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Tax Law Alert – Profits Interest

August 3, 2015

The IRS issued proposed regulations that severely curtail the practice of fund managers or other fee recipients waiving fees in exchange for a share of future LLC profits. These regulations highlight the continuing efforts of the IRS to disallow LLC managers, promoters and other service providers from foregoing fee income and instead receiving an interest in a LLC.  The proposed regulations provide for the circumstances under which LLC allocations and distributions will be treated as disguised payments for services.  The general purpose of the proposed regulations is to disallow fund managers to convert ordinary management fee income into tax-favored long-term capital gains through the use of management fee waivers.

The proposed regulations list six non-exclusive factors that indicate an arrangement constitutes a disguised payment for services.  Such factors are:

  • The arrangement lacks significant entrepreneurial risk.  This is the most important factor.  An arrangement lacking significant entrepreneurial risk constitutes a payment for services while an arrangement that has significant entrepreneurial risk will not generally constitute a payment for services.

  • The service provider holds, or is expected to hold, a transitory LLC interest or a LLC interest for only a short duration.

  • The service provider receives an allocation and distribution in a time frame comparable to the time frame that a non-partner service provider would typically receive payment.

  • The service provider becomes a member primarily to obtain tax benefits that would not have been available if the services were rendered to the LLC in a third-party capacity.

  • The value of the service provider’s interest in general and continuing LLC profits is small in relation to the allocation and distribution.

  • The arrangement provides for different allocations or distributions with respect to different services received, the services are provided either by one person or related persons, and the terms of the differing allocations or distributions are subject to significantly varying levels of entrepreneurial risk.

Additionally, the proposed regulations list the following facts and circumstances that would create a presumption that an arrangement lacks significant entrepreneurial risk and will be treated as a disguised payment for services:

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

  • An allocation for one or more years under which the service provider’s share of income is reasonably certain.

  • An allocation of gross income.

  • An allocation under a formula or otherwise that is predominantly fixed in amount, is reasonably determinable, or is designed to assure that significant net profits are highly likely to be available to make the allocation to the service provider (e.g., if the LLC agreement provides for an allocation of net profits from specific transactions or accounting periods and this allocation does not depend on the long-term future success of the enterprise).

  • An arrangement in which a service provider waives its right to receive payment for the future performance of services in a manner that is non-binding or fails to notify the partnership and its partners of the waiver and its terms on a timely basis.

The IRS also noted that Rev. Proc. 93-27 (which has been the resource relied upon for years), which treats a profits interest as having no value, will be amended to provide an additional exception for profits interests given in exchange for a member forgoing a fixed right to payment for services. This change would mean that even if the fee waiver has the requisite entrepreneurial risk, there would still be a chance that the IRS will treat the present value of the profits interest as compensation income.

Until the proposed regulations are finalized, service providers considering waiving future management fees or implementing new waiver arrangements should consider the impact, if any, of the proposed regulations. 

The proposed regulations, once finalized, will apply to any management fee waiver arrangement entered into on or after the date the final regulations are published.  For these purposes, each periodic management fee waiver election (e.g., annual) by a service provider could be viewed as a modification of such management fee waiver arrangement.  Arrangements entered into, or modified, prior to the date the regulations are finalized are subject to existing law and legislative history.

Overall, the result of the proposed regulations could result in the extinction of fee waivers altogether and cause uncertainty to the issuances of profits interests.

If you would like to discuss the proposed regulations or “profits” or “carried” interest in general, please feel free to contact Robert B. Canter at 301-230-5220.


Robert B. Canter