NYSBA Members Address Regs on Disguised Payments for Services

I am pleased to submit the attached report of the Tax Section of the New York State Bar Association. The report provides comments on the notice of proposed rulemaking issued on July 23, 2015, which contains proposed regulations concerning disguised payments for services under Section 707(a)(2)(A) and proposed conforming changes to the regulations governing guaranteed payments under Section 707(c) (the "Proposed Regulations") and statements regarding the interpretation of and planned changes to Revenue Procedure 93-27 relating to issuance of partnership profits interests to service providers.

We understand that the proposals are in large part a response to arrangements involving profits interests issued to service partners in private investment funds, which are sometimes referred to as "management profits interests" or "management fee waiver" interests, and those arrangements are a significant focus of the report. We note, however, that the proposals, especially the Proposed Regulations, will apply to a far wider range of arrangements, many of which do not involve fee waiver or indeed investment funds and urge the Internal Revenue Service and the Treasury to keep this in mind as they finalize the rules.

Section 707(a)(2)(A) provides that, when a partner performs services for a partnership other than as a partner, any allocations and distributions related to such performance are treated as a transaction between the partnership and one who is not a partner. The Proposed Regulations provide guidelines for determining when such allocations and distributions should be treated as a disguised payment for services and not a transaction between a partnership and its partner.

Section 707(c) and Treas. Reg. § 1.707-1(c) provide that payments made by a partnership to a partner for services or use of capital are considered as made to a person who is not a partner, to the extent such payments are determined without regard to the income of the partnership. The Proposed Regulations would change Example 2 of that regulation regarding the treatment of guaranteed minimum amounts to a partner otherwise entitled to a share of partnership income.

Revenue Procedure 93-27 provides a safe harbor under which a profits interest issued to a partner for services is not treated as a taxable event to either the partner or the partnership, except in certain circumstances. The proposed guidance indicates the Internal Revenue Service and the Treasury (1) have determined Revenue Procedure 93-27 does not apply to certain issuances of profits interests to an affiliate of an entity waiving its entitlement to fees and (2) intend to issue a new revenue procedure excluding from the Revenue Procedure 93-27 safe harbor certain issuances of profits interests connected to a partner forgoing fee payments.

We commend the Internal Revenue Service and the Treasury for their efforts to provide guidance in these areas. The Proposed Regulations generally adopt an approach consistent with what Congress intended, and together with statements relating to Revenue Procedure 93-27 reflect a thoughtful approach to address aggressive practices in a complex area.

In this report, we make recommendations in areas where revisions to the Proposed Regulations could be considered to provide clarification, to reflect the legislative history more closely or to avoid unintended results. We also include recommendations relating to Revenue Procedure 93-27.

As discussed in the report, our principal recommendations are as follows:

This report¹ of the Tax Section of the New York State Bar Association provides comments on the notice of proposed rulemaking issued by the Internal Revenue Service on July 23, 2015, which contains proposed regulations concerning disguised payments for services under Section 707(a)(2)(A), proposed conforming modifications to the regulations governing guaranteed payments under Section 707(c) (the proposals collectively, the "Proposed Regulations") and statements regarding the interpretation of and planned modifications to Revenue Procedure 93-27 relating to issuance of partnership profits interests to service providers.²

We commend the IRS and the Treasury for their efforts to provide guidance in these areas. The 1984 legislative history of Section 707(a)(2)(A)³ provides meaningful direction for when Congress intended Section 707(a)(2)(A) to apply. Although they depart from the legislative history in certain respects, the Proposed Regulations generally adopt an approach consistent with what Congress intended, and together with statements relating to Revenue Procedure 93-27 reflect a thoughtful approach to address aggressive practices in a complex area. The Proposed Regulations also address a separate issue, discussed below, relating to guaranteed payments.

We understand that the proposals are in large part a response to arrangements involving profits interests issued to service partners in private investment funds, which are sometimes referred to as "management profits interests" or "management fee waiver" interests and these arrangements are a significant focus of this Report. We note, however, that the proposals, especially the Proposed Regulations, will apply to a far wider range of arrangements, many of which do not involve fee waiver or indeed investments funds and urge the Internal Revenue Service (the "IRS") and the Treasury to keep this in mind as they finalize the rules.

In this report, we make recommendations in areas where revisions to the new rules could be considered to provide clarification, to reflect the legislative history more closely or to avoid unintended results. We also include recommendations regarding the proposed conforming change to the Section 707(c) regulations and the statements regarding Revenue Procedure 93-27.

This report is divided into five parts. Part I provides as background a general description of existing fee waiver arrangements. Part II provides a summary of our recommendations. Part III provides a summary of current law. Part IV provides a summary of the Proposed Regulations and statements regarding Revenue Procedure 93-27. Part V contains a detailed discussion of our recommendations.

