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Jan. 26 — Rules restricting how management fee waivers are structured will have to pass a two-part test to ensure the partner has enough entrepreneurial risk and that the profit allocation can't be easily valued, an IRS official said.
“We do think the issues are related, whether or not you have entrepreneurial risk,” Clifford M. Warren, special counsel (Passthroughs & Special Industries), said Jan. 26 at a New York State Bar Association Tax Section conference in New York. “And once you get there, we do think there is another issue under Revenue Procedure 93-27 about whether there is some ascertainable value.”
The Internal Revenue Service released proposed rules (REG-115452-14) 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 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).
The IRS is “expeditiously working” to issue final rules, said Ossie Borosh, an attorney-adviser in the Treasury Department's Office of Tax Legislative Counsel.
The IRS has scheduled a Feb. 26 public hearing on the proposed rules. Outlines of topics to be discussed at the hearing are due by Feb. 8, the IRS said in a hearing notice to be published Jan. 27 in the Federal Register.
Cause for Concern
Warren said partnerships where the fee is waived by one entity and issued to another entity shouldn't worry too much about technically being outside the disposition safe harbor rules in Rev. Proc. 93-27; this is a common situation for many New York private equity funds.
He said, however, that if such arrangements are coupled with a fixed fee or a formula fee, there could be cause for concern.
The rules reach beyond the scope of investment partnerships and could affect any partnerships with a service partner. Borosh said she has received comments from several industries. The rules would make it harder for firms to convert fees subject to ordinary rates into lower-taxed carried interest and take advantage of a 19.6 percentage-point difference in top tax rates.
Warren said the IRS was getting a lot of pushback about guaranteed payments in the capital context. The government primarily had service partnerships in mind when it was writing the rules, so this could lead to a second guidance project, he said.
Sen. Elizabeth Warren (D-Mass.) sent a letter to Treasury in July calling for quick finalization and swift enforcement of the rules. Warren signed the letter with Senate Democrats Al Franken (Minn.), Tammy Baldwin (Wis.) and Sheldon Whitehouse (R.I.). Dozens of individual taxpayers have also sent letters to the agency saying they support the senators' letter and asking the government to issue final rules (184 DTR G-1, 9/23/15).
“The intent was not to necessarily say that all profits interest of any color or stripe are suspect,” Borosh said. “The garden variety of profits interests are not done in such a way to eliminate the entrepreneurial risk. The intent was not to attack regular profits interest.”
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