PROPOSED IRS REGULATIONS TARGET MANAGEMENT FEE WAIVERS AND OTHER PARTNERSHIP INTERESTS RECEIVED FOR SERVICES

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1 July 28, 2015 PROPOSED IRS REGULATIONS TARGET MANAGEMENT FEE WAIVERS AND OTHER PARTNERSHIP INTERESTS RECEIVED FOR SERVICES To Our Clients and Friends: On July 22, 2015, the United States Treasury Department (the "Treasury Department") and the United States Internal Revenue Service (the "IRS") released proposed regulations under Section 707(a)(2)(A) of the Internal Revenue Code of 1986, as amended (the "Code"), regarding the treatment of certain issuances of partnership interests in exchange for services rendered. The IRS also announced changes to prior Revenue Procedures effective upon finalization of the proposed regulations, as well as its view of the current non-applicability of such Revenue Procedures to certain fee waiver arrangements. If finalized in their current form, the proposed regulations will have important practical implications for the taxation of profits interests granted in exchange for services, including management fee waiver arrangements commonly employed by private equity and certain other types of private investment funds. The proposed regulations provide that certain partnership interests received in exchange for services will be characterized as disguised payments for services rather than as the right to receive a distributive share of partnership income. An arrangement that is treated as a disguised payment for services under the proposed regulations will be treated as compensation for services for all purposes of the Code, which is generally taxable as ordinary income. The preamble to the proposed regulations also describes modifications to the current safe harbors governing the tax-free issuance of profits interests in exchange for the provision of services, which, if made, could treat profits interests granted in respect of waived management fees as taxable at fair market value upon grant. Proposed Regulations Generally Section 707 of the Code provides rules that recharacterize transactions between a partnership and a partner where the partner is acting in a non-partner capacity. Section 707(a)(2)(A) of the Code grants the Treasury Department authority to recharacterize certain arrangements pursuant to which a partner performs services for a partnership and receives a related allocation and distribution of income from the partnership as a compensatory payment from the partnership to the partner performing services. Such compensation generally is taxable as ordinary income. The proposed regulations invoke Section 707(a)(2)(A) in determining when an arrangement will be characterized as a disguised payment for services and apply a facts and circumstances test in making the determination. The factor given the most weight is whether the arrangement involves significant

2 entrepreneurial risk as to both the amount and fact of payment relative to the overall entrepreneurial risk of the partnership; if evidence of such risk is lacking, the partner will be treated as receiving compensation for services rendered. Allocation arrangements identified in the proposed regulations that support a presumption of a lack of entrepreneurial risk include (i) capped allocations of income, (ii) allocations for a fixed number of years under which the income that will go to the partner is reasonably certain, (iii) continuing arrangements in which purported allocations and distributions are fixed in amount or reasonably determinable under all facts and circumstances, and (iv) allocations of gross income items. Under the proposed regulations, arrangements that present a high likelihood that the service provider will receive an allocation of partnership income, regardless of the overall success of the business operation, are presumed to be disguised payments for services absent the presence of other facts and circumstances supporting a significant entrepreneurial risk by clear and convincing evidence. Additional factors that could bear on the determination as to whether a partnership allocation should be characterized as compensation income to the service provider include (i) whether the partner status of the recipient is transitory; (ii) whether the allocation and distribution that are made to the partner are close in time to the partner's performance of services; (iii) whether the facts and circumstances indicate that the recipient became a partner primarily to obtain tax benefits for itself or the partnership that would not otherwise have been available; and (iv) whether the value of the recipient's interest in general and in continuing partnership profits is small in relation to the allocation in question. The proposed regulations include six examples illustrating the application of the new rules, including several addressing fee waiver arrangements. As discussed in more detail below, the examples demonstrate the IRS's view that for such arrangements to be respected, allocations and distributions should be based on net profits rather than gross income, and the ability of the general partner to control the timing of the realization of gains and losses, as well as the presence or lack of a clawback obligation, are significant factors in proving that an arrangement lacks sufficient entrepreneurial risk. The examples also illustrate the importance of fees being waived irrevocably and in advance of the time they would be earned with prior written notice to the limited partners. Treatment of Certain Profits Interest Issuances Threatened Existing Revenue Procedures provide a safe harbor that treats certain issuances of profits interest in exchange for the provision of services to the partnership as non-taxable events. The preamble to the proposed regulations notes that the Treasury Department and the IRS believe the existing safe harbor does not apply to transactions in which one party provides services and another party receives a seemingly associated allocation and distribution of partnership income or gain. This interpretation could have implications for arrangements commonly used by private equity funds in which a management company waives fees due from the fund while a related party (e.g., the general partner) receives an interest in future profits, the value of which approximates the amount of the waived fee. Additionally, guidance to be issued by the IRS when the proposed regulations are finalized will further narrow the applicability of this safe harbor by excepting arrangements pursuant to which a profits interest is issued in conjunction with a partner foregoing payment of an amount that is substantially 2

