November/December 2013 Vol 27 / No 2
MANAGEMENT FEE WAIVERS: THE CURRENT STATE OF PLAY 5
Management Fee Waivers:
The Current State of Play
Private equity fund management fee waivers are once again on the radar, on the heels of recent comments by IRS officials
that the agency is contemplating issuing new guidance and the First Circuit’s decision in Sun Capital . If effective, the waiver
converts a fund manager’s ordinary income for services into a future profits interest in the fund that yields income taxed at
capital gains rates, so the industry has much at stake as this debate heats up. This article looks at recent developments in
fee waiver arrangements and analyzes the arguments that the IRS is likely to consider.
SABA ASHRAF AND ALYSON K. PIRIO
F
ee waivers have garnered a lot of attention since
2007. While used in a variety of partnership trans-
actions, their use by managers of private equity
funds
1
has received the most attention. Mechanically, fee
waivers can be broken down into two steps: under Step 1,
a partner (or manager in the case of a private equity
fund) that is entitled to a fee for services rendered to the
partnership (the fund in the case of private equity funds)
waives its right to the fees prior to the time the services
are rendered. Under Step 2, the partner (or manager) re-
ceives a profi ts interest in the partnership (or the private
equity fund) in exchange for the services.
This waiver, if effective, converts what otherwise
would have been ordinary income (currently taxed to
individuals at a rate of 39.6 percent), into capital gain
(currently taxed to individuals at a rate of 20 percent
2
).
Private equity fund managers argue that they have
exchanged a fi xed amount due to them for a claim for
future profi ts of the partnership and, since this future
profi ts interest is subject to economic risk, taxation at
capital gains rates is appropriate. However, depend-
ing on the underlying facts relating to the nature and
timing of the waiver, the allocation and distribution
pursuant to the profi ts interest actually may have little
economic risk.
As the Internal Revenue Service (IRS) contem-
plates the issuance of new guidance regarding fee
waivers, an examination of the recent developments
in this area and the application of existing law is
timely. This article first describes management fee
waiver arrangements in the private equity context,
and also highlights recent developments in New
York state and pronouncements by the IRS. Next,
the article examines the key tax issues related to
fee waivers, including whether (1) the underlying
income of most funds is in fact capital gain or or-
dinary income, (2) the issuance of a profits interest
in exchange for the fee waiver is tax-free pursuant
to Revenue Procedure 93-27,
3
and (3) the alloca-
tion and distribution pursuant to the profits inter-
est are in substance payments made for services to
the manager in a non-partner capacity pursuant to
Section 707(a)(2)(A).
4
Saba Ashraf is a partner in and leader of, and Alyson K.
Pirio is an associate in, the tax practice group of McKenna,
Long & Aldridge LLP. The authors thank Andy Immerman
for his comments on an earlier draft of this article. The
authors may be contacted by email, respectively, at
sashraf@mckennalong.com and [email protected].
3
1993-2 CB 343.
4
All references in the text to Sections are to the Internal Rev-
enue Code of 1986, as amended (the “IRC”), unless otherwise
specifically indicated.
1
We use the term private equity generally to encompass a variety
of funds, including venture capital, buyout, and growth funds. The
common fact in each of these funds is that they acquire the stock
of the portfolio companies for investment, and intend for most of
their income to be capital gain.
2
The current long-term capital gains tax rate for individuals
is 20 percent. An additional 3.8 percent net investment income
tax would apply to the capital gains. Similarly, while the highest
individual income tax rate is currently 39.6 percent, the manage-
ment fees would be subject to employment taxes, generally at a
rate of 3.8 percent applying to the uncapped portion. See infra text
accompanying notes 19-21.
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12
Id.
13
For example, this bifurcated structure can impact the amount
that is subject to New York City’s unincorporated business tax.
The unincorporated business tax generally applies to every indi-
vidual or unincorporated entity carrying on a trade or business in
New York City. However, there is an exemption from the tax for
activities that constitute trading for one’s own account and partial
exemption for an unincorporated entity that is primarily engaged
in trading for its own account. Therefore, the carried interest is
bifurcated from the management fee because the general partner
can generally claim that it is primarily engaged in self-trading (i.e.,
trading or investment of the assets in the fund) and not subject to
the unincorporated business tax. The management fee is, however,
subject to the unincorporated business tax. Cara Griffith, “The
Questionable Legality of New York City’s Proposed UBT Audit
Position,” Tax Notes, Feb. 27, 2012, p. 713.
14
The management company also may provide some manage-
ment services to some of the portfolio investment companies.
5
Joint Committee on Taxation Report, Present Law and Analy-
sis Relating to Tax Treatment of Partnership Carried Interests and
Related Issues, Sept. 4, 2007, JCX-62-07 (Part I) and JCX-63-07
(Part II) (hereinafter “2007 Joint Committee Report”); see also
Andrew W. Needham, 735 BNA Tax Management Portfolio Private
Equity Funds, VII.C.3. at A-15.
6
See discussion infra, under the subheading “Trade or Business/
Fund Gain as Capital Gain.”
7
By way of background, a partnership is not subject to federal
income tax. Instead, its income, gains, losses, deductions, and
credits are parsed out according to their character among the
categories listed in Section 702(a). Each partner then reports his
“distributive share” of the items in each of these categories on his
personal income tax return. William S. McKee, William F. Nelson &
Robert L. Whitmire, Federal Taxation of Partnership and Partners,
¶ 11.01(1) (4th ed. 2007 & Supp. 2013).
8
2007 Joint Committee Report, supra note 5.
9
Id.
10
See Rev. Proc. 93-27, 1993-2 CB 343, and Rev. Proc. 2001-43,
2001-2 CB 191 and discussed infra, under the subheading “Revenue
Procedure 93-27.”
11
2007 Joint Committee Report, supra note 5.
FEE WAIVER ARRANGEMENTS IN THE PRIVATE
EQUITY FUND CONTEXT
Typical Fund Structure. A private equity fund is most
commonly formed as a limited partnership or other
pass-through entity treated as a partnership for U.S.
federal income tax purposes.
5
The fund receives capital
contributions from investing limited partners, which it
then it invests in portfolio companies. The fund holds
the portfolio companies as capital assets—i.e., for
investment, with the goal of appreciation in value over
time.
6
Accordingly, most of the underlying income of
the fund is capital gain.
7
The fund is typically organized and managed by
a group of individuals that contribute a relatively
small amount of capital to the fund, oftentimes 1
percent of the total capital contributions, and provide
investment expertise in selecting, managing, and dis-
posing of fund assets.
8
The fund’s manager receives
a “carried interest” or profi ts interest in the fund. A
carried interest is a right to receive a percentage of
fund profi ts without an obligation to contribute to the
capital of the fund. A carried interest would not give
the manager a right to partnership assets on liquida-
tion of the partnership immediately after the carried
interest grant.
9
Generally the grant of a partnership
profi ts interest for services is a non-taxable event.
10
Income from a carried interest is long-term capital
gain to the extent that it is attributable to gains real-
ized by the fund from portfolio companies that are
capital assets held for more than one year.
11
In addition to a carried interest, a fund manager
commonly receives a management fee, calculated as
a percentage of fund assets, as compensation for the
services it performs. The combination of a manage-
ment fee and a carried interest has been referred to as
“two and twenty,” referring to the practice of provid-
ing the manager a fee equal to 2 percent of capital
and a carried interest equal to 20 percent of overall
partnership profi ts.
12
Bifurcated Interests. Often, fund organizers bifurcate
their interests in the fund in order to minimize local
taxes.
13
The general partner (typically a pass-through
entity) receives the carried interest and a separate
management company is formed (typically as a limited
liability company (LLC) or other pass-through entity)
that receives the 2 percent management fee.
14
In these
bifurcated structures, the general partner does not actively
engage in any activities, and the management company
and the general partner typically have completely or
largely overlapping interests. See Figure 1.
As mentioned above, the fi rst step in a fee waiver
arrangement is that the management company waives
its right to its management fee before it has performed
the services. Management fees are typically paid
semi-annually or quarterly, and are paid in arrears
(i.e., at the end of the period for which services are
provided). Some managers waive the right to receive
all of their fees at the time the fund is formed; others
decide whether to waive the fee each year or quarter.
Either way, the waiver is done prior to the time the
related services are performed. Under Step 2, the gen-
eral partner of the fund receives an additional profi ts
interest in lieu of the management fee. As a result of
this two-step process, the management fee that would
have been ordinary income is exchanged for a future
profi ts interest that is mostly capital gain.
