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On April 4, 2016, Treasury and the Internal Revenue Service released proposed regulations under Section 385 that would treat as stock certain related-party interests that otherwise would be treated as debt for federal income tax purposes. The proposed regulations extend far beyond inversion transactions and apply to instruments issued by one corporation in an expanded affiliated group to another corporation in an expanded affiliated group. If finalized in their current form, these proposed regulations could affect routine financing transactions, including investments by foreign corporations in related U.S. corporations. However, the proposed regulations exempt transactions within a U.S. consolidated group. They also generally would not apply to a loan to a U.S. corporation from a foreign partnership that is not otherwise 80% owned by members of the same expanded affiliated group as the U.S. corporation.
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| The proposed regulations also contain extensive documentation requirements, which apply (i) if stock of any member of the expanded group is traded on (or subject to the rules of) an established financial market, (ii) on the date the instrument is issued or otherwise becomes an expanded group instrument, total assets exceed $100 million, or (iii) on the date the instrument is issued or otherwise becomes an expanded group instrument, annual revenue exceeds $50 million. It is not clear if the total asset or annual revenue tests apply to the expanded affiliated group as a whole or to the corporation making or receiving the purported loan. Failure to comply with these documentation requirements will result in any interest being treated as per se debt. |
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| The proposed regulations will undoubtedly be subject to extensive comments. |
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| The proposed regulations provide that the final regulations will be effective as of the date of issuance of the proposed regulations. |
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| On December 18, 2015, President Barack Obama signed the Protecting Americans from Tax Hikes Act of 2015 (the “PATH Act”). The PATH Act made permanent a variety of provisions of the Internal Revenue Code of 1986, as amended (the “Code”), relating to mergers and acquisitions. Such changes include, among other things, the exclusion of gain on qualified small business stock and the reduction in the recognition period for built-in gains tax for S corporations. The PATH Act also made significant changes with respect to real estate investment trusts (“REITs”) and the provisions incorporated in connection with the Foreign Investment in Real Property Tax Act of 1980 (“FIRPTA”). |
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The PATH Act made permanent the Code section 1202 qualified small business (“QSB”) stock gain exclusion for noncorporate investors for stock acquired any time after September 27, 2010 and held for more than five years. Prior to the effective date of the PATH Act, QSB stock acquired after 2014 would have received only a 50% gain exclusion upon a sale after five years. The PATH Act extends and makes permanent the full 100% tax exemption for QSB stock acquired at any time after September 27, 2010.
The exclusion is available to noncorporate taxpayers who hold eligible QSB stock for more than five years. In general, stock of a domestic “C corporation” (other than stock in certain entities subject to special tax treatment, such as REITs) may qualify as QSB stock if it meets the following requirements:
- the stock was acquired by the taxpayer at original issue (after August 10, 1993) for money, stock itself that was QSB stock, property other than stock, or as compensation for services;
- the stock is issued by a corporation whose aggregate gross assets at any time on or after August 10, 1993, through and immediately following the issuance do not exceed $50 million (taking into account the amounts received for the stock on its issuance);
- during substantially all of the taxpayer’s holding period at least 80% (by value) of the issuing corporation’s assets are used in the active conduct of one or more qualified trades or businesses, which generally includes any trade or business other than certain service businesses, and businesses engaged in financial, farming, public accommodation, and certain natural resource activities; and
- the issuing corporation has not made any specified disqualifying redemptions of its stock or violated certain other requirements.
The amount of gain eligible for exclusion is generally limited to the greater of (i) $10 million (reduced by the amount of gain eligible for exclusion in prior taxable years) or (ii) ten times the taxpayer’s tax basis in the QSB stock, but is subject to limits computed on a per-issuer basis. The remainder of the gain above the applicable threshold amounts is usually capital gain, taxable at a maximum rate of 28 percent. In addition, the PATH Act provides that, for dispositions of QSB stock that are eligible for the 100% capital gain exclusion, no portion of the excluded gain is treated as a preference item for purposes of the alternative minimum tax (“AMT”). |
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The PATH Act permanently reduced the period for which S corporations could be subject to the built-in gain tax under Code section 1374. Unlike C corporations, S corporations generally pay no corporate-level tax; instead, items of income and loss of an S corporation pass through to its shareholders. However, if an S corporation that was previously taxed as a C corporation has built-in gains attributable to the period during which it was a C corporation, it is subject to a corporate-level tax (generally at a rate of 35%) when it recognizes the built-in gains within a certain period of time following its conversion to an S corporation.
