IRS Cracking Down on Fee Waivers in Real Estate Transactions
By: Bruce J. Belman, JD, CPA, a partner with Crowe Horwath LLP and the firm’s tax services leader on partnership taxation, and Steven R. Driver, Jr., CPA, MT, a member of the firm’s construction and real estate services group
Partnership payment agreements must focus on entrepreneurial risk to comply with proposed IRS regulations.
THE U.S. TREASURY Department has proposed new regulations that would make it more difficult for real estate developers to waive management fees that are taxed as ordinary income and to receive profits interests that are taxed at lower capital gains rates. The proposed regulations under Internal Revenue Code Section 707(a)(2)(A), which would go into effect in 2017, still would allow developers to waive management fees, but participants would have to demonstrate that their profits interests are subject to “entrepreneurial risks.”
Historically, in many private syndications developers received a profits interest in lieu of taking all or part of their developer’s fee. This interest participated in the venture’s profits, and investors received their investment back plus a return, providing them with the promised internal rate of return. Under the proposed regulations, these arrangements will still stand.
However, developers often manage projects through related entities. For these services, developers are entitled to a management fee. The proposed regulations focus on situations where developers waive their management fees for profits interests.
The IRS decided to tighten up the regulations affecting fee waivers because a number of developers that didn’t have any entrepreneurial risk were taking significant special cash distributions and were converting ordinary income into capital gains. In other words, these developers were paid at a preferred rate, whether the deal was successful or not, and had nothing at risk in the deal. The IRS calls such allocations “disguised payments.”
The fee waiver is simply an agreement to pay a developer for services provided on the project with an equity interest. The timing of the fee waiver by the developer is critical: The fee must be waived before it is earned. The interest received must be subject to the entrepreneurial risks of the project.
Facts and Circumstances Test
The proposed regulations apply a facts and circumstances test to determine whether a management fee waiver arrangement will be viewed as a disguised payment for services. The proposed regulations describe six factors that are relevant in this determination. The absence — or presence — of significant entrepreneurial risk (SER) is the most important factor.
An arrangement that lacks SER constitutes a disguised payment for services, irrespective of the presence of any other mitigating factor. Conversely, an arrangement that has SER generally will be recognized as a partnership interest as intended by the developer. Whether an arrangement lacks SER is based on the developer’s entrepreneurial risk relative to the overall entrepreneurial risk of the partnership.
Another five factors found in the proposed regulations lay out the facts and circumstances presuming that an arrangement lacks SER, according to Internal Revenue Bulletin: 2015-32, Aug. 10, 2015, REG–115452–14, “Disguised Payments for Services”:
1) Capped allocations of partnership income if the cap would reasonably be expected to apply in most years.
2) Allocations for a fixed number of years under which the service provider’s distributive share of income is reasonably certain.
3) Allocations of gross income items.
4) An allocation (under a formula or otherwise) that is predominantly fixed in amount, is reasonably determinable under all the facts and circumstances or is designed to assure that sufficient net profits are highly likely to be available to make the allocation to the service provider — for example, if the partnership agreement provides for an allocation of net profits from specific transactions or accounting periods and this allocation does not depend on the overall success of the enterprise.
5) Arrangements in which a service provider either waives its right to receive payment for the future performance of services in a manner that is nonbinding or fails to notify the partnership and its partners of the waiver and its terms in a timely manner.
Suspect arrangements include:
- Arrangements without clawback, which allows the recovery of money already disbursed to a service provider if the deal’s expected returns do not materialize.
- Providers of management services transferring potential rights to waived fee arrangements.
- Allocations of gross income.
How the Proposed Regulations Work
The proposed regulations conclude that, in this example, the arrangement with respect to the developer is a disguised payment for services. According to the proposed regulations, the arrangement lacks SER because the facts indicate that the allocation to the developer is reasonably determinable under all the facts and circumstances, and that sufficient net profits are highly likely to be available to make the priority allocation to the service provider.
The relevant facts to this determination are that the priority allocation to the developer is an allocation of net profit from a 12-month period and does not depend on the overall success of the enterprise. Moreover, the developer controls the timing of gains and losses.
The important point here is that the allocations do not depend on the long-term future success of the deal, and the developer was the party that controlled the timing of the purchases, sales and distributions. Thus, there was no SER.
The proposed regulations are not effective until finalized, so developers have time to plan their strategies accordingly. However, the preamble to the regulations and the regulations themselves state that the IRS and Department of Treasury view these regulations as reflecting current law under the legislative history of Section 707(a)(2)(A). It is important to make sure that any profits interests from deals reflect SER.