I. GENERAL DESCRIPTION OF EXISTING FEE WAIVER ARRANGEMENTS

Given the focus on fee waiver arrangements, we thought it would be useful to outline our understanding as to how these arrangements typically work. In private investment funds, the general partner or an affiliated manager (referred to collectively herein as a "sponsor") might, absent these arrangements be entitled to receive a fee for investment management services under a formula that applies a percentage (such as 2%) to capital commitments of investors and/or capital invested, subject to various adjustments. Although the specific terms of these arrangements vary widely, three aspects of the various alternatives are briefly described below.

Elective versus Hard-Wired Arrangements. In funds providing for these arrangements, the sponsor may be permitted to elect either at the inception of the partnership's activities (referred to herein as "one-time election" arrangements) or from time to time during the term of the partnership (referred to herein as "periodic arrangements") not to receive some or all of the fees otherwise payable in the future and instead to receive an interest in profits of the partnership. In other arrangements, the agreements simply provide for a lower fee amount that is not subject to adjustments relating to the profits interest and additional profits interest when the parties sign them and no election is available to the sponsor (referred to herein as "hard-wired" arrangements). These arrangements are discussed below at V.G.2.

Fixed Amount versus Variable Amount. There are two common alternative formats for measuring what the sponsor is entitled to receive. In the first, which can be referred to as a fixed amount format, the future fee is reduced and the sponsor receives a right to partnership profits equal to that fixed amount, provided the partnership has at least that amount of profits. In the second alternative, which can be referred to as a variable amount format, the future fee is reduced and the sponsor becomes entitled to receive an amount from the partnership equal to what the sponsor would have received had it invested amounts in such investments equal to the reduction in fees. Thus, if a $100 fee reduction related to a specific investment under the variable amount format, and the investment was eventually sold for 90% of its cost, the sponsor would be tentatively entitled to $90. On the other hand, if the investment were sold for 110% of cost, the sponsor would be tentatively entitled to $110. The right to receive any amount (whether $90 or $110 in the foregoing example), however, would be subject to the requirement that the partnership have sufficient profits ($90 or $110 in the example); the sponsor receives a distribution of the tentative entitlement amount only to the extent the partnership has profits available to allocate to the sponsor. So in either format, the sponsor's profits interest is subject to the possibility the relevant investment will be sold at a loss and the possibility the partnership will not have sufficient profits. In our experience, variable arrangements are far more common.

Various Ways to Define "Profits". Partnerships providing for those arrangements generally intend for them to be treated as partnership profits interests for tax purposes, but different partnerships may define "profits" for that purpose in different ways that have different degrees of economic risk. The lowest level of economic risk would be to consider the profit requirement to be met if the partnership has an item of gross income at any time in an amount sufficient to cover the intended allocation. Alternatively, the interest would be subject to greater economic risk if net income over the life of the partnership is required, and (if distributions are made before the liquidation of the partnership) either (a) unrealized gains or losses are taken into account or (b) a repayment (a "clawback") is required if subsequent losses cause cumulative net profits to be inadequate. Alternatively, "profit" could be defined to include solely profit from the specific investment to which the fee reduction had been allocated. Of course, other ways to define profits are possible as well, and arrangements all across the economic risk spectrum have been used.

For tax purposes, the character of a fee would be ordinary income and the inclusion in income would occur when the fee was paid or accrued. The character of the allocated amounts under the profits interest would flow through from the partnership level and could be long-term capital gain in whole or in part. Such amounts would often be allocated in a later year than when a fee would have been paid or accrued. The issuance of a profits interest to a sponsor, therefore, often has the effect of converting ordinary income into long-term capital gain and of deferring income recognition, in both cases as compared to payment of a fee to the sponsor.

The Proposals appear to reflect two types of concerns relating to fee waiver arrangements. The first, reflected in the proposed changes to Revenue Procedure 93-27, is that the IRS and the Treasury have concluded a valuation safe harbor of $0 is inappropriate where the recipient had, and waived, the right to receive a fixed or formula fee. The second, reflected in the Proposed Regulations, is that the IRS has understandably expressed concern that some arrangements of this type may not in fact subject the sponsor to any meaningful enough economic risk so as to justify treatment of the arrangement in accordance with its form as an allocation of partnership profits.

II. SUMMARY OF PRINCIPAL RECOMMENDATIONS

The legislative history lists five factors that "should be considered in determining whether [a service] partner is receiving the putative allocation and distribution in his capacity as a partner."⁵ The first factor listed in the legislative history, which the legislative history states is the most important factor, is whether the payment "is subject to an appreciable risk as to amount." The legislative history explains,

The legislative history further explains that Section 707(a)(2)(A) is generally intended to apply to an allocation that is contingent as to amount only in certain limited situations. Specifically, the legislative history provides:

IV. SUMMARY OF PROPOSED CHANGES

V. DISCUSSION

The proposed new rule has some common sense appeal in that the minimum amount is payable without regard to income of the partnership. However, the approach of the current regulation perhaps reflects the principle that, absent compelling policy considerations, partner sharing of partnership profits should be viewed as such rather than as wages or interest or otherwise as payments between third parties. It is also unclear whether partnerships are relying on the current rules in ways the IRS might consider problematic.

