Document 2526141

Tax Insights
from Mergers and Acquisitions, Private Equity, and Asset Management
Newly issued proposed regulations
under Section 707(a)(2)(A) address
disguised payments for services Initial observations
July 24, 2015
In brief
On July 22, 2015, the Treasury Department (‘Treasury’) and the IRS issued proposed regulations (REG115452-14) under Section 707(a)(2)(A) addressing when an arrangement with a service provider
structured as an allocation (typically of net capital gain or qualified dividend income) and a distribution
may be recharacterized as a disguised payment for services (treated as compensation income). The
proposed regulations were anticipated for several months and were expected to target management fee
waiver arrangements. However, the guidance is broader than anticipated and its applicability appears to
extend beyond management fee waiver arrangements.
In the background discussion to the proposed regulations (‘Preamble’), Treasury and the IRS describe
broad changes. The Preamble indicates that the safe harbor profit interest guidance (under Rev. Proc. 9327) may not apply to most (if not all) common management fee waiver arrangements. In addition, the
request for comments section of the Preamble also addresses issues that arise under targeted capital
account agreements, including potentially the tax characterization of preferred returns.
The proposed regulations are not effective until finalized. However, the regulations also state that the
current position of Treasury and the IRS is that the proposed regulations generally reflect current law
under the legislative history of Section 707(a)(2)(A).
In detail
Background
Generally, in a management fee
waiver arrangement, a private
equity or other fund manager
exchanges all or a portion of its
unearned management fees for
a ‘priority’ profit interest in the
fund under management. The
mechanics and features of a
management fee waiver
arrangement vary from fund to
fund, but a common goal of such
arrangements is to exchange
unearned management fees
(subject to ordinary tax rates)
for a distributive share of the
partnership’s income (character
flow-through and potential
deferral).
Treasury and the IRS have
signaled in recent months that
forthcoming guidance
addressing management fee
waivers would focus on
entrepreneurial risk and other
factors following the principles
of Section 707(a)(2)(A) and the
underlying legislative history.
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Highlights of the proposed
regulations under Section
707(a)(2)(A)
The proposed regulations provide that
an arrangement will be treated as a
disguised payment for services
(compensation income) if:
 a person (service provider), either
in a partner capacity or in
anticipation of being a partner,
performs services (directly or
through its delegate) to or for the
benefit of the partnership;
 there is a related direct or indirect
allocation and distribution to the
service provider; and
 the performance of the services
and the allocation and distribution
when viewed together are properly
characterized as a transaction
occurring between the partnership
and a person acting other than in
that person’s capacity as a partner.
Consistent with the legislative history
of Section 707(a)(2)(A), the proposed
regulations focus on all facts and
circumstances to determine whether
an arrangement should be treated as a
payment for services, and list six nonexclusive factors that may indicate
that an arrangement constitutes in
whole or in part a payment for
services. The first five factors are
derived from the legislative history
while the sixth factor (described
below) was added by the proposed
regulations and is apparently
specifically tailored to management
fee waiver arrangements. The six
factors are:
1. Significant entrepreneurial
risk – Significant entrepreneurial
risk is accorded more weight than
the other factors. An arrangement
that lacks significant
entrepreneurial risk will be treated
as a disguised payment for
services. Significant
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entrepreneurial risk will be
determined by comparing a service
provider’s entrepreneurial risk
relative to the overall
entrepreneurial risk. This
comparison affords service
providers providing services to
partnerships engaged in relatively
low-risk activities (e.g., investing in
high quality debt securities) the
same opportunity to bear
significant entrepreneurial risk as
service providers providing
services to partnerships engaged in
riskier activities (e.g., providing
venture capital).
The proposed regulations provide a
list of five factors that create a
presumption that an arrangement
lacks significant entrepreneurial
risk and will be treated as a
disguised payment for services
unless other factors establish the
presence of significant
entrepreneurial risk by ‘clear and
convincing’ evidence. Those
factors include:
 Capped allocations of
partnership income if the cap is
reasonably expected to apply in
most years;
 Allocations for a fixed number
of years under which the service
provider’s distributive share of
income is reasonably certain;
 Allocations of gross income
items;
 An allocation (under a formula
or otherwise) that is
predominately fixed in amount,
is reasonably determinable
under all the facts and
circumstances, or is designed to
assure that sufficient net profits
are highly likely to be available
to make the allocation to the
service provider; or
 An arrangement in which a
service provider either waives
its right to receive payment for
the future performance of
services in a manner that is
non-binding or fails to timely
notify the partnership and its
partners of the waiver and its
terms.
The other factors, described as
‘secondary’ in the Preamble, include:
2. Transitory partner status –
The service provider holds, or is
expected to hold, a partnership
interest for a short period of time.
