2015-Issue 42 — The second half of 2015 has been a busy period for partnership taxation. The Treasury issued proposed regulations under the long reserved IRC Section 1.707-2, and Congress passed a new law governing how large partnership audits will be performed. Unfortunately, the two changes when considered together may make life more difficult for many investment funds.

The recent partnership regulation developments have broad implications for the structure of partnership interests, especially in the context of hedge fund and private equity partnerships. On July 23, 2015, the IRS issued proposed regulations under IRC Section 707(a)(2)(A) that have the potential to substantially alter the issuance of partnership interests for services provided. If finalized in their current form, these proposed regulations will raise serious questions as to the appropriate tax treatment of certain partnership arrangements, including, in particular, valid structures of partnership profits interests and other structures commonly used in the hedge fund and private equity industries.

While the industry was working during the summer and fall to get its arms around the impact of these new proposed regulations and, more generally, the broader trend toward less taxpayer-favorable Treasury guidance, Congress created a new approach to audit procedures for partnerships when it passed the Bipartisan Budget Act of 2015. This Act created an entirely new audit structure under which partnerships and their partners are audited at the partnership level.

The Bipartisan Budget Act purports to address what Congress believed to be too little focus on the examinations of partnerships by making two changes:

1. The Act is expected to increase the IRS audit coverage rate for large partnerships, which reached just 0.8 percent in fiscal year 2012. The increased audit compliance activities under the new streamlined rules are expected to bring in net revenues of $9.3 billion over the next 10 years.
2. The Act imposes audit adjustments at a partnership level assessed in the year the adjustment is made instead of forcing the partners to reflect audit adjustments on their returns for the tax year to which the audit relates.

These new audit rules dramatically change which parties bear the economic risk of tax liabilities from audit adjustments in past partnership tax years. Under the new audit rules, current partners bear the economic risk with respect to tax positions taken in prior years — even if they were not a partner during the year under audit — unless the partnership complies with the fairly rigorous requirements to avoid this treatment. This shift of economic risk for past audit adjustments from a partnership’s historical partners to its current partners is particularly significant for large partnerships, including publicly traded partnerships, because it would be more difficult for these partnerships to meet the requirements to allocate audit adjustments to only historical  partners. Thus, the Act places a considerable premium on certainty for a large partnership’s tax positions.

As the Act does not ensure that the tax burdens of an audit fall on only the partners who received the benefit of the disputed tax position, accuracy becomes increasingly important for partnership tax returns. However, the ambiguities created by the new Section 707(a)(2)(A) proposed regulations reflect an emerging IRS trend away from providing clarity and bright-line safe harbor rules, which hinders partnerships’ ability to reach certainty when evaluating their tax positions. This combination seems to create an unnecessarily difficult environment for hedge funds and private equity partnerships.

New Audit Regime Amounts to Wholesale Change in the IRS Examination Process
Signed into law on November 2, 2015, the Bipartisan Budget Act makes sweeping changes to the rules governing audits of partnerships and other entities subject to flow through taxation. The current audit regime generally imposes audit adjustments at the individual partner’s level. In contrast, the Act creates a streamlined approach in which any adjustments are imposed at the partnership level for the year in which the adjustment is made. If the audit adjustments reveal a deficiency, the IRS will impose a tax on the partnership itself at the highest corporate rate as applicable to the year in which the audit is conducted instead of for the year to which the adjustments relate. Under the new regime, the economic cost of any additional tax due as a result of audit adjustments would be borne by only the current partners. Partnerships with 100 or fewer partners — each of whom is an individual, a C corporation, a foreign entity that would be treated as a C corporation if it were domestic, an S corporation, the estate of a deceased partner, or other types of partners designated by the IRS — may elect out of the new rules. In the case of a partner that is an S corporation, owners of the S corporation are counted as partners for purposes of the 100-or-fewer-partners test. Most importantly, a partnership that has, as one of its partners, another partnership would not be able to elect out of the new rules.

This new audit regime is essentially a wholesale change in partnership tax treatment, as the Act no longer requires that the IRS recalculate the tax liability of each partner in the partnership as it would have been in the year to which the adjustment relates. By imposing the adjustments on partnerships at the entity level, the IRS is no longer required to consider the particular status of each partner during the year audited. As a result, the examination process no longer ensures that the audit adjustments impact only the partners involved in the partnership during the audited tax year. Congress seems to believe that the Act creates a more practical audit system by reducing considerable administrative burdens on the IRS that existed under the previous partnership audit regime. Thus, the new law may trade fairness to the taxpayer for administrative ease for the IRS.

Partnerships attempting to allocate the economic liability imposed by these audit adjustments only to persons or entities who were partners during the tax year under audit must now comply with an election procedure. If this election is made, the partnership would compute adjusted Schedule K-1s allocating each partner’s share of any adjustments specifically between the partners during the year audited. These partners would not need to amend their returns as filed in the year audited, and instead must incorporate the adjustments on their returns for the tax year they receive their adjusted Schedule K-1. As written, the Act requires this election to be made within 45 days of the notice of final partnership adjustment, but it does not provide any further details. Thus, the IRS is left to draft regulations that will determine the procedural details for this election. The IRS has publically acknowledged the potential difficulties associated with complying with the new law and has indicated that it may ask Congress to alter it in some way.

Ultimately, the Act’s audit structure heightens a partnership’s risk related to any uncertain tax positions by imposing on current partners the burden of adjustments regarding tax positions taken by partners who could be long gone. This may be an administrative relief for some smaller partnerships, such as partnerships that do not have significant ownership changes and will no longer have to amend past returns for each partner. However, the opposite is likely the case in the hedge fund world, in which partnership tenure is often short and ownership turnover is high.

