Tax Challenges With Private Equity Management...

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Tax Challenges With Private Equity Management

Fee Waivers Given Newly Heightened IRS Scrutiny Structuring Waiver Arrangements in Light of the Proposed Regulations

and Possible Changes to Profits Interest Rules

Today’s faculty features:

1pm Eastern | 12pm Central | 11am Mountain | 10am Pacific

TUESDAY, OCTOBER 13, 2015

Presenting a live 90-minute webinar with interactive Q&A

Matthew P. Larvick, Shareholder, Vedder Price, Chicago

Daniel P. Meehan, Partner, Kirkland & Ellis, Chicago

Peter J. Withoff, Partner, Faegre Baker Daniels, Minneapolis

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Tax Challenges With Private Equity

Management Fee Waivers

Matthew P. Larvick

Daniel P. Meehan

Peter J. Withoff

October 13, 2015

Overview

Current management fee waiver design

Code § 707(a)(2)(A) and legislative history

Proposed regulations

Implications for existing funds

The future of management fee waiver

5

Current management fee waiver

design

6

Management fee waiver design

Big Picture: Substitute fund profits interest for management fee

Tax is typically deferred

Tax rate is generally reduced

Economic risk if requisite fund profits are not earned

Fund GP/Mgt Co waives a portion of fund management fee

Fund GP receives corresponding interest in fund profits

Pool of profits is typically restricted to achieve tax objectives

Economic risk imposed by either:

Restricting distributions until sufficient profits are earned, or

Requiring clawback of distributions if insufficient profits earned

Waiver timing alternatives

One-time waiver at fund inception

Timing of fee reductions may be fixed or determined periodically

Periodic elective waivers over fund’s life

Waiver election made before applicable fee period begins or, more conservatively,

before start of applicable calendar year

7


Profits interest may be a fixed/capped amount equal to

amount of waived fee

Received either when profits are earned or when management fee

would have been paid (with repayment obligation if profits never

earned)

Profits interest more commonly structured as a right to

receive distributions corresponding to a notional capital

contribution amount

Referred to as “deemed contribution” or “cashless contribution”

Profits interest represents a right to a “return of” and a positive or

negative “return on” the deemed capital contribution

8


To ensure that the interest is a “profits” interest rather than

a “capital” interest under Rev. Proc. 93-27, built-in gains

as of waiver date are excluded

To obtain tax rate benefit, pool of available profits typically

limited to items of long-term capital gain and qualified

dividend income

To reduce risk of “disguised payment for services”

characterization, pool of available profits limited each year

to net income for such year

9

Code 707(a)(2)(A) and legislative

history

10

Three choices for partnership payments to service

provider:

Section 704(b) – distributive share

Section 707(a)(1) – partner acting in non-partner capacity

Section 707(c) – guaranteed payment

11

Statutory underpinning for management fee waiver

issue:

Section 707(a)(2)(A) applies if:

A partner performs services for a partnership

There is a related direct or indirect allocation and

distribution to the partner; and

When viewed together, the above items are “properly

characterized” as occurring between the partnership and a non-

partner

12

Section 707(a)(2) (enacted in 1984) is to be implemented by

Regulations to determine how transactions should be

“properly characterized”:

Regulations issued under Section 707(a)(2) in 1992

Section 1.707-2 “Disguised payments for services” was

reserved originally

Current proposed regulations are under Section 1.707-2

Regulations are largely based on legislative history to

Section 707(a)(2)(A)

13

Statutory underpinning for management fee waiver

issue (cont.):

Legislative history

Practitioners believed §707(a)(2)(A) legislative history

supported flow-through treatment of fee waiver

arrangements (particularly where deemed contribution

model used)

“An allocation and distribution provided for a service partner . . .

which subjects the partner to significant entrepreneurial risk as to

both the amount and the fact of payment generally should be

recognized as a [partnership interest] while an allocation and

distribution . . . which involves limited risk as to amount and

payment should generally be treated as a fee”

“[W]hile net income allocations generally appear to constitute

distributive shares, some net income allocations may be fixed as

to amount and probability of payment and . . . should be

characterized as fees.”

