a disguised payment for services instead of a profits interest means that the service provider does not receive an allocable share of partnership income, and thus cannot change the character of its income to capital gain.

Prop. Reg. Section 1.707-2(c) gives dispositive weight to the existence or lack of significant entrepreneurial risk in determining when an arrangement is a disguised payment for services. If an arrangement does not have significant entrepreneurial risk, it is a disguised payment for services. If an arrangement has significant entrepreneurial risk, the proposed regulations do not treat the arrangement as a disguised payment for services unless all facts and circumstances establish otherwise.

The proposed regulations list five other factors that indicate an arrangement is a disguised payment for services even if it has substantial entrepreneurial risk: (1) a service provider who holds a transitory interest in the partnership; (2) receiving a purported partnership allocation and distribution over the same time frame that the service provider would otherwise typically receive payment; (3) the service provider became a partner primarily to obtain tax benefits; (4) the value of the service provider’s continuing interest in the partnership is small relative to the allocation and distribution that may constitute a disguised payment for services; and (5) the arrangement provides for different allocations or distributions for different services, the services are provided by one person or related parties under Section 707(b) or Section 267(b), and the different allocations and distributions have significantly different levels of entrepreneurial risk. 

The proposed regulations determine whether an arrangement has significant economic risk based on all of the facts and circumstances regarding “the service provider’s entrepreneurial risk relative to the overall entrepreneurial risk of the partnership.” To provide some clarity, Prop. Reg. Section 1.707-2(c)(1) lists five factual scenarios that create a rebuttable presumption that an arrangement lacks significant economic risk. Only the fifth scenario directly addresses the fee waiver transaction that was a main impetus behind issuing the proposed regulations. The other four scenarios that are presumed to lack substantial economic effect describe arrangements that can also apply to partnerships outside the private equity industry and to private equity partnerships that do not engage in fee waiver transactions.

Private Equity Fee Waiver Examples in the Proposed Regulations

The proposed regulations contain only two examples that consider waivers of management fees by private equity fund managers, both of which are acceptable under the proposed regulations.

Example 5 considers a private equity fund where the partnership agreement provides that the manager will receive less than a 2 percent annual management fee and will receive more than a 20 percent interest in future profits. The entire profits interest is subject to a “clawback provision,” which means that the profits interest is based on the overall, long-term performance of the fund. This example concludes that the arrangement is not a disguised payment for services.

Example 6 in the proposed regulations describes a private equity fee waiver. However, the terms of this waiver differ from the terms of fee waiver transactions common to the market. Specifically, Example 6 involves an investment fund that uses the standard “2 and 20” compensation model subject to a clawback provision. Sixty days before the start of the measurement period, the fund manager waives a portion of its annual management fee in exchange for an additional profits interest that has an estimated present value equal to that of the waived fee. Significantly, this additional profits interest is also subject to the same clawback provision as the 20 percent profits interest. Example 6 states that this additional profits interest is not a disguised payment for services.

It is unclear whether these examples indicate that a clawback provision is necessary for an arrangement not to be a disguised payment for services. The preamble to the proposed regulations states “the presence of each fact described in these examples [5 and 6] is not necessarily required to determine that section 707(a)(2)(A) does not apply to an arrangement.” However, Examples 5 and 6 each seem to rely on the presence of a clawback provision to support the existence of significant entrepreneurial risk. Moreover, the proposed regulations do not contain any examples where a fee waiver arrangement was not a disguised payment for service and the additional interest that the fund manager received was not subject to a clawback provision. This tension creates some additional uncertainty about when a clawback provision is required.

Examples That Illustrate the Proposed Regulation’s Application Outside Private Equity

Example 3 in the proposed regulations illustrates the potential breadth of these regulations. This example concludes that a purported profits interest was actually a disguised payment for services where a manager was entitled to receive “a priority allocation and distribution of net gain from the sale of any one or more assets during any 12-month accounting period in which the partnership has overall net gain.”

Example 3 states that this arrangement fails because the manager’s allocation of profit is based on any 12-month period, and thus does not depend on the overall, long-term success of the partnership. In addition, the arrangement in Example 3 failed because a related party to the fund manager controlled the timing of any gains, raising the likelihood that sufficient net profits would be available to make the priority allocation to the service provider.

Example 4 describes an arrangement that is not a disguised payment for services. In Example 4, the profits interest was calculated based on net profit from a specified 12-month taxable year, and was not subject to a clawback provision. This arrangement was not a disguised payment for services because the arrangement was for a specific year. In direct contrast to Example 3, it was not reasonably predictable whether the partnership in Example 4 would have net profit from its entire portfolio for that specified future tax year.

The contrast between Example 3 and Example 4 creates uncertainty regarding what period a profits interest can cover. Example 4 says a profits interest for a single specified year may be acceptable, but Example 3 indicates that an arrangement based on net profit in anyfuture tax year is not acceptable. It is unclear whether a partnership can grant a profits interest that relates to a period of more than one specified year but less than the entire life of the partnership.

In addition, Examples 3 and 4 create uncertainty regarding the assets to which a profits interest may relate. Under Example 3, an arrangement is a disguised payment for services where it relates to net gain from sale of “any one or more assets.” However, the arrangement in Example 4 was not a disguised payment for services where the net gain was calculated based on an investment fund’s entire portfolio. It is unclear based on these examples whether an arrangement can relate to a subset of a partnership’s assets without being a disguised payment for services and, if so, how many partnership assets must be included in a net profit calculation to be acceptable under the proposed regulations. These uncertainties can extend to profits interests for partnerships that are not involved in the private equity industry.

Alvarez & Marsal Taxand Says:

The preamble to the new proposed regulations under Section 707(a)(2)(A) suggest that Treasury intended to limit some of the more aggressive fee-waiver transactions by private equity managers. The proposed regulations accomplish that goal. However, the examples that call into question a partnership’s ability to grant a profits interest in a specific transaction or based on specific accounting periods may capture transactions that are more common and have less-perceived abuse. Partnership managers should pay close attention as these regulations are finalized because the regulations may make profits interests a somewhat less attractive part of executives’ overall compensation package.

About the Author

Andrew Johnson
Managing Director, Washington DC
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Tyler Horton
Managing Director, Washington DC
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Keith Kechik
Managing Director, Chicago
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McRae Thompson
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Jeffrey Richman
Senior Director, Washington DC
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Disclaimer

The information contained herein is of a general nature and based on authorities that are subject to change. Readers are reminded that they should not consider this publication to be a recommendation to undertake any tax position, nor consider the information contained herein to be complete. Before any item or treatment is reported or excluded from reporting on tax returns, financial statements or any other document, for any reason, readers should thoroughly evaluate their specific facts and circumstances, and obtain the advice and assistance of qualified tax advisors. The information reported in this publication may not continue to apply to a reader's situation as a result of changing laws and associated authoritative literature, and readers are reminded to consult with their tax or other professional advisors before determining if any information contained herein remains applicable to their facts and circumstances.

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