Private equity firms under IRS scrutiny for character conversion of compensation received

Proposed Treasury Regulation § 1.707-2 issued by the IRS on July 22, 2015, targets private equity managers looking to convert their management fee to an equity interest in hopes of being taxed at the lower long-term capital gain rate. Private equity managers have used this practice for more than a decade without any action by the IRS. So why the change? High profile private equity firms were using this strategy of converting management fees which are normally taxed at ordinary income rates to that of long-term capital gain rates. The IRS responded with the proposed § 1.707-2 regulation, which was released as a clarification of existing law, the Tax Reform Act of 1984, and allows the IRS to look at violations in a firm’s past three years of operation and does not allow grandfathering in of existing agreements.

The proposed regulation identified six attributes the IRS is considering. First and foremost is whether the amount of income is subject to significant entrepreneurial risk. The management fees in question are generally charged at the annual rate of 1 percent or 2 percent of invested amounts, regardless of how profitable the private equity entity is that year. These fees are generally used to pay salaries, rent, and professional fees of the private equity manager. To complete the conversion, the manager then waives the right to these fees for a capital interest in the partnership. This interest can then be sold after a year for a gain and taxed as a long-term capital gain. Because variations exist, the IRS has listed five factors that, if present, imply there is no significant entrepreneurial risk; therefore, the conversion to a lower tax rate would not work.

  1. The allocation of partnership income is capped and the cap is reasonably expected to apply in most years
  2. The share of income is reasonably certain
  3. The share is of gross income (not net)
  4. The formula calculating the income is predominantly fixed in amount, reasonably determinable under all the facts and circumstances, or is designed so that it’s highly likely to be paid (for example, if it is paid on specific transactions and not on the long-term success of the enterprise)
  5. The manager waives its right to payment for the future performance of services in a manner that is nonbinding or the partnership and partners aren’t timely notified of this

In addition to significant entrepreneurial risk, the other five attributes the IRS is considering are:

  1. The private equity manager holds, or is expected to hold, the partnership interest for only a short time
  2. The manager receives the allocation of income and subsequent distribution in the same time frame as an outside service provider would
  3. The manager became a partner primarily to save on taxes and could not have received these savings if he or she weren’t a partner
  4. The manager’s interest in general and continuing partnership profits is small in relation to the allocation and distribution
  5. The arrangement provides for different allocations or distributions for different services received, the services are provided by certain related parties, and the different allocations or distributions have significantly varying levels of entrepreneurial risk

This proposed regulation essentially negates the safe harbor provided by Revenue Procedure 93-27 by saying such interests do not comprise a “profits interest” under the safe-harbor.

So what now? A claw-back provision over the life of the entity could be added to the agreement, reducing management fees if profits fell in future years. This would add back the significant entrepreneurial risk required by the proposed regulation and possibly reduce the payout. It would, however, allow a priority allocation of fund income in lieu of a fee.

If the private equity entity did not want to subject the amount to a claw-back over its entire life, it could potentially elect a priority allocation of income to the manager in lieu of a fee for just one year. However, it would have to designate that year before the year the intended allocation begins (and possibly at the inception of the agreement) and the allocation would have to be contingent on the realization of an aggregate net gain. Further, if any of the assets of the private equity entity do not have a readily ascertainable fair market value at the beginning or end of the year, this may not be an option. Talk with your tax advisor to understand how this proposed regulation may affect you.

For more information on this topic, or to learn how Baker Tilly asset management specialists can help, contact our team.