The Preamble indicates the view of the IRS and the Treasury that Congress's emphasis on entrepreneurial risk and the principle that a Section 704(b) allocation must have significant entrepreneurial risk requires the change to existing regulations under Section 707(c). We would note, however, that Example 2 was in place when Congress amended Section 707(a)(2)(A), and nowhere in the legislative history to the Section 707(a)(2)(A) changes is there any mention of Congress having a concern with Example 2. Moreover, it is not immediately apparent why a change to Section 707(a)(2)(A) requires any change to regulations under Section 707(c). The two Code sections apply to different categories of partnership items (payments of income versus payments without regard to income) and to partners acting in different capacities (non-partner versus partner).

Under the new Example 2, parties seeking guaranteed payment treatment could provide for a guaranteed fixed payment amount that was well below expected allocation levels (and thus not viewed by the parties as meaningful) and thereby achieve treatment of the fixed amount as a guaranteed payment even if (as expected) the actual payment in fact exceeded the guaranteed minimum; affording such opportunities to taxpayers may be an unintended consequence of the proposed rules. The IRS should consider whether the current version of Example 2, which favors allocation treatment, might be more appropriate than the proposed new version in such cases. For example, a U.S. citizen living abroad seeking to exclude income under Section 911 might be entitled to the higher of a percentage of partnership net income and a guaranteed minimum that is much lower than the expected amount produced by the percentage allocation. Under the new rule, the individual would be able to rely on the minimum to qualify for the Section 911 exclusion even though the minimum is not meaningful.¹⁹ Similarly, such a provision for a partnership engaged in a U.S. service business might allow the parties to treat a foreign-based nonresident alien partner as having foreign source income, which would generally not be subject to U.S. federal income tax.²⁰

An anti-abuse rule could be added under which an allocation structured as the greater of a percentage and a minimum would be analyzed on a wait-and-see basis, as under current Example 2, if the minimum was highly likely to be irrelevant or was added primarily for tax avoidance reasons. The IRS might also consider excluding from the rule of new Example 2 (and applying the former wait-and-see rule to) certain arrangements such as those between a partnership where capital is not a material income-producing factor and a service partner who is involved in the general activities of the partnership on an ongoing basis (similar to the carve out from Section 707(a)(2)(A) described below at V.B.2). The IRS should also consider revising Example 2 to make clear the $60,000 income of Partnership CD is net income, which seems to be implicit in the reference to net income in the last sentence.

It is perhaps even less clear that a change in the rules for disguised payments for services should affect rules that govern whether amounts paid with respect to a capital investment should be treated as an allocation or as a guaranteed payment. (Principal Recommendation (1(a)).) Indeed, since the Proposed Regulations were released, government officials have acknowledged that in making the proposed change, their focus was on services, not capital.²¹ The issues in this area are quite complex and the law is quite unclear. Even if new Example 2 is retained, we believe that its application to guaranteed payments for capital should be considered further. For example, if the return on a preferred partnership interest is structured as an allocation but calls for any return that is accrued and unpaid on redemption to be payable in all events on redemption, and at a given time the accrued and unpaid return exceeds all equity capital of the partnership, additional returns of the preferred interest will only be paid if the partnership generates income or gain, which suggests such additional returns should not be viewed as guaranteed payments. But that would require the characterization to be determined (or changed) after the issuance of the preferred, while the new proposed rule seems to contemplate the interest being characterized at issuance.

In addition, treatment of a partnership interest that is entitled to a preferred allocation and distribution as instead being a guaranteed payment could accelerate the income (and corresponding deduction) resulting from the guaranteed payment as compared to when the underlying income is earned and could cause income recognition to the service partner, and loss recognition to the partnership, even where the corresponding amount is never paid. Converting an allocation into an income inclusion and deduction may have additional consequences, as deductions may be subject to limitations (such as under Section 212). Even if there is a perceived need to apply a new approach in the services area, the new Example 2 approach could be limited to services and not made applicable to payments for the use of capital. Given that neither the Preamble nor the Proposed Regulations include any discussion about payments for the use of capital, if the revised Example 2 is in fact intended to apply to use of capital payments, it would be helpful if the Preamble to the final regulations could shed light on the purpose of the change as it applies to such payments.

In any event, because it clearly changes the rule in the prior regulations, to the extent the new rule of Example 2 is retained, the final regulations should provide an effective date for this modification to Example 2. We believe that one reasonable approach could be to apply the new rule to arrangements entered into or modified after the date final regulations are published. (Principal Recommendation (1(b)).)