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| From 1986, when the built-in gains tax was first enacted, until 2009, the built-in gains tax applied to gains recognized during the first 10 years following an entity’s conversion to an S corporation. Since 2009, different pieces of tax legislation shortened the ten-year period. However, each one was temporary and was generally done retroactively, which limited the opportunities for practical tax planning. |
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| The PATH Act permanently changed the recognition period from ten years to five years. By making the change to the recognition period permanent, in contrast with the temporary changes that were made starting in 2009, the PATH Act will help reduce the uncertainty involved in tax planning for S corporations. |
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| The PATH Act made a number of changes that affect FIRPTA and REITs. Under FIRPTA, non-U.S. persons are generally subject to U.S. federal income tax with respect to gain from the disposition of certain United States real property interests (“USRPIs,” including stock in a domestic corporation for which the fair market value of its United States real property interests equals or exceeds 50% of the fair market value of its United States real property interests, its interests in real property located outside the United States, and any other of its assets which are used or held for use in a trade or business). If a non-U.S. person owns stock of a REIT, FIRPTA also generally applies to the investor’s receipt of certain distributions attributable to gain from the sales of U.S. real property interests by the REIT. To help enforce the collection of such taxes, FIRPTA imposes withholding taxes on the payer of such sale proceeds or distributions. |
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| Before the PATH Act, a foreign person owning 5% or less, actually or constructively, of a publicly traded REIT, was not subject to FIRPTA on the sale of the REIT stock or upon the receipt of a REIT capital gain dividend. The PATH Act increases the maximum ownership from 5% to 10% that a shareholder may hold in a publicly traded REIT without causing such stock to be subject to FIRPTA. |
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| Gain on the sale of the stock of a “domestically-controlled” REIT is not subject to FIRPTA. For this purpose, a REIT is a “domestically-controlled” REIT if less than 50% of its stock is held directly or indirectly by foreign persons at all times during an applicable testing period. The PATH Act provides greater certainty in determining whether a publicly traded REIT is domestically controlled by providing that a REIT shareholder that owns less than 5% of stock in a REIT that is regularly traded on an established securities market in the United States will be presumed to be a U.S. person unless the REIT has actual knowledge that such person is not a U.S. person. |
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| Before the PATH Act, foreign pension funds were subject to FIRPTA, but U.S. pension funds were generally exempt from U.S. federal income tax on capital gains. The PATH Act exempts certain qualified foreign pension funds from FIRPTA withholding; thus, qualified foreign pension funds will no longer be subject to FIRPTA on gain from the sale or disposition of USRPIs held directly, or indirectly through a partnership, or on capital gains distributions attributable to sales of USRPIS by the REIT. Importantly, this exemption from FIRPTA is not limited to foreign governmental pension plans but also applies more broadly to private pension plans, so long as they satisfy the requirements of being a “qualified foreign pension fund.” |
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| A “qualified foreign pension fund” includes a (i) non-U.S. created pension fund, (ii) that is established to provide retirement or pension benefits to current or former employees, (iii) does not have a single beneficiary with a right to more than 5% of its assets or income, (iv) is subject to government regulation and provides annual reports about its beneficiaries to the local government, and (v) with respect to which, under the laws of the country in which it is established or operates (A) contributions to such trust, corporation, organization, or arrangement which would otherwise be subject to tax under such laws are deductible or excluded from gross income of such entity or taxed at a reduced rate, or (B) taxation of any investment income of such trust, corporation, organization, or arrangement is deferred or such income is taxed at a reduced rate. |
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Foreign pension plans qualifying under the new exception will be able to invest in private U.S. REITs even if such REITs are not “domestically-controlled” REITs. Moreover, foreign pension plans that are investing in real estate funds via blocker corporations (to block taxable real estate gain) may want to consider restructuring; it should be noted, however, that the PATH Act does not alter the rules that can impose U.S. federal income tax on rent, interest, and other income.