Allocation of Proceeds. Distribution waterfalls in
fund partnership agreements establish the priority of
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MANAGEMENT FEE WAIVERS: THE CURRENT STATE OF PLAY 7
15
The profit allocation will increase the basis a partner has in
its partnership interest. IRC § 705(a)(1)(A). A distribution of cash
will result in taxable income only to the extent it exceeds the tax
basis of the distributee partner. IRC § 731(a)(1).
the distribution of proceeds from investments to the
fund investors and the general partner. The additional
profits interest issued in the lieu of the management
fee differs somewhat in timing and priority in the
distribution waterfall from the regular carried
interest that the general partner receives. Typically,
distributions related to a regular profits interest are
placed near the end of the waterfall. By contrast,
distributions related to the additional profits interest
received by the general partner are near the top of the
waterfall—sometimes even above the return of the
capital contributions of the investors. Therefore, the
amount and timing of the profit allocation is much
more certain than that of the regular profits interest.
Other factors that can make the additional prof-
its interest issued in lieu of a management fee more
certain than the ordinary carried interest include that
the additional profi ts interest:
Is frequently paid from gross income of the fund, •
while the carried interest is generally paid from net
income;
May be paid out of quarterly gross income rather •
than annual gross income; and
Is, in many circumstances, not subject to a claw-•
back, unlike the carried interest.
In the private equity context, rather than simply
waiving management fees for an additional profi t al-
location equal to the management fee, the fee is often
waived in exchange for a reduction of the amount of
the capital contribution required from the general
partner. For example, assume the general partner’s
capital contribution is $1 million. Instead of making
the capital contribution, the management company
will waive its management fee in the amount of $1
million, and in lieu of it receive a notional or deemed
capital contribution of $1 million. The allocation
provisions of the fund’s partnership agreement will
allocate profi ts to the general partner until it has been
allocated this $1 million. See Figure 2. The allocated
profi ts will be capital gain. The follow-on distribu-
tion of attendant cash by the fund will be tax-free.
15
Although not very common in our experience, at
times certain partnerships do not make the distribu-
tion to the management company out of cash fl ow
related to the future profi t allocation (i.e., proceeds at-
tendant to the sale of a portfolio investment). Instead,
Figure 1: Bifurcated Interests in Fund
20% profits
1% capital
contribution
19% capital
contribution
80% profits
Management Services
Management Fee
Fund
Portfolio
Investment Companies
Investors/Limited
Partners
General Partner
Management
Company
Overlapping
Owners
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16
Gregg D. Polsky, “Private Equity Management Fee Conver-
sions,” 122 Tax Notes 743 (Feb. 9, 2009).
17
IRC § 67 provides that miscellaneous itemized deductions can
only be deducted to the extent that, in the aggregate, they exceed
2 percent of adjusted gross income.
18
IRC § 68 reduces itemized deductions by the lesser of 80 per-
cent of itemized deductions and 3 percent of the amount by which
a taxpayer’s adjusted gross income exceeds an applicable amount
(currently $300,000 for joint filers) (the Pease limitation).
the distribution is made out of loan proceeds or cash
that the fund partnership has from other sources.
TAX BENEFITS OF WAIVERS
The fi rst and most important benefi t of fee waivers is
to convert income that would have been taxed as ordi-
nary income to the manager into income taxed as cap-
ital gain. It is important to note that in regard to this
and each of the other benefi ts of the waiver, managers
seek to achieve these benefi ts with as little deviation as
possible from the parties’ original arrangement with
respect to the management fees. In other words, the
goal is not simply to achieve capital gain treatment,
but to do so while maintaining the timing and risk that
would have existed if the waiver had not taken place.
A second benefi t relates to the time value of money.
In order to fund its $1 million capital contribution, the
manager would be required to pay that amount to the
fund upon formation. Use of the waiver gives the man-
ager an opportunity to satisfy its capital contribution
without contributing any up-front money—and allows
the manager to put its $1 million to other uses.
A third benefi t is the deferral of income. Rather than
receiving the management fee in the year earned and
recognizing the income in that year, the waiver defers
income to the year in which the gains related to the ad-
ditional carried interest are realized by the manager.
16
That said, the timing benefi t is only meaningful if
the deferral is for a signifi cant period of time. If, as
described above, an underlying goal is to keep the
risk and timing as close as possible to that of the
management fee, the deferral will not be for a very
long period of time.
A fourth benefi t relates to the deductibility of
the management fee by the fund’s investors. A U.S.
individual investor in a fund generally receives a de-
duction for his share of the management fees paid by
the fund to the manager. However, this Section 212
deduction is subject to the limits on miscellaneous
itemized deductions under Sections 67
17
and 68.
18
Figure 2: Fee Waived in Exchange for Reduced Capital Contribution
20% profits
Deemed capital
contribution =
waived
management fee
19% capital
contribution
80% profits
Management Fee
Fund
Portfolio
Investment Companies
Investors/Limited
Partners
General
Partner
Management
Company
Overlapping
Owners
Management Services
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MANAGEMENT FEE WAIVERS: THE CURRENT STATE OF PLAY 9
22
Reed Albergotti, Mark Maremont & Gregory Zuckerman,
“New York Probes Private-Equity Tax Practices” (Wall Street Jour-
nal, Sept. 3, 2012), available at http://online.wsj.com/news/articles/
SB10000872396390443571904577629831800831466.
23
Id.
24
Id., quoting Mr. Kleinbard.
25
Id.
26
Nicholas Confessore, Julie Creswell & David Kocieniewski,
“Inquiry on Tax Strategy Adds to Scrutiny of Finance Firms”
(N.Y. Times, Sept. 1, 2012), available at http://www.nytimes.
com/2012/09/02/business/inquiry-on-tax-strategy-adds-to-scruti-
ny-of-finance-firms.html?pagewanted=all&_r=0.
27
Lee Sheppard, “Mitt Romney Tax Clarifications” (Forbes,
Sept. 11, 2012), available at http://www.forbes.com/sites/
leesheppard/2012/09/11/mitt-romney-tax-clarifications/.
28
Supra note 13.
19
See Polsky, supra note 16.
20
The general Medicare component of SET is 2.9 percent in
2013, but starting in 2012, the SET applies to self-employment
income over a “threshold amount” ($250,00 for a joint return,
$125,000 for a married taxpayer filing separately, and $200,000
for a single return) at a rate of 3.8 percent. The old-age, survivors,
and disability insurance (OASDI) component of employment taxes
is 12.4 percent; however, it is subject to a wage cap of $113,700.
21
From a historical perspective, this is similar to what was done
in 1986, when the long-term capital gains tax rate was reduced
to equal the income tax rate. It was just a matter of time before
the ordinary income tax rate increased, thereby again creating a
rate differential.
Further, the fee is nondeductible for tax-exempt and
non-U.S. investors, because they are not subject to
U.S. tax. However, the conversion of the management
fee to additional carried interests results in additional
capital gain being shifted from the investors to the
general partner. For investors subject to tax, this pro-
vides an immediate offset against their gains, with the
effect of a full tax deduction. This gives fund investors
an incentive to acquiesce to the waiver.
A fi fth benefi t is that in some jurisdictions, there is
an advantage in converting ordinary income, which
may be subject to additional taxes (for example, the
New York City unincorporated business tax) into
capital gain. (This is concept is discussed further be-
low in regard to the investigations conducted by the
New York Attorney General’s offi ce.)
Another benefi t of waivers is no longer as signifi cant
as it once was. Prior to 2013, fee waiver arrangements
converted income that was subject to self-employment
taxes (i.e., management fees taxed as ordinary income)
into a profi ts interest not subject to employment
taxes.
19
However, the January 2013 imposition of
the net investment income tax (NIIT) pursuant to
Section 1411 may have thwarted this goal. Now,
income that is not subject to self-employment tax
(SET) may be subject to the NIIT at 3.8 percent—a
rate intended to approximate the current rate of em-
ployment taxes that apply to an uncapped amount
of wages or net earnings from self-employment.
20
Therefore, there is generally no rate differential be-
tween the payment of the SET above the threshold
amount and payment of the NIIT. It is possible that
the Medicare component of SET will increase in
the future and there will not be a corresponding increase
in the NIIT.
21
This would create a rate differential that
benefi ts the management fee waiver arrangement. It is
unclear, however, how likely that would be.
PRIVATE EQUITY FUND FEE WAIVERS IN THE NEWS
Fee waivers have been in the news regularly for
the past several years. Some key players in the private
equity industry, including Bain Capital LLC and
Apollo Global Management, have been identifi ed as
using them.
22
KKR & Co. reportedly used the strat-
egy from 2007 until 2009, when it became a public
company.
23
Many attribute the use of fee waiver
arrangements by these funds to the IRS’s silence on
this issue, which the funds viewed as a green light. Ed
Kleinbard, a professor at the USC School of Law and a
former chief of staff of Congress’s Joint Committee on
Taxation, said some fi rms “seemed to have interpreted
the silence of the IRS as acquiescence, which is not
correct, but the IRS failed to enforce the rules in this
area.”
