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.

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Roger Royse
rroyse@rroyselaw.com

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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