IRS Thinks Certain Profits Interests Are Too Good To Be True
An election year is upon us. Many presidential candidates are proposing their respective tax plans. But let us look backwards and consider one of the tax issues brought to national attention in the 2012 presidential campaign — an issue the IRS recently addressed in proposed regulations: management fee waivers. During the 2012 presidential campaign, Mitt Romney’s company, Bain Capital, became a topic of discussion when it was shown how, by using management fee waivers, Bain Capital converted what otherwise would have been management fees taxed as ordinary income into long-term capital gains taxed at preferential rates, resulting in significant tax savings.1 A management fee waiver is an income tax planning technique that generally converts what would otherwise be a fee for services taxed as ordinary income into a grant of a profits interest in the partnership. The conversion itself is not taxable. Subsequently, if the partnership has long-term capital gain, the recipient of the newly issued profits interest is allocated a share of such gain, which is taxed as long-term capital gain (as opposed to ordinary income).
On July 22, 2015, the Department of the Treasury and the IRS issued proposed regulations under I.R.C. §707(a)(2)(A) to treat the grant of certain profits interests as a disguised payment for services.2 This article discusses, in general, how profits interests are taxed and how management fees are converted into profits interests through waivers, how the proposed regulations would affect the use of profits interests, and certain shortcomings of the proposed regulations.
Partnership Capital Interests and Partnership Profits Interests
There are generally two types of partnership interests: capital interests and profits interests. A capital interest is an interest that would give the holder a share of the proceeds if the partnership’s assets were sold at fair market value and then the proceeds were distributed in a complete liquidation of the partnership. This determination generally is made at the time of receipt of the partnership interest. A profits interest is a partnership interest other than a capital interest.3 In other words, a profits interest is a partnership interest that entitles its holder to participate only in future profits of the partnership.
The tax law is relatively settled that receipt of a capital interest in exchange for services is taxable to the recipient.4 However, the taxation of profits interests is less certain.5 To provide guidance to taxpayers on the taxation of profits interests in exchange for services, the IRS issued Rev. Proc. 93-27, 1993-2 C.B. 343 (as modified by Rev. Proc. 2001-43, 2001-2 C.B. 191), which provides a safe harbor wherein the IRS will not seek to tax a profits interest issued in exchange for services provided that the recipient receives the profits interest either as a partner or in anticipation of becoming a partner. However, the safe harbor does not apply if 1) the profits interest relates to a substantially certain and predictable stream of income from partnership assets, such as high-quality debt or high-quality net lease; 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 under I.R.C. §7704.6
Private Equity Funds and Management Fee Waivers
In general, a private equity fund (PE fund), typically a limited partnership for state law purposes and taxed as a partnership for federal income tax purposes, holds various investments that are held long-term pending a liquidity event. The investors (i.e., the limited partners) of the PE fund provide the capital needed to make such investments. Income from such investments (whether interest, dividends, capital gains, etc.) flows through to the investors and retains the same character. The limited partners typically own 99 percent of the PE fund, and the general partner owns the remaining 1 percent.