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| Finally, the PATH Act increased the rate of withholding on dispositions of USRPIs from 10% to 15% for dispositions occurring on or after February 17, 2016. |
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On November 2, 2015, President Barack Obama signed into law the Bipartisan Budget Act of 2015 (the “Act”), which significantly modified how the IRS audits entities treated as partnerships for U.S. federal income tax purposes, including private equity funds, hedge funds, real estate, and other private investment vehicles.
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| The new partnership audit rules are effective for taxable years beginning after December 31, 2017, although partnerships may elect into the new rules earlier than the effective date. The new rules are intended to make it administratively less burdensome for the IRS to conduct partnership audits and collect resulting taxes, penalties, and interest attributable to any audit adjustments. It should be expected that the rate at which the IRS conducts audits of all partnerships, including private equity funds, will increase significantly under the new audit rules. |
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| Most partnerships are currently subject to audit rules adopted as part of the Tax Equity and Fiscal Responsibility Act of 1982 (“TEFRA”). Under these rules, the IRS conducts a single examination at the partnership level. If the IRS makes an audit adjustment, the partners during the tax year to which the adjustment relates are responsible for paying any tax due. Under the current audit rules, the IRS must flow the adjustment through to the ultimate partners. This can be complicated for partnerships with many partners and for partnerships in tiered structures where the IRS has to flow adjustments up through several levels before reaching the ultimate partners. |
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The new partnership audit rules will apply to all entities (including a flow-through limited liability company) treated as partnerships for U.S. federal income tax purposes, except for partnerships with 100 or fewer partners meeting certain requirements that affirmatively elect to opt out of the new audit rules. However, this “opt-out” election is expected to be unavailable for certain partnerships, including many private equity funds, because, in the absence of additional Treasury guidance, the “opt-out” election is not available for any partnership that has, as one of its partners, another partnership.
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| The new audit rules are intended to allow the IRS to more easily audit and assess taxes against large partnerships. To further this purpose, under the new partnership audit regime, the default rule provides that, if the IRS makes an adjustment at the partnership level, the IRS will assess and collect tax, penalties, and interest attributable to such audit adjustment at the partnership level. This is a significant departure from the existing TEFRA audit procedures, under which tax is assessed and collected from the partners who were partners of the partnership in the year to which the adjustment relates. |
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Note that, under the default rule, because the partnership is directly liable for its partners’ tax liabilities (including penalties and interest, if applicable) resulting from an audit adjustment, the persons who are partners during the tax year in which the audit is finalized will bear the economic burden of the tax liabilities of any former partners from the tax year to which the adjustment relates.
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| To avoid liability at the partnership level under the Act, a partnership can elect an alternative procedure where the partnership will issue adjusted IRS Schedules K-1 to each partner who was a partner during the tax year to which the adjustment relates. This alternative procedure under the Act is similar to the existing TEFRA audit procedures in that the partnership-level audit adjustments flow through to the partners who were partners during the tax year to which the adjustment relates. However, under the alternative procedures, the resulting tax underpayment is subject to a two percent higher rate of underpayment interest, which underpayment interest does not appear to be tax-deductible. |
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Although it will be several years before the IRS begins to conduct audits under the new partnership audit rules, existing partnership agreements, offering memorandums, subscription agreements, and side letters should be reviewed to determine whether any necessary or appropriate changes should be made to address the new audit rules. Specifically:
- Partnerships should decide whether they will elect to have the alternative procedure apply, and partnerships that meet the requirements for the “opt-out” election should decide whether such an election should be made.
- Offering memorandums should be updated to disclose the new partnership audit rules and resulting consequences, including that the partnership and its current partners may be liable for taxes that relate to prior years.
- Partnership operating agreements should be amended to designate a “partnership representative” that will act on behalf of the partnership for purposes of the new audit rules.
- Any partnership that has partners whose interests have changed over time, including private equity funds, venture capital funds, or other investment vehicles, should consider including in its partnership agreement general indemnity obligations whereby each partner and former partner agrees to indemnify the partnership for its appropriate share of any tax liabilities imposed on the partnership as a result of the default rule.
