On July 22, the Internal Revenue Service (the “IRS”) proposed new regulations (the “Proposed Regulations”) targeted at “fee waivers” commonly used by private equity fund managers. Importantly, the Proposed Regulations may have significantly broader application to a variety of common compensation practices utilized by other kinds of private investment funds, including hedge funds.

As discussed in more detail below, the Proposed Regulations, if finalized, would impose a “facts and circumstances” test to determine whether allocations made to persons who provide services to partnerships should be recharacterized as disguised payments for services as well as make certain other changes to the partnership compensation rules.

Background

In a fee waiver arrangement, a private equity fund manager agrees to forgo its “management fee” from a private equity fund in exchange for an additional share of the fund’s net profits or distributions. For example, a fund manager would waive its right to be paid a management fee equal to one percent of a fund’s capital commitments in exchange for a distribution of distributable cash from the fund’s net profits, if any, equal to the same amount. The fund manager has in effect given up a guaranteed right to periodic management fee payments in exchange for a potential future distribution that will be made only if and when the fund has sufficient distributable cash from net profits. Fee waiver arrangements often are elective on an annual basis and the election mechanism varies across the industry. Less frequently, fee waiver arrangements are built into the governing documents of a private equity fund.

If a fee waiver arrangement is respected, then the private equity fund manager will be treated for U.S. federal income tax purposes as receiving an allocation of the fund’s profits. Depending upon the character of the fund’s income, a significant portion of such an allocation could be taxed as long-term capital gain (subject to a maximum federal income tax rate of 20%) rather than as ordinary income (subject to a maximum federal income tax rate of 39.6%).

Fee waivers have spawned a great deal of scrutiny and criticism both in the tax press and subsequently in the general press. The Proposed Regulations represent the IRS’s response to this criticism.

Facts and Circumstances Test of the Proposed Regulations

The Proposed Regulations adopt a “facts and circumstances” test to determine whether a purported allocation of income to a partner is more properly characterized as a payment for services.

The facts and circumstances to be considered in determining whether an arrangement is really a disguised payment for services are:

1. a lack of entrepreneurial risk;
2. a partnership interest which is held by the service provider for a short period of time;
3. an allocation and distribution being made in a time frame that is comparable to a non-partner service provider;
4. the service provider becoming a partner primarily to obtain tax benefits;
5. the value of the service provider’s interest in general and continuing profits being small in relation to the allocation and distribution; and
6. the arrangement providing for different allocations or distributions with respect to different services received by the same person or related persons and these differences reflecting different levels of entrepreneurial risk.

The Proposed Regulations make clear that the most important factor to be considered in making this determination is whether the partner bears “entrepreneurial risk.” In fact, judging by the examples in the regulations, it often appears as if entrepreneurial risk is the only factor that is truly important. The Proposed Regulations list five facts and circumstances that create a rebuttable presumption that an arrangement lacks entrepreneurial risk:

1. Capped allocations of partnership income if the cap is reasonably expected to apply in most years (for example, a special allocation of the first $20,000 of income of a partnership where the partnership is expected to have at least that amount of income);
2. An allocation in which the service provider’s share of income is reasonably certain;
3. An allocation of gross income (instead of an allocation of net income);
4. An allocation that is predominantly fixed in amount, is reasonably determinable under all the facts and circumstances, or is designed to ensure that sufficient net profits are highly likely to be available to make the allocation (for example, allocations from specific transactions or specific periods where the allocation does not depend on the long-term success of the partnership, such as quarterly allocations or allocations not subject to a “clawback”); or
5. A waiver arrangement that is non-binding or with respect to which the service provider fails to timely notify the partnership or its partners of the waiver and its terms (for example, a fee waiver that is revocable).