The general partner, however, does not manage the PE fund. Rather, a private equity firm (such as Bain Capital) handles all investment and management duties. The manager is not a partner of the PE fund but rather is an independent contractor with a management agreement that entitles it to a fee equal to a percentage of assets under management (management fee). The general partner is an affiliate of the manager. As an incentive to grow the PE fund and align the manager’s interests with those of the investors, the general partner (not the manager) typically makes minimal capital contributions to the PE fund and the general partner (not the manager) receives a right to participate in some percentage (usually 20 percent) of the profits of the PE fund (carried interest) after the investors receive a certain return on their investment. In this structure, the general partner is merely a shell entity that holds the general partnership interest and the carried interest while the manager performs all management functions. There are nontax reasons for this bifurcation, including insulating the general partnership interest and carried interest from potential liabilities of the manager, mitigating the exposure of income allocated to the general partner from being subject to state and local taxes (particularly when the manager is located in a high-tax jurisdiction, such as New York City), and providing more varied compensation packages to various key personnel.7
The management fee is generally 2 percent of the PE fund’s assets under management. The management fee waiver is a contractual right the manager is granted, which allows it, at its sole option, to irrevocably waive any portion of the management fee prior to the time the right to receive the management fee accrues. As a result of such waiver, the general partner (and not the manager) is issued a profits interest in the PE fund (the special interest, in addition to its 1 percent capital interest and 20 percent carried interest). The contractual terms of the special interest entitle the general partner to receive a priority distribution of future PE fund profits on a first-dollar basis (before satisfying any required returns of capital, preferred returns, or the general partner’s own carried interest) in an amount equal to the portion of the waived fee. The special interest is generally paid out of the PE firm’s profits for a specific, limited accounting period, such as a fiscal quarter and each fiscal quarter thereafter until satisfied. With the manager controlling the timing of liquidity events, it creates opportunity for the special interest to be paid from certain profits despite the PE fund’s overall performance being a loss. For instance, if there is only a single liquidity event in a fiscal quarter that produces sufficient gain, the special interest will be satisfied from such gain, despite losses in the remaining three fiscal quarters, resulting in an overall net loss to the PE fund.
Applying the safe harbor, the PE fund, manager, and general partner may argue that the special interest is a profits interest because, were the PE fund to liquidate immediately after the general partner receives the special interest, the general partner would not receive any liquidating distributions with respect to the special interest. The special interest only entitles the holder to participate in profits accruing in subsequent accounting periods. Thus, the special interest is not a capital interest and, as such, is a profits interest. The general partner is only taxed on a pro-rata portion of the PE fund’s capital gains. Where such gain is long-term capital gain, amounts allocated under the special interest retains such character and the manager has essentially converted what would have been ordinary income (taxed at the highest marginal rate plus applicable employment taxes) into long-term capital gain (taxed at 20 percent and not subject to employment taxes) and has shifted such income to a related party. The contractual terms of the special interest all but ensure it will be paid regardless of the PE fund’s profitability. As a result, the manager may be able to unilaterally defer the recognition of such income by timing the liquidity events.
Proposed Regulations: Partner Not Acting in Capacity as a Partner
The forgoing management fee waiver is but one example of how contractual safeguards can be built in to a profits interest arrangement to insulate the recipient of such interest from the risk of the partnership business itself. Because of the great flexibility with which partnerships may be structured, it creates the potential for abuse. To curb the potential for abuse, I.R.C. §707(a)(2)(A) provides, that, under regulations prescribed by the Secretary, if a partner performs services for a partnership or transfers property to a partnership, there is a related direct or indirect allocation and distribution to such partner, and the performance of such services (or such transfer) and the allocation and distribution, when viewed together, are properly characterized as a transaction occurring between the partnership and a partner acting other than in his or her capacity as a member of the partnership, such transaction shall be treated as a transaction as occurring between the partnership and one who is not a partner.
The Treasury and the IRS have promulgated proposed regulations under I.R.C. §707(a)(2)(A) to treat certain arrangements not as a distribution of partnership income (including an allocable share of long-term capital gain) but rather as a payment for services with someone other than a partner. While the proposed regulations address management fee waivers, they are broad enough to include the issuance of any profits interest.