24
Mr. Kleinbard went on to say that “[f]irms
ended up taking positions that I think went beyond
what the law permitted. . . . But the IRS failed to do
its job of litigating those issues. Had they done so,
a lot of these structures, including possibly Bain’s,
would have been disallowed.”
25
In mid-2012, New York Attorney General Eric
Schneiderman issued subpoenas to several private
equity funds as part of a larger investigation focusing
on the use of management fee waiver arrangements.
26
At fi rst glance, it is diffi cult to understand why he
would conduct such an investigation, as there is no
rate differential between ordinary income and capi-
tal gains in New York. Many suspect that the state
was concerned with the deferral of income that is a
natural result of such arrangements.
27
That said, be-
cause most fee waiver arrangements try to interfere
as little as possible with the economic arrangement
that existed prior to the waiver, any income deferral
is likely only short-term. The real concern may have
been the possible avoidance of state income tax on
the waiver amounts. Conversion of management
fees from ordinary income to capital gain generally
prevents such amount from being subject to the New
York City unincorporated business tax, and nonresi-
dent members do not pay New York state income tax
on such amounts.
28
Finally, it has been suggested that
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32
Elliott, supra note 30.
33
Id.
34
Id.
35
Id.
36
Id.
37
Id. As noted, the IRS has concerns that some funds may
not keep clear books and records reflecting when a waiver takes
place and how much appreciation was inherent in their portfolio
investments at the time the profits interest was issued. This may
explain why the IRS is considering audits rather than legislation
to address these situations.
29
Eric Kroh, “Investigation Brings Management Fee Waivers
Under Scrutiny,” Tax Notes, Sept. 10, 2012, p. 1250.
30
Amy S. Elliott, “IRS Studying Fee Waivers,” Tax Notes,
May 6, 2013, p. 599. Although the IRS comments suggest that
there will not be a wholesale disallowance of management fee
waiver arrangements, the Senate Finance Committee appears to be
considering other ideas. On June 7, 2013, the Committee released
the eighth in a series of discussion papers on tax reform; at the
top of the list for reforming compensation, it suggests reforming
the treatment of carried interest and other partnership interests
received in whole or in part in exchange for services. This paper
included a suggestion that the conversion of management fees into
“partnership shares taxed at capital gains rates” be disallowed. Sen-
ate Finance Committee Staff Tax Reform Options for Discussion,
Types of Income and Business Equities, June 6, 2013.
31
Sheldon I. Banoff of Katten Muchin Rosenman LLP perhaps
said it best in discussing long-awaited carried interest legislation:
“unless and until it becomes real, I think it’s been a little bit like the
little boy who cried wolf.” Amy S. Elliott, “IRS Amplifies Its Views
on Management Fee Waivers,” Tax Notes, May 27, 2013, p. 999.
managers might have been treating the additional car-
ried interest as a nontaxable distribution of capital
for New York state tax purposes.
29
Although the New York state investigation ap-
pears to have lost momentum, it called into question
the validity of the tax strategy behind the manage-
ment fee waiver arrangement and has people in the
industry wondering whether there will be additional
federal or state level scrutiny of such arrangements
in the future.
CURRENT IRS PERSPECTIVE AND POSSIBLE
NEW GUIDANCE
If federal tax law is changed so that income from car-
ried interests is taxed as ordinary income, management
fee waivers would be moot. But whatever Congress
may do, in statements made on April 30, 2013, Clif-
ford Warren, Special Counsel in the IRS Offi ce of
Associate Chief Counsel (Passthroughs and Special
Industries), indicated that the IRS may take action re-
garding management fee waiver arrangements.
30
And
who can blame the IRS for not waiting for Congress
to act? At this point, claims that Congress will reform
carried interests taxation ring hollow.
31
According to Mr. Warren, the characterization of
management fee waivers is “fair game” and fee waiv-
ers are “something that [the IRS is] in fact studying.”
32
Despite the IRS’s concern with certain fee waiver ar-
rangements, he said, “[t]here’s a spectrum, and we’re
trying to fi gure out what’s good and what’s bad,”
33
and it is unlikely the IRS will make all management fee
waiver arrangements “strictly forbidden.”
34
Rather,
whether a fee waiver is on the permissible end of the
spectrum will be based on a facts-and-circumstances
analysis. Arrangements on the “bad” end of the spec-
trum may include those that (1) do not fall within
the Revenue Procedure 93-27 safe harbor (which, as
discussed below, requires the recipient be a partner
and hold the interest for at least two years) and (2)
those where the service provider would be treated
as acting in a non-partner capacity under Section
707(a)(2)(A).
35
For example, if a private equity fund
manager that contractually waived its right to a fi xed
management fee for the fi rst year on the day of the
fund’s formation in exchange for a profi ts interest that
it will receive only if there is suffi cient net gain on all
of the assets at the end of the fund’s life, that would
be permissible. But an arrangement involving a waiver
where the timing of the waiver was unclear because
it merely appeared in an internal memorandum or an
accounting entry and where, soon after the waiver,
the manager received a gross income allocation and
related distribution, which it reported as capital gain,
would not pass muster.
36
In addition to the timing is-
sues in the second example, the IRS is also concerned
the related parties in these arrangements can play fast
and loose with the documentation.
The examples above are at the far ends of the spec-
trum; we don’t know whether the IRS will provide
additional guidance on other arrangements deemed
permissible—or any specifi c guidance regarding
management fee waivers at all. However, accord-
ing to the IRS, if it comes, such guidance could be
in the form of a revenue ruling, or audit guidelines
designed to challenge arrangements at the bad end
of the spectrum.
37
A
lthough the New York state investigation
appears to have lost momentum, it called into
question the validity of the tax strategy behind the
management fee waiver arrangement and has
people in the industry wondering whether there
will be additional federal or state level scrutiny.
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MANAGEMENT FEE WAIVERS: THE CURRENT STATE OF PLAY 11
42
This may be the reason, for example, that developers that
are partners in traditional real estate development partnerships
(that typically generate ordinary income) do not waive their
development fees for a profits interest in the real estate develop-
ment partnership.
43
Sun Capital, 724 F.3d at 133. The First Circuit reversed
the decision of the United States District Court for the District
of Massachusetts, which had held that the Sun Funds were not
trades or businesses because they did not have any offices or
employees, and they did not make or sell goods or report income
other than investment income on their tax returns. Additionally,
the Sun Funds were not engaged in the management activities of
the general partner.
44
Amy S. Elliott, “Panelists Agree Fee Offsets Are Problematic,
But Disagree on Sun Capital’s Significance,” Tax Notes, Oct. 7,
2013, p. 16.
38
Amy S. Elliott, “New Guidance Will Clarify the Treatment
of Fee Waivers,” Tax Notes, Sept. 30, 2013, p. 1499.
39
Id.
40
Sun Capital Partners III, LP, et. al. v. New England Teamsters
& Trucking Indus. Pension Fund, 724 F.3d 129 (1st Cir. 2013).
41
Steven M. Rosenthal & Andrew W. Needham, “Taxing PE
Funds and Their Partners: A Debate on Current Law,” Tax Notes,
June 10, 2013, p. 1327; see James H. Lokey, Jr. & Donald E.
Rocap, “Selected Tax Issues in Structuring Private Equity Funds,”
631 PLI/Tax 9 (2004) § 1.05[5]; Peter J. Elias, “Effect of the New
Medicare Tax on U.S. Investors in Hedge Funds,” Tax Notes, Feb.
25, 2013, p.965 at n.15, stating:
U.S. tax law has long distinguished between invest-
ment funds that are considered to be traders and those
considered to be investors or non-traders. The principal
difference, for tax law purposes, is that a trader fund
(because of active trading) is deemed to be engaged in
an active trade or business, whereas a non-trader fund
is not. In general, an investment fund will be considered
a trader for this purpose if the fund’s trading activities
are frequent and substantial, and if the fund generally
seeks profits from short-term market swings rather than
long-term appreciation. See, e.g., Boatner v. Commis-
sioner, T.C. Memo. 1997-379, aff’d, 164 F.3d 629 (9th
Cir. 1998) (taxpayer deemed to be a trader when trading
activities were “frequent, regular and continuous”). By
contrast, an investor or non-trader is one who purchases
and sells securities with the principal purpose of realizing
investment income in the form of dividends, interest,
and gains from appreciation in value over a relatively
longer holding period. See, e.g., Higgins v. Commis-
sioner, 312 U.S. 212 (1941); King v. Commissioner, 89
T.C. 445 (1987).
In keeping with Mr. Warren’s statements, during a
September 24, 2013, meeting of the Passthroughs and
Real Estate Committee of the District of Columbia Bar
Taxation Section, Craig Gerson, attorney-advisor for
the Treasury Offi ce of Tax and Legislative Counsel,
advised that the Offi ce of Tax and Legislative Counsel
hopes to provide guidance that will brighten the line
between management fee waivers that are structured
correctly and those that are not.
