Upload
lamnhu
View
217
Download
0
Embed Size (px)
Citation preview
The audio portion of the conference may be accessed via the telephone or by using your computer's
speakers. Please refer to the instructions emailed to registrants for additional information. If you
have any questions, please contact Customer Service at 1-800-926-7926 ext. 10.
NOTE: If you are seeking CPE credit, you must listen via your computer — phone listening is no
longer permitted.
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
Tips for Optimal Quality
Sound Quality
If you are listening via your computer speakers, please note that the quality
of your sound will vary depending on the speed and quality of your internet connection.
If the sound quality is not satisfactory, you may listen via the phone: dial
1-866-328-9525 and enter your PIN when prompted. Otherwise, please
send us a chat or e-mail [email protected] immediately so we can address the
problem.
If you dialed in and have any difficulties during the call, press *0 for assistance.
NOTE: If you are seeking CPE credit, you must listen via your computer — phone
listening is no longer permitted.
Viewing Quality
To maximize your screen, press the F11 key on your keyboard. To exit full screen,
press the F11 key again.
FOR LIVE EVENT ONLY
Continuing Education Credits
In order for us to process your continuing education credit, you must confirm your
participation in this webinar by completing and submitting the Attendance
Affirmation/Evaluation after the webinar.
A link to the Attendance Affirmation/Evaluation will be in the thank you email that you
will receive immediately following the program.
For CPE credits, attendees must participate until the end of the Q&A session and
respond to five prompts during the program plus a single verification code. In addition,
you must confirm your participation by completing and submitting an Attendance
Affirmation/Evaluation after the webinar and include the final verification code on the
Affirmation of Attendance portion of the form.
For additional information about continuing education, call us at 1-800-926-7926 ext.
35.
FOR LIVE EVENT ONLY
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
Management fee waiver design
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
Management fee waiver design
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
Measurement of Profits
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
Measurement of Profits
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
Measurement of Profits
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
Measurement of Profits
Profits from limited periods (Cherry-Picking).
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
Measurement of Profits
Profits from limited periods (Cherry-Picking).
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
Measurement of Profits
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
Measurement of Profits
Profits from limited periods (Cherry-Picking).
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:
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
Example 3(iv) (Bad Allocation) 100
40
Measurement of Profits
Profits from limited periods (Cherry-Picking).
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
Measurement of Profits
Profits from limited periods (Cherry-Picking).
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):
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
Example 3(iv) (Bad Allocation) 100
Example 4 (Good Allocation) 100
42
Measurement of Profits
Profits from limited periods (Cherry-Picking).
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
Measurement of Profits
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
Measurement of Profits
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
Measurement of Profits
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
Measurement of Profits
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
Daniel P. Meehan
Peter J. Withoff
61