The proposed regulations identify six nonexclusive factors to be considered in the determination of whether an arrangement includes the necessary elements to be characterized (in whole or in part) as a payment for services. Such factors are generally divided into two categories: significant entrepreneurial risk (which is the most important factor considered) and five additional factors (which are secondary to significant entrepreneurial risk). The six nonexclusive factors are:
1) Whether an arrangement lacks significant entrepreneurial risk.8 This is based on the service provider’s entrepreneurial risk relative to the overall entrepreneurial risk of the partnership. The proposed regulations enumerate five specific factors that, if any one or more are present, create a presumption that an arrangement lacks significant entrepreneurial risk that may only be overcome by clear and convincing evidence:
• Capped allocations of partnership income if the cap is reasonably expected to apply in most years;9
• An allocation for one or more years under which the service provider’s share of income is reasonably certain;10
• An allocation of gross income;11
• An allocation (under formula or otherwise) 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 highly likely to be available to make the allocation to the service provider (e.g., if the partnership agreement provides for an allocation of net profits from specific transactions or accounting periods and this allocation does not depend on the long-term future success of the enterprise);12 or
• An arrangement in which a service provider waives its right to receive payment for the future performance of services in a manner that is nonbinding or fails to timely notify the partnership and its partners of the waiver and its terms.13
2) The service provider holds, or is expected to hold, a transitory partnership interest or a partnership interest only for a short duration.14
3) The service provider receives an allocation and distribution in a time frame comparable to the time frame that a nonpartner service provider would typically receive payment.15
4) 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.16
5) The value of the service provider’s interest in general and continuing partnership profits is small in relation to the allocation and distribution.17
6) 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 §707(b) or 267(b), and the terms of the differing allocations or distributions are subject to levels of entrepreneurial risk that vary significantly.18
The forgoing factors mirror the factors discussed in the legislative history accompanying the enactment of I.R.C. §707(a)(2)(A) with the addition of the sixth factor.19 Under the proposed regulations, the determination of whether an arrangement is a disguised payment for services is made at the time such arrangement is entered into or modified, regardless of when the associated allocation or distribution is made (even if in subsequent years).20 When the terms allow a management fee to be waived for any period subsequent to the date the arrangement is entered into, there is a modification for purposes of the proposed regulations if a waiver is exercised after the date final regulations are published.21 When characterized as a disguised payment, an allocation or distribution is treated as a payment for services for all purposes of the Internal Revenue Code.22 As such, the service provider is required to include such payment as ordinary income and the partnership is required to either deduct or capitalize the payment, depending on the nature of the services provided. The timing of income inclusion, deduction, and capitalization, as the case may be, is in accordance with applicable accounting laws under the code.23 If an allocation or distribution is characterized as a disguised payment for services under the proposed regulations, such characterization applies even if it results in the service provider not being a partner or it results in no partnership existing.24 The proposed regulations further provide a set of six examples that illustrate the application of the rules set forth therein.25
In addition, in the preamble to the proposed regulations, the IRS articulated its position that the safe harbor does not apply to the management fee waiver arrangement described above because:
[such arrangements] would not satisfy the requirement that receipt of an interest in partnership profits be for the provision of services to or for the benefit of the partnership in a partner capacity or in anticipation of being a partner, and because the service partner would effectively have disposed of the partnership interest (through a constructive transfer to the related party) within two years of receipt.26
The IRS went on to provide in the preamble that it intends to add an additional exception to the existing safe harbor, which shall apply to:
[A] profits interest issued in conjunction with a partner forgoing payment of an amount that is substantially fixed (including a substantially fixed amount determined by formula, such as a fee based on a percentage of partner capital commitments) for the performance of services, including a guaranteed payment under section 707(c) or a payment in a non-partner capacity under section 707(a).27
