Last week, the Internal Revenue Service issued proposed regulations that provide guidance to partnerships and their partners regarding when an arrangement will be treated as a "disguised payment" for services (REG-115452-14). One arrangement covered by the proposed rules concerns "fee waiver" arrangements in private equity funds. These arrangements are increasingly common, but their tax treatment is receiving more scrutiny. The proposed rules are the first official statement by the IRS about how it views these arrangements. If they are adopted, fund managers may see a significant change in the tax treatment related to such fee waivers.
The proposed regulations should be viewed in the following context. Fund managers typically charge a 2% management fee on assets managed and receive 20% of any profits of the fund (a "carried interest" or "carry"). The taxation of a carried interest has been consistent for many years. The holder of a profits interest in a partnership is taxed, as all partners are, on the appreciation of the assets at capital gains rates, which are currently taxed at a maximum federal rate of 20%. This treatment recognizes that the carry is subject to the "entrepreneurial risk" of partnership operations because asset appreciation is not guaranteed. Nevertheless, during the last several years, various objections have been raised to taxation of a carried interest at capital gains rates. For example, one argument is that a fund manager's carried interest is actually compensation for services and thus should be taxed as ordinary income, with a top federal tax rate of 39.6%.
In contrast to a carried interest, a fixed management fee is treated as compensation for services and taxed at the higher ordinary income rates. However, some fund partnership agreements include an option for fund managers to waive payment of the fixed 2% fee in exchange for an additional (and, in some cases, priority) profits interest in the fund. Under these circumstances, the fund manager benefits in that its total return is paid out of fund profits (i.e., capital appreciation) and treated as capital gains. Limited partners can benefit from this strategy in that it reduces current cash expenses of the fund and substitutes a future profits interest opportunity for a guaranteed fee, further aligning the manager's interests with those of the limited partners. Nevertheless, consistent with the general criticism of the capital nature of a carried interest, some commentators have challenged fee waivers as a further attempt to artificially lower the amount of taxes paid by private equity and similar firms. The rulemaking proposed by the IRS last week squarely and formally addresses this specific issue.
In the proposed rules, several examples deal with fee waiver arrangements. The IRS considers two elements key: (i) how the fee is waived, and (ii) how the right to future profits is determined. In general, if a waiver is executed in advance and cannot be revoked and if the future profits allocation is neither "highly likely" to be available nor "reasonably determinable" at the time of the waiver, the proposed rules would not re-characterize a profits allocation related to a fee waiver as ordinary income. On the other hand, profits allocations that will be presumed to be compensation (ordinary) income include allocations that are capped, where the cap is reasonably expected to apply, and allocations out of partnership gross income, rather than net income.
Because these regulations are proposed, there is a 90-day notice and comment period from the date of publication of the rules in the Federal Register (July 23, 2015). Significantly, the IRS has solicited comments "regarding fee waiver requirements that sufficiently bind the waiving service provider and that are administrable by the partnership and its partners." This implies that the IRS is open to hearing from stakeholders in the private equity community regarding the parameters of fee waiver arrangements that will be respected as generating capital gains income and will not be treated as disguised payments for services subject to tax at ordinary income rates. Comments can be submitted to the IRS by regular or electronic mail until October 21, 2015.