What’s Next for Management Fee Waivers?

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.

What Are Management Fee Waivers?

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:

1. The profits interest relates to a substantially certain and predictable stream of income from partnership assets;
2. The partner disposes of the profits interest within two years of receipt; or
3. The profits interest is a limited partnership interest in a publicly traded partnership.

Proposed Regulations Under IRC Sec. 707

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:

1. A person (service provider) performs services, directly or indirectly, to or for the benefit of the partnership, either in their partner capacity or in anticipation of being a partner,
2. There is a direct or indirect allocation and distribution to said service provider, and
3. The performance of services, the allocation, and the distributions are characterized as a transaction occurring between the partnership and a person acting outside their capacity as a partner.

The proposed regulations include six non-inclusive factors that may indicate that the arrangement constitutes a disguised payments for services, including:

1. The lack of significant entrepreneurial risk,
2. The service provider holds an interest for a short duration,
3. The service provider receives an allocation and distribution in a comparable time frame to that of a non-partner service provider receiving payment,
4. The service provider becomes a partner primarily to obtain tax benefits that would not have been available if the services had been rendered in a third-party capacity,
5. The value of the service provider’s interest in general and continuing partnership profits is small in relation to the allocation and distribution, and
6. The arrangement provides for different allocations or distributions for different services rendered, the services are provided either by one person or certain related parties, and the terms of differing allocations or distributions are subject to significantly varying levels of entrepreneurial risk.

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.

When Will Fee Waivers be Respected?

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:

1. The management fee waiver is irrevocable and made in advance of the time the fees would be earned;
2. Allocations and distributions in respect of the waiver “profits” interest are made out of cumulative net income and gain over the life of the partnership;
3. The partner receiving allocations and distributions in respect of the waiver interest undertakes an enforceable obligation to repay amounts not supported by allocations of cumulative net income and it is reasonable to anticipate that the partner can and will comply fully with this “clawback obligation;” and
4. The allocations are neither reasonably determinable nor highly likely to be available.

Future of Proposed Regulations

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:

1. Defer the timing of recognition of revenue,
2. Create a “deductible” expense to the limited partners by shifting income away from themselves to the general partner (“GP”), when a management fee itself would be subject to IRC Sec. 212 limitations,
3. Allows for the funding of the GP capital contribution with “pre-tax” dollars, and
4. Has some benefit at the local tax level if the locality has an unincorporated business tax, like New York City.

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.