Management Fee “Waiver” Tax Treatment

The Treasury and the Internal Revenue Service issued proposed regulations relating to disguised payments for services rendered by a partner to a partnership. Private fund managers have used management fee “waiver” mechanisms by reducing the management fee payable to the fund’s manager and the receipt of a corresponding profits interest by the general partner. The proposed regulations take a new look at whether that waiver mechanism would be invalid as a disguised payment for services.

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The proposed regulations focus primarily on whether the payment to the service provider lacks “significant entrepreneurial risk.” In determining whether an allocation and distribution arrangement will be treated as a disguised payment for services, the proposed regulations focus on whether the allocation and distribution are subject to this significant entrepreneurial risk. The regulations call for a determination at the time the arrangement is entered into and re-tested at the time of any later modification. An arrangement that lacks significant entrepreneurial risk would be treated as a disguised payment for services. An arrangement that has significant entrepreneurial risk generally will not be treated as a disguised payment for services, although additional factors must be considered.

The proposed regulations set up a presumption that certain circumstances lack significant entrepreneurial risk:

Capped allocations of partnership income, if the cap is reasonably expected to apply in most years.
An allocation for one or more years under which the service provider’s share of income is reasonably certain;
Allocations of gross income;
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 provider (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);
An arrangement in which a service provider 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.

These are just proposed regulations and are still open for comment. That also means the regulations may change if adopted.

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