38
Mr. Gerson said
two variables that the government may address are
(1) the timing of when the waiver occurs, and (2) the
likelihood that profi t is available to pay the general
partner in lieu of the fee.
39
ANALYSIS OF KEY TAX ISSUES
Trade or Business / Fund Gain as Capital Gain. Until the
Sun Capital
40
decision, it was generally taken as a given
that private equity funds were not engaged in a trade
or business and, therefore, the gain on the sale of their
portfolio investments was capital gain.
41
In order for
a fee waiver to convert ordinary income into capital
gain, the fund in which the profits interest is issued
must have capital gains that it can pass through to its
partners. If the underlying income of a partnership is
ordinary income, then a major incentive for engaging
in a management fee waiver is taken away, and the
frequency with which such waiver arrangements are
implemented (and for that matter, carried interests in
general issued) would significantly decrease.
42
Sun Capital. In Sun Capital , the First Circuit
Court of Appeals held that a private equity fund was
not merely a passive investor in one of its portfolio
companies, but rather that it could be in a “trade or
business” for purposes of withdrawal liability under
the Multiemployer Pension Plan Amendments Act
(MPPAA).
43
Some have expressed concern that Sun
Capital puts into question whether the income attrib-
utable to the carried interest in a private equity fund
is capital gain.
44
In Sun Capital , two limited partnership private
equity funds (the “Sun Funds”) formed a limited
liability company to invest in Scott Brass, Inc. As is
typical in private equity arrangements, general part-
ners of the Sun Funds oversaw the funds and received
an annual fee of 2 percent of the total capital com-
mitments plus a percentage of the Sun Funds’ profi ts
from investments. Sometime after the Sun Funds’
investment, Scott Brass stopped making contributions
to its multiemployer pension fund, and became liable
for withdrawal liability. Approximately one year
thereafter, an involuntary Chapter 11 bankruptcy was
brought against Scott Brass. The pension fund sought
I
n
Sun Capital
, the First Circuit Court of
Appeals held that a private equity fund was
not merely a passive investor in one of its
portfolio companies, but rather that it could be
in a “trade or business.”
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51
Sun Capital, 724 F.3d at 145-46. See infra notes 53 and 54
and accompanying text.
52
Id.
53
Id. at 142. Other factors it considered included that (1) the
Sun Funds’ investments in portfolio companies are for the general
purpose of making a profit and (2) the profits are made from the
sale of stock of the portfolio company at a gain.
54
Id. at 143.
55
If a fund renders management services to its portfolio
companies in exchange for fees, its tax-exempt investors have
unrelated business taxable income, and its foreign investors have
effectively connected income—which the tax-exempt and foreign
investors would like to avoid. The fees related to the services may
be significant, however, and many funds are hesitant to not receive
them. Andrew Needham explains:
To protect the tax-exempt and foreign investors, there-
fore, the sponsor will usually adopt some form of pro-
phylactic strategy to purge “bad income” from the fund.
The most common of these strategies is to separate, both
under the fund agreement and in practice, the activities
of the fund manager as a provider of investment advisory
services from the activities of the fund as a passive inves-
tor. As is so often the case, however, this effort to delineate
the activities of the two entities to achieve a tax objective
tends to conflict with the primary non-tax objective of the
fund investors, which is to maximize portfolio returns. In
the typical fund, therefore, although the fund manager
will capture 100% of most categories of fee income, the
fund investors will receive some form of compensating
adjustment to the periodic management fee.
Andrew W. Needham, 735 BNA Tax Management Portfolio Private
Equity Funds, VII.C.3. at A-47.
45
MPPAA § 402(a); 29 U.S.C.A. § 1301(b)(1); Employee
Retirement Income Security Act of 1974, § 4203(a), 29 U.S.C.A.
§ 1383(a).
46
The court also considered a 2007 appeals letter from the
Pension Benefit Guaranty Corporation (PBGC) addressing what
constitutes a trade or business in the single-employer pension plan
context. The appeals letter held that a private equity fund was in
a trade or business because its controlling stake in the portfolio
company allowed it to exercise control over the company through
its general partner. Sun Capital, 724 F.3d at 138. The PBGC reached
this conclusion after applying a two-prong test that it apparently
derived from Comm’r v. Groetzinger, 480 U.S. 23 (1987). The
two-prongs are: (1) whether the private equity fund was engaged
in an activity with the primary purpose of income or profit, and
(2) whether it conducted its activity with continuity and regularity.
Groetzinger, 480 U.S. at 35. The First Circuit stated that the 2007
PBGC appeal letter is owed no more than Skidmore deference.
47
312 U.S. 212 (1941).
48
Id. at 218.
49
373 U.S. 193 (1963).
50
Id. at 203.
to collect the unfunded benefi ts of Scott Brass from
the Sun Funds and the Sun Funds sought a declaratory
judgment that they were not liable under the MPPAA
for the payment of withdrawal liability.
By way of background, the MPPAA requires em-
ployers that withdraw from a multiemployer plan to
pay their proportionate share of the pension fund’s
vested but unfunded benefi ts. In order for withdrawal
liability to be imposed on an organization other than
the one obligated to the pension fund, the organiza-
tion must be a trade or business.
45
The Sun Funds
asserted, among other arguments, that they were not
a trade or business and so they had no liability.
The phrase “trade or business” is not defi ned in
either the relevant provision of the MPPAA or Treasury
Regulations. The First Circuit considered two seminal
Supreme Court cases addressing U.S. trade or business.
46
In Higgins v. Commissioner ,
47
the taxpayer had numer-
ous investments in real estate, stocks, and bonds and
spent time overseeing these investments. The Supreme
Court held that merely keeping records and collecting
interest and dividends from securities through manage-
rial attention to those investments is not suffi cient to
constitute carrying on a trade or business no matter how
large the estate or continuous the work.
48
In Whipple
v. Commissioner ,
49
the Supreme Court held that full-
time service to a corporation was not in and of itself a
trade or business and, therefore, did not permit a full
deduction of a worthless loan by the corporation as a
business bad debt. The Court went on to state, “furnish-
ing management and other services to corporations for
a reward not different from that fl owing to an investor
in those corporations is not a trade or business.”
50
The First Circuit noted that the defi nitions of trade
or business found in Whipple and Higgins are not
controlling for MPPAA purposes, and did not fi nd
its determination that the Sun Funds could be in a
trade or business to be inconsistent with them. The
First Circuit emphasized that (1) unlike the taxpayer
in Higgins, the Sun Funds (through affi liated entities)
participated in the management of Scott Brass
51
and
(2) unlike the taxpayer in Whipple , the Sun Funds re-
ceived a direct economic benefi t for such management,
above and beyond that received by an investor.
52
In concluding that one of the Sun Funds was
engaged in a trade or business, the circuit court
placed its greatest emphasis on the fact that the fund
undertook activities related to Scott Brass’s business
and received a direct economic benefi t in addition
to that of an investor.
53
The court noted that “active
involvement in management under the [management]
agreements provided a direct economic benefi t to at
least Sun Fund IV that an ordinary, passive investor
would not derive: an offset against the management
fees it otherwise would have paid its general partner
for managing the investment”
54
in Scott Brass. Fee
offset arrangements such as the one used by the Sun
Fund are a strategy employed by funds that have tax-
exempt and foreign investors to protect such investors
from certain types of income that would be taxable to
them.
55
Specifi cally, in Sun Capital , Scott Brass made
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59
See Whipple, supra note 49; Higgins, supra note 47.
56
Sun Capital, 724 F.3d at 143.
57
Id. at n.26. The Court noted that “[t]he ‘developing business
enterprises for resale’ theory was not presented to the district court
nor in the opening briefs to us. Whatever the merit of the theory,
our decision does not engage in an analysis of it.”
58
See generally Rosenthal & Needham, supra note 41.
payments of greater than $186,000 to the general
partner of one of the Sun Funds; this amount offset
the fee that the Sun Fund had to pay to the general
partner.
56
The court found that this offset was not the
result of ordinary investment activity.
The pension fund also put forth the additional
argument that the Sun Funds were in the trade or busi-
ness of developing, promoting, and selling companies.
However, the First Circuit did not address the argu-
ment because it was presented to the court too late.
57
Finally, the court noted that the defi nition of trade or
business did not have to be uniform across different
areas of tax law, and, more importantly, that its deci-
sion was strictly limited to the ERISA context.
Potential Implications. Where does Sun Capital
leave us? Although Sun Capital specifi cally limited it-
self to the issue of a trade or business for purposes of
withdrawal liability under the MPPAA, a broad inter-
pretation of the holding could suggest that where the
general partner or other agent of the fund is perform-
ing services for the portfolio investment companies,
the fund may be deemed to be engaged in the trade
or business of the portfolio company itself or that of
providing managerial services.