14

Legislative history

“There may be instances in which allocation/distribution arrangements

that are contingent in amount may nevertheless be recharacterized as

fees. Generally, these situations should arise only when (1) the partner in

question normally performs, has previously performed, or is capable of

performing similar services for third parties; and (2) the partnership

agreement provides for an allocation and distribution to such partner that

effectively compensates him in a manner substantially similar to the

manner in which the partner’s compensation from third parties normally

would be computed.”

Under typical deemed contribution fee waiver model with annual net

income limitation

Fee waiver profits interest subject to entrepreneurial risk as to fact and

amount since dependent upon investment returns of fund

Legislative history indicated that net income allocations would generally

be ok if not fixed in amount

Fund GPs typically do not perform services for third parties in a non-

partner capacity and a return based on fund performance is not

substantially similar to how compensation from third parties would

normally be computed

15

Movement toward regulations

Initial statements by IRS suggest that “mainstream” fee

waiver arrangements would be acceptable

Proposed regulations issued 7/23/15 apply more broadly

than anticipated

16

Proposed Regulations - Specifics

17

Analyze all facts and circumstances:

Six key factors:

1. Significant entrepreneurial risk

2. Transitory partner status

3. Timing of service performance and allocation/distribution

4. Primary purpose to obtain tax benefits

5. Relatively small general and continuing interest

6. NEW – impact on related persons

18

Significant entrepreneurial risk is accorded the most

weight:

Five factors creating a presumption of a lack of significant

entrepreneurial risk:

Capped allocations if the cap is reasonably expected to

apply in most years

Allocations for a fixed number of years in which service

provider’s share is reasonably certain

Allocations of gross income items

Allocation that is predominantly fixed in amount or highly

likely to be available

Non-binding commitment or failure to notify partnership

and partners of waiver

19

Example 1:

Architect performs services and invests in a 25%

partnership interest

Instead of $40,000 architect fee, architect receives

$20,000 of gross income for first two years

Conclusion: Disguised payment for services

20

Example 2:

Stockbroker owns 51% interest in partnership

In lieu of brokerage commission, broker receives a

comparable allocation of gross income

Conclusion: Disguised payment for services

21

Example 3:

Investment fund of illiquid assets with general partner

(GP) and management company (M)

M contributes $500,000 for 1% interest, but also receives

priority allocation and distribution during any 12-month

accounting period replicating management fee

GP controls partnership and has a 10% carried interest,

subject to a clawback

Conclusion: Disguised payment for services for M because

allocation is highly likely to be available is

based on any 12-month accounting period, and

GP controls timing of sales of assets

22

Example 4:

Same as Example 3, but investments are marketable

securities and 12-month period is specified in advance

Conclusion:

Arrangement is respected rather than recharacterized

Assets are subject to market-to-market valuation and 12-month

period is specified in advance; no presumption that portfolio will

have gains for period

23

Example 5:

Investment fund with general partner (GP) and

management company (M)

GP has nominal capital and 20% carried interest, plus an

additional 1% of capital commitments annually, with

clawback covering both

M has 1% management fee

Conclusion: Arrangement is respected because 1%

additional interest is not highly likely to be

achieved and GP has agreed to a clawback

24

Example 6:

Investment fund with general partner (GP) and

management company (M)

GP contributes 1% and has a 20% carried interest with a

clawback

M has a waivable 2% management fee

If M waives, M receives a partnership gain allocation

replicating the fee; M agrees to clawback

Conclusion: Arrangement is respected because allocations

are only out of net income, and both GP and M

have agreed to clawback

25

Effective Date:

Prospective effective date after regulations become final,

BUT

IRS view is that Regulations are largely based on the

existing legislative history to Section 707(a)(2)

26

If Regulations apply:

Service provider is treated as receiving payments in a

non-partner capacity for all tax purposes

Applies even if this causes service provider to not be

treated as a partner at all or if no partnership exists

Reclassification will eliminate capital gain characterization

Is service provider an employee or independent contractor

Timing of partnership deduction and service provider

income not addressed

Potential impact of Section 409A for deferred

compensation

Interplay with entrepreneurial risk

27

Modification of Treas. Reg. §1.707-1(c) (Example 2):

Partner entitled to an allocation of the greater of (i) 30% of partnership income or (ii) minimum guaranteed amount

Existing Regulation provides that if income allocation exceeds the minimum, the entire income allocation is a distribution share

If income allocation is less than the minimum, the difference to achieve the minimum is guaranteed payment

