[author: Jeffrey Aber]
A manager of a private investment fund may consider employing a management fee waiver strategy, under which the manager waives its management fees in exchange for a profit interest in the fund (typically organized as a limited partnership). Properly structured, this approach can provide meaningful tax advantages while aligning the manager’s compensation with fund performance[1].
The Tax Opportunity
By implementing a fee waiver strategy, a manager has the opportunity to convert compensation that would otherwise be taxed as ordinary income (the management fee) into profit interests taxed at long-term capital gains rates. In essence, this allows the manager to participate in long-term appreciation of the fund while potentially achieving more favorable tax treatment.
Revenue Procedure Framework
Generally, a manager’s interest in a fund that arises from waived management fees is treated as a “profits interest” within the meaning of Revenue Procedure 93-27[2], as clarified by Revenue Procedure 2001-43[3]. Together, these authorities provide a safe harbor under which the receipt of a profits interest is not a taxable event, provided certain conditions are met:
- The manager’s profit interest does not relate to a substantially certain and predictable stream of income from partnership assets;
- The profit interest is not disposed of within two years of receipt; and
- The partnership is not a publicly traded partnership.
Proposed Regulations and Additional Guidance
Although not yet finalized, the Treasury Department and IRS proposed regulations in 2015 offering further guidance on management fee waiver arrangements[4]. The proposed rules were promulgated under Internal Revenue Code Section 707(a)(2)(A), which authorizes the IRS to re-characterize certain allocations or distributions as “disguised payments for services.”
Under the proposed regulations, payments made by a partnership to a partner who provides services may be reclassified as disguised payments if the arrangement lacks significant entrepreneurial risk or otherwise fails to reflect genuine profit participation.
The regulations identify six non-exclusive factors to evaluate whether an arrangement constitutes a disguised payment for services. The most significant is the presence (or absence) of entrepreneurial risk – that is, whether the manager’s potential return is substantially tied to the overall success and risk profile of the fund.
Other factors include:
- Whether the manager’s partnership interest is transitory or short in duration;
- Whether the timing of the manager’s allocations and distributions is comparable to payments typically made to non-partner service providers;
- Whether the manager became a partner primarily to obtain tax benefits that would not have been available if the services had been rendered in a third-party capacity;
- Whether the value of the manager’s continuing interest in partnership profits is small in relation to allocations and distributions; and
- Whether different allocations or distributions are provided for different services, particularly where those allocations and distributions reflect differing levels of entrepreneurial risk[5].
Best Practices for Structuring Fee Waivers
To preserve the intended tax treatment and avoid re-characterization, managers should observe several key best practices drawn from the proposed regulations:
- Provide advance written notice to all partners of the manager’s irrevocable election to waive all or a portion of its management fees – generally at least 60 days prior to the taxable year in which the fees would otherwise be paid;
- Ensure that allocations and distributions to the manager in respect of the waived fees are made solely from cumulative net income and gains over the life of the fund; and
- Incorporate a clawback provision requiring the manager to return distributions related to waived fees that exceed the fund’s cumulative net profits.
Conclusion
When properly designed and documented, a management fee waiver strategy can serve as an effective tool for aligning incentives between fund managers and investors while offering potential tax efficiency. However, success depends on demonstrating real entrepreneurial risk and adhering to both the Revenue Procedures and the 2015 Proposed Regulations. Because the rules in the area remain complex and evolving, managers should consult with experienced legal counsel and a qualified tax adviser to ensure compliance and preserve the intended benefits.
[1]See I.R.C. § 707(a)(2)(A) (authorizing re-characterization of disguised payments for services).
[2]Rev. Proc. 93-27. 1993-2 C.B. 343 (providing that the receipt of a profits interest in a partnership for the provision of services is generally not taxable, provided it is not a capital interest and certain conditions are satisfied).
[3]Rev. Proc. 2001-43-2001-2 C.B. 191 (clarifying that a profits interest meeting the requirements of Rev. Proc. 93-27 is not taxable at either grant or vesting if the parties treat the service provider as the owner from the date of grant).
[4]Prop. Treas. Reg. § 1.707-2, 80 Fed. Reg. 43652 (July 23, 2015) (proposed regulations addressing disguised payments for services under I.R.C. §707(a)(2)(A))
[5]See id. (listing six non-exclusive factors to determine whether an arrangement constitutes a disguised payment for services, with significant entrepreneurial risk as the primary consideration).
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