Tax Challenges With Private Equity Management Fee Waivers Given Newly Heightened IRS Scrutiny

Transcription

1 Presenting a live 90-minute webinar with interactive Q&A Tax Challenges With Private Equity Management Fee Waivers Given Newly Heightened IRS Scrutiny Structuring Waiver Arrangements in Light of the Proposed Regulations and Possible Changes to Profits Interest Rules TUESDAY, OCTOBER 13, pm Eastern 12pm Central 11am Mountain 10am Pacific Today s faculty features: Matthew P. Larvick, Shareholder, Vedder Price, Chicago Daniel P. Meehan, Partner, Kirkland & Ellis, Chicago Peter J. Withoff, Partner, Faegre Baker Daniels, Minneapolis The audio portion of the conference may be accessed via the telephone or by using your computer's speakers. Please refer to the instructions ed to registrants for additional information. If you have any questions, please contact Customer Service at ext. 10. NOTE: If you are seeking CPE credit, you must listen via your computer phone listening is no longer permitted.

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4 Tax Challenges With Private Equity Management Fee Waivers Matthew P. Larvick Daniel P. Meehan Peter J. Withoff October 13, 2015

5 Overview Current management fee waiver design Code 707(a)(2)(A) and legislative history Proposed regulations Implications for existing funds The future of management fee waiver 5

6 Current management fee waiver design 6

7 Management fee waiver design Big Picture: Substitute fund profits interest for management fee Tax is typically deferred Tax rate is generally reduced Economic risk if requisite fund profits are not earned Fund GP/Mgt Co waives a portion of fund management fee Fund GP receives corresponding interest in fund profits Pool of profits is typically restricted to achieve tax objectives Economic risk imposed by either: Restricting distributions until sufficient profits are earned, or Requiring clawback of distributions if insufficient profits earned Waiver timing alternatives One-time waiver at fund inception Timing of fee reductions may be fixed or determined periodically Periodic elective waivers over fund s life Waiver election made before applicable fee period begins or, more conservatively, before start of applicable calendar year 7

8 Management fee waiver design Profits interest may be a fixed/capped amount equal to amount of waived fee Received either when profits are earned or when management fee would have been paid (with repayment obligation if profits never earned) Profits interest more commonly structured as a right to receive distributions corresponding to a notional capital contribution amount Referred to as deemed contribution or cashless contribution Profits interest represents a right to a return of and a positive or negative return on the deemed capital contribution 8

9 Management fee waiver design To ensure that the interest is a profits interest rather than a capital interest under Rev. Proc , built-in gains as of waiver date are excluded To obtain tax rate benefit, pool of available profits typically limited to items of long-term capital gain and qualified dividend income To reduce risk of disguised payment for services characterization, pool of available profits limited each year to net income for such year 9

10 Code 707(a)(2)(A) and legislative history 10

11 Three choices for partnership payments to service provider: Section 704(b) distributive share Section 707(a)(1) partner acting in non-partner capacity Section 707(c) guaranteed payment 11

12 Statutory underpinning for management fee waiver issue: Section 707(a)(2)(A) applies if: A partner performs services for a partnership There is a related direct or indirect allocation and distribution to the partner; and When viewed together, the above items are properly characterized as occurring between the partnership and a nonpartner 12

13 Statutory underpinning for management fee waiver issue (cont.): Section 707(a)(2) (enacted in 1984) is to be implemented by Regulations to determine how transactions should be properly characterized : Regulations issued under Section 707(a)(2) in 1992 Section Disguised payments for services was reserved originally Current proposed regulations are under Section Regulations are largely based on legislative history to Section 707(a)(2)(A) 13

14 Legislative history Practitioners believed 707(a)(2)(A) legislative history supported flow-through treatment of fee waiver arrangements (particularly where deemed contribution model used) An allocation and distribution provided for a service partner... which subjects the partner to significant entrepreneurial risk as to both the amount and the fact of payment generally should be recognized as a [partnership interest] while an allocation and distribution... which involves limited risk as to amount and payment should generally be treated as a fee [W]hile net income allocations generally appear to constitute distributive shares, some net income allocations may be fixed as to amount and probability of payment and... should be characterized as fees. 14

