At the end of July 2015, the IRS released proposed regulations on certain “disguised” payments by a partnership to partners for services. Under such arrangements, the service provider typically receives a tax-deferred distribution of cash, or an allocation of long-term capital gain or qualified dividend income. Under the proposed regulations, some of these arrangements may be re-characterized as disguised payments for services and treated as ordinary compensation income. The proposed regulations have been anticipated for several months and were intended to target management fee waiver arrangements, in which a private equity or other fund manager exchanges all or a portion of its unearned management fees for a profit interest in the fund under management. However, the proposed regulations are broader than anticipated, and their applicability may extend beyond management fee waiver arrangements.
Disguised payments can often resemble the typical “carried interest” structure, in which the sponsor receives a share of the up-side in the venture. A carried interest generally is structured such that, upon its receipt at the outset of the venture, it has no value and therefore is not taxable to the recipient. A carried interest generally is held on a tax deferred basis; such that distributions during the life of the venture may be tax-deferred or taxed at favorable capital gain tax rates, and capital events are taxed at favorable capital gain rates.
For several years, Congress and the Obama Administration have proposed law changes to combat carried interests because of the perception that a carried interest is akin to a fee and should be taxed at ordinary income tax rates. In most versions of these proposals, a right, received by sponsors or other service partners, to share in partnership profits without a capital investment on their part would be treated as a fee and taxed as ordinary income. However, legislation to this effect has not been passed.
The proposed regulations provide tests for determining whether an allocation of partnership income is taxable as a fee (ordinary income) or an allocation of partnership income (often comprising unrealized gains, and tax-favored net long-term capital gains and qualified dividend income). The most significant test looks to see whether there is a lack of significant entrepreneurial risk. Some of the factors that indicate a lack of entrepreneurial risk, according to the proposed regulations, include allocations that are capped in amount and can reasonably be expected to be paid; allocations from gross income; allocations for a fixed number of years under which the service provider’s distributive share of income is reasonably certain; an allocation (under a 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; and arrangements 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. It appears that interests that are dependent on the entrepreneurial risk of the venture even without a capital investment by the partner pass this test and would not be taxed as fees.
The proposed regulations provided other tests that can be less heavily weighted, and that a typical carried interest might fail or possibly pass. Straightforward allocations of amounts in lieu of fees, we believe, will not pass the tests and will be taxed as fees.
The proposed regulations will become effective on the date they become final. However, the IRS has expressed its position that the proposed regulations reflect Congressional intent as to “which arrangements are appropriately treated as disguised payments for services.” This appears to indicate that the IRS may take the position that arrangements entered into before the regulations become final could be tested under the proposed regulations.
We currently believe that typical carried interests, such as those that provide the holder a share in pure up-side in partnerships (depending on the terms of such interests), would pass the test for entrepreneurial risk and would not be taxed as ordinary income. It may very well be that the proposed regulations help end the speculation about future legislation that might take a broad stroke and tax all carried interests as ordinary income, as prior (unpassed) law proposals would have done. We will continue to monitor the proposed regulations as (and if) they become final, and the effects on taxpayers resulting from them.
Every partnership structure with allocations to the sponsor, manager or similar “service” partners, as well as the related operating agreement, should be examined to determine if the tests in the proposed regulations may be satisfied. FGMK can assist you in reviewing the structure of your partnership or joint venture and recommending potential curative actions. Contact Steven Bokiess or Randy Markowitz
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