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| The new audit rules leave many issues unanswered. The IRS intends to issue significant guidance before the new partnership audit rules become effective. |
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| On May 3, 2016, the IRS released temporary and proposed regulations under section 7701 of the Internal Revenue Code of 1986, as amended (the “Code”), which address certain self-employment tax issues regarding partners in a partnership which is the sole owner of a disregarded entity. The regulations clarify that where the partners are working for the disregarded entity in such a circumstance, they may not be treated as employees of the disregarded entity. |
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| Although the general rule for disregarded entities is that they are disregarded as separate entities from their owners, there is an exception to this rule in Treasury Regulations section 301.7701-2(c)(2)(iv)(B) which provides that, for employment tax purposes, disregarded entities are treated as a corporation. There is a carveout from this exception, however, which provides that, in the self-employment context, the general rule (that a disregarded entity will be disregarded) is applied instead. The regulations providing this carveout include an example illustrating that an individual owning a disregarded entity is not considered an employee of that entity for employment tax purposes. The regulations did not, however, include an example in which a partnership owns a disregarded entity. |
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| It is the IRS’s view that the lack of a specific example addressing partnerships has caused confusion and led some taxpayers to take the position that a partner in a partnership which owns a disregarded entity can be considered an employee of that disregarded entity. Because the characterization as an “employee” grants access to various employee benefit plans which are unavailable to self-employed individuals, this has been an attractive position for some taxpayers. The IRS disagrees with this position, and the temporary and proposed regulations make clear that disregarded entities remain disregarded in the self-employment context even when owned by a partnership. |
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| In the preamble to the regulations, the IRS reiterates its support of Rev. Rul. 69-184, which stands for the general proposition that a bona-fide partner in a partnership cannot be an employee of that same partnership (but will, instead, be treated as self-employed to the extent performing services for the partnership outside of his/her capacity as partner). The IRS notes, however, that these regulations do not address the applicability of Rev. Rul. 69-184 in the tiered-partnership context. Instead, the IRS requests comments on this issue as well as circumstances in which it might be appropriate to permit partners to also be employees of the partnership (e.g., when employees receive small incentive grants of ownership interests). |
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| Because the IRS views these regulations as a clarification, rather than as a new rule, it is unclear whether taxpayers who have taken a contrary position on past returns will be at risk for adjustment. The fact that the IRS has endeavored to “allow adequate time for partnerships to make necessary payroll and benefit plan adjustments” before the regulations become applicable, however, may suggest that these regulations are meant to be forward-looking. The regulations will generally begin to apply on August 1, 2016, though their applicability may be delayed to the first day of the latest-starting plan year following May 4, 2016, of an “affected plan”. |
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| In July 2015, the Treasury and the Internal Revenue Service issued proposed regulations that address whether arrangements in which the private equity fund managers receive an interest in the managed partnership’s future profits in exchange for waiving part or all of their management fees (generally a fixed payment for services provided to the partnership) constitute disguised compensation. The proposed regulations attempt to determine whether such arrangements should be characterized as a disguised fee, which would be taxable as ordinary income to the manager, or whether such arrangements should be respected as a legitimate allocation of the partnership’s profits, which would generally be taxable as capital gains to the manager. Under the proposed regulations, any arrangement that is determined to be disguised compensation will be treated as disguised compensation for all tax purposes, meaning it will be taxed as compensation for purposes of all sections of the Internal Revenue Code of 1986, as amended (the “Code”), including section 707. If finalized in their current form, the proposed regulations could adversely affect some fee waiver practices that private equity funds currently utilize. |
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| Management fee waivers can take many forms, but generally involve a decrease in the fee paid to the manager for managing the partnership (often because the manager has waived the fee) in return for the receipt of a profit interest in the partnership. The specific details of the fee waiver mechanism often vary from partnership to partnership, such as when the manager is allowed to waive its fee, the timing of the profit allocations to the manager, and the type of allocation involved. In some instances, a waiver is not required by the manager; rather, the manager’s fees and profit interests are determined using a formula agreed to at the inception of the partnership. |
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The proposed regulations provide that several factors should be used in determining whether a fee waiver arrangement is treated as a disguised compensation arrangement, though ultimately it is a facts and circumstances determination and the factors are a non-exhaustive list. However, the most significant factor in determining the treatment is whether the arrangement has “significant entrepreneurial risk”. Under the proposed regulations, if an arrangement lacks significant entrepreneurial risk, it is automatically reclassified as disguised compensation and thus subject to ordinary income rates, regardless of the application of the remaining factors to the arrangement. Significant entrepreneurial risk is presumed not to be present when one or more of the following are true:
- sufficient net profits are highly likely to be available to make the allocation to the manager;
- there is a cap on the additional partnership income allocated to the manager as partner (if the cap is reasonably expected to apply in most years);
- the allocation applies to a fixed number of years under which the amount of the manager’s distributive share of income can be determined with reasonable certainty;
- the allocation consists of gross (rather than net) income; and
- the waiver is not binding on the manager, or the manager fails to timely notify the partnership of the waiver and its terms.