Two aspects of the Sun Capital decision are some-
what puzzling. First, the First Circuit noted that the
Sun Funds, through affi liated entities, participated in
the management of Scott Brass. The fact that a gen-
eral partner or a management company is providing
services to a portfolio company should not result in
the fund being treated as providing those services to
the portfolio company. Activities of agents should
be attributed to a principal only when performed on
behalf of a principal. Unless the general partner or
management company is performing the services on
behalf of the fund , the fund should not be treated as
engaged in those activities.
58
Second, while it is clear
the Sun Fund was receiving an economic benefi t be-
cause of the fee offset, it did not itself engage in any
activities to earn such services. If no actual services
are performed by the fund or an agent on its behalf,
then it is diffi cult to reach the conclusion that the
fund is engaged in a trade or business. Perhaps the
thought process of the court was as follows: Even
though the fund did not directly perform any activi-
ties for Scott Brass, its agents (the general partner and
the management company) did. It is appropriate to
deem the general partner and management company
to be agents of the fund in performing services for
Scott Brass because, effectively, the fund received the
approximately $186,000 for its services from Scott
Brass, and then assigned it over to its agents.
That said, even if the broad interpretation that where
a general partner of a fund is performing services for
the portfolio investment companies, the fund may be
deemed to be engaged in a trade or business is accepted,
this should not mean that the fund’s gain on the sale of
its portfolio companies is ordinary income rather than
capital gain. Even if the fund is said to be engaged in
these trades or businesses, unless it can be shown that
the purchase price being paid on the sale of the portfolio
companies is essentially a payment to the fund for the
managerial services it may have performed for the port-
folio companies, the gain should be capital gain.
59
Employees of LLCs and corporations are com-
monly given equity interests as performance incentives.
It is generally accepted that such employees’ gains on
the sale of the LLC or corporation are capital gains.
That the portfolio company receives services from the
employee does not mean that a portion of the gain on
the sale of the employee’s investment in the company
is converted into fees for the services. The return the
employee receives on the sale of its investment is no
different that the return that any investor would re-
ceive. Analogously, even if—based on the Sun Capital
rationale—it is concluded that the typical private
equity fund is engaged in the business of its portfolio
company, or of managing the portfolio company, this
should not convert the fund’s gain on the sale of its
portfolio investments into ordinary income.
If, on the other hand, a fund is in the trade or busi-
ness of promoting its portfolio investments for sale
to customers in the ordinary course of business, then
the First Circuit has left open the possibility that the
gain may be ordinary income rather than capital gain.
Theoretically, on this particular set of facts, it may be
possible to show that the gain on the sale represents
T
he fact that a general partner or a
management company is providing services
to a portfolio company should not result in the
fund being treated as providing those services
to the portfolio company. Activities of agents
should be attributed to a principal only when
performed on behalf of a principal.
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62
See Hamilton Nat’l Bank of Chattanooga v. Comm’r, 29 BTA
63, 67 (1933) (“A taxpayer may not deliberately turn his back upon
income. . . .”). See also Treas. Reg. § 1.451-1(a) (“Under [the accrual]
method of accounting, in the case of compensation for services, no
determination can be made as to the right to such compensation
or the amount thereof until the services are completed. . . . Under
the cash receipts and disbursements method of accounting, such an
amount is includible in gross income when actually or constructively
received.”); Treas. Reg. § 1.451-2(a) (“Income although not actually
reduced to a taxpayer’s possession is constructively received by him
in the taxable year during which it is credited to his account, set apart
for him, or otherwise made available so that he may draw upon it
any time, or so that he could have drawn upon it during the taxable
year if notice of intention to withdraw had been given. However,
income is not constructively received if the taxpayer’s control of its
receipt is subject to substantial limitations or restrictions.”)
63
In 2001, Rev. Proc. 2001-43, 2001-2 CB 191, was issued to
clarify that when a partnership grants a profits interest for services, the
appropriate time to determine whether there is a realization event for
tax purposes is the time of issuance, even if, at that time, the interest is
substantially nonvested. In addition, proposed regulations relating to
profits interests were issued in 2005. REG-105346-03. Notice 2005-43,
2005-1 CB 1221 (May 24, 2005). Prop. Reg. § 1.83-3(l)(i) (providing
that IRC § 83 principles will control the tax consequences of the issu-
ance of either a capital or profits interest in a partnership). The proposed
regulations reach the same results as Rev. Procs. 93-27 and 2001-43,
but require jumping through some hoops to get there. The proposed
regulations have not been finalized, and given the length of time that
has passed since their issuance, it is unclear that they will be finalized.
This article does not address their application to fee waivers.
60
Rosenthal & Needham, supra note 41 (Needham’s comments
generally). See also Ivan Mitev, “Sun Capital: Trade or Business
Armageddon Talk” (Fund-Taxation.com, Aug. 9, 2013), available
at http://fund-taxation.com/sun-capital-trade-or-business-armaged-
don-talk (“[a]s a practical matter, it is also difficult to argue that
a private equity fund, which is inherently an investment vehicle,
should be taxed as a developer or promoter of companies.”).
61
Andrew Velarde, “Treasury Official, Practitioners Discuss
Sun Capital,” Tax Notes, Sept. 9, 2013, p. 1066.
not appreciation of value in assets held for investment,
but rather a payment wholly or in part for the promo-
tion services. However, with respect to most private
equity funds, the facts simply do not support that the
funds are in the business of promotion. The private
equity funds serve as vehicles to collect the capital
of the investors and invest that capital in portfolio
companies. They do not have an intent to resell the
portfolio companies as part of an ordinary business.
60
The fact that the private equity fund receives some
investment management services, whether it be from
its general partner or a third party, does not mean that
the fund is holding its portfolio companies as some-
thing other than investments. We do not suggest that
there could never exist such a set of facts. We simply
note that it is not common for the fund, either directly
or through its agents, to engage in the promotion of
companies for sale on a regular basis.
Even Treasury seems to be reluctant, for now, to
embrace the argument that, based on Sun Capital ,
private equity funds can be said to be engaged in the
trade or business of selling its portfolio companies for
sale to customers in the ordinary course of business.
61
The remainder of this article assumes that the gains
generated by the portfolio companies are in fact capi-
tal gains, and moves on to examine whether there are
other bases on which fee waivers could be unsuccess-
ful in converting ordinary income to capital gain.
The Revenue Procedure 93-27 Safe Harbor. A key basis
for concluding that fee waivers successfully convert
ordinary income to capital gains is that the issuance
of the profits interest in lieu of the fee is tax-free. As
discussed earlier, management fee waivers involve a
two-step construct. Under Step 1, the management
company waives a right to receive the fee it would
receive upon the performance of management services.
Step 2 involves receiving a profits interest in exchange
for the performance of services.
Step 1 should not result in any taxable income to
the manager. A basic rule of taxation is that if income
or compensation has already been earned, and the
taxpayer has the right to the income, then the taxpayer
cannot turn her back on the compensation and avoid
the taxable income.
62
On the fl ip side, if compensation
is waived prior to the time that it is earned or there is a
right to it, then there should not be taxable income.
T he receipt of a new profi ts interest under Step 2
is intended to be tax free. Under Revenue Procedure
93-27, if a person receives a profi ts interest for the pro-
vision of services to or for the benefi t of a partnership in
a partner capacity, the IRS will not treat the receipt of
such an interest as a taxable event of the partner or the
partnership, unless one of three exceptions applies:
1. The profi ts interest relates to a substantially cer-
tain and predictable stream of income from part-
nership assets, such as income from high-quality
debt securities or a high-quality net lease;
2. Within two years of receipt, the partner disposes
of the profi ts interest; or
3. The profi ts interest is a limited partnership inter-
est in a “publicly traded partnership” within the
meaning of Section 7704(b).
63
E
ven Treasury seems to be reluctant, for now,
to embrace the argument that based on Sun
Capital, private equity funds can be said to be
engaged in the trade or business of selling its
portfolio companies for sale to customers in the
ordinary course of business.
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MANAGEMENT FEE WAIVERS: THE CURRENT STATE OF PLAY 15
67
See IRC § 731, 721.
68
Polsky, supra note 16.
64
McKee et al., supra note 7, at ¶ 5.02(7).
65
See Lee A. Sheppard, “From the Archives: Carried Away: Man-
agement Fee Conversion,” Tax Notes, Aug. 13, 2007, p. 532.
66
The allocation of profits that accrued prior to the time the
fee was waived raises the question of whether the interest issued to
a partner was a capital interest as opposed to a profits interest. A
profits interest entitles a partner to only future profits, and nothing
on liquidation of the partnership. If a general partner is entitled
to a payment immediately after the issuance of a profits interest
upon a hypothetical liquidation of the fund, then the general
partner may have been issued a capital interest. See Lokey, Jr. &
Rocap, supra note 41.
