IRS Thinks Certain Profits Interests Are Too Good To Be True

In 2012, Mitt Romney’s company, Bain Capital, used a tax planning technique called management fee waivers to save on taxes. This technique allowed them to convert management fees into long-term capital gains, resulting in significant tax savings. The IRS has since proposed regulations to treat the grant of certain profits interests as disguised payments for services. There are two types of partnership interests: capital interests and profits interests. A capital interest gives the holder a share of the proceeds if the partnership’s assets are sold, while a profits interest only entitles the holder to future profits. In general, if you receive a share of the profits from a business in exchange for your work, it’s usually taxable. However, there are some specific rules that apply, and the IRS has issued guidance on this. For example, if you receive a share of the profits because you’re a partner in the business or will become one, it may not be taxed right away. This usually applies to private equity funds, which are investment funds that hold onto investments for a long time. The people who put money into the fund (the limited partners) usually get most of the profits, while the people who manage the fund (the general partners) get a smaller share. The general partner of a private equity fund doesn’t actually manage the fund. Instead, a private equity firm like Bain Capital handles all the investment and management work. The manager gets a fee for managing the fund, and the general partner gets a share of the profits. The manager can choose to waive some of its fee and give the general partner a priority share of the profits, which can be paid out even if the overall fund is losing money. The manager of the PE fund is trying to argue that a special interest they received should be treated as a profits interest, not a capital interest, for tax purposes. This would allow them to pay lower taxes on their earnings. However, new regulations are being proposed to prevent abuse of this loophole by partners who are really acting more like a business owner than a partner. The Treasury and the IRS have released new rules for how certain business arrangements are taxed. These rules might change how some people get paid for their work in a partnership. They are broad enough to affect anyone who gets a share of the profits from a partnership. The proposed regulations outline six factors to determine if an arrangement is a payment for services. The most important factor is whether the service provider takes on significant risk. Other factors include how long the service provider is a partner, when they receive payment, and their reasons for becoming a partner. These regulations only apply to new or changed arrangements, and may change the tax treatment of payments for services. The IRS’s position is that certain profits interests, like management fee waivers, are not legitimate. However, the final impact of these regulations is still uncertain. The new regulations proposed by the IRS might not actually apply to the typical management fee waiver because the manager providing the services is not a partner in the partnership. The proposed regulations also don’t give clear enough guidelines for taxpayers to follow when it comes to structuring their business affairs. For example, they don’t explain what period of time would create significant entrepreneurial risk for the recipient of a profits interest. The examples provided are not very helpful and create a lot of uncertainty for taxpayers. The IRS and taxpayers should make clear regulations for profits interests, with examples, to avoid recharacterizing them as payments for services. Taxpayers should be careful when setting up these arrangements to make sure they will actually get paid. This is a list of regulations and articles related to tax law. It includes proposed regulations and explanations of tax laws. It also mentions an attorney who specializes in federal taxation. The attorney’s column is submitted on behalf of the Tax Law Section.

Source: https://www.floridabar.org/the-florida-bar-journal/irs-thinks-certain-profits-interests-are-too-good-to-be-true/