2015 has been a busy period for partnership taxation. The Treasury issued proposed regulations under the long reserved IRC Section 1.707-2, and Congress passed a new law governing how large partnership audits will be performed. Taxand USA highlights how the two changes when considered together may make life more difficult for many investment funds.
The recent partnership regulation developments have broad implications for the structure of partnership interests, especially in the context of hedge fund and private equity partnerships. On 23 July 2015, the IRS issued proposed regulations under IRC Section 707(a)(2)(A) that have the potential to substantially alter the issuance of partnership interests for services provided. If finalised in their current form, these proposed regulations will raise serious questions as to the appropriate tax treatment of certain partnership arrangements, including, in particular, valid structures of partnership profits interests and other structures commonly used in the hedge fund and private equity industries.
While the industry was working during the second half of 2015 to get its arms around the impact of these new proposed regulations and the broader trend toward less taxpayer-favorable Treasury guidance, Congress created a new approach to audit procedures for partnerships when it passed the Bipartisan Budget Act of 2015. This Act created an entirely new audit structure under which partnerships and their partners are audited at the partnership level.
The proposed regulations would create significant uncertainty for certain hedge fund and private equity partnerships, for perhaps somewhat different reasons, in determining proper tax treatment of partnership income allocations. Drafted with the intent to limit management fee waiver arrangements by private equity general partners, the proposed regulations create significant uncertainty as to whether many common arrangements will continue to be respected as partnership interests or whether they will be characterised as compensation.