What s News in Tax Analysis That Matters from Washington National Tax

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1 What s News in Tax Analysis That Matters from Washington National Tax IRS Issues Proposed Regulations on Disguised Payments for Services Proposed regulations relating to disguised payments for services made by partnerships to service providers, if finalized, would affect many taxpayers, particularly private equity and others in the investment fund industry. This article provides an overview of the proposed regulations, makes observations regarding their application, and explains why the proposed regulations should be considered when evaluating both existing and future arrangements. August 3, 2015 by Deanna Walton Harris, Washington National Tax Deanna Walton Harris is a senior manager in the Passthroughs group of Washington National Tax ( WNT ) and was with the IRS Office of the Chief Counsel (Passthroughs). On July 22, 2015, the Internal Revenue Service (the IRS ) and the Department of Treasury ( Treasury ) released to the public proposed regulations relating to disguised payments for services made by partnerships to service providers (the Proposed Regulations ). If finalized, the Proposed Regulations will affect many taxpayers, particularly private equity investors and managers and others in the investment fund industry. One issue addressed by the Proposed Regulations management fee waivers was expected to be addressed by IRS guidance for several months. The Proposed Regulations, however, are broader than anticipated. Moreover, the preamble to the Proposed Regulations indicates that the Proposed Regulations reflect the government s view as to the current state of the law relating to disguised payments for services. Thus, although the Proposed Regulations are generally effective when finalized, it is important to consider the positions taken by the government in the Proposed Regulations with respect to both existing and future arrangements particularly in light of an apparent increase in IRS audit activity relating to management fee waivers. KPMG Observation: The Proposed Regulations have broader implications than management fee waivers and should be considered when evaluating both existing and future arrangements. The KPMG name, logo and cutting through complexity are registered trademarks or trademarks of KPMG International.

2 IRS Issues Proposed Regulations on Disguised Payments for Services page 2 This article provides an overview of the provisions of the Proposed Regulations and KPMG observations regarding their application. Background In 1954, Congress added section 707 to the Code to clarify the treatment of transactions between a partner and a partnership. Section 707(a) addresses arrangements in which a partner engages with the partnership other than in its capacity as a partner. The provision was intended to apply to the sale of property by the partner to the partnership, the purchase of property by the partner from the partnership, and the rendering of services by the partner to the partnership or by the partnership to the partner. Congress simultaneously added section 707(c) to address payments to partners of the partnership acting in their partner capacity. Section 707(c) provides that to the extent determined without regard to the income of the partnership, partner-capacity payments for services will be considered as made to a person who is not a partner, but only for purposes of sections 61(a) and 162(a). Disguised Payments for Services Congress made changes to section 707 in 1984 to prevent circumvention by partnerships of certain capitalization requirements by structuring payments for services as an allocation of partnership income. Specifically, 707(a)(2)(A) provides that if a partner performs services for a partnership and receives a related direct or indirect allocation of income and a distribution, then the transaction will be treated as a payment for services if the performance of services and the distribution are properly characterized as a transaction between the partnership and a partner acting in a non-partner capacity. 1 Essentially, then, section 707(a)(2)(A) treats allocations and distributions that are, in substance, disguised payments for services as actual payments for services. Unless otherwise indicated, section references are to the Internal Revenue Code of 1986, as amended (the Code ) or the applicable regulations promulgated pursuant to the Code (the regulations ). The legislative history accompanying enactment of section 707(a)(2)(A) makes it clear that Congress drew a distinction between 1) disguised payments for services; and 2) situations in which a partner receives an allocation of income for an extended period in exchange for services performed for the partnership. Congress anticipated that five factors H.R. Rep. No. 432 (Pt. 2), 98th Cong., 2d Sess (1984) (H.R. Rep.); S. Prt. No. 169 (Vol. 1), 98th Cong., 2d Sess (1984) (S. Prt.).

3 IRS Issues Proposed Regulations on Disguised Payments for Services page 3 would be taken into account in making that distinction. 2 The first, and most important factor, is whether the payment is subject to significant entrepreneurial risk as to both the amount and fact of payment. Other factors listed by Congress include whether: The partner status of the recipient is transitory; The allocation and distribution that are made to the partner are close in time to the partner's performance of services; The facts and circumstances indicate that the recipient became a partner primarily to obtain tax benefits for itself or the partnership that would not otherwise have been available; and The value of the recipient's interest in general and in continuing partnership profits is small in relation to the allocation in question. Profits Interests Revenue Procedure provides that if a person receives a profits interest for the provision of services to or for the benefit of a partnership in a partner capacity or in anticipation of becoming a partner, the IRS will not treat the receipt of such interest as a taxable event for the partner or the partnership unless: The profits interest relates to a substantially certain and predictable stream of income from partnership assets, such as income from high-quality debt securities or a high-quality net lease; Within two years of receipt, the partner disposes of the profits interest; or The profits interest is a limited partnership interest in a "publicly traded partnership" (within the meaning of section 7704(b)). Revenue Procedure provides that, for purposes of Revenue Procedure 93-27, if a partnership grants a substantially nonvested profits interest in the partnership to a service provider, the service provider will 2 H.R. Rep. at ; S. Prt. at C.B C.B. 191.