Proposed Regulation Examples

The Proposed Regulations contain six examples of the application of the above rules. The examples focus heavily on private equity funds, although one example could be read to potentially apply to a hedge fund. The examples further illustrate some of the facts and circumstances discussed above. In particular, the examples emphasize the presence of clawback arrangements as being highly favorable to the entrepreneurial risk analysis because they suggest that an allocation is dependent on the overall success of the enterprise rather than a shorter period.¹ Another takeaway from the examples is that fee waivers should either be built into documents or be irrevocable and should be clearly documented in writing.

Changes to Profits Interest Taxation

In the Preamble to the Proposed Regulations, the IRS indicates that it is likely to make changes to current IRS guidance regarding the taxation of “profits interests.” Under current rules, a partner is not subject to U.S. federal income tax on the receipt of an interest in the future profits of the partnership if the “liquidation value”² of the interest is zero (the “liquidation value safe harbor”), provided that certain specified requirements are met.

Many fund managers take the position that the liquidation value safe harbor applies even when a profits interest is granted to a related party (such as the general partner of a fund) even though the related party does not technically provide services to the fund. Under the IRS proposal, a profits interest apparently could only qualify for the liquidation value safe harbor if it was granted to the same entity which is performing the services. Under this construct, the interest granted in exchange for a fee waiver would need to be granted to the investment manager of a private investment fund rather than the general partner of the fund.

If these changes are made by the IRS, fund managers that have separate investment manager entities and general partner entities may need to consider the proper structuring of any new incentive arrangements to avoid any inadvertent adverse tax consequences.

In addition, the IRS states in the Preamble that it will amend current guidance to exclude many fee waiver arrangements (including those with entrepreneurial risk) from the “liquidation value” safe harbor. If this proposal is adopted, then a fund manager receiving a partnership interest in exchange for a fee waiver would be required to include the fair market value of such interest in income as ordinary income at the time of grant. The fair market value of such an interest would be unclear and, in fact, this uncertainty regarding valuation is one of the reasons that the IRS adopted the liquidation value safe harbor in the first place. In our view, this proposal, if adopted, would reintroduce substantial uncertainty into tax compliance in this area and we would expect substantial industry feedback on this point.

Potential Broader Application

Although the Proposed Regulations are directed primarily at fee waiver provisions in private equity funds, they apply by their terms to any arrangement between a partner and a partnership.

For example, the Proposed Regulations would need to be considered in the case of:

1. A hedge fund manager that, rather than receiving a management fee, instead receives a preferred profit allocation in an amount equal to a percentage of the net asset value of the Fund to the extent the fund has profits; and
2. A reallocation of a portion of the profits of a general partner entity to an individual who is an employee of a related management company either as a special limited partner of a fund or a special member of the general partner entity.

The Proposed Regulations clearly do not shut down all fee waivers or similar profit allocation arrangements. However, private fund managers will need to carefully consider whether their profit allocation arrangements have sufficient “entrepreneurial risk” to be respected as allocations of partnership income rather than as compensation income. In particular, private equity fund managers may want to carefully review their existing fee waiver arrangements with a view towards modifying them to comply as much as possible with the Proposed Regulations.

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The Proposed Regulations are effective on the date they are finally published in the Federal Register and would apply to any arrangement entered into or modified after such date. It should be noted that any new waiver of fees is treated as a modification for this purpose. The Proposed Regulations are subject to a 90 day public comment period and a possible public hearing. We anticipate that there will be significant industry feedback on the various issues raised by the Proposed Regulations.

We will continue to monitor the progress of the Proposed Regulations. If you have any questions regarding the Proposed Regulations, please contact Ronald P. Cima (212-574-1471), Jonathan P. Brose (212-574-1615), James C. Cofer (212-574-1688), Peter E. Pront (212-574-1221) or Daniel C. Murphy (212-574-1210).

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¹ The application of the clawback examples to an arrangement between an investment manager and an open-end “hedge fund” that has perpetual life is uncertain.

² The “liquidation value” of a partnership interest is the amount that the recipient would receive if the fund distributed all of its assets in accordance with the partnership’s governing documents immediately after the grant of the partnership interest.