Management Fee Waiver - Partnership Profits Interest or Disguised Compensation for Services

On July 22, 2015, the Treasury Department released Proposed Regulations under Internal Revenue Code Sec. 707, Transactions Between Partner and Partnership, addressing the taxation of management fee waivers (MFW).

In a typical MFW, a private equity fund manager agrees to waive the right to a management fee from the fund partnership and receives in its place a profits interest in the fund partnership.

If such an interest in the profits of the fund partnership is acquired, future allocations of profits in the fund partnership to the Service Providing Partners may be allocations of capital gain amounts, depending upon the investments of the partnership.

IRS has believed for some time that Service Providing Partners to business or investment partnerships who receive what purports to be a distributive share of partnership income may, in substance, be receiving compensation-type ordinary income in exchange for the services rendered.

The Proposed Regulations conclude that if a purported profits interest in a partnership is economically without normal entrepreneurial risk incurred by a partner in the undertakings of a partnership’s business, the related distributions to a Service Providing Partner are economically compensation for services and taxable as ordinary income as a payment to a person other than in their capacity as a partner.

The Proposed Regulations set out six factors the Treasury Department considers important in this determination of the income tax treatment of a receipt of a profits interest by a Service Providing Partner.

Additionally, the Proposed Regulations include six examples intended to clarify the fundamental concepts set out in the Proposed Regulations. Several of the examples consider arrangements in which a Service Providing Partner agrees to forgo fees for services and also receives a share of future partnership income and gains.

These regulations will apply to all arrangements entered into or modified after the date they are published as final regulations.

Importantly, however, the Treasury Department has indicated that it believes the analysis set forth in these Proposed Regulations is explanatory of, and consistent with, existing income tax law applicable to the types of transfers of partnership profits interests described in these Proposed Regulations.