4 IRS Issues Proposed Regulations on Disguised Payments for Services page 4 be treated as receiving the interest on the date of its grant (without making an election under section 83(b)), provided that certain requirements (including satisfaction of the conditions in Revenue Procedure 93-27) are satisfied. Overview of Proposed Regulations The Proposed Regulations provide a mechanism for determining whether or not an arrangement is treated as a disguised payment for services under section 707(a)(2)(A). If it is, such a payment will be treated as a payment for services for all federal tax purposes. The Proposed Regulations characterize the nature of an arrangement at the time at which the parties enter into or modify it. As more fully discussed below with respect to the effective date of the Proposed Regulations, it is worth noting that an arrangement is considered modified on the date or dates that a fee is waived. As a result, if the Proposed Regulations are finalized as is, they would apply to all fee waivers made after the effective date of the final regulations, even if the fee waivers were made pursuant to an agreement that was entered into before that date. Factors to Be Considered Whether an arrangement constitutes a payment for services (in whole or in part) depends on all the facts and circumstances. The Proposed Regulations include a list of six, nonexclusive factors that may indicate that an arrangement constitutes a disguised payment for services. The first five factors are those contained in the legislative history described above. The Proposed Regulations add a sixth factor not specifically identified by Congress. That sixth factor is whether the arrangement provides for different allocations or distributions with respect to different services received, the services are provided either by a single person or by persons that are related under section 707(b) or section 267(b), and the terms of the differing allocations or distributions are subject to levels of entrepreneurial risk that vary significantly. As indicated by the legislative history, the most important factor in determining whether there is a disguised payment for services is the existence of significant entrepreneurial risk. Indeed, under the Proposed Regulations, an arrangement that lacks significant entrepreneurial risk

5 IRS Issues Proposed Regulations on Disguised Payments for Services page 5 constitutes a disguised payment for services. In contrast, an arrangement that has significant entrepreneurial risk generally will be recognized as a distributive share, but the ultimate determination depends on the totality of the facts and circumstances. The weight given to each of the other five factors depends on the particular case. KPMG Observation: Under the Proposed Regulations, significant entrepreneurial risk is a superfactor. If the allocation and distribution to a partner lacks significant entrepreneurial risk, the arrangement will give rise to a disguised payment for services. If significant entrepreneurial risk exists, the arrangement generally will not be a disguised payment for services (unless other factors establish otherwise). Significant Entrepreneurial Risk Whether an arrangement lacks significant entrepreneurial risk is based on the service provider's entrepreneurial risk relative to the overall entrepreneurial risk of the partnership. For example, a service provider who receives a percentage of net profits in each of a partnership that invests in high-quality debt instruments and a partnership that invests in volatile or unproven businesses may have significant entrepreneurial risk with respect to both interests. 5 The Proposed Regulations set forth a series of arrangements that presumptively lack significant entrepreneurial risk; these arrangements are presumed to result in a disguised payment for services (unless other facts and circumstances can establish the presence of significant entrepreneurial risk by clear and convincing evidence). The specific arrangements giving rise to the presumption are: Capped allocations of partnership income if the cap would reasonably be expected to apply in most years; Allocations for a fixed number of years under which the service provider's distributive share of income is reasonably certain; 5 Although the preamble language on this point is not a model of clarity, it appears that the IRS and Treasury intend that significant entrepreneurial risk is determined by reference to the relevant partnership s assets, rather than to all possible types of investments. So, a partner may have significant entrepreneurial risk with regard to a particular partnership, even if that partnership invests in relatively safe investments.

6 IRS Issues Proposed Regulations on Disguised Payments for Services page 6 Allocations of gross income items; An allocation (under a formula or otherwise) that is predominantly fixed in amount, is reasonably determinable under all the facts and circumstances, or is designed to assure that sufficient net profits are highly likely to be available to make the allocation to the service provider (for example, if the partnership agreement provides for an allocation of net profits from specific transactions or accounting periods and this allocation does not depend on the overall success of the enterprise), and Arrangements in which a service provider either 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. KPMG Observation: As highlighted above, the Proposed Regulations introduce terms that are intended to help taxpayers make determinations as to the nature of a payment. The Proposed Regulations use a variety of terms, none of which are defined within the Proposed Regulations. This results in a set of subjective factors that are fairly difficult to apply. Regulatory Examples The Proposed Regulations contain a series of six examples, many of which relate to the treatment of fee waivers by a partner. In the examples, the IRS and Treasury consider whether the fee waiver should be treated as a disguised payment for services based on the manner in which the service provider waives its right to fees and is entitled to share in future partnership income and gains. Broadly speaking, the examples indicate that a fee waiver should not give rise to a disguised payment for services when: The service provider foregoes its right to fees before the period of providing services begins by executing a binding waiver and notifying the other partners of such waiver;