The Proposed Regulations set forth a list of factors that create presumptions that an arrangement will fail unless the taxpayer can show significant entrepreneurial risk by clear and convincing evidence. Although the legislative history anticipates the IRS may describe other factors than those listed in the legislative history, it has no presumptions other than identifying "an appreciable risk as to amount" as the most important factor. Two of the proposed presumption factors vary to some extent from the legislative history. First, the Proposed Regulations treat a gross income allocation as establishing an unfavorable presumption, whereas the legislative history generally treats gross income allocations as a problem only if the amount is reasonably certain. Second, the Proposed Regulations treat an allocation predominantly fixed in amount as establishing the presumption that the purported allocation is actually a payment for services without regard to the likelihood of the allocation, whereas the legislative history generally focuses on fixed or limited allocations where the fixed amount or limit is likely to apply. The Proposed Regulations also do not include a rule similar to the contingent amount rule from the legislative history.²⁵

Individual layers within an integrated set of allocations almost necessarily involve differing levels of entrepreneurial risk. For example, suppose that on the sale of a business whose value was $900 upon formation, the first $100 of gain is allocated to a service partner and the remaining profit is allocated 90% to a capital partner and 10% to the service partner. This is a simplified version of an arrangement sometimes referred to as a "catch up" profits interest that is commonly used in a wide range of partnerships that conduct operating businesses, including many partnerships that are not private equity or other types of investment funds. Under the Proposed Regulations, it appears the service partner's right to the first $100 (to "catch up" to a 10% share of the sales proceeds) could be analyzed separately from the service partner's right to be allocated 10% of the residual profits.

Or consider a real estate partnership in which a service provider invests no capital and a capital partner invests $100, where the service partner has a profits interest at one level (for example, 10% with other 90% allocated to the capital partner) until the capital partner has received a specified return on capital (for example, 9% per annum), and has a higher profits interest (for example, 20%) thereafter. The 90/10 layer produces a maximum allocation under a fixed formula (1% of capital per annum). Again, it appears that this layer could be analyzed separately under the Proposed Regulations.

These are common and entirely commercial arrangements, yet every partnership with a service partner entitled to fixed or formula amounts in individual layers of the waterfall could have Section 707(a)(2)(A) payments if the layers are analyzed separately and the first layer was likely to be exceeded. (Indeed, the first layer will always be more likely to be achieved than later layers, so the sixth factor of the Proposed Regulations would always seem to be present in any complex arrangement (at least where the different layers are considered to be for different services).) Bifurcation could thus lead to the odd result that a partner, in performing the same services, would do so partly in a partner capacity and partly in a non-partner capacity. We believe that it seems sensible and consistent with the legislative history for the final regulations not to require bifurcation of individual layers of an integrated waterfall. (Principal Recommendation (2).)

We would recommend that an integrated waterfall be defined so that, if a layer of an allocation waterfall allocates a category of net income to both a service partner and one or more capital partners and if the service partner is then entitled to all or a portion of an additional layer of allocations of the same category of net income after a specified target amount of net income has been allocated in the first layer, the two layers of allocation to the service partner would be integrated. That approach would cause the layers in the second example above to be integrated. An anti-abuse rule could be provided so that neither (1) provisions to allocate income to a partner that are not expected to result in allocations of substantial income to the partner nor (2) allocation provisions determined to have a principal purpose to avoid Section 707(a)(2)(A) would receive the benefit of this proposed integration of waterfall layers.

In addition, if a layer of an allocation waterfall allocates a category of net income disproportionately to capital partners, and the next layer allocates the same category of net income disproportionately to the service partner to equalize the partners' cumulative returns in proportion to subsequent sharing levels between capital and service partners, the layers of allocation to the service partner should be integrated. That approach would allow allocations that catch up the service partner to prior allocations of income to the capital partner to be integrated with additional allocations to the service partner, consistent with the statement in the Preamble that such catchup allocations should generally be respected.³⁰

The first example in this section does not meet either of those criteria. Many of our members believe that the first example is also a sympathetic case for integration. Others, however, disagree, noting that its economic terms bear some similarity to the economics of certain fee waiver arrangements, while recognizing that there are differences, such as that the service provider's allocation depends on there being a gain on the ultimate sale of the business in which the partnership invests. In addition, of course, the arrangement described in the first example is not actually a private equity fee waiver, and it may also be the case that the Proposed Regulations do not intend to attack private equity fee waiver based on a bifurcation argument. We have not (yet) been able to come up with a rule that shields the first example from bifurcation without allowing fee-waiver type arrangements also potentially to avoid bifurcation. We urge the IRS and the Treasury to consider whether examples such as the first example should be caught by rules designed to attack fee waiver arrangements on the basis of bifurcation.