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| The preamble to the propped regulations describes additional factors that may be used to determine whether sufficient net profits are highly likely to be available to make the allocation to the manager: |
The value of partnership assets is not easily ascertainable and the partnership agreement allows the manager or a related party to control the determination of asset values (or events that impact such values); and the manager or a related party controls the entities in which the partnership invests. The significant entrepreneurial risk factors discussed above attempt to determine whether the manager can expect to receive the allocation of partnership income, and the presence of any of the factors can only be rebutted through the presentation of clear and convincing evidence. For example, if the profit interest is “highly likely” to yield the amount of the waived fee to the manager, the manager is not taking sufficient economic risk for the arrangement to be respected. The proposed regulations provide additional factors of secondary importance to consider in determining whether or not an arrangement is a disguised payment for services:
- the arrangement provides for different allocations for different services provided;
- the differing allocations are subject to different levels of entrepreneurial risk;
- the manager holds, or is expected to hold, the partnership interest for a short period of time, or holds a transitory partnership interest;
- the manager receives an allocation in a time frame that is similar to the time frame that the manager would receive payment for services if the manager were a third party (and not a partner);
- the primary purpose of the manager becoming a partner in the partnership was to obtain tax benefits unavailable to the manager if the services were rendered and the manager was a third party; and
- the manager’s allocation is significantly larger than the manager’s interest in the partnership’s continuing profits.
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The proposed regulations provide several examples illustrating the difference between an arrangement that is respected as the right to receive future allocations of partnership income and distributions and an arrangement that is treated as a disguised payment for services. In so doing, those examples illustrate the importance of the following factors:
- the timing of a management fee waiver;
- the existence and scope of a clawback obligation;
- whether allocations of net profits to the manager are reasonably determinable or highly likely to be available based on all facts and circumstances that are available at the time of the waiver;
- whether the manager can control the timing of the realization of gains and losses by the partnership.
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| In addition, the preamble to the proposed regulations indicates the intention to possibly preclude additional, or possibly all, partnership interest distributions in lieu of waived fees from qualifying for the safe harbor under Revenue Procedure 93-27. Revenue Procedure 93-27 provides that, in some circumstances, if an individual receives an interest in a partnership in exchange for providing services to that partnership in anticipation of becoming a partner, that receipt of that interest will not be a taxable event for either the partnership or the partner. |
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| The proposed regulations provide that traditional “catch-up allocations” typically will not lack significant entrepreneurial risk, and thus typically will not be classified as disguised compensation. However, all of the facts and circumstances need to be taken into account when the determination is made. |
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| The final regulations will apply to fee waiver arrangements entered into or modified on or after the date the final regulations are finalized. It appears that for fee waivers that occur periodically, the regulations will apply to any waiver that occurs after the effective date of the final regulations. The preamble to the proposed regulations indicates that the IRS may seek to apply the principles embodied in the proposed regulations to fee waiver arrangements entered into before the regulations are finalized on the theory the proposed regulations reflect Congressional intent. |
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Pending further guidance from the IRS regarding management fee waivers, we recommend our private equity clients do the following:
- Review current fee waiver arrangements to determine the best administrative practices for such arrangements given the factors identified in the proposed regulations.
- Consider whether fee waiver arrangements should be utilized moving forward, and, if so, what structural changes should be contemplated in light of the factors outlined in the proposed regulations.
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