By Scott R. Cosentine, CPA, CAMS, CGMA
It is no surprise the IRS has its sights on the investment management industry, and especially the private fund space. However, last summer when the IRS issued proposed regulation to effectively limit management fee waiver or carried interest practices, it left many firms questioning their current fund agreements or even the economics of launching a new fund. The essence of the proposal is to limit the conversion of normal management fees (taxed as ordinary income) to a profits interest (potentially allowing for income deferral and a preferential capital gains tax rate under existing Revenue Procedure 93-7).
Although I get a lot of inquiries, I don’t personally see this regulation having as much of an impact as the Treasury Department intended. No, not because Presidential campaigning is well underway and I think the flat tax has enough momentum, but because the proposal provides reasonable facts and circumstances to work from. In addition, the vast majority of hedge funds trading liquid products don’t have the same fee waiver structures as private equity, other illiquid or real-asset funds. The taxation of the transaction comes down to whether or not it is perceived to be a disguised payment for services. The proposed regulations include six (6) non-exclusive factors, as well as examples, that may indicate an arrangement resulting in a disguised payment for services. The most heavily weighted factor, and in my opinion, easiest to remedy, is the existence of “significant entrepreneurial risk” (SER). An arrangement that lacks SER will be treated as a disguised payment for services. As examples and history indicate, the following facts and circumstances create the presumption that an arrangement lacks SER:
- Capped allocations of partnership income, if the cap is reasonably expected to apply in most years.
- An allocation of one or more years under which the service provider’s share of income is reasonably certain.
- An allocation of gross income.
- An allocation (formula-driven 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.
- 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.
To spare you from repeating over simplified market examples, the proposal suggests that a waiver containing the following core elements generally should be respected:
- Cumulative Net Income – allocations and distributions in respect of the waiver interest are made out of (and only to the extent of) cumulative net income and gain over the life of the partnership (or hurdle rates).
- Clawback – the partner receiving allocations and distributions in respect of the waiver interest agrees to return to the partnership any distributions that ultimately are not supported by allocations of cumulative net income and gain, and it is reasonable to believe the partner will be able to (and actually will) satisfy the clawback obligation if applicable.
The proposed regulations would be effective on the date final regulations are published in the Federal Register and would apply to any arrangement entered into or modified on or after the date of publication. There is already similar regulation in Britain, and I anticipate this to be finalized in the U.S. as well. As the year has turned, and in anticipation of a potential industry shift in the new-normal for fee structures, if you have an existing fund (or launching a new fund) with a waiver structure you should consider the above provisions.