If the final regulations retain the "predominantly fixed" presumption factor in some form, additional guidance on the meaning of "predominantly fixed in amount" would be helpful. (Principal Recommendation (3).) In particular, we do not believe a profits interest should be regarded as predominantly fixed merely because it reflects a hypothetical investment of a specific amount. Such an allocation is not fixed merely because one of the inputs to the formula for making the allocation is a specific amount.

The third factor of clause (iv) ("highly likely to be available") also seems susceptible of interpretations that may be unintended. The factor presumes insufficient risk if net income is highly likely to be available to make the allocation, but it is not limited to fixed or targeted amounts that are highly likely to be exceeded. For example, if a partnership divides all profits 90% to a capital partner and 10% to a service partner, the presumption would appear to apply if the possibility of a single dollar of profit were considered highly likely. It would make more sense to us if the drafting were revised as follows:

We believe that an allocation should not automatically be treated as a disguised payment for services merely because it is based on (1) a period of at least 12 months that is shorter than the life of the partnership and/or (2) an asset or activity or subset of assets or activities of the partnership that are less than all of the assets or activities of the partnership, so long as the time period, asset(s) or activity(ies) are specified in advance and are being used for measurement for a business reason. (Principal Recommendation (4).) Example 4 of Prop. Treas. Reg. § 1.707-2(d) blesses a profits interest based on net profit from a single specified year but under the facts of the example the partnership owns only marketable securities and the profit calculation is based on all assets of the partnership (as well as having a Section 475 election in place). As discussed below, the same treatment should apply in appropriate cases even if the allocation relates to assets that are non-public securities or to only a single asset or subset of assets of the partnership (and where no Section 475 election applies). One possible approach could be to revise the current general rule to provide that whether an arrangement lacks significant entrepreneurial risk is based on the service partner's entrepreneurial risk relative to the overall entrepreneurial risk of the partnership for the period or assets or activities to which the arrangement relates.

We acknowledge that there are a number of situations involving subsets of partnership assets or shorter periods that are inappropriate. For example, if an allocation to a service provider allows the partnership to "cherry pick" periods with net income to fund the provider's allocation after the arrangement is in place, even if other periods have losses, such arrangement may be abusive and should be considered to have a factor favoring disguised payment for services treatment. On the other hand, when the service provider receives a distribution only from net income earned over a one-year or longer period and the period is determined in advance when the lower fee is set and for a business reason, there would seem to be little potential for abuse, even if the partnership agreement lacks a clawback provision (discussed below), at least where the net income for the period includes unrealized gain and loss as well as recognized income, gain and loss. Likewise, allowing the service provider to cherry pick assets after the arrangement is in place for the purpose of deciding which assets generate net income to be allocated to the partner may be abusive where it serves to make it likely income will be available to cover the service partner's allocation. On the other hand, providing that an allocation will be from net income of an asset or subset of assets or activities of the partnership specified in advance (when the lower fee is set or when the asset is acquired) and for a business reason does not seem to create a similar potential for abuse, and should not create a disguised payment for services.³¹

The examples in the Proposed Regulations could be viewed as implying that a clawback is required at least where another profits interest in the same partnership is subject to a clawback. However, requiring a partnership agreement to have a clawback provision to avoid treating allocations to a service provider as a disguised payment for services would seem to attach too much importance to a specific commercial term. Many partnerships provide for profits interests with no clawback or deficit restoration obligation or impose such an obligation on some but not all partners. In some cases, a clawback may be illogical or unwanted, such as where the partnership is intended to continue indefinitely. Even if other profits interests are subject to a clawback provision, the absence of a clawback may not be abusive where the arrangement depends on cumulative net income over a period of one year or more determined in advance. In other words, a partner without a clawback may be subject to entrepreneurial risk. Based on our own experiences, we question whether a sponsor in the real world would manipulate arrangements that lack a clawback to optimize its profits interest (in light of fiduciary concerns, the desire to enhance returns for track record presentations in subsequent fundraising, etc.). Such concerns would be further reduced it there is a requirement to mark to market the relevant investments that remain unsold at the end of the measurement period and take into account the unrealized gain or loss inherent in such investments would seem to address any such concern, which would also give limited partners the ability to contest the sponsor's entitlement to the allocation. Concern about a sponsor using an artificially high valuation for nontraded assets could be further allayed by requiring the sponsor to use the same valuations as those that are included in periodic reports to investors or are used to determine redemption prices, and by requiring special scrutiny if assets are sold at significantly lower prices shortly after the valuation date.

Regardless of how the rules treat allocations based on periods shorter than the life of the partnership or subsets of partnership assets, we believe an allocation should not fail to have significant entrepreneurial risk merely because certain expenses are excluded from the calculation, provided the exclusion is for a business reason. For example, overall net income for the service partner's allocation might omit certain expenses as part of the commercial arrangement (such as fees paid to the service partner itself for services provided to the partnership).

