IRS Proposes Changes to the Taxation of Fee Waivers and Possibly Other Transactions in Which Partners Provide Services: IRS Proposals Would Re-characterize Partnership Income from Some Fee Waiver Arrangements (and Potentially Other Transactions) as Service Income

Sullivan & Cromwell LLP - July 24, 2015

The IRS issued proposed regulations that would address when a partnership allocation and distribution in exchange for services will be re-characterized as a disguised fee. Although the proposed regulations appear to apply to all disguised payments for services, the proposed regulations directly address fee waivers, which are commonly used by private equity funds and venture capital funds. The IRS also announced that it intends to remove profits interests received in exchange for waived fees from an existing safe harbor under which the receipt of certain profits interests is not currently taxable. In contrast to fee waivers, the proposed regulations appear to leave more common carried interests (particularly those subject to clawbacks) generally untouched.

While final regulations will apply only prospectively, the IRS’s position is that the proposed regulations reflect congressional intent as to which arrangements are appropriately treated as disguised payments for services. Consequently, the IRS may seek to apply the substance of the proposed regulations to existing arrangements.