7 IRS Issues Proposed Regulations on Disguised Payments for Services page 7 The allocation to the service provider is determined out of net income and gains as measured over the life of the partnership; 6 and The service provider enters into a clawback obligation and is reasonably expected to be able to comply with that obligation. 7 KPMG Observation: Some may conclude, based on the examples in the Proposed Regulations that the above factors result in a determination that the amount of partnership income or gains allocable to the service provider is neither highly likely to be available nor reasonably determinable such that the fee waiver should not be a disguised payment for services. We anticipate, however, that many (if not all) existing fee arrangements will vary from the specific facts of the examples and will need to be evaluated to determine whether the fee waiver should be treated as a disguised payment for services. In addition, the above factors should be taken into account for any future arrangements. The Proposed Regulations also contain examples illustrating situations in which an arrangement is a disguised payment for services because an allocation is reasonably determinable and sufficient net profits are highly likely to be available when: The allocation is a capped amount and the cap is likely to apply, 6 One example does bless a situation in which available income is determined by reference to a one-year period. That example involves an investment partnership that has validly elected to mark-to-market under section 475(f)(1). Significantly, the mark-to-market election eliminates the possibility of targeting for sale only gain assets during a specific period so as to provide for available income. In addition, the available income in the example would come only from a specified future 12-month taxable year. Thus, it appears that the taxpayer could not look to income or gain during any year following waiver of the management fee other than the specified year. 7 The examples do not describe any terms relating to the clawbacks. Of course, a clawback is required in a typical fee waiver arrangement to the extent that the partner receives a distribution or capital contribution credit and is not ultimately allocated income to match such amounts. Given the focus of the proposed regulations on measurement of available income by reference to net profit over the life of the partnership, however, the clawback reference may be intended to ensure that an enforceable repayment obligation will exist if losses are allocated to offset early income allocations, thus eliminating the entitlement to the fee waiver payment.

8 IRS Issues Proposed Regulations on Disguised Payments for Services page 8 The allocation is out of gross income, The allocation does not depend on the overall success of the enterprise, and The timing of gains and losses is controlled by a party related to the service provider. KPMG Observation: If a fee waiver is treated as a disguised payment for services, a service provider would likely recognize ordinary income. If finalized as proposed, the Proposed Regulations may create a strong disincentive to undertake what currently are typical fee waiver arrangements. Although the Proposed Regulations provide examples of fee waiver arrangements that generally will not be treated as disguised payments for services, the arrangements described are not like those typically used in fund structures today. Revisions to Profits Interests Safe Harbors In the Proposed Regulations, the IRS and Treasury indicate that they do not believe the profits interest safe harbor contained in Revenue Procedure applies to a situation in which one party provides services and another party receives a seemingly associated allocation and distribution of partnership income or gain. Thus, the IRS does not believe the profits interest safe harbor applies to the common situation in which a management company that provides services to a fund in exchange for a fee may waive that fee, while a party related to the management company receives an interest in future partnership profits the value of which approximates the amount of the waived fee because (1) the receipt of the profit interest was not for the provision of services to or for the benefit of the partnership in a partnership capacity (or in anticipation of being a partner); and (2) the service provider would effectively have disposed of the partnership interest within two years of receipt.

9 IRS Issues Proposed Regulations on Disguised Payments for Services page 9 KPMG Observation: Assuming that the IRS is correct in stating that there is disposition of the profits interest as a result of a constructive transfer, such grant would be outside of the safe harbor of both Revenue Procedure and Revenue Procedure If the profits interest safe harbor does not apply, receipt of the profits interest may be taxable if the interest has an ascertainable fair market value. Arguments relating to the speculative nature of the profits interest value may be more difficult for a profits interest relating to a fee waiver than for a more traditional carried interest. Furthermore, if the grant is outside of Revenue Procedure and was subject to vesting restrictions, it will also be outside of Revenue Procedure making it more important than ever for the taxpayer to make a protective election under section 83(b). The IRS and Treasury also note a plan to issue a new revenue procedure providing an additional exception to the safe harbor in Revenue Procedure when the Proposed Regulations are finalized. The additional exception will apply to a profits interest issued in conjunction with a partner forgoing payment of an amount that is substantially fixed (including a substantially fixed amount determined by formula, such as a fee based on a percentage of partner capital commitments) for the performance of services, including a guaranteed payment under section 707(c) or a payment in a non-partner capacity under section 707(a). KPMG Observation: This change to Revenue Procedure potentially sets up a situation in which a sponsor establishes a qualifying management fee waiver that is not treated as a disguised payment for services, yet the sponsor may still be required to include the fair market value of the fee waiver profits interest in income on a current basis. In addition, the sponsor would be required to include its future allocable share of partnership income relating to the fee waiver interest, which results in a double inclusion of income for the sponsor. The duplicated income generally would be offset by a capital loss on the sale of the partnership interest or liquidation of the partnership. If this is the ultimate result of the modification of Revenue Procedure 93-27, the change would strongly discourage the use of management fee waivers.