We have two suggestions relating to the proposed rules for gross income allocations. First, we recommend that the IRS consider in the final regulations generally treating gross income allocations as a factor for the IRS to consider rather than as a basis for presuming the lack of significant entrepreneurial risk. If that recommendation is followed, a presumption might still be appropriate for certain types of gross income allocations, such as those described in the legislative history that replicate what the service provider charges third parties. Gross income allocations that are fixed or capped might also fall within other presumptions. Second, the final regulations should provide that net gain from an asset sale, even if technically included in "gross income" under the Code, should not be treated as gross income that triggers the presumption. The gross income allocations in the legislative history involved gross income that was highly likely to be earned, such as rent or interest. Net gain from an asset sale is not generally highly likely to be earned at the outset and is thus in the nature of net profit.³³ A service provider should be entitled to an allocation from net gain of an asset sale without treating the allocation as triggering a presumption that the allocation is in fact a payment for services. (Principal Recommendation (5).)

It would appear the conclusion regarding M may reflect governmental concern that arrangements are more susceptible to manipulation where the profits interest recipient controls the timing or realization of income and the integrity of the arrangement is not protected either by a clawback or by taking into account unrealized gains and losses. Some of us question whether this concern may be overstated, as control by a profits interest holder over the timing of sales does not necessarily mean that sales will be manipulated to maximize the allocation being tested. The sponsor owes fiduciary duties to other partners and has an incentive to maximize long-term investment returns to enhance marketing of future funds and otherwise improve standing with investors. Those duties and incentives should generally deter the sponsor from manipulating the timing of sales at the expense of the overall success of the partnership. Moreover, the illiquid nature of many private investments would also impede attempts to manipulate the timing of sales. However, as noted above, we acknowledge that the IRS and Treasury may feel that greater safeguards are needed in this context, and that taking into account net unrealized loss may be appropriate to address those concerns.

Clause (iv) of Example 3 changes the facts to allow ABC to fund the priority allocation to M from the revaluation of partnership assets pursuant to Treas. Reg. § 1.704-1(b)(2)(iv)(f). It concludes that because the valuation of the assets is controlled by A and M's profits may be determined by reference to a specific accounting period, the arrangement lacks significant entrepreneurial risk and is a disguised payment for services.

Because clause (iv) of Example 3 adds a bad fact (the partnership can fund M's priority allocation from any revaluation of partnership assets pursuant to Treas. Reg. § 1.704-1(b)(2)(iv)(f) as well as from what appears to be realized net profit in any 12-month period) to an arrangement that already is treated as a disguised payment for services, the conclusion that the arrangement with an additional bad fact is also treated as a disguised payment for services is unsurprising. The example is presumably intended to highlight the fact that valuations of nontraded assets on the occurrence of any bookup event (such as a redemption or issuance of interests) may be particularly susceptible to manipulation. If so, the IRS may wish to revise the example or provide a new example to make that point.³⁵

As noted above, Example 4 describes an investment partnership that has made a mark-to-market election under Section 475(f)(1). In our experience private investment funds using mark-to-market book accounting (which would be many hedge funds but not most other private investment funds) often do not make a Section 475 election. We believe it would be reasonable to respect allocations made pursuant to book market-to-market accounting for an annual or longer specified regular interval, provided they are subject to a "high-water mark," meaning any net losses incurred before the testing period must first be covered by net profits in the testing period (measured at the end of such period) before the profits interest begins to share. Such arrangements are not generally subject to a clawback, reflecting the commercial reality that investors are protected by the mark-to-market and do not need a clawback. Perhaps the example could be revised to reflect such an arrangement. We also believe it would be helpful to address the case of mark-to-market book accounting applied to less than all of the partnership's assets where net unrealized gains and losses are taken into account. In any event, it would be helpful if the IRS could clarify the relevance of the Section 475 election to the analysis set forth in the example.

Example 5 refers to the fact that funds "comparable" to the investment fund being analyzed (i) "commonly require" the general partner to contribute capital equal to 1% of the capital committed by the limited partners, (ii) provide the general partner with a profits interest equal to 20% of future partnership income and (iii) pay the fund manager a fee equal to 2% of committed capital. In reality, actual fee and profit sharing arrangements among private investment funds vary widely as to fee percentage, the base on which the fee is calculated and other terms. As a result, it may be difficult for a fund to determine the precise compensation arrangements for comparable funds. In addition, we are not sure why the fee arrangements of comparable funds is important to the analysis in the example, and would suggest that it be removed in the final regulations.