Regulation examples revised to provide that, in this case, the entire minimum amount should be treated as a guaranteed payment

Note the absence of any entrepreneurial risk in the economic deal

28

Revenue Procedure 93-27:

Receipt of profits interest for services rendered is not a taxable event

Exception for (1) predictable revenue stream, (2) dispositions within two years of receipt, and (3) interests in publicly-traded partnership

IRS view that waiver by management company in exchange for additional interest for related general partner runs afoul of Rev. Proc. 93-27

Not for services provided by the partner, and

Disposition within two years of receipt

IRS proposes to add additional exception to Rev. Proc. 93-27 for profits interest received in exchange for waiving a substantially fixed fee

Narrowed scope of Rev. Proc. 93-27 will require partnerships to rely on unclear existing law

29

Standard Carried Interests

Goes guidance impact “standard” carried interest

structures?

Although not per se exempted, see:

Example 3: General partner received a 10% interest in

profits/losses over the life of the partnership, and is subject to a

clawback that it is reasonably expected to comply with.

Example 6: General partner receives 20% of future net income

and gains, and is similarly subject to a clawback.

In both cases, the examples conclude the arrangements have

SER and thus are not disguised payments for services. See also

Example 5.

Watch for legislative changes.

30

Elective versus Hard-Wired Structures

A waiver is often “elective”- sponsor can elect post-

formation.

Recall key tax goals of a fee waiver structure:

the increased equity interest in the fund will qualify as a “profits

interest” that can be received without triggering an up-front tax,

and

after the interest is received, the holder will be entitled to flow-

through allocations of income (such as capital gains) in respect of

the interest.

The proposed regulations focus on the second goal.

However, in the preamble, the IRS announced proposed

changes that could jeopardize the first goal.

31

Elective versus Hard-Wired Structures

Additional proposed exception to Revenue Procedure 93-

27:

Exception will apply to a profits interests 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).

To be issued “in conjunction with” the final regulations.

If Rev. Proc. 93-27 is modified as apparently intended:

Elective waivers subject to non-safeharbor valuation (common

law).

Sponsors may consider ‘hard-wired’ structures. (see Example 5)

32

Measurement of Profits

What income can be used to “fill the bucket?”

Review of context:

Distribution must depend on an allocation of “income.” If so, then

a section 704(b) distributive share -- unless section 707(a)(2)

recharacterizes.

If so-called “distribution” is payable without regard to income, then

it’s a section 707(c) guaranteed payment.

33


Gross income allocations: presumptively lack SER.

Example 1 (discussed earlier).

Note that legislative history (but not the proposed regulations)

contains a favorable example involving gross income allocations.

34


Net profit allocations.

SER presumed lacking if allocation (under formula or otherwise) is:

Substantially fixed in amount,

reasonably determinable under all the facts and circumstances, or

designed to ensure that sufficient net profits are highly likely to be

available to make the allocation (e.g., allocations of net profits from

specific transactions or accounting periods and this allocation does not

depend on the overall success of enterprise).

35


Profits from limited periods (Cherry-Picking).

Example 3(iii):

M provides services to a new investment partnership. M is controlled by

A, the general partner. M contributes $500,000 for a 1% interest.

M is also entitled to a priority allocation/distribution intended to

approximate the fee that M would normally charge.

M receives priority allocation/distribution of net gain from:

sale of one or more assets,

but only during any 12 month accounting period in which partnership has

“overall net gain.”

36



Think about impact of this arrangement:

Losses from other years not netted, and

Unrealized losses in current year (apparently) are not netted.

Illustration (assume fee amount is $100):

Year 1 Year 2 Year 3 Year 4 Total

Recognized Net Gain/Loss (1,000) 2,000 (1,000) 0 0

Unrealized Net Gain/Loss 0 (2,000) 2,000

Total (1,000) 0 1,000 0

Allocation to Service Provider:

Example 3(iii) (Bad Allocation) 100

37



Result: Arrangement lacks SER (and thus is a fee):

Net profit can be generated in any 12 months; not dependent

on overall success.

General Partner is related to M, and can control timing of sales

and thus recognition gain/losses.

Given nature of partnership’s assets and GP’s ability to control

timing of sales, partnership income is “highly likely” to be

available and is reasonably determinable.

