On July 22, 2015, the IRS issued proposed regulations intended to address when certain management fee waiver arrangements would be treated as disguised payments under IRC Sec. 707(a)(2)(A). Nearly a decade later, these regulations have yet to be finalized. But with a newly reinvigorated IRS focusing its attention on high income and high wealth taxpayers, these regulations may finally see movement.
Management fee waivers are a commonly used arrangement for private equity or hedge funds. Managers are usually compensated in two ways: a percentage of the net profits of the fund, and a percentage of the assets or committed capital. The percentage of the assets or capital is the management fee and is treated as a guaranteed payment (and therefore ordinary income) for tax purposes. The net profits are treated as distributive share, making them taxable at the more favorable capital gains rate. Additionally, these net profits may not be subject to self-employment tax, further reducing the tax impact.
A partner may waive their management fee in exchange for an increased share of profits. If structured correctly, this increase will be considered a “profits interest” under IRS guidance; allowing the partner to essentially defer income and pay taxes on it as capital gains when the income is eventually taxed. Revenue Procedure 93-27 (“Rev. Proc. 93-27”) allows a grant of a “profits interest” in exchange for services without the interest being taxed, provided none of the following apply:
The proposed regulations would potentially modify the treatment of management fee waivers and treat some transactions as disguised payments. An arrangement will be treated as disguised payment for services if:
The proposed regulations include six non-inclusive factors that may indicate that the arrangement constitutes a disguised payments for services, including:
Of these factors, the proposed regulations give significantly heavier weight to the lack of significant entrepreneurial risk.
Additionally, the proposed regulations state the IRS intends to amend the safe harbor in Rev. Proc. 93-27. Under the amendment, the safe harbor would not apply to a profits interest issued to partner who waives payment of a substantially fixed amount for the performance of services, even in the case where the service provider has significant entrepreneurial risk.
The proposed regulations also address when management fee waiver is likely to be respected. A transaction will likely be respected if all of the following are met:
The abuses in converting ordinary service income to capital gains that the proposed regulations intend to prevent have been somewhat mitigated by enactment of IRC Sec. 1061. This section, added under the Tax Cuts and Jobs Act, requires a three-year holding period on profits from a partnership to qualify for capital gains treatment. Nonetheless, the benefits of “management fee waivers” comprise more than just the capital gains tax rate differential. Management fee waivers also:
With renewed scrutiny by the IRS on higher income taxpayers, it is prudent to verify that a management fee waiver has real entrepreneurial risk, and meets some of the other requirements mentioned above. For waivers to qualify for the requirement that they be made in advance, ideally, the ability to waive should be “hard-wired” into the limited partnership agreement from the start.
For instance, some funds insert management fee waivers midstream in a partnership’s life, or even have the right to waive in advance of the following quarter’s payment. These are less than ideal circumstances. It is also advisable to not have a 100% waiver of fees. Typically, practitioners recommend leaving at least 20 basis points (i.e., .2%) of the GP capital contribution to be contributed in cash without use of the waiver.
If finalized without substantiative changes, these regulations could force private equity and hedge funds to re-evaluate how they structure their management fee waivers. Taxpayers who currently utilize management fee waivers or are considering their use in fund ventures should engage a trusted tax advisor to keep them apprised of any new developments and regulations related to these arrangements and determine whether their current management fee waivers comport with these rules.