We would suggest that the IRS reconsider this position for two reasons. (Principal Recommendation (10(a)).) First, in most cases of which we are aware, those structures may not truly involve any transfers of the ultimate indirect ownership of the profits interest. Most typically, the ultimate individuals who receive the profits interests are in fact the same people who would have received the waived fee (either as owners of the fee earning entity or as employee compensation). In many cases, what motivates the sponsor to form one entity to earn fees and a separate entity to earn investment returns are state or local tax concerns having nothing to do with federal income tax planning or objectives.

In addition, even if the interest is viewed as issued first to the fee entity and then transferred to a separate entity, the ownership of the profits interest by a separate entity would not seem to violate the principle intended to be protected by the two-year test. The purpose of the two-year rule is presumably to exclude a profits interest that can be more readily valued based on the facts of the transfer within that period.⁴⁰ Thus, a third-party sale within two years for a cash price might be considered to provide an objective basis to conclude that the interest could have been reasonably valued when issued, and would also provide information about that value. But a constructive transfer to an affiliate for no consideration sheds no light on the value of the interest, or the ease with which it could have been valued, when issued. Particularly in light of the tension between the annual accounting principle and the two-year rule, it may be appropriate to limit the two-year rule to cases such as third-party cash sales that establish a clear value and thus further the underlying policy. More generally, it may be useful to revise the two-year rule to exclude affiliate transfers, gifts and other transfers that do not establish a clear value.

If clear valuation is the basis for the change, we recommend that the amended Revenue Procedure make it clear that the exception will not apply to hard-wired arrangements (those where the lower fee and additional profits interests are provided for when the documents are signed). (Principal Recommendation (10(b)).) In that case, there is no fixed contractual right to a particular amount and thus there is no clear way to determine the value of the "forgone" fee that the sponsor might have received had it negotiated a different deal.⁴³

² REG-115452-14, 80 Fed. Reg. 43,652 (July 23, 2015). All "Section" references are to the Internal Revenue Code of 1986, as amended (the "Code"), and all "Treas. Reg. §" references are to the Treasury Regulations promulgated under the Code.

³ See H.R. Rep. No. 98-432, at 1216-21 (1984); S. Prt. No. 98-169, at 223-32 (1984); H.R. Rep. No 98-861 (1984), at 859-62; see also Staff of Joint Comm. on Taxation, General Explanation of H.R. 4170 (1984), at 223-33.

⁴ S. Prt. No. 169 (hereinafter "Senate Report"), at 226 (1984).

⁵ Id., at 227. The Senate Report provides a sixth factor which relates to purported allocations and distributions for property.

⁶ Id.

⁷ Id., at 227, 228.

⁸ Id., at 228.

⁹ Senate Report, at 229 (emphasis added); see also Staff of Joint Comm. on Taxation, at 230.

¹⁰ Rev. Proc. 93-27, 1993-2 CB 343 (June 9, 1993).

¹¹ Rev. Proc. 2001-43, 2001-2 CB 191 (Aug. 2, 2001) provides guidance on the treatment of a grant of a substantially nonvested partnership interest to a service provider if the requirements of Revenue Procedure 93-27 and certain other requirements are met.

¹² Prop. Treas. Reg. § 1.707-2(c)(1).

¹³ Prop. Treas. Reg. § 1.707-2(c)(1)(i)-(v).

¹⁴ Prop. Treas. Reg. § 1.707-2(c)(2).

¹⁵ Prop. Treas. Reg. § 1.707-2(c)(3).

¹⁶ Prop. Treas. Reg. § 1.707-2(c)(4).

¹⁷ Prop. Treas. Reg. § 1.707-2(c)(5).

¹⁸ Prop. Treas. Reg. § 1.707-2(c)(6).

¹⁹ Miller v. Comm'r, 52 T.C. 752 (1969) (law firm partner living abroad received a guaranteed payment from the partnership; the guaranteed payment was compensation for purposes of Section 911 and therefore not included in gross income), acq. 1972-2 CB 2; Carey v. U.S., 427 F.2d 763 (Ct. C1. 1970) (fixed payment to accounting firm partner living abroad was a guaranteed payment under Section 707(c) and therefore excluded from the partner's income under Section 911).

²⁰ Such foreign sourcing of income would be based on treating the guaranteed payment for services as having a source in the place where the services were performed. See Section 862(a)(3); Philip Stoffregen, Kenneth Harris, and Francis Wirth, "Partners and Partnerships -- International Tax Aspects," 910 Tax Mgmt. (BNA) Foreign Income, at A-43 (June 1, 2015). In that event, if guaranteed payment treatment applied, the other partners generally would be entitled to a (foreign source) deduction for the guaranteed payment and would report the corresponding income.

²¹See Amy S. Elliot, Fee Waiver Regs May Change Guaranteed Payment Example, TAX NOTES, Nov. 2,2015, at 607; Amy S. Elliot, Disguised Fee Waiver Regs Could Affect PTPs in 2 Ways, TAX NOTES, Oct. 26, 2015, at 473.

