In July 2015, the U.S. Department of the Treasury issued proposed regulations that address whether the waiver of a service provider’s fee and the granting to the service provider of an interest in the partnership’s future profits is taxable compensation to the service provider or the non-taxable grant of a profit’s interest.
Private equity funds often enter into arrangements with fund sponsors in which the sponsor’s management fee is waived in exchange for a profit’s interest in the fund. The waiver of a management fee in exchange for a profit’s interest potentially allows the service provider to enjoy preferential tax treatment. The receipt of a management fee is taxable as compensation at ordinary income rates while income deriving from a profit’s interest in a partnership is typically taxable as capital gains.
The proposed regulations clarify that if a fee waiver constitutes payment for services depends on all of the facts and circumstances. The most important factor is whether the allocation and distribution to the service provider is subject to significant entrepreneurial risk. If significant entrepreneurial risk does not exist, the arrangement is payment for services. Various factors indicate an arrangement’s lack of significant entrepreneurial risk:
(i) capped allocations of partnership income,
(ii) an allocation for one or more years in which the service provider’s share of income is reasonably certain,
(iii) an allocation of gross income,
(iv) an allocation that is predominantly fixed in amount, is reasonably determinable under all the facts and circumstances, or is designed to assure that sufficient net profits are likely to be available to make the allocation to the service provider, or
(v) an arrangement in which a service provider 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 above factors create a presumption that the arrangement lacks significant entrepreneurial risk and the taxpayer must then show by clear and convincing evidence that other factors indicate the presence of such risk.
An arrangement that possesses significant entrepreneurial risk may still constitute payment for services if other factors are present:
(i) the service provider holds, or is expected to hold, a transitory partnership interest or a partnership interest for only a short duration,
(ii) the service provider receives an allocation and distribution in a time frame comparable to the time frame that a non-partner service provider would typically receive payment,
(iii) the service provider became a partner primarily to obtain tax benefits that would not have been available if the services were rendered to the partnership in a third party capacity,
(iv) the value of the service provider’s interest in general and continuing partnership profits is small in relation to the allocation and distribution, or
(v) the arrangement provides for different allocations or distributions with respect to different services received, the services are provided either by one 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.
Revenue Procedure 93-27 provides that in certain circumstances if a person receives a profit’s interest in exchange for the performance of services for the partnership, the IRS will generally not treat the receipt of the interest as a taxable event. The preamble to the proposed regulations states that the IRS and Treasury have determined that Revenue Procedure 93-27 does not apply to transactions in which a person performs services for a partnership and waives the fee, but the partnership grants an interest in future partnership profits to another person. Additionally, in conjunction with finalizing the proposed regulations, Treasury and the IRS plan to release a revenue procedure describing another exception to Revenue Procedure 93-27.
The proposed regulations would be effective on the date the final regulations are published in the Federal Register and would apply to any arrangement entered into or modified after the date of publication of the final regulations. For arrangements entered into prior to the publication of the final regulations, section 707(a)(2)(A) and its legislative history govern whether an arrangement constitutes the non-taxable grant of a profit’s interest or taxable compensation for services. However, Treasury made clear in the preamble that both Treasury and the IRS believe that the proposed regulations generally reflect congressional intent.
alliantNational, alliantgroup’s national practice, provides subject matter expertise on complex and emerging federal, state and international tax issues as well as legislative and regulatory affairs to help businesses receive timely and precise guidance on all their tax matters. Contact us today to learn how your business can benefit from alliantgroup’s tax consulting services.