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COLORADO REAL ESTATE JOURNAL
— September 2-September 15, 2015
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C
arried interest has
always been a point
of contention with
the IRS. On July 23, the IRS
issued proposed regulations in
an attempt to close one aspect
that it has always viewed as
abusive.
Carried interest is a common
vehicle used to compensate a
service partner (an individu-
al/entity) for setting up and
managing an investment. This
usually includes raising capital
from investors, identifying and
securing the investment, and
often the operation of the prop-
erty. The service partner may or
may not invest its own cash for
a capital interest, but regardless
of a capital investment the ser-
vice partner still has the upside
of the carried interest it receives
in the partnership for setting
up the deal. Like other partners
in the partnership, the carried
interest would be taxed on the
appreciation of the investment
at capital gain rates as low as
20 percent for federal income
tax purposes (the current fed-
eral rate for long-term capital
gains).
Common in these types of
arrangements are the payments
of fees to the service partner
that relate to the acquisition
and/or management of the
investment. These fees are gen-
erally paid without regard to
the success of the investment,
and constitute ordinary income
that can be taxed up to the
maximum rate of 39.6 percent
and will be taxed when earned.
Often in the operating agree-
ments of these types of invest-
ments, there are clauses that
allow for fee waivers. These fee
waivers allow for the conver-
sion of the fee, which would be
taxable now, into a preferred
distribution in the future. In
essence, these clauses allow
the service partner to convert
their ordinary income taxable
now to likely capital gain on
a preferred distribution in the
future.
n
How do the proposed reg-
ulations impact fee waivers?
The proposed regulations have
various factors that are consid-
ered in determining if there is
a “disguised payment” for ser-
vices but are primarily focused
on whether the arrangement
has “entrepreneurial risk.” If
the arrangement does not have
“ e n t r e p r e -
neurial risk,”
then the fee
waiver will
be ignored
and will be
deemed
a
“d i s gu i s ed
payment” for
services tax-
able to the
service part-
ner at ordi-
nary income
rates when
earned.
The regulations specifically
state the following presume a
lack of entrepreneurial risk: 1)
capped allocations of partner-
ship income if the cap is rea-
sonably expected to apply; 2)
an allocation for one or more
years under which the service
provider’s share of income is
reasonably certain; 3) an allo-
cation of gross income; 4) an
allocation that is predominant-
ly fixed in amount; or 5) an
arrangement in which a ser-
vice provider waives its right
to receive a payment for the
future performance of services
in a manner that is nonbinding.
In essence, the “entrepreneur-
ial risk” boils down to two tests:
1) how the fee is waived and 2)
how the future profits alloca-
tions are structured. To satisfy
the first test, the fee needs to be
waived in writing, in advance
of the fee being earned, and be
irrevocable by the partner.
To satisfy the second test, the
service partner needs to truly
be at risk of loss – meaning
there can’t be allocations that
are fixed or allocations that are
reasonably certain to occur.
In addition, the allocations of
income can’t be capped to the
service partner, if the cap is
reasonably expected to occur in
most years.
There are numerous exam-
ples that illustrate how the IRS
views these arrangements and
“entrepreneurial risk.” Follow-
ing is Example 1 from the pro-
posed regulations for illustra-
tion purposes:
Example (1). Partnership
ABC constructed a building
that is projected to generate
$100,000 of gross income annu-
ally. A, an architect, performs
services for partnership ABC
for which A's normal fee would
be $40,000 and contributes cash
in an amount equal to the value
of a 25 percent interest in the
partnership. In exchange, Awill
receive a 25 percent distributive
share for the life of the partner-
ship and a special allocation
of $20,000 of partnership gross
income for the first two years
of the partnership's operations.
Under the above example the
service partner fails to have
“entrepreneurial risk” based on
the fact that the special allo-
cation of income in the first
two years is reasonably cer-
tain to occur, the allocation is
made out of gross income, and
the allocation is capped. This
would result in the fee being
taxable as ordinary income to
the service partner in the year
it was earned.
Since the regulations are pro-
posed, there is a 90-day com-
ment period from the date of
publication, July 23, 2015. The
Treasury Department and the
IRS are requesting comments
on whether there are arrange-
ments that could exist that do
not have “entrepreneurial risk”
but shouldn’t be re-character-
ized as “disguised payments”
for services. In addition, they
are requesting comments on
what is sufficient notification of
a fee waiver. Comments can be
submitted to the IRS by regular
or electronic mail by Oct. 21,
2015.
n
So how does a service
partner proceed?
Assuming
that these proposed regulations
stay in their current form, the
key takeaway is that the income
allocation to the service partner
must be based on the success of
the deal. The allocations should
be based on net income and
there should be a real risk of
loss to the service partner. The
risk of fee waivers being re-
characterized as a “disguised
payment” for services may be
minimized if the arrangement
is properly planned for and
the service partner is willing to
accept the risk of loss should
the investment fail to perform.
A focus on proactive plan-
ning, analysis of operating
agreements with fee waiver
provisions and smart deal
structuring may mitigate the
potentially detrimental impacts
and leave the service partner in
the best possible position.
s
Bryan Adam
Senior tax manager,
Anton Collins Mitchell
LLP, Denver
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