15 Legislative history There may be instances in which allocation/distribution arrangements that are contingent in amount may nevertheless be recharacterized as fees. Generally, these situations should arise only when (1) the partner in question normally performs, has previously performed, or is capable of performing similar services for third parties; and (2) the partnership agreement provides for an allocation and distribution to such partner that effectively compensates him in a manner substantially similar to the manner in which the partner s compensation from third parties normally would be computed. Under typical deemed contribution fee waiver model with annual net income limitation Fee waiver profits interest subject to entrepreneurial risk as to fact and amount since dependent upon investment returns of fund Legislative history indicated that net income allocations would generally be ok if not fixed in amount Fund GPs typically do not perform services for third parties in a nonpartner capacity and a return based on fund performance is not substantially similar to how compensation from third parties would normally be computed 15

16 Movement toward regulations Initial statements by IRS suggest that mainstream fee waiver arrangements would be acceptable Proposed regulations issued 7/23/15 apply more broadly than anticipated 16

17 Proposed Regulations - Specifics 17

18 Analyze all facts and circumstances: Six key factors: 1. Significant entrepreneurial risk 2. Transitory partner status 3. Timing of service performance and allocation/distribution 4. Primary purpose to obtain tax benefits 5. Relatively small general and continuing interest 6. NEW impact on related persons 18

19 Significant entrepreneurial risk is accorded the most weight: Five factors creating a presumption of a lack of significant entrepreneurial risk: Capped allocations if the cap is reasonably expected to apply in most years Allocations for a fixed number of years in which service provider s share is reasonably certain Allocations of gross income items Allocation that is predominantly fixed in amount or highly likely to be available Non-binding commitment or failure to notify partnership and partners of waiver 19

20 Example 1: Architect performs services and invests in a 25% partnership interest Instead of $40,000 architect fee, architect receives $20,000 of gross income for first two years Conclusion: Disguised payment for services 20

21 Example 2: Stockbroker owns 51% interest in partnership In lieu of brokerage commission, broker receives a comparable allocation of gross income Conclusion: Disguised payment for services 21

22 Example 3: Investment fund of illiquid assets with general partner (GP) and management company (M) M contributes $500,000 for 1% interest, but also receives priority allocation and distribution during any 12-month accounting period replicating management fee GP controls partnership and has a 10% carried interest, subject to a clawback Conclusion: Disguised payment for services for M because allocation is highly likely to be available is based on any 12-month accounting period, and GP controls timing of sales of assets 22

23 Example 4: Same as Example 3, but investments are marketable securities and 12-month period is specified in advance Conclusion: Arrangement is respected rather than recharacterized Assets are subject to market-to-market valuation and 12-month period is specified in advance; no presumption that portfolio will have gains for period 23

24 Example 5: Investment fund with general partner (GP) and management company (M) GP has nominal capital and 20% carried interest, plus an additional 1% of capital commitments annually, with clawback covering both M has 1% management fee Conclusion: Arrangement is respected because 1% additional interest is not highly likely to be achieved and GP has agreed to a clawback 24

25 Example 6: Investment fund with general partner (GP) and management company (M) GP contributes 1% and has a 20% carried interest with a clawback M has a waivable 2% management fee If M waives, M receives a partnership gain allocation replicating the fee; M agrees to clawback Conclusion: Arrangement is respected because allocations are only out of net income, and both GP and M have agreed to clawback 25

26 Effective Date: Prospective effective date after regulations become final, BUT IRS view is that Regulations are largely based on the existing legislative history to Section 707(a)(2) 26

27 If Regulations apply: Service provider is treated as receiving payments in a non-partner capacity for all tax purposes Applies even if this causes service provider to not be treated as a partner at all or if no partnership exists Reclassification will eliminate capital gain characterization Is service provider an employee or independent contractor Timing of partnership deduction and service provider income not addressed Potential impact of Section 409A for deferred compensation Interplay with entrepreneurial risk 27

28 Modification of Treas. Reg (c) (Example 2): Partner entitled to an allocation of the greater of (i) 30% of partnership income or (ii) minimum guaranteed amount Existing Regulation provides that if income allocation exceeds the minimum, the entire income allocation is a distribution share If income allocation is less than the minimum, the difference to achieve the minimum is guaranteed payment Regulation examples revised to provide that, in this case, the entire minimum amount should be treated as a guaranteed payment Note the absence of any entrepreneurial risk in the economic deal 28