²² Prop. Treas. Reg. § 1.707-2(c).

²³ Senate Report, at 227 (emphasis added).

²⁴ Id.

²⁵ See supra note 9 and accompanying text.

²⁶ Sections 409A and 457A subject certain deferred compensation arrangements to interest and additional income tax but do not apply to partnership allocations.

²⁷ For example, application of Section 707(a)(2)(A) to a payment received by a partner in a foreign country could cause the income to have a foreign source and not be considered effectively connected with a U.S. trade or business ("ECI"), while an allocation of income could be treated as U.S. source ECI.

²⁸ See Senate Report, at 228-30.

²⁹ In Example 5, the general partner received both a 20% carried interest and an "additional interest." Although not entirely clear, it seems as though both types of interests were established upon the formation of the partnership, could be satisfied only from net income over the life of the fund and were subject to a clawback.

³⁰ 80 Fed. Reg. at 43,655.

³¹ For example, a partner may perform services relating to some assets and not others and have a greater interest in the relevant assets and a lower or no interest in the other assets. No reason is apparent for treating such a partner as automatically flunking the "significant entrepreneurial risk" test because the partner's risk differs from that of the partnership as a whole.

³² Senate Report, at 227, 229-30.

³³ Under Treas. Reg. § 1.61-6(a), gain realized on the sale or exchange of property is included in "gross income" under Section 61, but is clearly defined as the excess of amount realized over cost or other basis.

³⁴ See New York State Bar Association Tax Section, Report on Partnership Target Allocations (Sept. 23, 2010) for discussion about the growing use of "target allocations" as an alternative method for allocating a partnership's items of income and loss among its members. Furthermore, in 2004, the IRS proposed regulations concerning proper allocation of creditable foreign tax expenditures ("CFTEs") for partnerships. T.D. 9121, I.R.B. 2004-20. The proposed regulations provided a safe harbor under which partnership allocations of CFTEs would be deemed in accordance with the partners' interests in the partnership. One requirement to use the proposed safe harbor was that the partnership agreement had to provide for liquidating distributions in accordance with capital account balances. When the regulations were finalized in 2006, the safe harbor no longer required liquidation in accordance with capital accounts; the regulations merely required the allocations to be proportionate to the distributive shares of income to which the CFTEs related. T.D. 9292, I.R.B. 2006-47.

³⁵ We would also point out, as noted above, any concern about a sponsor using artificially high valuations for nontraded assets could be addressed by requiring use of the same valuations as are used in periodic reports to investors or to determine redemption prices and by imposing special scrutiny where subsequent sales occur shortly after the valuation at significantly lower prices.

³⁶ We are not aware of any investment funds that create additional interests in future profits based on such a present value calculation.

³⁷ We note that this example is consistent with Example 5, and may simply represent a further fleshing out of the facts of that example, but we believe the additional detail will provide helpful guidance to taxpayers.

³⁸ 80 Fed. Reg. at 43,656. An IRS official has stated publicly the statement in the Preamble is not technically a modification of Rev. Proc. 93-27 but is instead the government's interpretation of the revenue procedure.

³⁹ Id.

⁴⁰See, e.g., Diamond v. Comm'r, 492 F.2d 286 (7th Cir. 1974) ("[I]t is clear that a partner who receives only an interest in future profits of the partnership as compensation for services is not required to report the receipt of his partnership interest as taxable income. The rationale is twofold. In the first place, the present value of a right to participate in future profits is usually too conjectural to be subject to valuation . . ." (internal citation omitted)).

⁴¹ 80 Fed. Reg. at 43,656.

⁴²Cf. Philadelphia Park Amusement Co. v. U.S., 126 F.Supp. 184 (Ct. Cl. 1954).

⁴³ Perhaps one could argue a separate profits interest is issued for each investment, but the agreement to pay fees at the lower level is reached at inception when the actual fee amounts that will be payable in the future may not be easy to determine, and the only compensatory award of the profits interest also occurs at inception, all of which seems inconsistent with a determination that compensatory transfers are occurring as each investment is made.

⁴⁴ Campbell v. Comm'r, 943 F.2d 815 (8^th Cir. 1991).

⁴⁵ The New York State Bar Association Tax Section submitted an extensive report on proposed regulations and a proposed revenue procedure issued on May 20, 2005. The report enumerates and discusses some of the myriad complexities and uncertainties associated with compensatory transfers of partnership profits interests and other partnership interest. New York State Bar Association Tax Section, Report on the Proposed Regulations and Revenue Procedure Relating to Partnership Equity Transferred in Connection with the Performance of Services (Oct. 23, 2005).

⁴⁶ 80 Fed. Reg. at 43,654.

⁴⁷Id.