These exceptions “attempt to isolate for further re-
view and possible litigation those interests that are
easily valued at or about the time of receipt.”
64
The fi rst Revenue Procedure 93-27exception, a
profi ts interest relating to a substantially certain and
predictable stream of income, may raise issues in the
fee waiver context. One reason cited for why waivers
are not effective is that, in practice, there is no eco-
nomic risk associated with the future profi ts interest.
65
Unlike traditional profi ts interests issued by funds,
which are typically the last rung in the distribution
waterfall, a profi ts interest issued in place of man-
agement fees typically appears near the top, in some
instances, even prior to the repayment of the capital
contributions of the investors. The higher a distribu-
tion is in the waterfall, the greater the certainty that
the payment will be made by the fund. Depending
on the quality of the portfolio investments that the
fund has made, the income required to pay the top
tiers of the waterfall could arguably be substantially
certain and predictable. That said, it likely is not as
certain and predictable as the income stream from
high quality debt securities, or high-quality net leases.
Therefore, it is unclear whether the fi rst exception
will apply.
If the profits to be paid in place of the manage-
ment fees come out of fund gains that were accrued
by the fund at the time the fee was waived, but not
realized until after the waiver, then there is a stron-
ger argument that the profits interest falls within
the first exception.
66
However, note that Revenue
Procedure 93-27 refers to a “substantially certain
and predictable stream of income from partnership
assets.” It is unclear whether a one-time predictable
payment of income, as opposed to a predictable
stream of income, would fall within the first excep-
tion described above. Given that the exceptions to
Revenue Procedure 93-27 are aimed at excluding
situations where the profits interest is capable of
easily being valued, it should not matter whether the
predictable income of the partnership is a one-time
event or a stream of income. That said, however,
a literal reading requires a “stream” of income in
order to be excepted.
The second exception to the application of Rev-
enue Procedure 93-27 is the disposition of the profi ts
interest by the partner within two years of its receipt.
In a typical fund the contractual arrangement to
receive the management fee is between the manage-
ment company and the fund (see Figure 2 on page 8),
whereas immediately after the waiver, the profi ts
interest is issued to the general partner. In addition
to the usual two steps involved in a fee waiver, in the
private equity context involving bifurcated interests,
there is an implied third step: after the waiver of the
management fee and the receipt of a profi ts interest,
the management company transfers (or is deemed
to transfer) this profi ts interest to the general part-
ner. Specifi cally, upon receipt of the profi ts interest,
the management company is deemed to distribute
the interest to its members. Assuming completely
overlapping ownership between the management
company and the general partner, immediately
thereafter, the members of the general partner entity
are deemed to contribute this profi ts interest to the
general partner. Assuming completely overlapping
ownership, the distribution and the contribution
should be tax-free.
67
Technically, because the transfer (or the deemed
transfer) of the profi ts interest by the management
company to the general partner takes place within two
years of the receipt of the profi ts interest, the situation
where the management company is a separate entity
from the general partner would seem to fall squarely
within the second exception to Revenue Procedure
93-27. However, some commentators note that
this is a technical argument and that there appears
to be no policy reason why the manager’s decision
to bifurcate should infl uence whether the Revenue
Procedure 93-27 safe harbor applies.
68
(As discussed
earlier, separating the management company from
the general partner is generally done for state or local
tax planning purposes. Many funds do not have this
as a feature of their structure. Thus, this issue would
not arise for them.)
As the discussion above illustrates, although there
are many situations in which Revenue Procedure
93-27 may apply to the issuance of profi ts interests
in lieu of fees, there may be circumstances where the
safe harbor does not apply. In these situations, we are
left with the confusing general body of case law as to
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72
Pratt, 64 TC at 211-212. The Tax Court also held that a pay-
ment based on a partnership’s gross income is not a guaranteed pay-
ment under Section 707(c) because it was computed as a percentage
of “gross income” of the partnership (as discussed below).
73
1981-2 CB 143.
74
Id. The IRS simultaneously issued Rev. Rul. 81-301, 1981-2
CB 144. This involved a partner/advisor that rendered services
to an investment partnership and was allocated 10 percent of the
daily gross income of the partnership in return. The services were
substantially the same as the services it rendered as an independent
contractor or agent to persons other than its partners. The IRS
ruled that IRC § 707(a) applied to the services because: (i) the
adviser provided similar services to others as part of its regular
trade or business, (ii) its services to the partnership were supervised
by the directors of the partnership, (iii) the partner/advisor could
be relieved of its duties and right to compensation at any time by
a majority vote of the directors, (iv) the partner/advisor paid its
own expenses and was not personally liable to the other partners
for any losses incurred in the investment and reinvestment services
that he provided.
69
Rev. Proc. 93-27 describes the case law that existed immedi-
ately prior to its issuance:
Under section 1.721-1(b)(1) of the Income Tax Regula-
tions, the receipt of a partnership capital interest for
services provided to or for the benefit of the partnership
is taxable as compensation. On the other hand, the issue
of whether the receipt of a partnership profits interest for
services is taxable has been the subject of litigation. Most
recently, in Campbell v. Commissioner, 943 F.2d 815 (8th
Cir. 1991), the Eighth Circuit in dictum suggested that
the taxpayer’s receipt of a partnership profits interest
received for services was not taxable, but decided the
case on valuation. Other courts have determined that in
certain circumstances the receipt of a partnership profits
interest for services is a taxable event under section 83
of the Internal Revenue Code. See, e.g., Campbell v.
Commissioner, T.C.M. 1990-236, rev’d, 943 F.2d 815
(8th Cir. 1991); St. John v. United States, No. 82-1134
(C.D. Ill. Nov. 16, 1983). The courts have also found
that typically the profits interest received has specula-
tive or no determinable value at the time of receipt.
See Campbell, 943 F.2d at 823; St. John. In Diamond
v. Commissioner, 56 T.C. 530 (1971), aff ’d, 492 F.2d
286 (7th Cir. 1974), however, the court assumed that
the interest received by the taxpayer was a partnership
profits interest and found the value of the interest was
readily determinable. In that case, the interest was sold
soon after receipt.
70
P.L. 99-514).
71
64 TC 203 (1975), aff’d in part and rev’d in part, 550 F2d
1023 (5th Cir. 1977).
the taxation of profi ts interests that existed prior to
the issuance of this revenue procedure.
69
Section 707(c). Section 707(c) states:
to the extent determined without regard to the
income of the partnership, payments to a partner for
services . . . shall be considered as made to one who
is not a member of the partnership, but only for the
purposes of section 61(a) (relating to gross income)
and, subject to section 162, for purposes of section
162(a) (relating to trade or business expenses).
In its recent statements, curiously, the IRS has not
mentioned Section 707(c) when discussing its re-
newed interest in “getting at” management fee waiver
arrangements.
Pre TRA-84. To understand the IRS’s current posi-
tion, a review of the relevant historic case law is help-
ful. The seminal case addressing nonpartner capacity
prior to the Tax Reform Act of 1984
70
(TRA-84) is
Pratt v. Commissioner .
71
In Pratt , three individuals
formed partnerships to purchase, develop, and oper-
ate shopping centers. In return for these services, the
partners received a fee equal to a percentage of gross
rental from the shopping center. The partners main-
tained that the fees should be treated as payments
under Section 707(a) or 707(c), and reported the fees
in the year received rather than the year earned. The
IRS asserted that the partners, cash basis taxpayers,
should include the fee income as distributive shares in
the years in which they were earned.
The Tax Court held that the fees were not Section
707(a) payments because the partners were perform-
ing “basic duties of their partnership business pursu-
ant to the partnership agreement” and were acting
“within the normal scope of their duties as general
partners.”
72
It found that the fees were properly
treated as a distributive share of partnership income
and were includable in the partner’s gross income
for the years in which the services were rendered and
not in the years when the payments were ultimately
received. On appeal, the Fifth Circuit affi rmed the
Tax Court’s decision, fi nding the partners performed
the managerial services in their capacities as partners.
Both the Tax Court and the Fifth Circuit focused their
“partner capacity” analysis on an evaluation of the
“nature of the services” when compared to the activi-
ties in which the partnership was engaged.
In response to Pratt , the IRS issued Revenue Ruling
81-300,
73
which was based on facts very similar to
Pratt ’s. The IRS agreed with Pratt that the partners in
their capacities as partners rendered the managerial
services, and thus Section 707(c) applied. It said
the term “guaranteed payment” should not be limited
to fixed amounts. A payment for services determined
by reference to an item of gross income will be a
guaranteed payment, if based on all of the facts and
circumstances, the payment is compensation rather
than a share of profits. . . . It is the position of the
[IRS] that in Pratt the management fees were guaran-
teed payments under Section 707(c) of the Code.