29 Revenue Procedure 93-27: Receipt of profits interest for services rendered is not a taxable event Exception for (1) predictable revenue stream, (2) dispositions within two years of receipt, and (3) interests in publicly-traded partnership IRS view that waiver by management company in exchange for additional interest for related general partner runs afoul of Rev. Proc Not for services provided by the partner, and Disposition within two years of receipt IRS proposes to add additional exception to Rev. Proc for profits interest received in exchange for waiving a substantially fixed fee Narrowed scope of Rev. Proc will require partnerships to rely on unclear existing law 29

30 Standard Carried Interests Goes guidance impact standard carried interest structures? Although not per se exempted, see: Example 3: General partner received a 10% interest in profits/losses over the life of the partnership, and is subject to a clawback that it is reasonably expected to comply with. Example 6: General partner receives 20% of future net income and gains, and is similarly subject to a clawback. In both cases, the examples conclude the arrangements have SER and thus are not disguised payments for services. See also Example 5. Watch for legislative changes. 30

31 Elective versus Hard-Wired Structures A waiver is often elective - sponsor can elect postformation. Recall key tax goals of a fee waiver structure: the increased equity interest in the fund will qualify as a profits interest that can be received without triggering an up-front tax, and after the interest is received, the holder will be entitled to flowthrough allocations of income (such as capital gains) in respect of the interest. The proposed regulations focus on the second goal. However, in the preamble, the IRS announced proposed changes that could jeopardize the first goal. 31

32 Elective versus Hard-Wired Structures Additional proposed exception to Revenue Procedure 93-27: Exception will apply to a profits interests 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). To be issued in conjunction with the final regulations. If Rev. Proc is modified as apparently intended: Elective waivers subject to non-safeharbor valuation (common law). Sponsors may consider hard-wired structures. (see Example 5) 32

33 Measurement of Profits What income can be used to fill the bucket? Review of context: Distribution must depend on an allocation of income. If so, then a section 704(b) distributive share -- unless section 707(a)(2) recharacterizes. If so-called distribution is payable without regard to income, then it s a section 707(c) guaranteed payment. 33

34 Measurement of Profits Gross income allocations: presumptively lack SER. Example 1 (discussed earlier). Note that legislative history (but not the proposed regulations) contains a favorable example involving gross income allocations. 34

35 Measurement of Profits Net profit allocations. SER presumed lacking if allocation (under formula or otherwise) is: Substantially fixed in amount, reasonably determinable under all the facts and circumstances, or designed to ensure that sufficient net profits are highly likely to be available to make the allocation (e.g., allocations of net profits from specific transactions or accounting periods and this allocation does not depend on the overall success of enterprise). 35

36 Measurement of Profits Profits from limited periods (Cherry-Picking). Example 3(iii): M provides services to a new investment partnership. M is controlled by A, the general partner. M contributes $500,000 for a 1% interest. M is also entitled to a priority allocation/distribution intended to approximate the fee that M would normally charge. M receives priority allocation/distribution of net gain from: sale of one or more assets, but only during any 12 month accounting period in which partnership has overall net gain. 36

37 Measurement of Profits Profits from limited periods (Cherry-Picking). Think about impact of this arrangement: Losses from other years not netted, and Unrealized losses in current year (apparently) are not netted. Illustration (assume fee amount is $100): Year 1 Year 2 Year 3 Year 4 Total Recognized Net Gain/Loss (1,000) 2,000 (1,000) 0 0 Unrealized Net Gain/Loss 0 (2,000) 2,000 Total (1,000) 0 1,000 0 Allocation to Service Provider: Example 3(iii) (Bad Allocation)

38 Measurement of Profits Profits from limited periods (Cherry-Picking). Result: Arrangement lacks SER (and thus is a fee): Net profit can be generated in any 12 months; not dependent on overall success. General Partner is related to M, and can control timing of sales and thus recognition gain/losses. Given nature of partnership s assets and GP s ability to control timing of sales, partnership income is highly likely to be available and is reasonably determinable. Query: Is it highly likely a PE fund will have at least 1 winning year? 38