Proposed Regulations Addressing Disguised Payments for Services Raise as Many Questions as They Provide Answers, Leading to More Uncertainty
The IRS proposed new regulations under Section 707(a)(2)(A) primarily to address its concerns regarding private equity fee waivers by treating certain partnership income arrangements as disguised payments for services. Prop. Reg. Section 1.707-2 provides for a facts and circumstances analysis as to whether an arrangement constitutes a payment for services utilizing a six-factor test, the first of which is whether the arrangement lacks “significant entrepreneurial risk,” with that factor having five sub-factors. At a high level, this first factor (along with its sub-factors) is considered a super factor. If an arrangement fails to meet the standards proposed in the regulations, it is not considered a partnership interest, even if such treatment would effectively create a disregarded entity. Therefore, the partner providing the service to the partnership does not receive an amount considered a compensatory payment as an allocable share of partnership income; rather, the amount will be treated as current ordinary income from services, thereby preventing the partner from treating the amount as capital gain. While in some respects this result may seem proper, there are many circumstances where arrangements that do not represent “management fee waivers” are also common in the industry and would therefore be affected.

Many Comments Critique Proposed Regulation Section 1.707-2
The comment period on these proposed regulations closed on November 16, 2015. A high-level review of the substantive comments revealed general concerns that the proposed regulations are ambiguous, overbroad and reliant on assumptions that are either unrealistic or inaccurate within the private equity industry.

Several of the comments criticized the factors used to determine whether a transaction has significant economic risk as ambiguously worded. To address this, some comments proposed revisions to enhance predictability and ease of administration. Proposed revisions include amending the factors to consider risk of loss posed by an arrangement, or to distinguish between equity ownership and compensatory arrangements. Additionally, the comments consistently expressed concern that the proposed regulations were overbroad and ran the risk that they would be applied to deem true partnership equity interests to be disguised compensatory agreements.

Other critiques asserted that the proposed regulations’ examples made assumptions that were generally inaccurate within the private equity context. These comments were concerned that the proposed regulations demonstrated a tone-deaf approach to the industry they were clearly intended to reform. Specifically, the comments were concerned that the examples’ overemphasis on clawback features in respecting fee waiver arrangements as valid is an inappropriate consideration for determinations involving hedge fund arrangements. Hedge funds do not generally incorporate clawback features into their arrangements. Several comments noted that the proposed regulations also seem to operate on the unrealistic assumption that the general partner’s control of certain partnership assets is not bound by the typical fiduciary duties, regulatory requirements, and market conditions that govern the hedge fund industry. Finally, the comments criticized the limitations that the proposed regulations discussed for the Rev. Proc. 93-27 safe harbor, which currently provides guidance about the proper income tax consequences of profits interests, are inappropriate in the private equity context because the limitations will create the valuation issue that the safe harbor itself was designed to avoid.

Other commenters identified questions related to the Treasury’s approach with respect to several typical hedge fund arrangements. Some commenters criticized Prop. Reg.1.707-2(c)(1)’s emphasis on “long-term financial success of the enterprise” as fundamentally inappropriate with regard to incentive allocations typical to hedge funds. The comment claimed that future long-term success generally does not relate to economic risk for hedge funds because of the open-ended nature of these funds. Instead of long-term success, the comment suggested that the IRS should revise Example 4 in the proposed regulations to evaluate economic risk on the basis of risk of loss.

Finally, the comments addressed the proposed regulations’ failure to account for multi-advisor funds. Multi-advisor funds are a common hedge fund structure in which the partner’s risk, by design, does not depend on the collective success of total firm investments. The proposed regulations prohibit arrangements that entitle portfolio managers to incentive allocations based solely on the performance of a specific portfolio of assets unless the hedge fund treats each portfolio as a separate partnership, something that would impose significant administrative costs on the hedge funds. Contending that it is impractical to evaluate entrepreneurial risk as it relates to the entire partnership under this structure, the comments recommended adding an example to ensure that risk is determined with regard to each investment singularly where investors are able to select the allocation of their investments.

In summary, for private equity firms, the concern with the proposed regulations is largely about the management fee waivers and not the typical carried interest, since the proposed regulations seem to permit the current carry regime for a traditional private equity fund. Often management fee waivers are accompanied by supercharged allocations equal to a fixed amount, which seem to be in the crosshairs of the new proposed regulations. For hedge funds, the issue of the increased emphasis in the proposed regulations on the existence of a clawback is more of an issue because the performance allocation, in most current funds, gets paid as long as the assets have appreciated and then remains in the account of the manager even if the asset values go down. There is also a general concern across industries that some of the examples do not make clear that the impact is limited to services. As a result, the many partnerships that contain targeted allocations or gross income allocations in respect of preferred units (i.e., master limited partnerships, or MLPs) might be adversely affected if the change ultimately applies to capital arrangements and not just service arrangements.

Alvarez & Marsal Taxand Says:
The proposed regulations under Section 707(a)(2)(A) would, if passed in their current form, create significant uncertainty for certain hedge fund and private equity partnerships, for perhaps somewhat different reasons, in determining proper tax treatment of partnership income allocations. Drafted with the intent to limit management fee waiver arrangements by private equity general partners, the proposed regulations create significant uncertainty as to whether many common arrangements will continue to be respected as partnership interests or whether they will be characterized as compensation.

Despite this uncertainty, the Bipartisan Budget Act’s new audit regime places a greater emphasis on accuracy, as partners are under increased danger of incurring economically liability for riskier tax positions undertaken by prior partners. In light of the competing implications of these two significant changes to partnership taxation, taxpayers in the investment fund industry should pay close attention to the final regulations and forthcoming guidance related to the new audit procedures.

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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