2016 year-end tax letter: Regulatory guidance

In the recent past, the Department of Treasury issued proposed regulations that, when finalized, will significantly affect multiple areas of taxation and planning. These regulations include liability allocations for partnerships, management fee arrangements, debt-to-equity rules and valuation discounts for gifting purposes. The Treasury indicated final regulations in all these areas will be issued “soon.” Expectations are that many, if not all, of these regulations will be finalized before the current administration leaves office. With this in mind, we’ve summarized the regulations as they stand and the potential impacts if adopted as proposed.

Debt-equity regulations

The debt equity regulations were recently finalized. In general, these regulations give the IRS authority to recharacterize certain intercompany debt instruments as stock (most likely, preferred equity). For more details on these regulations, see our recent Tax Alert as well as the International taxation section of this letter.

Management fee waivers

The IRS issued proposed regulations that would provide guidance to partnerships and partners regarding when an arrangement will be treated as a disguised payment for services under Internal Revenue Code (IRC) section 707(a)(2)(A). Notably, the proposed regulations would establish a test (based on legislative history) under which payments made pursuant to an arrangement that lacks “significant entrepreneurial risk” are treated as disguised payments for services. In short, the proposed regulations would restrict the ability to use “fee waivers” to convert ordinary income into capital gains. Further, the proposed regulations could cause the receipt of a profits interest to be taxable upon receipt even if no payment or distribution is received.

These regulations are critical developments that could significantly affect real estate and private equity partnership structures. In addition, the IRS indicated treatment of a profits interest issuance may narrow.

Under the proposed regulations, six factors are used to determine whether a transaction is properly characterized as a fee for services. All factors are not considered equal. The primary factor is whether the payment is subject to entrepreneurial risk. The underlying concept is that partners extract the profits of the partnership based on the success of the venture, while third parties generally receive payments that are not subject to this risk.

The other five factors which serve as additional indicators of risk are:

  1. a cap that could be expected to be exceeded;
  2. an allocation when the service provider’s share of income is reasonably determinable;
  3. an allocation of gross income;
  4. an allocation designed to ensure sufficient profits; and
  5. a nonbinding, untimely waiver.

These regulations are critical developments that could significantly affect real estate and private equity partnership structures. In addition, the preamble indicates when the regulations are finalized, the IRS intends to narrow the scope of Revenue Procedure 93-27 regarding the issuance of profits interests.

While they are expected to be issued in the coming weeks, the finalized regulations will likely have some changes from the proposed regulations.

Action steps

  • Fund managers should review any potential or existing management fee waiver arrangements in light of the proposed regulations. The examples in the proposed regulations strongly suggest the management fee waiver arrangement should be economically at risk — and supported by an enforceable return obligation (i.e., a claw back) — to the extent amounts received by reason of the fee waiver exceeds the cumulative net profits over the life of the fund. Accordingly, fund managers should consider structuring their arrangements to conform to these guidelines.
  • Monitor legislative developments. Both President Obama (in the fiscal year 2016 budget) and the presidential candidates are proposing to tax carried interests as ordinary income rather than capital gains.
  • Watch for issuance of final regulations. The Treasury indicated it may make modifications from these proposed regulations based on comments it received.

Fee waiver background

Management fee waivers are intended to defer fee income and convert it to capital gain. In a typical scenario, a fund manager contractually waives the right to a fixed fee for managing the fund’s investments in exchange for a separate substitute profits interest in the fund with a special distribution on that interest. Rather than receiving the fixed fee — which is taxable immediately at ordinary rates — the manager is allocated a distributive share of capital gain when the fund sells investments.

In the extreme cases, managers waived their fees when they were already due and gave themselves broad discretion to define profits in such a way that they could receive an allocation and a distribution even when the fund was not profitable overall.

Proposed regulations

The proposed regulations are designed to compel managers to waive their right to fees long before they are earned, in exchange for profits interests that cannot be readily valued and without the power to define profits to their own advantage. The regulations provide a three-prong test, which the preamble stresses is “consistent with the language of section 707(a)(2)(A),” to identify when an arrangement is characterized as a disguised payment to a nonpartner for services.

Reg. 1.707-2(b) states that (1) if a partner, or partner-to-be, or his delegate, performs services for the partnership; and (2) that service provider receives a related, even indirect, allocation or distribution from the partnership; and (3) the arrangement (prong 1 and prong 2 viewed together) is “properly characterized as a transaction occurring between the partnership and a person acting other than in that person’s capacity as a partner,” then the allocation or distribution will be treated as a disguised payment for services. In other words, the “fee waiver” will be taxable immediately as ordinary income.

Effective date

The proposed regulations are effective the date they are published as final and apply to any arrangement entered into or modified on or after that date. However, in the case of any arrangement entered into or modified before that date, the determination of whether an arrangement is a disguised payment for services under section 707(a)(2)(A) is made on the basis of the statute and its legislative history. Since the IRS is stating these regulations are based on legislative history, this statement could be interpreted to mean the IRS believes it can apply the regulations retroactively.

Liability allocation regulations

In early October, the IRS released long-awaited guidance on liability allocations under IRC section 752 and disguised sales under IRC section 707. These regulations represent some of the most significant changes to partnership taxation in years and will have a major impact on partnership formation and restructuring transactions.