39 Measurement of Profits Regulations generally (and Ex 3 specifically) do not consider: Risk that distribution may not ultimately be made. Income allocation to capital account may be offset by future losses before distribution. Apply regs when arrangement is entered into/modified, regardless of what ultimately happens. Statute: Requires allocation and distribution. Preamble: Income allocation correlates with increased distribution right (704(b)). Administratively difficult to recast upon later distribution. Query result: M s distribution is deferred until LP capital is returned, and is subject to loss allocations before distribution. 39

40 Measurement of Profits Profits from limited periods (Cherry-Picking). Example 3(iv): Same as above, except: Allocation can also be satisfied out of net gain from a revaluation under Reg (b)(2)(iv)(f). This would account for current year unrealized losses (but could also create unrealized gains). Illustration: Year 1 Year 2 Year 3 Year 4 Total Recognized Net Gain/Loss (1,000) 2,000 (1,000) 0 0 Unrealized Net Gain/Loss 0 (2,000) 2,000 Total (1,000) 0 1,000 0 Allocation to Service Provider: Example 3(iii) (Bad Allocation) 100 Example 3(iv) (Bad Allocation)

41 Measurement of Profits Profits from limited periods (Cherry-Picking). Result: Arrangement lacks SER (and thus is a fee): General partner can control revaluation events, assets are difficult to value, and profits determined by reference to specified accounting period. Thus, net profits are highly likely to be available. What if limited partner committee was required to approve revaluations? See Reg (b)(2)(iv)(h)(1). 41

42 Measurement of Profits Profits from limited periods (Cherry-Picking). Example 4. Same as above, except: Partnership s investment assets are marketable securities, partnership is a trader (rather than an investor), and partnership makes a section 475(f) (mark-to-market) election. Allocation is made for a specified future 12 month year. Illustration (assume fee is $100): Year 1 Year 2 Year 3 Year 4 Total Recognized Net Gain/Loss (1,000) 2,000 (1,000) 0 0 Unrealized Net Gain/Loss 0 (2,000) 2,000 Total (1,000) 0 1,000 0 Allocation to Service Provider: Example 3(iii) (Bad Allocation) 100 Example 3(iv) (Bad Allocation) 100 Example 4 (Good Allocation)

43 Measurement of Profits Profits from limited periods (Cherry-Picking). Result: Arrangement does not lack SER (and thus is not a fee): Allocation is out of net profits. Assets have readily ascertainable value determined annually. Can t reasonably predict presence of overall net profits for the specified year (also an assumed fact). Example may not be directly relevant to PE structures, but note absence of a clawback. 43

44 Measurement of Profits Cumulative Profits. Example 5 (Hard-Wired Waiver). A is general partner of new investment fund. A receives a 20% interest in future partnership income and gains measured over life of the fund. A makes no capital commitment. A also receives an Additional Interest interest in future partnership net income and gains intended to approximate 1% of capital commitments, determined annually. A agrees to clawback for both interests. M, a controlled management company, accepts a 1% management fee (rather than 2% that would be paid by similar funds). Net profits not highly likely to be available or reasonably determinable, based on facts upon formation of partnership. 44

45 Measurement of Profits Cumulative Profits. Result: Additional Interest has SER (and thus not a fee): Allocation is out of net profits. A undertakes clawback obligation, and it is reasonable to expect A will comply. Allocation is not reasonably determinable nor highly likely to be available. 45

46 Measurement of Profits Cumulative Profits. Example 6 (Elective Waiver). A (general partner) 1% capital commitment, 20% carry with clawback. M 2% fee based on capital commitments. M can waive fee for Additional Interest interest in subsequent income and gain estimated to equal PV of waived fee. Waiver must be made at least 60 days before applicable year. M agrees to clawback. Immediately before issuing partnership interest to M, partnership is required to revalue capital accounts. Partnership agreement complies with economic effect safe harbor of Reg (b)(2)(ii), including the capital account liquidation requirement. 46

47 Measurement of Profits Cumulative Profits. Result: Allocations to M (and A) don t lack SER (and thus not a fee): Allocations are out of net profits. Subject to clawback over life of fund and compliance is reasonably anticipated. Allocations neither reasonably determinable nor highly likely to be available. Not addressed: Whether Additional Interest would qualify under Rev. Proc Line between life of fund allocations (Ex. 5/6), and single period allocations (Ex. 3)? 47

