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July 2015


Proposed Regulations on Disguised Payments for Services and Management Fee Waivers







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William J. Sanders

Practice Area Chair


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Robert A. N. Cudd


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On July 23, 2015, the Internal Revenue Service ("IRS") issued a Notice of Proposed Rulemaking (the "Notice") which proposed Treasury regulations under Section 707(a)(2)(A) of the Internal Revenue Code of 1986, as amended (the "Code"). That section of the Code characterizes certain partnership allocations and distributions as payments for services rather than a distributive share of partnership income under Section 702 of the Code. The Notice proposed the addition of Treasury Regulations Section 1.707-2 and amended Treasury Regulations Section 1.707-1.

The most important consequence to understand about the proposed Treasury regulations is what they do not do. Ordinary carried interest structures with a percentage management fee based on capital commitments are not affected, and binding management fee waivers in exchange for an interest in future net profits over the life of the partnership are also respected and not recharacterized as disguised payments for services under Section 707(a)(2)(A).

The Notice contains a detailed description of the legislative history of Section 707(a)(2)(A) which provides that an arrangement will be treated as a disguised payment for services if (i) a person (service provider) in a partner capacity performs services to or for the benefit of the partnership; (ii) there is a related direct or indirect allocation and distribution to the service provider; and (iii) the performance of the services and the allocation and distribution when viewed together are properly characterized as a transaction occurring between the partnership and a person acting other than in that person's capacity as a partner. The Notice explains that according to the legislative history of Section 707(a)(2)(A), the most important factor in determining whether a payment is a disguised payment for services is whether the payment is subject to significant entrepreneurial risk as to both the amount and fact of the payment. The Notice quotes the legislative history to the effect that partners receive distributions of profits with respect to the business success of the venture whereas third parties generally receive payments which are not subject to this risk. Other non-exclusive factors may also be considered but they are secondary to the entrepreneurial risk factor. The determination of whether an arrangement will be characterized as a disguised payment for services under the proposed regulations is made at the time this arrangement is entered into and is not retroactively recharacterized.

The proposed regulations list six factors which indicate that an arrangement is a disguised payment for services. However, an arrangement that lacks significant entrepreneurial risk is presumed to be a disguised payment for services, unless the other factors establish otherwise. This is the most important point of the proposed regulations, because partnership allocations of net profits which are not highly likely or reasonably determinable will not ordinarily be treated as disguised payments for services. The other five factors that create a presumption that an allocation of partnership income should be characterized as a payment for services include:

  1. Capped allocations
  2. Allocations for one or more years of reasonably certain income
  3. An allocation of gross income
  4. Certain formula allocations predominately fixed in amount
  5. Non-binding management fee waivers for future services

Proposed Treasury Regulations Section 1.707-2(d) contains six examples which provide the most helpful guidance of the proposed regulations. In each of the examples, the partnership maintains capital accounts, satisfies the economic effect test of Treasury Regulations Section 1.704-1(b)(2)(ii), and liquidation distributions are made in proportion to capital accounts. In addition, in all cases in which the partnership allocation involved a carried interest, the examples state that the service partner entered into a clawback obligation.

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