3. Timing of service and
allocation / distribution - An
allocation and a distribution to the
service provider is made within a
time frame that is comparable to
the time frame that a non-partner
service provider would receive
payment. The legislative history
explains that when the income
subject to allocation arises over an
extended period or is remote in
time from the performance of
services, the risk of not receiving
payment (the first factor described
above) may also increase.
4. Primary purpose of US tax
benefits - The service provider
becomes a partner primarily to
obtain US tax benefits that would
not have been available if the
services had been rendered in a
non-partner capacity.
5. Relatively small general and
continuing interest - The value
of the recipient's interest in general
and continuing partnership profits
is small in relation to the allocation
and distribution in question.
6. Related persons - The
arrangement provides for different
allocations or distributions with
respect to different services
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received in which the services are
provided either by a single person
or by persons that are related
under Sections 707(b) or 267(b),
and the terms of the differing
allocations or distributions are
subject to levels of entrepreneurial
risk that vary significantly (e.g.,
general partner receives a 20%
carry subject to a clawback and a
related management company
receives an amount of partnership
net income not subject to a
clawback).
The proposed regulations may apply
even if it is determined that no
partnership exists. In these scenarios,
the service provider is treated as
providing services directly to the other
purported partner.
The proposed regulations include six
examples that illustrate whether an
arrangement constitutes a payment
for services or whether it will be
respected as an allocation and
distribution. We provide a summary
for each example and brief
observations below:
Example 1
Summary: A, an architect, performs
services for a partnership. Rather than
charge a $40,000 fee, A contributes
cash in exchange for a 25%
partnership interest. A receives a
special allocation of $20,000 from the
partnership’s gross items for the first
two years. The partnership is
projected to generate $100,000 of
gross income annually.
Result: A’s special allocation is a
capped amount and made out of gross
income. Therefore, the allocation
lacks significant entrepreneurial risk
(unless other facts and circumstances
establish otherwise by clear and
convincing evidence) and the special
allocation is treated as a disguised
payment for services.
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Example 2
Summary: A, a stock broker, effects
trades for a partnership without the
normal brokerage commission.
Instead, A contributes 51% of
partnership capital in exchange for a
51% interest in residual partnership
profits and losses. In addition, A
receives a special allocation of gross
income that is computed in a manner
which approximates its foregone
commissions. It is reasonably
expected that the partnership will
have sufficient gross income to make
the special allocation.
Result: A’s special allocation is an
allocation of gross income and is
reasonably determinable under the
facts and circumstances. Thus, the
special allocation is presumed to lack
significant entrepreneurial risk
(unless additional facts and
circumstances establish otherwise by
clear and convincing evidence) and
the special allocation is treated as a
disguised payment for services.
Example 3
Summary: Management Company: M
performs services for an investment
partnership with assets that are not
readily tradable and not readily valued
which would normally entitle M to a
fee. M also contributes $500,000 in
exchange for a 1% interest in the
partnership’s capital and profits. In
addition, M is 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 in an
amount intended to approximate the
fee that would normally be charged
for the services M performs.
General Partner: GP is a company that
controls M and also controls the
operations of the partnership and
timing of distributions (including M’s
priority distribution). GP will be
allocated 10% of any net profits and
losses of the partnership earned over
the life of the partnership and enters
into a clawback obligation.
Result: Management Company: The
facts and circumstance indicate that
the amount of partnership net income
or gains that will be allocable to M
under the partnership agreement is
highly likely to be available and
reasonably determinable given that
the priority allocation is from any 12month accounting period and thus
does not depend on the overall success
of the enterprise, and the GP has the
ability to control the timing of asset
dispositions. Thus, unless additional
facts and circumstances establish
otherwise by clear and convincing
evidence, M’s arrangement is treated
as a disguised payment for services.
The example includes a variation of
the facts in which the partnership can
fund M’s priority allocation and
distribution of net gain from a
revaluation of any partnership assets
pursuant to Reg. sec. 1.7041(b)(2)(iv)(f). GP’s control of the
valuation of assets that are difficult to
value, taken in combination with the
partnership’s determination of M’s
allocation of net income or gains by
reference to a specific accounting
period, also results in a disguised
payment for services unless additional
facts and circumstances establish
otherwise by clear and convincing
evidence.
General Partner: The facts and
circumstances indicate that the GP’s
arrangement creates significant
entrepreneurial risk because the
allocation is out of net profits earned
over the life of the partnership and
subject to a clawback obligation with
which the GP is reasonably expected
to comply. Thus, GP’s arrangement is
respected and not recharacterized a
disguised payment for services.
