On July 22, 2015, the U.S. Department of the Treasury issued proposed regulations addressing the tax treatment of certain private equity management fee waivers. These new rules could result in many common management fee waivers being treated as disguised payments for services.

Carried Interest as Capital Gains vs. Management Fees as Ordinary Income

In a traditional private equity fund, the general partner receives an allocation of profits from the fund (commonly 20 percent) in addition to whatever allocation of profits it may be entitled to based on its proportionate ownership of the fund. While this profits interest is in some sense the general partner’s “compensation” for successfully managing the fund, current law establishes that this 20 percent “carried interest” retains its character when allocated to the general partner. So, if the private equity fund generates a capital gain and 20 percent of that capital gain is allocated to the general partner, that 20 percent carried interest retains its character as capital gain, notwithstanding the compensatory element underlying the carried interest.

In addition to the 20 percent carried interest, the general partner or an affiliate is typically entitled to a periodic management fee. While the amount and specific terms of this fee vary, a common formulation for a private equity management fee would be between 1 percent and 2 percent annually of committed capital to the fund. This fee is typically extracted pro rata on a quarterly or monthly basis to the general partner or its affiliate. When structured in this fashion, the annual management fee is clearly taxable as ordinary income to the fee recipient.

Use of Management Fee Waivers in Return for Greater Portion of Profits

General partners have long been aware that they could experience a distinct economic advantage if they could somehow convert some or all of the periodic management fee into a carried interest. This “conversion” is sometimes effected by an arrangement that is commonly referred to as a management “fee waiver.” In exchange for waiving its right to receive all or a portion of its annual management fee, the general partner receives the right to receive a larger allocable share of fund profits. Regardless whether this exchange results in higher gross income to the general partner, the character of that income will switch from ordinary income to capital gain if the fund generates a capital gain.

Most private equity fund partnership agreements contain language permitting the recipient of the management fee to elect to waive the right to receive fees in exchange for an enhanced share of the profits (presumably capital gains) from the fund. The mechanics of these fee waiver provisions vary widely among private equity funds. Most permit the fee to be waived on an annual basis and provide that either the management fee recipient or the general partner receive in exchange an interest in fund profits that matches identically the amount of the waived fee.

How Management “Fee Waivers” Are “Properly Characterized”

The IRS has long been suspicious of management fee waivers, but there does not appear to have been significant audit activity on the issue. That may be about to change.

The proposed regulations focus on a need for “entrepreneurial risk” associated with any management fee waiver. Without this risk, the IRS view is that the management fee waiver is an unsuccessful attempt to convert an ordinary income amount into a share of partnership profits.

Support for this conclusion comes from Section 707(a)(2)(A) of the Internal Revenue Code. The statute applies if a partner:

1. Performs services for a partnership
2. Receives a related direct or indirect allocation and distribution from the partnership
3. And if the items described in (1) and (2) are “properly characterized” as occurring between the partnership and a non-partner.

The operative provision of the statute is obviously the “properly characterized” language. How a transaction should be “properly characterized” is open to debate.

The legislative history behind Section 707(a)(2)(A) focuses on the level of entrepreneurial risk associated with the exchange; the lesser the entrepreneurial risk, the greater the likelihood that the transaction should be “properly characterized” as something else.

The proposed regulations focus on this entrepreneurial risk standard as well as a number of other factors drawn from the legislative history of Section 707(a)(2)(A). Unfortunately, the result under this analysis will often be that a routine fee waiver will not pass muster as measured against the “properly characterized” standard. By its very nature, a fee waiver will virtually always apply to a fee amount that can be characterized with some specificity, and the amount in question will typically not be subject to any type of clawback or future adjustment.

The consequence is that a typical management fee waiver may be vulnerable to attack by the IRS. However, there is a strong argument that this vulnerability already exists since, as noted above, the proposed regulations draw heavily on the legislative history to the existing law. The IRS position is that this is merely an attempt to clarify the existing law rather than creating any new requirements.

This focus on existing law is evident in the effective date provisions. While the new regulations would be effective only on a prospective basis, fee waivers already in place still need to qualify under the vague “properly characterized” standard. Since the new regulations are based on the same legislative history and largely rely on the same elements of “entrepreneurial risk,” even transactions that predate any new regulations may be vulnerable to attack.

Next Steps for Private Equity Fund Managers

It remains to be seen how this will play out. In many respects the proposed regulations do not break new ground. They are really just a reiteration of existing criteria that practitioners have focused on in resolving the question of how a transaction should be “properly characterized.” However, the mere promulgation of the proposed regulations, regardless whether finalized, may signal that the IRS intends to take a harder look at management fee waivers. Private equity fund managers that currently use or may be considering using a management fee waiver will want to review the new proposed regulations with their tax advisers to determine what changes, if any, can be made to their current arrangement to increase the level of entrepreneurial risk behind the management fee waiver, and therefore hopefully decrease the risk of an IRS challenge to the arrangement.

To the extent any other type of private fund that includes incentive allocations payable to the entity responsible for managing the fund (e.g., venture capital funds, hedge funds, funds-of-funds, commodity pools, etc.) uses a management fee waiver like the structure described above, this same analysis would apply.