Service fee or management fee waivers have become common in the commercial real estate finance industry over the past decade. Developer’s in developer-sponsored real estate syndications have grown accustomed to trading in some or all of their negotiated management, developer or other service fees (“management fees”) for a profits interest in the real estate project. This profits interest (also known as a “carried interest” or “promote” is simply a right to future profits of the fund, which can be attractive for a variety of reasons, including favorable tax rates and additional or enhanced participation in economic success of the project. Prior to the Proposed Regulation (defined below), but subject to additional potential compliance issues, the fee waiver arrangements were generally viable provided that the fee was waived prior to being earned and the profits interest received was subject to entrepreneurial risk. Fee waiver arrangements are prevalent in hedge funds and private equity funds and other investment partnerships, and, as such, the Proposed Regulations apply equally to fund managers of such hedge funds and private equity funds.
Treasury and the IRS issued proposed Treasury Regulations (“Proposed Regulations”) under Section 707(a)(2)(A) of the Code in 2015, addressing management fee waiver arrangements. Under the Proposed Regulations, these arrangements remain permissible, but the IRS has tightened the conditions that must be met. The IRS’s intent was to curb management fee waivers where the developer had little or no entrepreneurial risk in the profits interest received.
Under the Proposed Regulations, certain management fee waiver arrangements will be treated as disguised payments for services for income tax purposes, resulting in ordinary income treatment (and possibly significant penalties under deferred compensation rules).
While the Proposed Regulations are not technically effective unless and until final regulations are published, the Treasury and IRS believe that the Proposed Regulations generally reflect current law. In other words, the government’s position is that the core principles outlined in the Proposed Regulations apply under current law. As of the date of this client alert, the Proposed Regulations have not been made final. Such delay, however, might be more related to higher priority items at the Treasury and IRS in recent times, as well as the confusion related to the interrelationship between the Proposed Regulations and Revenue Procedure 93-27, than a change in the position of the IRS.
Management Fee Waiver Arrangements
In a typical management fee waiver arrangement, the general partner of a private investment fund (often the developer or sponsor, or an entity owned by the developer or sponsor) is permitted to satisfy all or a portion of its capital commitment to the fund with “deemed” capital contributions. In connection with the deemed contributions, there is a reduction in the management or other fee fee payable by the fund to the general partner or an affiliate of the general partner.
The general partner is entitled to a priority allocation of subsequent net profits of the fund, if and when they occur, equal to the amount of its deemed capital contributions to the fund. If such priority profit allocation includes net long-term capital gain or qualified dividend income, the fund’s general partner (and its partners) would be subject to tax at the lower U.S. federal capital gains tax rate as compared to the higher ordinary income tax rate that otherwise would have applied to the waived management fee. The priority allocation may also result in deferral of the tax that would have been due if management or other fees had not been waived.
Analysis of Management Fee Waiver Arrangements Under Proposed Regulations
The Proposed Regulations provide that whether an arrangement between a partner and a partnership constitutes a payment for services depends on all of the facts and circumstances surrounding such arrangement. The Proposed Regulations identify 6 non-exclusive factors that should be taken into consideration when making such determination. The most influential factor is the entrepreneurial risk of the arrangement (an arrangement that lacks significant entrepreneurial risk is treated as a payment for services without regard to any other factor). The 5 other factors identified by the Proposed Regulations that are suggestive of a disguised payment for services are as follows:
(i) the service partner holds, or is expected to hold, a transitory partnership interest or a partnership interest for only a short duration;
(ii) the service partner receives an allocation and distribution in a time frame comparable to the time frame that a non-partner service partner would typically receive payment;
(iii) the service partner became a partner primarily to obtain tax benefits that would not have been available if the services were rendered to the partnership in a third-party capacity;
(iv) the value of the service partner’s interest in general and continuing partnership profits is small in relation to the allocation and distribution; and
(v) the arrangement provides for different allocations or distributions with respect to different services received, the services are provided either by one person or by persons that are related under Sections 707(b) or 267(b) of the Internal Revenue Code, and the terms of the differing allocations or distributions are subject to levels of entrepreneurial risk that vary significantly.