The proposed regulations do not take effect until the date final regulations are published in the Federal Register and would apply only to arrangements entered into or modified on or after such date.28 However, it is the position of the Treasury and the IRS that, prior to the publication of final regulations, 1) the determination of whether an arrangement is a disguised payment for services under I.R.C. §707(a)(2)(A) is made on the basis of the statute itself and the legislative history of I.R.C. §707(a)(2)(A); and 2) the proposed regulations generally reflect congressional intent regarding when to characterize an arrangement as a disguised payment for services.29 Effective July 23, 2015, Rev. Rul. 81-300, 1981-2 C.B. 143 (treating a fee payable to the general partners in return for management services equal to five percent of the gross rentals received by the partnership as a guaranteed payment) is obsoleted. Rev. Rul. 66-95, 1966-1 C.B. 196 (treating the excess of a partner’s guaranteed minimum profit participation over such partner’s distributive share of income as a guaranteed payment) and Rev. Rul. 69-180, 1969-1 C.B. 183 (providing examples for the proper method of computing the partners’ distributive shares of ordinary income and capital gain, under the partnership agreement, where a partner received a guaranteed payment) will be obsoleted the date final regulations are published.30
Potential Impact of IRS Safe Harbor Position and Proposed Regulations
The proposed regulations, including the preamble to them, make clear that the Treasury and the IRS view the grant of certain profits interests that are not subject to risk of the partnership business, such as in the context of management fee waivers, as too good to be true. With regard to the safe harbor, the IRS’ position (as set forth in the preamble to the proposed regulations) is hyper-technical and appears to ignore the fact that there may be bona fide nontax reasons for a bifurcating ownership. With respect to the proposed regulations themselves, the question is whether while in proposed format, I.R.C. §707(a)(2)(A) is self-executing (including the guidance provided in the legislative history accompanying I.R.C. §707(a)(2)(A)) absent final regulations or, whether so-called “phantom regulations” exist.31 The Tax Court and the Seventh Circuit have applied phantom regulations to uphold the application of other provisions.32 The black letter of I.R.C. §707(a)(2)(A) provides that its provisions shall apply only “[u]nder regulations prescribed by the Secretary….” As we learned in Mayo Foundation for Medical Educ. and Research v. U.S., 562 U.S. 44 (2011), there is no carve-out for tax law from the general tenets of administrative law (i.e., no “tax exceptionalism”).33 In nontax cases, courts (including the Supreme Court) have refused to enforce phantom regulations.34 To do so would essentially be, as one court put it, “placing policy decisions in the courts.”35 As a result of Mayo, prior tax jurisprudence applying phantom regulations should no longer be valid. This should weaken the IRS and Treasury’s statement in the proposed regulations that I.R.C. §707(a)(2)(A) and the legislative history thereunder shall be applied in evaluating management fee waivers.
If finalized in their current form, such regulations may not even apply to the typical management fee waiver arrangement described above. The first element of I.R.C. §707(a)(2)(A) requires that a partner perform services or transfer property to the partnership. However, in the typical management fee waiver arrangement, the manager providing the services is not a partner. The proposed regulations do not provide for any attribution of ownership rules so, unless such rules are included in the final regulations, such regulations arguably would not apply.
The language of the proposed regulations themselves, including the examples set forth therein, does not provide sufficient guidance to taxpayers. The proposed regulations provide that all the facts and circumstances will be evaluated. However, while a nonexclusive list of factors are provided for taxpayers to consider, such factors include qualifying language such as “reasonably expected,” “reasonably determinable,” and “highly likely” without any further discussion of what facts, if present, would meet those standards. In addition, the examples do not provide any examples of what facts, if present, would meet the clear and convincing standard to overcome any presumption the proposed regulations create. None of the examples provided in the proposed regulations isolate and focus on these material terms. Rather, the examples are conclusory in nature. This creates a gray area for taxpayers trying to appropriately structure their affairs, including management fee waivers.
The proposed regulations provide that an allocation of net profits over the life of a business venture favors significant entrepreneurial risk, whereas an allocation of net profits over a 12-month or less accounting period does not. Would an allocation of net profits for an 18-month period be sufficient to create significant entrepreneurial risk? What about a 48-month period? A period less than the life of a business venture but greater than 12 months would subject the recipient of a profits interest to the risks of the business. The proposed regulations give no indication of what that period would be.
Given the wide range of facts and circumstances under which profits interests can be arranged, including the varying degree by which contractual safeguards ensure the recipient of a profits interest will be paid, both the IRS and taxpayers would be well served by providing for a more fully formed set of final regulations under I.R.C. §707(a)(2)(A), including, but not limited to, a more detailed set of examples. Nonetheless, the proposed regulations should serve as a warning to taxpayers that if their profits interest is too good to be true, the IRS will likely agree and seek to recharacterize it as a payment for services. Thus, when drafting such arrangements, taxpayers should be mindful of the extent to which contractual safeguards ensure payment.
1 Jack Otter, Bain’s Capital Tax Breaks: Are They Legal?, CBS News, Sept. 11, 2012, available at http://www.cbsnews.com/news/bain-capitals-tax-breaks-are-they-legal/; Dan Primack, How Bain Capital Execs Lower Their Taxes, Fortune, Aug. 28, 2012, available at http://fortune.com/2012/08/28/how-bain-capital-execs-lower-their-taxes/.
