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Feb. 26 — Investment fund management fee waivers in which the deal-making partner forgoes a fee in return for a share of the profits should be subject to a safe harbor provision because the partner is gambling on an uncertain outcome, a tax practitioner said at an IRS hearing.
Michael Spiro, representing the Connecticut Bar Association Tax Section, said there are some cases where the partner is reasonably assured of the value of the allocation or the partner is only managing the fund for a short time, and these shouldn't fall under the safe harbor.
But there are many circumstances, “especially at the outset of a new enterprise or investment fund where a service provider will forgo compensation to take a gamble on the enterprise via receiving a profits interest,” he said at the Feb. 26 hearing. “To say that choice fixes the value of the equity is tantamount to saying a $1,000 bet on a roulette number fixes that number.”
The hearing was held to garner public comment on regulations (REG-115452-14) proposed in July to more strictly limit the practice of reducing private equity fund manager tax bills by classifying the funds as carried interest, which is taxed at a lower rate than ordinary income. The IRS also said in the proposal that it would amend Revenue Procedure 93-27, which provides a safe harbor provision for some guaranteed payment arrangements (141 DTR G-1, 7/23/15).
Glenn Dance, special counsel in the Office of Associate Chief Counsel (Passthroughs & Special Industries), asked Spiro, who is a partner at Finn Dixon & Herling LLP in Stamford, Conn., how to distinguish between fee waiver arrangements that have entrepreneurial risk from those that are just tax-motivated.
“I would suggest those that are done at the outset, that are baked into the document, fall into the safe harbor, but those that are annual might fall outside the safe harbor,” Spiro said. An annual arrangement would give the manager a greater ability to opt to waive a fee when the prospects for gain looked better.
Donald Susswein, a principal at RSM US LLP, requested the IRS make obsolete Revenue Ruling 69-184, which directs that partners can't also be employees of the partnership. The 1984 Deficit Reduction Act redefines the way a partner should be compensated, which he said changes the scope of the regulations to deal with non-partner capacity payments rather than guaranteed payments.
“Now, I realize the fact is that this is a big ask, and so alternatively you could be silent on it” and remove the reference in the preamble, he said.
Gregg Polsky, a law professor at the University of North Carolina, asked the IRS and Treasury officials at the hearing to make the regulations clearer in stating that cashless contributions don't pass muster, because he can't “think of another circumstance where you can invest your salary on a pre-tax basis.” He said this change would kill off fee waivers.
Survival Going Forward
“Investors tolerate fee waivers right now because the managers want them so badly,” Polsky said. They tell investors, “this has nothing to do with you. This a tax game between the general partners and the IRS.”
Government officials have said the final rules should be issued in the coming months. If the final rules are published without substantial changes from the proposed version, there is still a “safe harbor” fee waiver example in the rules that require the fee to be waived 60 days before the start of the year, and require the profits interest to be subject to a clawback.
“People will use that,” Spiro said. “I'm not sure management fee waivers will go away.”
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