10 IRS Issues Proposed Regulations on Disguised Payments for Services page 10 Implications of Recharacterizing Arrangements as Disguised Payments for Services As previously stated, recharacterized allocations and distributions will be treated as a payment for services for all federal tax purposes. Such treatment may be important for a number of reasons. For individual investors, the deduction attributable to the payments may be subject to the two-percent floor for miscellaneous itemized deductions under section 212. Further, in some situations, payment will not give rise to a deduction at all, but rather must be capitalized. Moreover, the Proposed Regulations specifically reference the deferred compensation provisions of sections 409A and 457 as potentially being applicable to the payments. These provision may implicate the timing of income inclusion and, if applicable, may result in the imposition of significant penalties with respect to such income. Revision to Existing Guaranteed Payment Example The Proposed Regulations also revise Example 2 in section (c), which is relied on by partners and partnerships in certain situations in which a partner is provided a guaranteed minimum return. Currently, Example 2 provides that if a partner is entitled to an allocation of the greater of a certain percent of partnership income or a minimum guaranteed amount, and the income allocation exceeds the minimum guaranteed amount, then the entire income allocation is treated as a distributive share under section 704(b) (i.e., none of the minimum guaranteed amount is treated as a guaranteed payment). In contrast, if the income allocated to the partner is less than the guaranteed amount, then the partner is treated as receiving a distributive share to the extent of the income allocation and a guaranteed payment to the extent that the minimum guaranteed payment exceeds the income allocation. The Proposed Regulations would revise Example 2 to provide that the entire minimum amount is treated as a guaranteed payment under section 707(c) regardless of the amount of the income allocation.

11 IRS Issues Proposed Regulations on Disguised Payments for Services page 11 KPMG Observation: Many partnerships using targeted income allocations rely on the treatment of the guaranteed minimum in Example 2 for purposes of characterizing arrangements in which the preferred return for one or more partners that contribute capital may be satisfied using capital contributed by other partners if the partnership has insufficient income. After finalization of the Proposed Regulations, such treatment may no longer be supportable. Effective Date The effective date of the Proposed Regulations is out of the ordinary, and worthy of consideration with respect to existing arrangements (as well as those that may be entered into prior to publication of final regulations). First, the Proposed Regulations are proposed to be effective on the date they are published as final regulations in the Federal Register, and would apply to any arrangement entered into or modified on or after that date. A fee-waiver election made after the effective date would be treated as a modification to the arrangement, and thus would become subject to the regulations. Of significant interest is language in the regulation package relating to the state of current law. Specifically, the description of the effective date provides: In the case of any arrangement entered into or modified before the final regulations are published in the Federal Register, the determination of whether an arrangement is a disguised payment for services under section 707(2)(A) is made on the basis of the statute and the guidance provided regarding that provision in the legislative history of section 707(a)(2)(A). Pending the publication of final regulations, the position of the Treasury Department and the IRS is that the proposed regulations generally reflect Congressional intent as to which arrangements are appropriately treated as disguised payments for services. This language appears to be a clear indication that the IRS and Treasury believe that the positions taken in the Proposed Regulations generally are consistent with current law.

12 IRS Issues Proposed Regulations on Disguised Payments for Services page 12 KPMG Observation: Taxpayers and their advisors should consider the possibility that the IRS intends to challenge certain positions contrary to those in the Proposed Regulations for periods prior to their finalization. Contacts For further information regarding the Proposed Regulations, please contact one of the parties listed below or your client service partner. Deborah Fields Jim Sowell Sarah Staudenraus Jim Tod Paul Kugler John Rooney Deanna Harris What's News in Tax is a publication from the Washington National Tax practice of KPMG LLP ( KPMG ) that contains thoughtful analysis of new developments and practical, relevant discussions of existing rules and recurring tax issues. The information contained in this article is of a general nature and based on authorities that are subject to change. Applicability of the information to specific situations should be determined through consultation with your tax adviser. This article represents the views of the author or authors only, and does not necessarily represent the views or professional advice of KPMG LLP.

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