Observation: The drafters apparently
do not take into account the fiduciary
duty of fund sponsors to their
investors by referring to the control
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the general partner has over
valuations of difficult to value assets
and the timing of dispositions. The
example also addresses a typical GP
carried interest supported with a
clawback obligation and concludes the
GP’s 10% carried interest is respected
under the new regulations.
Example 4
Summary: The facts are the same as
the facts in example 3, except the
partnership’s investment assets are
securities that are readily tradable on
an established securities market, and
the partnership is in the trade or
business of trading in securities and
has validly elected to mark-to-market
under Section 475(f)(1). In addition,
M is entitled to receive a special
allocation and distribution of
partnership net gain attributable to a
specified future 12-month taxable
year.
compute its taxable income under a
mark-to-market election. In both
cases, it cannot be reasonably
predicted whether the partnership will
have the requisite net income.
Observation: Example 5 illustrates a
common hard-wired waiver of 50% of
a 2% management fee for the benefit
of the GP.
Example 5
Summary: GP is responsible for
providing management services to an
investment fund partnership, but has
delegated the management function to
M (which is controlled by GP). The
partnership agreement provides that
GP will contribute 1% of capital and
that GP will receive an interest in 20%
of future partnership net income and
gains as measured over the life of the
fund. M is entitled to receive an
annual fee equal to 2% of committed
capital. GP undertakes a clawback
obligation.
Summary: GP is responsible for
providing management services to an
investment fund partnership, but has
delegated the management function to
M (which is controlled by GP). The
partnership agreement provides that
GP will contribute nominal capital to
the partnership and that the
partnership will annually pay M an
amount equal to 1% of capital
committed by the partners, and that
GP will receive an interest in 20% of
future partnership net income and
gains as measured over the life of the
fund.
Result: The special allocation to M is
allocable out of net profits, the
partnership assets have a readily
ascertainable market value that is
determined at the close of each
taxable year, and it cannot reasonably
be predicted whether the partnership
will have net profits with respect to its
entire portfolio for the year to which
the special allocation would relate.
Thus, the special allocation is neither
reasonably certain nor highly likely to
be available because the partnership
assets have a readily ascertainable fair
market value that is determined at the
beginning and at the end of the year.
Thus, the arrangement is respected
and not recharacterized as a disguised
payment for services.
GP will also receive an additional
interest in future partnership net
income and gains determined by a
formula (‘Additional Interest’). The
parties intend that the estimated
present value of the Additional
Interest approximately equals the
present value of 1% of capital
committed by the partners
determined annually over the life of
the fund. However, the amount of net
profits that will be allocable to GP
under the Additional Interest is
neither highly likely to be available
nor reasonably determined based on
all facts and circumstances available
upon formation of the partnership.
Also, GP undertakes a clawback
obligation, which is apparently
applicable to the 20% profit interest
and the Additional Interest.
Observation: The result should be the
same for a partnership whose
investment assets are readily tradable
on an established securities market
and that bases the special allocation
on the partnership's GAAP net
income, even if the partnership is not
engaged in the trade or business of
trading in securities or does not
Result: The arrangement with the GP
creates significant entrepreneurial
risk because the allocation to the GP is
of net profits and the allocation is
subject to a clawback obligation over
the life of the fund. Thus, the
arrangement is respected and not
recharacterized as a disguised
payment for services.
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Example 6
M (as GP’s appointed delegate) can
waive all or a portion of its fee for any
year if it provides written notice to the
limited partners at least 60 days prior
to the commencement of the
partnership taxable year for which the
fee is payable. If M waives its fee, M
will receive an interest in future
partnership net income and gains
determined by a formula (‘Additional
Interest’). The parties intend that the
estimated present value of the
Additional Interest approximately
equals the estimated present value of
the fee that was waived. M undertakes
a clawback obligation.
Result: The facts and circumstances
indicate that GP and M’s
arrangements create significant
entrepreneurial risk because the
allocations are out of net profits and
subject to a clawback obligation over
the life of the fund. Thus, the
arrangements are respected and not
recharacterized as disguised payments
for services.
Observation: Example 6 illustrates an
annual waiver (60 days before the
beginning of the year in which the
waiver will take effect). M can waive
and in return M (not GP) gets the
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waiver interest. In contrast, some
management fee waiver arrangements
in practice contemplate that M can
waive the fee for the benefit of an
affiliated GP. These arrangements
may be set up for limited liability or
other non-federal income tax
purposes.
Changes to safe harbor profits
interest treatment and
guaranteed payments are
forthcoming
The Preamble states that Treasury and
the IRS do not believe that Rev. Proc.
93-27 (i.e., the profit interest safe
harbor) applies to common
management fee waiver arrangements
(where the service provider and the
allocation recipient are separate legal
entities).
