Tax News
Proposed Regulation 1.707-2 makes the future of “fee waivers” dim!
July 24, 2015
Administrative Actions
The topic of “fee waivers” has been covered several times by fund-taxation.com.  A "fee waiver" is a technique often used in the private equity fund context whereby the fund manager waives all or portion of its 2% fee in exchange for a profit interest or an offset against the GP’s capital commitment. A lot has been written on this topic by various authors debating the tax issues associated with the strategy. As many practitioners who follow the industry know, the IRS has been studying “fee waivers” for the last few years. Moreover, the IRS had promised that it will come up with proposed regulations that will address the issue based on the concept of “entrepreneurial risk.” The regulations were promised to come in a timely fashion, and they just did. They were issued a few days ago and there is already a stir about them.

Stakeholders should start tackling the regulations right away. They can be found here. Our view is that the regs hammer fee waivers with a proverbial 1,000 pound sledge hammer. The regs go beyond what was expected, at least by fund-taxation.com.  While we would not go as far to say that this is the end of “fee waivers,” we would say that this might be the end of “fee waivers” as we know them, unless of course practitioners are willing to go against the proposed regs and chance it in court.

So what is happening in the regulations? As most knew and expected, the central concept of the regulations is “entrepreneurial risk.” The concept is designed to weed out arrangements that do not expose the profits interest allocations attributable to the fee waiver to economic risk. While the issue of whether particular arrangement is subject to “entrepreneurial risk” ultimately depends on all the facts and circumstances, the IRS has given us plenty of factors and examples to consider. Five facts and circumstances create a presumption against “entrepreneurial risk” and will spell doom for a waiver unless the taxpayer can rebut the presumption by clear and convincing evidence (a very high burden of proof). Those include: (i) capped allocations of partnership income if the cap is reasonably expected to apply in most years; (ii) an allocation for one or more years under which the service provider’s share of income is reasonably certain; (iii) an allocation of gross income; (iv) 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 (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.

On top of these, the following factors, while not as heavily weighed as “entrepreneurial risk,” may also indicate a faulty fee waiver: (i) the service provider has a transitory partnership interest, (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, and (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 with respect to different services received.

We venture to say that the above factors lay a very tight net through which few of the fee waivers in existence will pass through. The examples in the regulations provide little solace. Example 4 illustrates one instance of a successful waiver, but the example is of very limited application to a private equity fund because it involves marketable securities with a Sec. 475 election. Presumably the Example is tailored for hedge funds, but fee waivers in that industry are unusual. The Example may be topical to regulated investment advisers that trade ETFs through trusts treated as partnerships, but again, this is not topical to private equity. Example 5 is one place that practitioners may look to, but that Example clearly favors only a hardwired waiver and on top of that it requires a clawback, a concept alien in the waiver context. Example 6, another place many may look, but that Example requires a 60 day election period and a clawback.

Now, if you move through the gauntlet of all of these requirements, you need to face the suggested changes to the profits interest rev. procs (i.e. Rev. Proc. 93-27 and 2001-43).  The IRS is on the record, in the prop. reg. preamble, that it will basically follow Gregg Polsky’s suggestion. The IRS does not like related party waivers, such as a manager waiving a fee in favor of the GP. The IRS will treat the waiver as violating the Rev. Procs and as a constructive transfer to the GP. That creates a FMV issue. While practitioners may attempt to claim $0 or low value for the profits interest under common law, things become rather nebulous. In addition to this, the IRS is planning an amendment to the Rev. Procs that will carve out from their application 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. In other words, say you manage to successfully wade through the regulations, you nonetheless may get hammered under the Rev. Procs.

It will take a while for practitioners to wrap their arms around all the nuances of the regulations, but things are looking quite bleak for fee waivers right now. 
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Tags: fee waiver, proposed regulations 1.707-2