Earlier this year, the Internal Revenue Service proposed regulations that address when an allocation of income by a partnership to a partner in exchange for services is really a disguised fee that should be taxable to the service provider, not as a partnership allocation, but as ordinary compensatory income. While directed primarily at the practice of “fee waivers” by investment advisers who provide asset management services to private equity and hedge funds, the proposed regulations may also cast doubt on the use of certain special income allocations to other sorts of service providers to a partnership.

Section 707(a)(2)(A) of the Internal Revenue Code distinguishes between allocations and distributions from a partnership to a partner that are received in a partner capacity, and are therefore taxed as a distributive share of partnership income and may involve a pass-through of capital gains, and allocations and distributions received in a non-partner capacity, such as payments for services that are taxable to the service provider at ordinary income rates. The proposed regulations under the statute explain that an arrangement will be treated as a disguised payment for services if a person provides services to the partnership and is allocated partnership income in return, but the transaction is really one between the partnership and the service provider acting in a non-partner capacity.

The proposed regulations then provide a non-exclusive list of factors that may indicate that the services are provided in a non-partner capacity. The most important of these factors is whether the arrangement lacks “significant entrepreneurial risk” to the service provider. The presence of any of the factors listed in the regulations (below) will create a presumption that there is no significant entrepreneurial risk.

• An allocation (under a formula or otherwise) that is predominantly fixed in amount or is reasonably determinable.

• All allocation (under a formula or otherwise) that is designed to ensure that sufficient profits are “highly likely to be available” to make the allocation (because, for example, the allocation is from the net profits of specific transactions or specific accounting periods, and does not depend on the long-term future success of the enterprise).

• Capped allocations of income if the cap is expected to apply in most years.

• Allocations for one or more years where the service provider’s share of income is “reasonably certain.”

• Allocations of gross income.

• Certain late or non-binding fee waivers.

If the allocation does have “significant entrepreneurial risk,” it will generally not constitute a payment for services. However, the existence of the certain other additional factors set forth in the regulation may establish otherwise.

If the services are provided in a capacity other than as a partner, the taxpayers must then look to “relevant authorities” to determine the status of the service provider, as either an independent contractor or as an employee.

The proposed regulations are most directly addressed to the practice of fee waivers, a technique frequently used by private equity funds and some hedge funds to replace ordinary-income, fixed asset-based management fees with profits interests by permitting the manager to “waive” the management fee in return for an allocation of income as a partner. However, they also put some pressure on profits interests for partners or prospective partners (including employees being “promoted” to partner) that provide for priority, formula-based or other special allocations of income where there is a high likelihood that the service provider will receive the allocation regardless of the long-term business success of the partnership. For example, the following service provider income allocation designs may be at risk:

• A profits interest in a partnership that provides for a priority allocation of income in a fixed-dollar amount or a fixed formula (perhaps with a cap), from the partnership’s first profits in a particular year.

• Fixed dollar or formula allocations that carry over to the following and subsequent years to the extent unsatisfied in the initial year.

• Allocations from income derived from the revaluation of “hard-to-value” partnership assets, where the service provider is in a position to control the timing and amount of the revaluations.

While the proposed regulations will apply only prospectively (to arrangements entered into or modified after publication of the final rules) the preamble notes that the proposed regulations generally reflect congressional intent in crafting Section 707(a)(2)(A), possibly also signaling the current view of the IRS with respect to existing arrangements. Accordingly, care should be taken when crafting priority, delayed, or other special income allocations for service provider partners.