The Preamble also describes the plan
by Treasury and the IRS to issue a
revenue procedure providing an
additional exception to the safe harbor
that will apply to any profit interest
issued in conjunction with a partner
forgoing payment of an amount that is
substantially fixed (including amounts
fixed by formula such as a fee based
on a percentage of capital
commitments).
The forthcoming exception will
effectively place at issue the valuation
of many management fee waiver
interests even when the service
provider and recipient are the same
legal entity. That is, for the same
recipient, even if those interests are
hard-wired at the inception of a
partnership and presumably subject
to a clawback obligation.
Observation: These developments
do not necessarily mean that
management fee waiver interests are
taxable when issued, but restarts the
valuation controversies illustrated in
such cases as Diamond v.
Commissioner, 56 T.C. 530 (1971) and
Campbell v Commissioner, 943 F.2d
815 (8th Cir. 1991).
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The proposed regulations also change
a key example related to guaranteed
payments in Reg. sec. 1.707-1(c). In
Example 2, Partner C, a partner in
partnership CD, is to receive 30% of
partnership income but not less than
$10,000. The income of CD is
$60,000, and C is entitled to $18,000
(30% of $60,000). Example 2, as
currently in effect, concludes that no
part of the $18,000 is a guaranteed
payment. It also illustrates that if CD
only had income of $20,000, C would
have a distributive share of net
income of $6,000 ($20,000 x 30%)
and a guaranteed payment of $4,000.
Example 2, as proposed, would
reverse the priority of net income and
guaranteed payment treatment. With
CD income of $60,000, C recognizes a
guaranteed payment of $10,000. The
guaranteed payment reduces CD’s
income to $50,000, and C’s
distributive share is $8,000 (only 16%
of the net income). The example thus
recharacterizes $10,000 of net income
as a guaranteed payment without
distorting the economic arrangement.
C is only entitled to $18,000 under
the facts.
The nuances of Example 2 should be
considered by any partnerships and
their partners relying on ‘targeted
capital account’ partnership
agreements. As indicated in the
Preamble, Treasury and the IRS
generally believe that existing rules
under Reg. secs. 1.704-1(b)(2)(ii) and
1.707-1(c) require partner capital
accounts to reflect the partner’s
distribution rights as if the
partnership liquidated at the end of
the year. They, however, request
comments on specific issues and
examples with respect to which
further guidance would be helpful,
including possibly whether and when
targeted capital account agreements
can satisfy the economic effect
equivalence rule of Reg. sec. 1.7041(b)(2)(ii)(i). The positions reflected
in the Preamble warrant additional
consideration.
Effective date
The proposed regulations are not
effective until finalized. However, the
Preamble and the regulations state
that the IRS and Treasury view
Section 707(a)(2)(A) as self-executing
and that the proposed regulations
generally reflect current law under the
legislative history of Section
707(a)(2)(A) and Congressional intent
as to which arrangements are
appropriately treated as disguised
payments for services. Furthermore,
the regulations are effective in the
case of any arrangement entered into
or modified on or after the effective
date. What this means in practice as
these arrangements are operated is
still being assessed.
The takeaway
These proposed regulations are likely
to impact many taxpayers, especially
private equity and other investment
funds that employ management fee
waiver arrangements.
The extent to which arrangements
have significant entrepreneurial risk
or run afoul of the other factors will
need to be assessed for each
arrangement, as the facts and
circumstances are typically different
in each situation. Significantly, those
arrangements that do not properly
provide for clawback of amounts upon
subsequent losses (i.e., taking into
account cumulative net profit) are
particularly prone to risk, as are
arrangements where the provider of
management services transfers the
potential right to waived fee amounts
to a separate recipient of the
allocation and distribution, such as
the general partner. Allocations of
gross income items could also be
problematic.
Treasury and the IRS have requested
comments on the proposed
regulations by October 21, 2015.
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Let’s talk
For a deeper discussion of how this might affect your fund arrangements or other matters, please contact:
Mergers & Acquisitions
Todd McArthur, Washington D.C.
+1 (202) 312-7559
[email protected]
Audrey Ellis, Washington, D.C.
+1 (202) 346-5234
[email protected]
Michael Hauswirth, Washington D.C.
+1 (202) 346-5164
[email protected]
Matthew Arndt, Washington, D.C.
+1 (202) 312-7633
[email protected]
John Schmalz, Washington D.C.
+1 (202) 414-1465
[email protected]
Private Equity
Judith Daly, Boston, MA
+1 (617) 530-6146
[email protected]
Bridgett Maillet, Boston, MA
+1 (617) 530-5567
[email protected]
Asset Management
Miriam Klein, New York, NY
+1(646) 471-0988
[email protected]
Alan Biegeleisen, New York, NY
+1(646) 471-3588
[email protected]
Sol Basilyan, New York, NY
+1(646) 471-0306
[email protected]
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