The new section 752 regulations severely curtail taxpayers’ ability to use “bottom-dollar guarantees.” Under the new rules, which are effective immediately, taxpayers must be “on the hook” for the first dollar of the debt in order to receive basis credit for a payment obligation. The changes to the section 707 regulations will limit the effectiveness of the debt-financed distribution exception to the disguised sale rules. This exception is often used to defer income on so-called leveraged partnership transactions. These rules will be effective in early 2017.

For further information on these developments, please see our recent Tax Alert.

Valuation discount regulations

The proposed regulations on valuation discounts, if finalized, will reduce their availability when transferring interests in family-controlled entities between family members. Valuation discounts are frequently used to lessen the value of interests in closely held entities for estate, gift and generation-skipping transfer tax purposes. See the Estate and gift planning section of this letter for a more detailed discussion of these discounts and the impact of the new regulations.

Final regulations provide guidance on definition of real property for REITs

The IRS issued final regulations at the end of August that clarify the definition of “real property” for purposes of real estate investment trusts (REITs). The final regulations apply to tax years that begin on or after Aug. 31, 2016; however, taxpayers may rely on the final regulations before the effective date.

To maintain its tax status, a REIT must pass a number of annual income tests and quarterly asset tests. Under the 75 percent asset test, at the end of each quarter, at least 75 percent of the value of a REIT’s assets must consist of real estate assets, cash and cash items, and government securities. The tax rules define “real estate assets” as real property (i.e., land or improvements thereon) and interests in real property.

Over the years, the IRS issued revenue rulings as well as many private letter rulings (PLRs) on what types of assets constitute real property for the REIT asset test. Since REITs are continually investing in new kinds of assets and PLRs only apply to the specific taxpayer that received the ruling, the IRS and Treasury recognized the need for updated guidance. The final regulations consolidate and clarify previously published guidance.

Caution – The preamble notes that if a previously issued PLR is inconsistent with the final regulations, the PLR is revoked prospectively from the effective date of the final regulations. At this time, it is unknown if any existing PLRs will be rendered obsolete by the final regulations.

Final regulations

Under the final regulations, the term “real property” includes land and improvements to land. Improvements to land include buildings and other inherently permanent structures and their structural components. To the extent an intangible asset derives its value for real property, the intangible asset may also qualify as real property.

Land. Land includes water and air space over/above the land as well as natural products (e.g., crops) and natural deposits (e.g., minerals, ores).

Buildings. Under the safe harbor in the final regulations, buildings include houses, apartments, hotels, motels, enclosed stadiums and arenas, enclosed shopping malls, factory and office buildings, warehouses, barns, enclosed garages, and enclosed transportation stations and terminals.

Other inherently permanent structures. The final regulations provide a safe harbor for structures that are permanently affixed to land or another structure. Distinct assets covered by the safe harbor include: microwave, cell, broadcast and electrical transmission towers; telephone poles; parking facilities; bridges; tunnels; roadbeds; railroad tracks; transmission lines; pipelines; fences; in-ground swimming pools; offshore drilling platforms; storage structures such as silos and oil and gas storage tanks; stationary wharves and docks; and outdoor advertising displays. For structures not listed in the safe harbor, the regulations allow for a facts-and-circumstances determination of whether an asset is an inherently permanent structure for purposes of the REIT rules.

Structural components. The safe harbor for structural components includes all the components and systems that are typically part of a building: walls, floors, ceilings, wiring, plumbing, HVAC, elevators, escalators, fire suppression, security, etc. There is also a facts-and-circumstances test for structural components not listed in the safe harbor. In addition, the regulations note that if a building component or system is customized in connection with the rental of space, the customization does not affect whether the asset is a structural component.

  • For example, a REIT owns a data center that it leases to a tenant under a long-term contract. In order to accommodate the servers, certain building components and systems (central heating and air, telecom infrastructure, security, fire suppression, humidity control, electrical backup system) have been customized and upgraded to provide a higher level of functionality than a standard office building. The customization of the various systems does not affect their status as structural components of the building — they qualify under the safe harbor or the facts-and-circumstances test.

Intangibles. An intangible asset is real property or an interest in real property if it derives its value from real property or an interest in real property, is inseparable from that real property or interest in real property, and does not produce or contribute to the production of income other than consideration for the use or occupancy of space.

  • For example, a REIT acquires an office building subject to a long-term lease with a single tenant, under which the tenant pays above-market rents. The portion of the value of the above-market lease asset that is attributable to rents from real property (70 percent in the example) derives its value from real property, is inseparable from that real property, does not produce or contribute to the production of income other than consideration for the use or occupancy of space. Therefore, this intangible asset is an interest in real property and a real estate asset for purposes of the REIT rules.

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The information provided here is of a general nature and is not intended to address the specific circumstances of any individual or entity. In specific circumstances, the services of a professional should be sought. Tax information, if any, contained in this communication was not intended or written to be used by any person for the purpose of avoiding penalties, nor should such information be construed as an opinion upon which any person may rely.  The intended recipients of this communication and any attachments are not subject to any limitation on the disclosure of the tax treatment or tax structure of any transaction or matter that is the subject of this communication and any attachments.