The Entrepreneur
IRS Cracking Down on Fee Waivers in Real Estate Transactions
Partnership payment agreements must focus on entrepreneurial
risk to comply with proposed IRS regulations.
By Bruce Belman and Steven Driver, Crowe Horwath LLP
T
HE 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.”
Background
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
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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.
Bruce Belman
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”:
Steven Driver, Jr.
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
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
Consider this example: A developer
performs management services for
which it would normally charge a
fee to partnership ABC. The fee is
equal to 2 percent of gross rents. In
lieu of the fee, the developer takes
an interest in ABC. This interest
entitles the developer to receive a
priority allocation and distribution of
net gain from the sale of any assets
during any 12-month accounting
period. The management company
controls ABC and is also the general
partner of ABC. The developer will
also be allocated 10 percent of the
net profits and losses ABC earns over
the lifetime of the partnership. The
partnership interest received in lieu of
the development fee is not subject to
a clawback obligation.
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
ROOFLIFTERS
controlled the timing of the purchases, sales and distributions.
Thus, there was no SER.
www.naiop.org
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.
Looking Ahead
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. n
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
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