Query: Is it “highly likely” a PE fund will have at least 1 winning

year?

38


Regulations generally (and Ex 3 specifically) do not consider: Risk that distribution may not ultimately be made.

Income allocation to capital account may be offset by future losses before

distribution.

• Apply regs when arrangement is entered into/modified,

regardless of what ultimately happens.

Statute: Requires “allocation and distribution.”

Preamble: Income allocation correlates with increased distribution right (704(b)).

Administratively difficult to recast upon later distribution.

Query result: M’s distribution is deferred until LP capital is

returned, and is subject to loss allocations before distribution.

39



Example 3(iv):

Same as above, except:

Allocation can also be satisfied out of net gain from a

revaluation under Reg. 1.704-1(b)(2)(iv)(f).

This would account for current year unrealized losses (but

could also create unrealized gains).

Illustration:




Total (1,000) 0 1,000 0



Example 3(iv) (Bad Allocation) 100

40



Result: Arrangement lacks SER (and thus is a fee):

General partner can control revaluation events, assets are

difficult to value, and profits determined by reference to

specified accounting period.

Thus, net profits are “highly likely” to be available.

What if limited partner committee was required to approve

revaluations? See Reg. 1.704-1(b)(2)(iv)(h)(1).

41



Example 4. Same as above, except:

Partnership’s investment assets are marketable securities,

partnership is a trader (rather than an investor), and

partnership makes a section 475(f) (mark-to-market) election.

Allocation is made for a “specified future” 12 month year.

Illustration (assume fee is $100):




Total (1,000) 0 1,000 0



Example 3(iv) (Bad Allocation) 100

Example 4 (Good Allocation) 100

42



Result: Arrangement does not lack SER (and thus is not a fee):

Allocation is out of net profits.

Assets have readily ascertainable value determined annually.

Can’t reasonably predict presence of overall net profits for the

specified year (also an assumed fact).

Example may not be directly relevant to PE structures, but note

absence of a clawback.

43


Cumulative Profits. Example 5 (Hard-Wired Waiver).

A is general partner of new investment fund. A receives a 20% interest in future partnership income and gains measured over life of the fund. A makes no capital commitment.

A also receives an “Additional Interest” – interest in future partnership net income and gains intended to approximate 1% of capital commitments, determined annually.

A agrees to clawback for both interests.

M, a controlled management company, accepts a 1% management fee (rather than 2% that would be paid by similar funds).

Net profits not highly likely to be available or reasonably determinable, based on facts upon formation of partnership.

44


Cumulative Profits.

Result:

Additional Interest has SER (and thus not a fee):

Allocation is out of net profits.

A undertakes clawback obligation, and it is reasonable to

expect A will comply.

Allocation is not reasonably determinable nor highly likely to be

available.

45


Cumulative Profits.

Example 6 (Elective Waiver).

A (general partner) – 1% capital commitment, 20% carry with

clawback. M – 2% fee based on capital commitments.

M can waive fee for “Additional Interest” – interest in

subsequent income and gain estimated to equal PV of waived

fee. Waiver must be made at least 60 days before applicable

year. M agrees to clawback.

Immediately before issuing partnership interest to M,

partnership is required to revalue capital accounts.

Partnership agreement complies with economic effect safe

harbor of Reg. 1.704-1(b)(2)(ii), including the capital account

liquidation requirement.

46


Cumulative Profits.

Result:

Allocations to M (and A) don’t lack SER (and thus not a fee):

Allocations are out of net profits.

Subject to clawback over life of fund and compliance is

reasonably anticipated.

Allocations neither reasonably determinable nor highly likely to

be available.

Not addressed: Whether Additional Interest would qualify under

Rev. Proc. 93-27.

Line between “life of fund” allocations (Ex. 5/6), and single

period allocations (Ex. 3)?

47

Catch-Up Allocations

Regular carried interests often have a ‘catch-up’

component.

For example, assume distributions are made: First, to the limited partners (investors) until their capital has been

returned;

Second, to the limited partners until an 8% IRR has been achieved;

Third, 100% to the general partner, until the GP receives distributions

equal 20% of the total distributions under (b) and (c); [the “catch-up”]

Fourth, 20% to the general partner and 80% to the limited partners.