74
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79
See Philip F. Postlewaite & David Cameron, “Twisting Slowly
in the Wind: Guaranteed Payments After the Tax Reform Act of
1984,” 40 Tax Law. 649, 660 (1986-1987).
80
Id.
81
A partnership is generally required to capitalize (rather than
currently deduct) expenditures that relate to the improvement
of property or create an asset the useful life of which extends
substantially beyond the end of the taxable year. Similarly, under
IRC § 709, a partnership may not currently deduct amounts paid
or incurred to organize the partnership. Absent the application of
IRC § 707(a)(2)(A), if the organizer of a partnership was also a
partner of the partnership, allocations of partnership gross or net
income to the organizer and related income distributions to him
in payment of his services, could, if respected, have the effect of a
current deduction for organizational and syndication fees (because
the allocation and related distribution, which in this case were
economically indistinguishable from a direct payment, reduced the
taxable income allocated to the remaining partners in the year of the
allocation. In enacting IRC § 707(a)(2)(A), Congress was concerned
that partnerships were being used to circumvent the requirement
to capitalize certain expenses by making allocations of income and
corresponding distribution in place of direct payments for property
or services. See 1985 Joint Committee Report, supra n.75, at 225:
“The provision is aimed at preventing a partnership from obtaining
an effective deduction for the cost of services rendered that must
otherwise be capitalized. S. Rep. No. 169, 98th Cong., 2d Sess. 225
(1984) (‘Senate Report’). The effect of the provision is to deny the
service provider or the transferor of property the status of a partner,
thus denying the partnership the advantage sought.” Id.
75
Joint Committee on Taxation, General Explanation of the
Revenue Provisions of the Deficit Reduction Act of 1984, 226
(1985) [hereinafter “1985 Joint Committee Report”] at 230-231.
76
See Seth H. Poloner, “Structuring Hedge Fund Manager
Compensation: Tax and Economic Considerations,” 11 J. Tax’n
304, 308-309 (May 2010), and the authorities cited therein.
77
See id. for a more in depth discussion of IRC § 707(c).
78
See IRC § 707(a)(2)(A); 1985 Joint Committee Report,
supra note 75.
Post-TRA-84. Curiously, the legislative history of
TRA-84, addressing Section 707(a)(2)(A) (discussed
further below) states that
Congress intended that [Section 707(a)(2)(A)] lead
to the conclusions contained in [Rev. Rul. 81-300],
except that the transaction described in Rev. Rul.
81-300 would be treated as a transaction described
in section 707(a) (rather than section 707(c)).
75
It is not clear why Congress did not agree with the
IRS position that Section 707(c) applies to such allo-
cations. It could be that Congress agreed with the Tax
Court in the Pratt decision.
76
The IRS currently appears inclined not to use Section
707(c) as the basis for asserting that management fee
waivers result in ordinary income. Perhaps it is because
of the position Congress took in enacting TRA-84, or
perhaps it thinks Revenue Procedure 93-27 and Section
707(a)(2) provide suffi cient ammunition.
77
Therefore,
we focus our attention on Section 707(a)(2)(A).
Section 707(a)(2)(A). In recent statements, IRS
representatives have repeatedly asserted Section 707(a)
(2)(A) as a possible basis for fee waivers resulting
in ordinary income. Added to the Code as a part of
TRA-84, Section 707(a)(2)(A) provides, in relevant
part, that under Treasury regulations, if:
(1) a partner performs services for a partnership,
(2) there is a related direct or indirect partnership
allocation and distribution to the partner, and
(3) when viewed together, the performance of such
services and the allocation/distribution are prop-
erly characterized as a transaction between the
partnership and a partner acting in a non-partner
capacity, the transaction is to be treated as a
transaction between the partnership and a person
who is not a partner.
78
Where Section 707(a)(2)(A) applies, the amount paid
to the partner is treated as a payment for services rather
than a distributive share of partnership income whose
character is determined at the partnership level.
Prior to its amendment by TRA-84, Section 707(a)
simply provided that partners engaging in transactions
with a partnership in a nonpartner capacity should be
treated as third parties for tax purposes. Generally,
services that were closely related to the business of
the partnership were found to be services rendered in
a partner capacity, and those not closely related were
held to be services rendered in a nonpartner capacity.
79
As discussed below, Section 707(a)(2)(A) redefi ned
the determination of whether a partner is acting in its
capacity as a partner by focusing on risk, specifi cally
the risk as to the amount and fact surrounding a special
allocation, as opposed to the nature of the services.
80
Although the pre-1984 authorities continue to be
relevant in determining whether a payment is treated
as a Section 707(a) payment, they became less im-
portant with the enactment of Section 707(a)(2)(A).
Treasury has not yet issued regulations pursuant to
Code Section 707(a)(2)(A); however, the legislative
history provides signifi cant guidance for determining
when a partner is acting in a non-partner capacity.
A large aim of Congress in enacting Section 707(a)
(2)(A) was to prevent partnerships from effectively
obtaining current deductions for payments that
would otherwise be required to be capitalized and
deducted over a longer period of time.
81
However,
T
he IRS currently appears inclined not to use
Section 707(c) as the basis for asserting that
management fee waivers result in ordinary income.
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87
See 1985 Joint Committee Report, supra note 75, at 227-228.
88
Id. at 228.
89
Id.
82
See 1985 Joint Committee Report, supra note 75, at 224 (in
addressing issues under prior law, it notes “if a service-providing
partner was allocated a portion of the partnership’s capital gains
in lieu of a fee, the effect of the allocation/distribution could be to
convert ordinary income (compensation for services) into capital
gains”); see also Senate Report, supra note 81, at 228.
83
1985 Joint Committee Report, supra note 75, at 227.
84
TAM 9219002 (Jan. 27, 1992).
85
1985 Joint Committee Report, supra note 75, at 227.
86
See supra note 84.
Congress was also clearly mindful of the potential
manipulation by some to characterize income that
would otherwise be ordinary as capital gain,
82
and
intended for Section 707(a)(2)(A) to address any such
potential manipulations.
Congress believed that certain factors should be
considered in determining whether a partner receives
the putative allocation and distribution in his capac-
ity as a partner.
83
In Technical Advice Memorandum
9219002,
84
in ruling as to whether an allocation of
capital gain to a limited partner was a payment within
the scope of Section 707(a)(2)(A), the IRS considered
this legislative history and analyzed these factors.
Payments Subject to Appreciable Risk. The Joint
Committee Report states:
The first, and generally the most important, factor
is whether the payment is subject to an appreciable
risk as to amount. Partners extract the profits of the
partnership with reference to the business success
of the venture, while third parties generally receive
payments which are not subject to this risk. Thus,
an allocation and distribution provided for a service
partner under the partnership agreement which
subjects the partner to significant entrepreneurial
risk as to both the amount and the fact of payment
generally should be recognized as a distributive share
and a partnership distribution, while an allocation
and distribution provided to a service partner under
the partnership agreement which involve limited risk
as to the amount and payment should generally be
treated as a fee under section 707(a).
85
Notably, in Technical Advice Memorandum
9219002, the IRS gave great weight to the fi rst fac-
tor in ruling that allocations to a partner were in its
capacity as a partner. It noted that the allocation was
“subject to signifi cant entrepreneurial risk as to both
the fact and the amount of the allocation” and that
the amount of any appreciation in the assets of the
partnership (and resulting allocation) was “highly
speculative.”
86
The Joint Committee Report provides two spe-
cifi c examples of limited partner’s risk: (1) capped
allocation of partnership income (i.e., percentage or
fi xed dollar amount allocations subject to an annual
maximum amount when the parties could reason-
ably expect the cap to apply in most years); and (2)
allocations for a fi xed number of years under which
the income that will go to the partner is reasonably
certain.
87
Similarly, continuing arrangements in which
purported allocations and distributions are fi xed in
amount or reasonably determinable under all the
facts and circumstances and which arise in connection
with services also shield the purported partner from
entrepreneurial risk.
88
Regarding the existence of appreciable risk when
gross income allocations are involved the Joint Com-
mittee Report provides:
Although short-lived [i.e., capped or for a fixed num-
ber of years] gross income allocations are particularly
suspect in this regard, gross income allocations may,
in very limited instances, represent an entrepreneurial
return, which is classifiable as a distributive share
under section 704.
89
The fi rst factor is the most important one, and
should be carefully analyzed in the private equity
context. Fee waivers often involve capped allocations
of fund income. Also, unlike the general carried in-
terests issued to most general partners in funds, the
allocations related to the fee waivers are not only
much higher in the waterfall, but specifi cally tied to
the amount of the management fee, or the reduced
capital contribution. Further, fee waivers frequently
involve allocations of gross income rather than net
income, and sometimes allocations of gross income
on a quarterly basis rather than an annual basis. The
reality is that most partners engaging in fee waivers
want to do so on terms that do not meaningfully alter
their right to receive the underlying funds, or subject
it to greater risk. The ideal result for most waiver
arrangements is one where, if tax considerations are
put aside, there is essentially no change to their right
to receive the funds. Depending on the general expec-
tations regarding the fund’s underlying income, it is
quite possible that the waivers would—and should—
be treated as not subject to entrepreneurial risk as to
fact or amount.
