There are currently two regulatory changes underway that will affect chief financial officers (CFOs) and the structure of private equity partnerships.
In July 2015, the Internal Revenue Service (IRS) proposed regulations to curb the use of fee waivers, which enable private equity firms to “waive” part or all of the two percent management fee owed to them by LPs in exchange for a profits interest in the fund.
Separately, the Bipartisan Budget Act (BBA) was signed into law in November 2015 and makes changes to the rules governing audits of partnerships.
Management fee waiver proposals
Under current regulations, general partners (GPs) that waive their management fees receive an increased share of profits. This allows them to take advantage of a deferral of tax and a reduced capital gains tax rate.
However, for proceeds to be taxed as capital gains, GPs need to be at risk of losing the money, which fund managers under the waiver were not perceived to be.
According to the IRS, there is an absence of ‘entrepreneurial risk’ in the way some GPs who have previously waived their fees are being remunerated.
The proposed regulations include six factors that may indicate that an arrangement constitutes a disguised payment for services. One of these six factors includes the existence of significant entrepreneurial risk. Arrangements that lack significant entrepreneurial risk are treated as disguised payments for services, according to an IRS bulletin.
The other five factors describe additional elements, of lesser importance, that further help to determine whether or not an arrangement that gives the appearance of significant entrepreneurial risk constitutes a payment for services. Ultimately, the IRS says it depends on each particular case.
“The proposals were made because the IRS believed that the fee waiver arrangement was being abused and that some fund managers were structuring management fee payments as capital gain, while it was impossible for them not to receive the money,” said Jeff Chazen, tax partner at EisnerAmper.
Chazen says he expects that under the proposals the main issue for more junior members of the GP is going to be cashflow. Under current arrangements, the waiver entity enables new or junior GPs, who may not yet have the assets available to meet their requirement, to invest in the fund.
“Losing the management fee waiver really hurts, more than anyone else, the new person who does not have the wherewithal to fund his/her required capital commitment,” says Chazen.
Under the proposals, the IRS also said that it would amend Revenue Procedure 93-27, which provides a safe harbour provision for guaranteed payment arrangements, such as fixed fee amounts.
This amendment would change how management company and waiver entities are structured, says Chazen.
The adjustment is expected to affect the fund structure, which typically sees the GP set up two separate structures: one for the management company and one for waiver entity/GP.
“The amendment of Revenue Procedure 93-27 has the following implications: a) now there may be a single entity that can cause complications at state and local levels, and b) from an accounting standpoint, it will potentially make one partnership two, for economic purposes,” explains Chazen.
Ultimately, making changes to existing agreements is likely to have implications on the back-office professionals tasked with carrying out compliance.
Because the fee waiver is a modification of proposed regulations, it will not come into effect until the final regulations are issued. However, the regulation stipulates that if GPs modify existing partnership agreements after the proposed regulations are finalized then they are subject to the new rules.
If GPs have an annual waiver, whereby the fee is waived prior to the beginning of each year, it will be considered a modification and therefore subject to the new regulation.
“Firms that want to continue to use the waiver, need to make it a permanent provision within their agreement now, so that when the new regulation comes into effect, they are not making a modification,” warns Chazen.
In particular, Chazen says that the biggest administrative issue for the back office is going to be the new structure that firms are going to need to implement, especially when changes are made to the fund partnership agreement to make sure that entrepreneurial risk is included.
Partnership audit reform
When President Obama signed the Bipartisan Budget Act of 2015 (BBA) into law, it changed the way the IRS conducts partnership audits.
Under previous regimes, the IRS required each partner involved in a partnership to pay taxes on adjustments. However, the new audit procedures apply at the partnership level and require the partnership to pay any tax shortages resulting from audit adjustments, unless the partnership elects to pass the adjustments on to its partners.
The new regime will apply to partnership tax years beginning after December 31, 2017. As part of the reform, the IRS is also expected to increase the amount of audits it makes on large partnerships, a rate which reached just 0.8 percent in 2012, according to a Government Accountability Office study. All partnerships will be subject to this rule unless they are eligible to elect out. Since most funds have partners that are taxed as partnerships, they will not be eligible to elect out.
In addition, the IRS will examine a partnership’s items of income, gain, loss, deduction, credit and partners’ distributive shares for the “reviewed year” of the partnership. The IRS will assess tax at the partnership level in the year of the audit (the adjustment year) rather than making an assessment based on the partners’ returns.
If a tax underpayment arises from the partnership level adjustment, the underpayment – or imputed underpayment – is calculated at the highest tax rate. However, under the reform, the amounts can be reduced if all partners voluntarily file amended returns or if the partnership can demonstrate that a partner was subject to a lower tax rate.
Under the imputed underpayment regime, current LPs could be charged tax for adjustments made in previous years to former partners that are no longer part of the fund.
“If a change was made three years ago, there is a chance that the partners that were there three years ago are not still there today. Therefore, the partners that are there today could bear a tax bill for someone that has gone,” says Chazen.
Therefore, Chazen advises that the partnership agreement should address how the partnership will deal with partners that are no longer partners in the adjustment year.
In preparation for the audit reform, at this stage managers should be looking at their partnership agreements, but should wait for the regulations to be put in place in 2018 before making any amendments, says Chazen.
While regulatory change is well intentioned, says Chazen, the results can often raise issues. “You hope that the treasury understands the implications when they put these rules into place, and that they do it in such a way that would not affect the economics between partners.”
Trouble on the horizon
While this could be ‘double trouble’, these new waiver regulations are currently only in proposed form. Although the new audit rules are two years away, no regulations have been issued yet. Both new and existing partnerships should be reviewing their partnership agreements before these new rules take effect, but also need to be patient and wait for updates, Chazen concludes. For CFOs at private equity firms, it is a case of ‘watch this space.’
Jeffrey Chazen is a tax partner at EisnerAmper and member of its financial services group. He has nearly 25 years of diverse tax and accounting experience and routinely consults on tax matters related to private equity, hedge funds, high net worth individuals and family offices.