IRS thinks certain profits interests are too good to be true.

• Author: Goldberg, Mitchell W.

An election year is upon us. Many presidential candidates are proposing their respective tax plans. But let us look backwards and consider one of the tax issues brought to national attention in the 2012 presidential campaign--an issue the IRS recently addressed in proposed regulations: management fee waivers. During the 2012 presidential campaign, Mitt Romney's company, Bain Capital, became a topic of discussion when it was shown how, by using management fee waivers, Bain Capital converted what otherwise would have been management fees taxed as ordinary income into long-term capital gains taxed at preferential rates, resulting in significant tax savings. (1) A management fee waiver is an income tax planning technique that generally converts what would otherwise be a fee for services taxed as ordinary income into a grant of a profits interest in the partnership. The conversion itself is not taxable. Subsequently, if the partnership has long-term capital gain, the recipient of the newly issued profits interest is allocated a share of such gain, which is taxed as long-term capital gain (as opposed to ordinary income).

On July 22, 2015, the Department of the Treasury and the IRS issued proposed regulations under I.R.C. [section]707(a)(2)(A) to treat the grant of certain profits interests as a disguised payment for services. (2) This article discusses, in general, how profits interests are taxed and how management fees are converted into profits interests through waivers, how the proposed regulations would affect the use of profits interests, and certain shortcomings of the proposed regulations.

Partnership Capital Interests and Partnership Profits Interests

There are generally two types of partnership interests: capital interests and profits interests. A capital interest is an interest that would give the holder a share of the proceeds if the partnership's assets were sold at fair market value and then the proceeds were distributed in a complete liquidation of the partnership. This determination generally is made at the time of receipt of the partnership interest. A profits interest is a partnership interest other than a capital interest. (3) In other words, a profits interest is a partnership interest that entitles its holder to participate only in future profits of the partnership.

The tax law is relatively settled that receipt of a capital interest in exchange for services is taxable to the recipient. (4) However, the taxation of profits interests is less certain. (5) To provide guidance to taxpayers on the taxation of profits interests in exchange for services, the IRS issued Rev. Proc. 93-27, 1993-2 C.B. 343 (as modified by Rev. Proc. 2001-43, 2001-2 C.B. 191), which provides a safe harbor wherein the IRS will not seek to tax a profits interest issued in exchange for services provided that the recipient receives the profits interest either as a partner or in anticipation of becoming a partner. However, the safe harbor does not apply if 1) the profits interest relates to a substantially certain and predictable stream of income from partnership assets, such as high-quality debt or high-quality net lease; 2) the partner disposes of the profits interest within two years of receipt; or 3) the profits interest is a limited partnership interest in a publicly traded partnership under I.R.C. [section]7704. (6)

Private Equity Funds and Management Fee Waivers

In general, a private equity fund (PE fund), typically a limited partnership for state law purposes and taxed as a partnership for federal income tax purposes, holds various investments that are held long-term pending a liquidity event. The investors (i.e., the limited partners) of the PE fund provide the capital needed to make such investments. Income from such investments (whether interest, dividends, capital gains, etc.) flows through to the investors and retains the same character. The limited partners typically own 99 percent of the PE fund, and the general partner owns the remaining 1 percent.

The general partner, however, does not manage the PE fund. Rather, a private equity firm (such as Bain Capital) handles all investment and management duties. The manager is not a partner of the PE fund but rather is an independent contractor with a management agreement that entitles it to a fee equal to a percentage of assets under management (management fee). The general partner is an affiliate of the manager. As an incentive to grow the PE fund and align the manager's interests with those of the investors, the general partner (not the manager) typically makes minimal capital contributions to the PE fund and the general partner (not the manager) receives a right to participate in some percentage (usually 20 percent) of the profits of the PE fund (carried interest) after the investors receive a certain return on their investment. In this structure, the general partner is merely a shell entity that holds the general partnership interest and the carried interest while the manager performs all management functions. There are nontax reasons for this bifurcation, including insulating the general partnership interest and carried interest from potential liabilities of the manager, mitigating the exposure of income allocated to the general partner from being subject to state and local taxes (particularly when the manager is located in a high-tax jurisdiction, such as New York City), and providing more varied compensation packages...