02 Nov Challenge IRS Fee Waiver Rules
In July 2015, the U.S. Department of the Treasury issued proposed regulations (REG-115452-14) pursuant to IRC 707(a)(2) addressing the tax treatment of certain private equity management fee waivers. Under the proposed regulations, the conversion of a management fee to a capital contribution without any “significant entrepreneurial risk” may be a “disguised payments for services.” Such waivers would be taxed as ordinary income instead of capital gains. However, some commentators argue that the Internal Revenue Service overstepped the authority granted by the governing statute in the proposed regulations.
IRC 707(a)(2)(A) grants the Secretary broad regulatory authority to identify transactions involving “disguised payments for services.” The section explicitly states that the transactions to be regulated are “the performance of services . . . and [an] allocation and distribution [ ] viewed together[.]” (Emphasis added)
Under Prop. Reg. 1.707-2(b)(2)(i), the transaction is tested “at the time the arrangement is entered into or modified and without regard to whether the terms of the arrangement require the allocation and distribution to occur in the same taxable year[.]” Because a partnership might allocate income to a partner in one year, but make the related distribution in a (much) later taxable year, it is arguable that regulations recharacterize income allocations without considering any related distribution under the proposed regulations. This arguably exceeds the regulatory authority granted by IRC 707(a)(2), which requires allocations and distributions, along with the performance of services, to be viewed together.
On the other hand, the regulations arguably do still view together all three elements (the performance of service, the allocations, and distributions). Allocations imply distribution rights; one may argue that viewing allocations implicitly causes one to view likely future distributions. Further, “view together” the three elements might not in fact require the IRS to definitively know all three elements. This would be much as one can view together a math problem with three variables, while only knowing two of them; even so, one can often conclude certain things about the final answer (e.g., it’s greater than x, it’s a rational number, it’s a disguised payment for services) without being certain of the third variable.
Agency officials have said the final rules could be issued this year. Prop. Reg. 1.707-2(b)(2)(i), if finalized, could be challenged by the private equity industry, but such a challenge would be an uphill battle.Disclaimer: This blog and website are public sources of general information concerning our firm and its lawyers, as well as the information presented. They are intended, but not promised or guaranteed, to be correct, complete, and up-to-date as of the date posted. This blog and website are not intended to be, and are not, sources of legal opinion or advice. The materials, information, and communications on this blog and website do not apply to any particular person, entity, or situation, and do not apply to you or to your specific situation. You will need to consult with an attorney and/or other appropriate professional about your specific situation. Thank you.