48 Catch-Up Allocations Regular carried interests often have a catch-up component. For example, assume distributions are made: First, to the limited partners (investors) until their capital has been returned; Second, to the limited partners until an 8% IRR has been achieved; Third, 100% to the general partner, until the GP receives distributions equal 20% of the total distributions under (b) and (c); [the catch-up ] Fourth, 20% to the general partner and 80% to the limited partners. 48

49 Catch-Up Allocations Based on the above waterfall, the GP would be entitled to a priority allocation of 100% of profits up to a formula amount (after the LPs have been allocated profits to satisfy their IRR). Preamble: Priority allocations intended to equalize a service provider s return with priority allocations already allocated to investing partners over the life of the partnership typically will not lack SER, although all facts and circumstances are considered. 49

50 Clawbacks Clawback Enforceable obligation to repay any amounts distributed on its interest (reduced by reasonable allowance for tax payments on flowthrough income) that exceed [20%] of the overall net amount of partnership profits computed over the partnership s life. (Preamble) How do clawbacks impact the SER analysis? Preamble The presence of each fact described in examples 5 and 6 is not necessarily required to determine that 707(a)(2) does not apply. However, absence of certain facts, such as failure to measure future profits over 12 month period, may suggest that the arrangement is a fee. 50

51 Clawbacks May be more relevant for priority and capped allocations - e.g., receive 100% of specified net profits until $X has been allocated. (E.g., avoid the cherry-picking result of Ex. 3(iii)). Regular carried interests are based on a percentage (e.g., 20%) of future income and gains, rather than all income up to a capped or formula amount. Structuring clawbacks: Reasonable to anticipate compliance? After-tax computations. 51

52 Providing Notice of Waiver Procedural manner of waiver is a substantive SER factor. Components to avoid bad presumption: Binding. Timely notification (Example 6: 60 days before beginning of year). Notify partnership and all partners. Alternatively, can be hard-wired (see Example 5). IRS solicits comments on administrable alternatives. 52

53 Bifurcated Structures Bifurcated Structure: General partner is one entity (e.g., LLC). Management company is separate (related) entity. First Issue - Waiver and receipt by different parties. Management company waives fee, but related GP receives special profits interest. Preamble: Rev. Proc doesn t apply. Interest not awarded for provision of services in a partner capacity. Service provider (M) constructively disposed of interest within 2 years of receipt. 53

54 Bifurcated Structures Related parties subject to differing levels of risk. Secondary (non-ser) factor: Different allocations and distributions for different services. Services provided by one person or related persons. Differing allocations/distributions subject to entrepreneurial risk that vary significantly. Example: GP receives a 20% carry subject to a clawback. Related management company is entitled to a preferred income allocation with no clawback. Management company s allocations might be a disguised services payment, depending on all the facts. 54

55 Design/Drafting and Audit Implications: Existing and Future Funds 55

56 Audit Implications Preamble says proposed regulations reflect Congressional intent Audits initiated even before regulations issued 56

57 Drafting/design implications for existing funds Existing fund with up-front waiver Timing considerations Audit considerations Funds with periodic/elective waivers Post-finalization Rev. Proc concern Funds with fee paid to separate management company Current Rev Proc concern 57

58 Drafting/design for future funds Possible to avoid disguised payment for services Cumulative net income over the life of the fund Profit measurement period longer than a year but shorter than the remaining life of the fund? In calculating net profits, will exclusion of management fee and organizational expenses be permitted? But will Rev. Proc safe harbor be available? If not, is fee waiver still viable? 58

59 Illustration Effective tax rates: ordinary income (45%); long-term capital gain (25%) Management fee payable: $1m Gross fund return: 2x 59

60 Illustration Scenario 1: Fund pays management fee in cash and manager invests the after-tax amount Scenario 2: Manager waives fee; makes deemed investment of pretax amount; current tax rules apply Scenario 3: Manager waives fee; makes deemed investment of pretax amount; pretax amount is treated as a disguised fee for services Scenario (1) (2) (3) Tax on actual management fee paid 450,000 - Net amount invested (actual or deemed) 550,000 1,000,000 1,000,000 Gross proceeds from investment 1,100,000 2,000,000 2,000,000 Tax on disguised payment amount ,000 Tax on profit from investment 137, , ,000 Manager s net after-tax proceeds 962,500 1,500,000 1,300,000 60

61 Thank You Matthew P. Larvick Daniel P. Meehan Peter J. Withoff 61