In May of 2014 we made you aware of an ongoing IRS guidance project on the taxability of fee waivers. On July 22, 2015, the Treasury and IRS issued proposed regulations aimed at addressing their concerns over the increased use of fee waivers with respect to private equity management fees. Fee waivers in exchange for a larger carried interest, common in private equity, provide for capital gain income taxed at favorable capital gains as opposed to the normal ordinary income tax rates. While the proposed regulations continue to accept carried interests as viable under current law, the regulations would attack fee waivers that lack the appropriate entrepreneurial risks and would treat the receipt of the interest as a disguised payment for services. This may result in immediate taxation at ordinary income rates as opposed to the current treatment of deferred capital gain.
The proposed regulations focus in large part on a facts and circumstances definition of entrepreneurial risk providing a number of factors for consideration. In general, an interest would not carry significant entrepreneurial risk if the allocation associated with the interest is reasonably certain to be met.
If finalized, these proposed regulations will significantly impact most private equity firms that have utilized fee waivers and may also impact waivers occurring under existing agreements. Therefore, it is essential that private equity firms seek appropriate tax advice on the treatment of any existing or future fee waiver agreements.