Disguised Payments for Services in Partnerships and Management Fee Waivers

Service partnerships and fund managers best beware: The IRS has issued proposed regulations under §707(a)(2) to determine when distributions to a partner are in fact disguised payments for services. These proposed regulations target various disguised payments for services, but especially attack management fee waivers.

In a management fee waiver, a private investment firm manager waives a portion of its management fees to get an increased allocation of the partnership distributions down the road. By waiving the fees, the managers are sometimes deemed to make a capital contribution. This technique has produced many favorable tax outcomes. By converting management fees to distributions, managers switch their tax treatment from a service provider’s to a partner’s. Thus, managers convert ordinary income to capital gains, and exchange current taxation for deferred taxation.

Basic Structure of the Regulations

The regulations attack this and similar schemes. Per Prop. Reg. § 1.707-2(b), the proposed regulations will trigger where

(1) there is a person who is a partner or anticipates becoming a partner

(2) who directly or indirectly provides services to a partnership,

(3) the partnership directly or indirectly allocates or distributes to that person, and

(4) altogether, judging at the time of the modification of the partnership agreement inserting the new allocation, these steps are best viewed as a transaction between a partnership and a service provider, rather than a partnership and a partner.

When triggered, the proposed regulations recharacterize the payment as a payment for services for every part of the Internal Revenue Code.

The key step of this analysis is the fourth. To determine whether the steps altogether are best viewed as a payment to a service provider, the proposed regulations say to apply a multifactor test. The test has one heavily weighted factor, five factors whose weights depend on facts and circumstances, and one that permits the use of further unstated factors.

The Key Factor: Significant Entrepreneurial Risk

The heavily weighted factor regards whether the payment lacks significant entrepreneurial risk. The idea here is that, in most cases, employees and other service providers are reasonably guaranteed to be paid even when a business fails. Entrepreneurs, however, are not, and lose money when businesses fail; their fate is directly tied to the business’s. In other words, they bear significant entrepreneurial risk. If a distribution to a service partner lacks such risk, it is a disguised payment. Period.

The regulations set forth factual scenarios that presumptively lack significant entrepreneurial risk. See Prop. Reg. §1.707-2(c)(1). In general, these cover scenarios where, by basing allocations off of things like gross profits or net profits from certain transactions, allocations for the service-providing partner have been designed to be almost certainly paid out, no matter the business’s health.

Included in these scenarios are management fee waivers, particularly where waivers are non-binding or are not told to the other partners until a very late point in the day. Multiple examples in Prop. Reg. § 1.707-2(d) cover further such scenarios, and focus heavily on management fee waivers. The IRS also has made clear the proposed regulations will cover situations where one partner waives a management fee/ guaranteed payment/ other reasonably certain payment, and a related partner suddenly gets future profits interests approximating the value of the waived amount.

To correspond to this heightened standard of entrepreneurial risk, the IRS will also revise older §707(c) regulation. In these regulations, minimum guaranteed distributions to partners were not considered disguised payments in the event that the partnership had so much income to distribute that everyone would have received the same distributions even if there were no minimum guarantees. Now, minimum guaranteed payments will be disguised payments, period.

The Other Factors

The remaining stated factors to look at are:

1. Whether the partner holds or is expected to hold partnership interests for a short duration;

2. Whether the partner is paid about as quickly as non-partner service providers;

3. Whether the service provider became a partner primarily to get tax benefits unavailable to third parties;

4. Whether the service provider’s interest in continuing partnership profits is small compared to his or her allocation and distribution; and

5. Whether a service partner, or multiple related service partners, are entitled to multiple allocations for their services, some of which have significantly different entrepreneurial risk than others. For example, where one service partner’s allocation is subject to a clawback (i.e., contractually must be repaid if partnership performance suffers), and another related service partner’s is not, the latter is likely a disguised payment for services.

As noted, the regulations allow any further factors of relevance to be considered.

Takeaways for Private Investment Firms and Service Partnerships

Fund managers should pay attention to the proposed regulations and their finalized versions to ensure their compensation remains tax favored. For instance, they should consider structuring a clawback provision that lives up to the (admittedly vague) standards of the regulations. The proposed regulations speak favorably of clawback provisions that are likely to be practically enforceable, and which depend on the fund’s net profits over its life.

A second takeaway is to stay tuned; there are many key issues for final regulations to address, including how targeted allocations will be handled.

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Roger Royse

Roger Royse, the founder of the Royse Law Firm, works with companies ranging from newly formed tech startups to publicly traded multinationals in a variety of industries. Roger regularly advises on complex tax structuring, high stakes business negotiations and large international financial transactions. Practicing business and tax law since 1984, Roger’s background includes work with prominent San Francisco Bay area law firms, as well as Milbank, Tweed, Hadley and McCloy in New York City.
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