This is not to say that allocations of gross income
are never subject to entrepreneurial risk. For example,
there certainly may exist the risk that the fund may
not have suffi cient gross income in a fi scal year or
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93
Id. (emphasis added).
90
Id. (emphasis added).
91
Id.
92
Id.
quarter to make the allocation in lieu of the fee.
The allocation in the partnership agreement may be
structured so as to be required to be allocated to the
general partner only once certain hurdles have been
achieved. The partnership may have a right to claw
back the distributed fee in certain events. The point,
however, is that this is a factual determination, and
in many circumstances, risk is not present. In these
cases, there may be a strong argument that the receipt
of the allocation and the related distribution is not
subject to entrepreneurial risk.
We note that the situation, described earlier in this
article, where certain partnerships make distributions
to the manager from cash proceeds prior to and
unrelated to the sale of portfolio investments would
seem to be a circumstance where there is very little
entrepreneurial risk. In such cases, the application of
Section 707(a)(2)(A) may be particularly relevant.
Partner Status of Recipient Is Transitory. The sec-
ond factor is whether the recipient’s partner status is
transitory. Transitory partner status (which limits the
duration of a purported joint undertaking for profi t)
suggests that a payment is a fee. “The fact that partner
status is continuing, however, is of no particular rele-
vance in establishing that an allocation and distribution
are received in an individual’s capacity as a partner.”
90
In
most cases, partner status of the general partner receiv-
ing the additional profi ts interest will not be transient.
While the existence of this factor supports characteriza-
tion as a fee, its absence appears to be neutral.
Allocation and Distribution Close in Time to Per-
formance of Services. The third factor is whether the
allocation and distribution are close in time to the
partner’s performance of services for the partnership.
91
Such an allocation is more likely to be related to the
services. When the income subject to allocation arises
over an extended period or is remote in time from the
services, the risk of not receiving the payment (the fi rst
factor) may also increase.
92
Generally, allocations of income to general part-
ners in lieu of fee waivers are relatively high up in
the waterfall, and are relatively close in time to the
performance of the ongoing services. This factor, as
applied to many situations, would seem to support
characterization as a fee.
Recipient Became Partner Primarily to Get Tax
Benefi ts. The fourth factor is whether, under all the
facts and circumstances, the recipient became a part-
ner primarily to obtain tax benefi ts for himself or the
partnership which would not have been available if
he had rendered services to the partnership in a third-
party capacity. While it certainly could not be said
that the general partner became a partner in the fund
for the purpose of obtaining a tax benefi t, it may be
said that the general partner is opting to receive the
specifi c allocation in lieu of a fee waiver (i.e., increas-
ing its profi ts interest) primarily to obtain tax benefi ts
for himself.
Size of Profi ts Interest. The fi fth factor is whether
the value of the partner’s interest in the general and
continuing partnership profi ts is small in relation
to the allocation in question (thus suggesting that
the purported allocation is, in fact, a fee). Typically
the general partner’s profi ts interest, not taking into
account any profi ts interest granted in lieu of the
management fee, is quite large. “The fact that the
recipient’s interest in general and continuing partner-
ship profi ts is substantial does not, however, suggest
that the purported partnership allocation/distribution
arrangement should be recognized.”
93
While application of the fi ve factors will yield dif-
ferent results depending on the underlying facts and
circumstances, generally, the fi rst (and most impor-
tant) and the third factors will support that Section
707(a)(2)(A) should apply, and the remaining factors
will be neutral.
Illustrative Example. After describing the fi ve fac-
tors, the legislative history sets forth two illustrative
examples, one of which seems quite relevant to man-
agement fee waivers:
Example 1: A commercial office building con-
structed by a partnership is projected to gener-
ate gross income of at least $100,000 per year
indefinitely. Its architect, whose normal fee for
such services is $40,000, contributes cash for a
25-percent interest in the partnership and receives
both a 25-percent distributive share of net income
for the life of the partnership, and an allocation
of $20,000 of partnership gross income for the
T
ransitory partner status (which limits the
duration of a purported joint undertaking for
profit) suggests that a payment is a fee.
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96
Id.
94
Id. at 229.
95
Id. at 229-230.
first two years of partnership operations after
lease-up. The partnership is expected to have
sufficient cash available to distribute $20,000 to
the architect in each of the first two years, and
the agreement requires such a distribution.
94
The Joint Committee Report concludes that the
purported gross income allocation and partnership
distribution in this example should be treated as a
fee under Section 707(a), rather than as a distributive
share, because as to those payments the architect is
insulated from the risk of the joint enterprise. Factors
which contribute to this conclusion are: (1) the special
allocation to the architect is fi xed in amount and there
is a substantial probability that the partnership will
have suffi cient gross income and cash to satisfy the
allocation/distribution; (2) the distribution relating to
the allocation is fairly close in time to the rendering of
the services; and (3) it is not unreasonable to conclude
from all the facts and circumstances that the architect
became a partner primarily for tax reasons.
95
The Joint Committee Report goes on to note that
if the agreement allocates to the architect 20 percent
of gross income for the fi rst two years following con-
struction of the building, a question arises as to how
likely it is that the architect will receive substantially
more or less than his imputed $40,000 fee. In this
case, if the building is pre-leased to a high-credit ten-
ant under a lease requiring the lessee to pay rent of
$100,000 per year, or if there is a low vacancy rate
in the area for comparable space, it is likely that the
architect will receive approximately $20,000 per
year for the fi rst two years of operations. Therefore,
he assumes limited risk as to the amount or payment
of the allocation; as a consequence, the allocation/
distribution should be treated as a disguised fee. If,
on the other hand, the project is a “spec building,”
and the architect assumes signifi cant entrepreneurial
risk that the partnership will be unable to lease it, the
special allocation might (even though a gross income
allocation), depending on all the facts and circum-
stances, properly be treated as a distributive share
and a genuine partnership distribution. (The second
example is not quite as applicable as Example 1 to the
fund situation. Hence, we do not delve into it here.)
The Joint Committee Report example illustrates
how factually sensitive the determination is of
whether a purported income allocation is in substance
a payment subject to Section 707(a)(2)(A). The ex-
ample suggests that in the private equity context focus
should be placed on the probability that the fund will
have enough income to make the allocation of the
profi t in lieu of the fee, whether the amount is fi xed,
and the expected timing of the distribution in relation
to when the fee would have been paid.
While some may view Code Section 707(a)(2)(A)
as diffi cult to apply in the absence of regulations, the
fi ve factors cited in the legislative history do provide
helpful guidance.
The Joint Committee Report examples illustrate
how factually sensitive the determination of whether a
purported income allocation is in substance a payment
subject to Section 707(a)(2)(A) will be. While situations
at one end of the spectrum (up-front waiver prior to
the time any services have been performed; limited cer-
tainty as to how much and timing of income the fund
will generate; and allocations out of net income) appear
to not fall within the purview of Section 707(a)(2)(A),
many situations that are in a more gray area may do
so. Facts and circumstances of each situation have to
be weighed and considered. This spectrum analysis is
precisely what the IRS has stated it will use to provide
greater clarity as to permissible and impermissible fund
management fee waiver arrangements. Specifi cally, two
areas that the government has said it may address are:
(1) the timing of when the waiver occurs, and (2) the
likelihood that profi t is available to pay the general
partner in lieu of the fee.
96
Both of these factors are
relevant to the Section 707(a)(2)(A) analysis.
CONCLUSION
The question of whether management fee waivers suc-
cessfully convert a fee taxed as ordinary income into a
share of the fund’s income allocable to a partner under
Section 704(b) is highly fact dependent. An exami-
nation of the existing case law and legislative history
suggests that the waiver will not be successful under
certain circumstances. The IRS has expressed that it
views the factual situations as landing on a spectrum.
While situations at one end of the spectrum (up-front
waiver prior to the time any services have been per-
formed; limited certainty as to how much and timing
of income the fund will generate; and allocations out
of net income) appear to not fall within the purview
of Section 707(a)(2)(A) or an exception to Revenue
Procedure 93-27, many situations in a more gray area
may do so. In order to avoid risk of taxation of the is-
suance of the profi ts interest, and risk of characteriza-
tion as payment for services pursuant to Section 707(a)
(2)(A), managers of funds should (1) be mindful of the
timing of the waiver, and (2) be willing to subject the
receipt of the funds to a certain level of risk. Q
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