Significant Entrepreneurial Risk
As noted above, entrepreneurial risk is the most important factor as the Proposed Regulations treat a management fee waiver arrangement that lacks significant entrepreneurial risk as a payment for services on a defacto basis. Whether an arrangement lacks significant entrepreneurial risk is based on the service partner’s entrepreneurial risk relative to the overall entrepreneurial risk of the fund.
Under the Proposed Regulations, each of the following facts and circumstances creates a presumption that an arrangement lacks significant entrepreneurial risk and will be treated as a disguised payment for services unless other facts and circumstances exist that establish significant entrepreneurial risk by clear and convincing evidence:
(i) capped allocations of partnership income if the cap is reasonably expected to apply in most years;
(ii) an allocation for one or more years under which the service partner’s share of income is reasonably certain;
(iii) an allocation of gross income;
(iv) an allocation (under a formula or otherwise) that is predominantly fixed in amount, is reasonably determinable under all the facts and circumstances, or is designed to assure that sufficient net profits are highly likely to be available to make the allocation to the service partner (e.g., if the partnership agreement provides for an allocation of net profits from specific transactions or accounting periods and this allocation does not depend on the long-term future success of the enterprise); or
(v) an arrangement in which a service partner waives its right to receive payment for the future performance of services in a manner that is non-binding or fails to timely notify the partnership and its partners of the waiver and its terms.
Examples in Proposed Regulations and Insights
The Proposed Regulations include examples of management fee waiver arrangements that presumptively lack significant entrepreneurial risk and those that meet the standard of significant entrepreneurial risk. These examples show that where an allocation of income is reasonably determinable and available profits to allocate to the service partner are highly likely, the arrangement will lack significant entrepreneurial risk. A number of specific principles can be gleaned from the examples. For one, allocations should be based on net profits, not gross income. The ability of the general partner to manipulate the timing of the realization of gains and losses is a significant factor in determining that an arrangement lacks sufficient entrepreneurial risk. It is important that fees are waived irrevocably and in advance of the time they would be earned. Further, the examples seem to strongly suggest that a management fee waiver arrangement should be supported by an enforceable return obligation to the extent amounts received by reason of the fee waiver exceed the cumulative net profits over the life of the fund.
Certain Transactions Not Within IRS Revenue Procedure 93-27
Revenue Procedure 93-27 generally provides that if a person receives a profits interest for the provision of services to or for the benefit of a partnership, the IRS will not treat the receipt of such interest as a taxable event for the partner or the partnership. The Revenue Procedure does not apply if (i) the profits interest relates to a substantially certain and predictable stream of income, (ii) within two years of receipt, the partner disposes of the profits interest, or (iii) the profits interest is a limited partnership interest in a publicly traded partnership.
The Preamble to the Proposed Regulations provides that Treasury and the IRS plan to issue a revenue procedure in conjunction with finalizing the Proposed Regulations, which revenue procedure is expected to provide that the Revenue Procedure 93-27 will not apply to profits interest issued in connection with management fee waivers or other similar situations.
The Preamble suggests that the IRS intends that Revenue Procedure 93-27 will not apply even to fee waiver arrangements that are subject to significant entrepreneurial risk. How the IRS intends to treat profits interest that are not recharacterized under the Proposed Regulations if not covered by the safe harbor in Revenue Procedure 93-27 remains unclear.
Developers, Fund Manager and Sponsors should continue to review any potential or existing management fee waiver arrangements in light of the current law and the Proposed Regulations, as well as continue to monitor updates to the legal status of such arrangements.
If you would like to discuss the Proposed Regulations or management fee waiver arrangements generally, including the impact on existing arrangements, please contact Bradley Wooldridge or your Manning Fulton relationship attorney.