2 Disguised Payments for Services, 80 Fed. Reg. 43,652, 43,657 (Jul. 23, 2015). All references made to the Internal Revenue Code shall mean the Internal Revenue Code of 1986 as amended.
3 Rev. Proc. 93-27, 1993-2 C.B. 343 (as modified by Rev. Proc. 2001-2 C.B. 191).
4 See I.R.C. §83.
5 Gregg D. Polsky, Private Equity Management Fee Conversions at 19 (Nov. 4, 2008), FSU College of Law, Public Law Research Paper No. 337; FSU College of Law, Law, Business & Economics Paper No. 08-18, available at SSRN: http://ssrn.com/abstract=1295443.
6 Rev. Proc. 93-27, 1993-2 C.B. 343 (as modified by Rev. Proc. 2001-43, 2001-2 C.B. 191).
7 Gregg D. Polsky, Private Equity Management Fee Conversions (Nov. 4, 2008), FSU College of Law, Public Law Research Paper No. 337; FSU College of Law, Law, Business & Economics Paper No. 08-18, available at SSRN: http://ssrn.com/abstract=1295443.
8 Prop. Treas. Reg. §1.707-2(c)(1).
9 Prop. Treas. Reg. §1.707-2(c)(1)(i).
10 Prop. Treas. Reg. §1.707-2(c)(1)(ii).
11 Prop. Treas. Reg. §1.707-2(c)(1)(iii).
12 Prop. Treas. Reg. §1.707-2(c)(1)(iv).
13 Prop. Treas. Reg. §1.707-2(c)(1)(v).
14 Prop. Treas. Reg. §1.707-2(c)(2).
15 Prop. Treas. Reg. §1.707-2(c)(3).
16 Prop. Treas. Reg. §1.707-2(c)(4).
17 Prop. Treas. Reg. §1.707-2(c)(5).
18 Prop. Treas. Reg. §1.707-2(c)(6).
19 See Staff of Joint Comm. on Taxation, H.R. 4170, 98th Cong., Public Law 97-248, General Explanation of the Revenue Provisions of the Deficit Reduction Act of 1984 at 227-29 (Comm. Print 1984).
20 Prop. Treas. Reg. §1.707-2(b)(2)(i).
21 Prop. Treas. Reg. §1.707-9(a)(1).
22 Prop. Treas. Reg. §1.707-2(b)(2)(i).
23 Prop. Treas. Reg. §1.707-2(b)(2)(ii).
24 Prop. Treas. Reg. §1.707-2(b)(3).
25 Prop. Treas. Reg. §1.707-2(c)(d).
26 Disguised Payments for Services, 80 Fed. Reg. 43,652, 43,656 (Jul. 23, 2015).
28 Prop. Treas. Reg. §1.707-9(a)(1).
29 Prop. Treas. Reg. §1.707-9(a)(2).
30 Disguised Payments for Services, 80 Fed. Reg. 43,652, 43,657 (Jul. 23, 2015).
31 Amandeep S. Grewal, Mixing Management Fee Waivers with Mayo, 16 Fl. Tax Rev. 1, 3 (2014); Under general principles of administrative law, for a substantive agency regulation to carry for the force of law, it must first have been subject to public notice and comment. See National Family Planning and Reproductive Health Assoc., Inc. v. Sullivan, 979 F.2d 227, 241 (D.C. Cir. 1992) (holding that an agency’s substantive rule first required notice and comment under 5 U.S.C. §553 in order to carry the force of law). Because proposed regulations have not been subject to notice and comment, they should not carry the force of law.
32 Id. at 18-27.
33 Mayo, 562 U.S. at 55.
34 Grewal, Mixing Management Fee Waivers with Mayo, 16 Fl. Tax Rev. at 3.
35 Id. at 30 (citing to Phillips v. Amoco Oil, 799 F. 2d 1464, 1471 (11th Cir. 1986)).
Mitchell W. Goldberg is an attorney in Boca Raton with Berger Singerman, LLP, whose practice area focuses primarily on federal taxation and related business transactions.
This column is submitted on behalf of the Tax Law Section, James Herbert Barrett, chair, and Michael D. Miller and Benjamin Jablow, editors.