3 fixed (including a fixed amount determining by formula, such as a fee based on a percentage of partner capital commitments) for the performance of services. With this additional exception, even arrangements that otherwise comply with the requirements of the proposed regulations could nonetheless result in the inclusion of compensation income by the recipient. Implications for Management Fee Waiver Arrangements The proposed regulations include several examples targeting common features of private fund management fee waiver arrangements pursuant to which a manager waives its right to fees for services rendered and instead receives (or a related entity receives) a share of future partnership income and gains. The examples illustrate the general principle that if a fee waiver arrangement lacks significant entrepreneurial risk, specifically where an allocation of income is reasonably determinable and it is highly likely that profits will be available to allocate to the service provider, the arrangement will be characterized as a disguised payment for services rather than as an interest in a partnership's allocations of income and distributions. Example 3 illustrates a scenario where the manager is entitled to a priority distribution of profits and the general partner, which is related to the manager, has the power to sell or revalue assets to find net gain in any 12-month accounting period to make such priority distribution, the amount of which is intended to approximate the fee that the manager would normally charge for the services performed. The example concludes that there is no significant entrepreneurial risk with respect to the manager because the allocation is "highly likely to be available and reasonably determinable" and does not depend on the overall success of the business. Conversely, the general partner's own profits interest involves significant entrepreneurial risk because (i) the allocation to the general partner consists of net profits earned over the life of the partnership, (ii) the allocation is subject to a clawback obligation with which the general partner is reasonably expected to comply, and (iii) the allocation is neither reasonably determinable nor highly likely to be available. Examples 5 and 6, on the other hand, address fee waiver arrangements where significant entrepreneurial risk is present. Example 5 involves an "upfront" waiver structure. Specifically, in example 5, the general partner receives an additional interest in future partnership net income and gains determined by a formula. The parties intend that the estimated present value of such additional interest approximates the present value of one percent of capital committed by the partners determined annually over the life of the fund. The amount of net profits allocable under the additional interest is neither highly likely to be available nor reasonably determinable, and the general partner is subject to a clawback obligation with which it is reasonably expected to comply. Example 6, on the other hand, presents a scenario where the manager is allowed to waive its management fee for any year if it provides written notice to the limited partners at least sixty days prior to the beginning of the partnership taxable year for which the fee is payable. In the event the manager waives its fee, it is entitled to receive an additional interest (like in example 5). In both examples 5 and 6, the proposed regulations take the position that the management fee waiver arrangements include the following facts and circumstances, which, taken together support the 3

4 existence of significant entrepreneurial risk: (i) the allocation to the service provider is determined out of net profits and is neither highly likely to be available nor reasonably determinable based on all facts and circumstances available at the outset of the arrangement, and (ii) the service provider undertakes a clawback obligation with which it is reasonably expected to be able to comply. In these examples, the service provider waives its right to receive fees in a manner that supports the existence of significant entrepreneurial risk by effectuating the waiver prior to the commencement of the relevant period and by executing a waiver that is binding, irrevocable, and clearly communicated to the other partners. Therefore, the IRS concludes that the arrangements in examples 5 and 6 do not constitute a disguised fee for services rendered. The IRS notes that while the presence of each factor described in these examples is not required to determine that section 707(a)(2)(A) of the Code does not apply to an arrangement, the absence of certain facts, such as a failure to measure future profits over at least a 12-month period, may suggest that a management fee waiver arrangement constitutes a disguised payment for services. Conclusion The proposed regulations threaten to impact existing management fee waiver arrangements that are common in the private equity world. Despite the fact that the regulations are only in proposed form, the IRS takes the position that they reflect Congressional intent as to which arrangements are appropriately treated as disguised payments for services and should be viewed as an interpretation of current law rather than a prospective change. Therefore, pending further guidance, fund sponsors should carefully scrutinize any management fee waiver arrangements currently in place and consider alternatives to such arrangements for new funds and for future fee waivers. The tax lawyers at Gibson, Dunn are available to discuss the potential impact of the proposed regulations in general and current fee waiver structures. We will continue to provide updates on any developments regarding the proposed regulations, which remain subject to change. Gibson, Dunn & Crutcher's lawyers are available to assist in addressing any questions you may have regarding these developments. Please contact the Gibson Dunn lawyer with whom you usually work, or the authors of this alert: Benjamin Rippeon - Washington, D.C. ( , brippeon@gibsondunn.com) John-Paul Vojtisek - New York ( , jvojtisek@gibsondunn.com) Vanessa B. Grieve - New York ( , vgrieve@gibsondunn.com) Please also feel free to contact the any of the following practice leaders and members: 4

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