48

Catch-Up Allocations

Based on the above waterfall, the GP would be entitled to

a priority allocation of 100% of profits up to a formula

amount (after the LPs have been allocated profits to

satisfy their IRR).

Preamble: Priority allocations intended to equalize a

service provider’s return with priority allocations already

allocated to investing partners over the life of the

partnership typically will not lack SER, although all facts

and circumstances are considered.

49

Clawbacks

Clawback Enforceable obligation to repay any amounts distributed on its interest (reduced by reasonable allowance for tax payments on flow-through income) that exceed [20%] of the overall net amount of partnership profits computed over the partnership’s life. (Preamble)

How do clawbacks impact the SER analysis?

Preamble The presence of each fact described in examples 5 and 6 is not necessarily required to determine that 707(a)(2) does not apply. However, absence of certain facts, such as failure to measure future profits over 12 month period, may suggest that the arrangement is a fee.

50

Clawbacks

May be more relevant for priority and capped allocations -

e.g., receive 100% of specified net profits until $X has

been allocated. (E.g., avoid the cherry-picking result of Ex.

3(iii)).

Regular carried interests are based on a percentage (e.g.,

20%) of future income and gains, rather than all income

up to a capped or formula amount.

Structuring clawbacks:

Reasonable to anticipate compliance?

After-tax computations.

51

Providing Notice of Waiver

“Procedural” manner of waiver is a substantive SER

factor.

Components to avoid bad presumption:

Binding.

Timely notification (Example 6: 60 days before beginning of year).

Notify partnership and all partners.

Alternatively, can be hard-wired (see Example 5).

IRS solicits comments on “administrable” alternatives.

52

Bifurcated Structures

Bifurcated Structure:

General partner is one entity (e.g., LLC).

Management company is separate (related) entity.

First Issue - Waiver and receipt by different parties.

Management company waives fee, but related GP receives special

profits interest.

Preamble: Rev. Proc. 93-27 doesn’t apply.

Interest not awarded for provision of services in a partner capacity.

Service provider (M) constructively disposed of interest within 2 years of

receipt.

53

Bifurcated Structures

Related parties subject to differing levels of risk.

Secondary (non-SER) factor:

Different allocations and distributions for different services.

Services provided by one person or related persons.

Differing allocations/distributions subject to entrepreneurial risk

that vary significantly.

Example:

GP receives a 20% carry subject to a clawback.

Related management company is entitled to a preferred income

allocation with no clawback.

Management company’s allocations “might” be a disguised

services payment, depending on all the facts.

54

Design/Drafting and Audit Implications:

Existing and Future Funds

55

Audit Implications

56

Preamble says proposed regulations “reflect

Congressional intent”

Audits initiated even before regulations issued

Drafting/design implications for existing funds

Existing fund with up-front waiver

Timing considerations

Audit considerations

Funds with periodic/elective waivers

Post-finalization Rev. Proc. 93-27 concern

Funds with fee paid to separate management company

Current Rev Proc. 93-27 concern

57

Drafting/design for future funds

Possible to avoid “disguised payment for services”

Cumulative net income over the life of the fund

Profit measurement period longer than a year but shorter than

the remaining life of the fund?

In calculating net profits, will exclusion of management fee and

organizational expenses be permitted?

But will Rev. Proc. 93-27 safe harbor be available?

If not, is fee waiver still viable?

58

Illustration

Effective tax rates: ordinary income (45%); long-term capital

gain (25%)

Management fee payable: $1m

Gross fund return: 2x

59

Illustration

Scenario 1: Fund pays management fee in cash and

manager invests the after-tax amount

Scenario 2: Manager waives fee; makes deemed investment

of pretax amount; current tax rules apply

Scenario 3: Manager waives fee; makes deemed investment

of pretax amount; pretax amount is treated as a disguised

fee for services

Scenario (1) (2) (3)

Tax on actual management fee paid 450,000 -

Net amount invested (actual or deemed) 550,000 1,000,000 1,000,000

Gross proceeds from investment 1,100,000 2,000,000 2,000,000

Tax on disguised payment amount - - 450,000

Tax on profit from investment 137,500 500,000 250,000

Manager’s net after-tax proceeds 962,500 1,500,000 1,300,000

60

Thank You

Matthew P. Larvick

[email protected]

Daniel P. Meehan

[email protected]

Peter J. Withoff

[email protected]

61

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