Finance that Matters Fall 2015
Management Fee Waivers: IRS Proposed Regulations
By Anthony Tuths, JD, LLM, Partner
The IRS has stated on numerous occasions that it felt the practice was, at times, being abused and guidance was being developed. On July 22, 2015, the IRS and Treasury Department released proposed regulations under Section 707 of the Internal Revenue Code that are intended to provide guidance on when a compensation arrangement between a partnership and a partner will be treated as a disguised payment for services to a partner not acting in a partner capacity. The proposal is not limited to private equity funds but would reach any partnership arrangement including hedge funds and real estate funds. As a general matter, the proposed regulations do not target standard incentive allocations or carried interest provisions common to asset management funds. Rather, the proposal is aimed squarely at management fee waivers.
Treatment as a disguised payment for services would cause the payment to be treated as compensation for all purposes of the Code which would have the effect of subjecting the partner to tax at ordinary income rates, potentially subject such payments to compliance with the deferred compensation regimes of Sections 409A and 457A of the Code, and cause such payments to be subject to the applicable capitalization and deduction rules. This differs greatly from the treatment accorded to a “profits interest” which typically permits tax deferral and conversion from ordinary income to long-term capital gains in many instances.
The proposed regulations take a “facts and circumstances” approach to determining which fee waivers should be recharacterized as disguised compensation. The most important factor is “significant entrepreneurial risk.” That is, the waiver will not be respected as a partnership allocation unless the service provider partner bears real risk that the partnership will have income to satisfy the related allocation to the partner. Several facts the IRS will take into account in determining if significant entrepreneurial risk exists include, (i) the existence and scope of a “clawback” provision; (ii) whether or not the service provider (or related party) can control the timing of asset dispositions of the fund; (iii) how profits are determined for purposes of the partnership allocations and distributions to the service provider (e.g., on a gross or net basis); and (iv) the timing of the waiver, whether the waiver is legally binding and whether the partnership and its partners are notified of the waiver in a timely manner.
Additionally, the preamble to the proposed regulations make clear that the IRS believes that Revenue Procedure 93-27 (the legal authority for the tax-free transfer of a profits interest in a partnership), was never applicable to the fact pattern where a service provider partnership (e.g., management company) waives management fees in exchange for a related partnership (e.g., general partner) receiving a priority partnership allocation. Thus, for New York City based funds that are routinely formed with a separate GP and management company, the management fee waiver in exchange for the GP receiving an additional allocation will not be respected. In fact, the IRS may challenge past waivers of this sort. Funds of this variety should amend their documents immediately to come within compliance.
In addition, the proposed regulations modify an example in existing Treasury Regulations related to guaranteed payments that many taxpayers have relied on in order to attain favorable character benefits. The modification recharacterizes a portion of an allocation to a partner as a guaranteed payment in circumstances where a partner is allocated a percentage of partnership profits subject to a guaranteed floor, regardless of whether such allocation actually exceeds the floor in a given period.
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Anthony Tuths, JD, LLM, Partner 212-751-9100 [email protected] View Experience
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SEC Announces New ReTIRE Initiative
[author-style]By Jessica Cicero, CPA[/author-style]
In June 2015, the Securities and Exchange Commission (SEC) announced the launching of a new initiative, the Retirement-Targeted Industry Review and Examinations (ReTIRE) Initiative. Recently, the SEC has placed more emphasis on protecting individuals’ retirement savings as more individuals become dependent on their own investment accounts for income post-retirement. In that regard, this initiative will focus on Registered Investment Advisors and Broker-Dealers who provide clients with retirement planning advice. SEC staff will use information from previous examinations, data analytics and due diligence driven by their examiners to determine which registrants to review under this initiative.
Examiners will place focus on four high-risk areas of a representative’s operations. The first is the basis a representative has for providing a recommendation for both initial investments and those made on an on-going basis to ensure they are recommending appropriate investments for each investor. Secondly, they will scrutinize the identification of conflicts of interest among representatives and service providers. There is inherent risk in this area as the personal relationships and compensation structure between service providers and registrants could cause a representative not to act in a client’s best interest if they are not diligent in identifying certain conflicts. Third, SEC staff will review controls around compliance and supervision of those acting on behalf of a registrant to be certain they are complying with enacted laws and regulations. Lastly, examiners will scrutinize disclosures in marketing materials that could be misleading to investors.
The SEC believes the ReTIRE initiative will encourage registrants to improve upon their oversight of representatives as well as reflect on their supervisory and compliance programs in order to provide the individual investor with appropriate investment advice. The SEC has not announced when the examinations will begin.
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Jessica Cicero, CPA 212-751-9100 [email protected]
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Considering a Contribution of Assets to an Investment Company? Here’s What You Need to Know
[author-style]By Robert Traester, MST[/author-style]
Transferring assets to a company or partnership that constitutes an “investment company” for tax purposes creates a unique set of complications. In certain situations you may have to recognize gain under Internal Revenue Code Section 351(e) or 721(b) when contributing appreciated assets to an investment company in exchange for an equity interest.
What is an Investment Company?
An investment company is defined under IRC Section 351(e)(1) as a company holding at least 80% of its assets in stocks, securities, cash, notes, options, foreign currency, certain financial instruments, interests in REITs, and ownership in entities holding such assets. Section 721(b) extends the same asset test to partnerships. Assets such as real estate and certain mineral interests are not included in the numerator towards reaching the 80% asset threshold. This is important to understand as gain on appreciated assets is only recognized when these assets are contributed to an investment company in exchange for equity. Contributing assets to a company that does not fit the “investment company” definition will likely not trigger a gain to be recognized as a result of IRC Sections 721(a) and 351.
I’ve Contributed to an Investment Company, Now What?
The next step is to determine if your contribution has resulted in a diversification of your investments. Internal Revenue Code Section 721(b) was created to disallow taxpayers from creating a tax-free diversification of an investment portfolio. Put simply, if you’re putting a share of Apple into a company and receiving an interest in a portfolio as diverse as the S&P 500 you should consider it a deemed sale. Please also note that only gains are recognized. If you’re considering contributing assets that are at a loss you would be better served to sell the assets, immediately recognize the loss, and contribute the cash proceeds.
How Do I Know if my Contribution Creates a Diversified Investment?
The idea of diversification is defined under IRC Section 368(a)(2)(F)(ii) which states that a taxpayer is diversified, “if not more than 25 percent of the value of its total assets is invested in the stock and securities of any one issuer, and not more than 50 percent of the value of its total assets is invested in the stock and securities of 5 or fewer issuers” . This includes a look-through rule for investments in mutual funds or other pass-through entities. Furthermore, under Section 368(a)(2)(F)(iv) government securities are included in the total assets for purposes of the denominator 25%/50% computation but are excluded from the numerator. If you’re contributing an already diversified portfolio as defined under IRC Section 368(a)(2)(F)(ii) then you will not have to recognize gain upon the contribution.
What if my Contribution is Not Diversified?
Treasury Reg. 1.351-1(c)(5) provides an exception to gain recognition for situations in which certain nonidentical assets are insignificant to other assets transferred. A more clear depiction of this concept can be found under Example 1 of Treasury Reg 1.351-1(c)(7). The example shows a situation in which three investors are contributing to a corporation with 101 shares of common stock. Investors A and B each contribute $10,000 worth of one marketable security in exchange for 50 shares each. Investor C then contributes $200 worth of a different marketable security in exchange for 1 share of common stock. Under this example the $200 worth of marketable securities contributed by Investor C is insignificant, does not create diversification, and therefore will not cause gain recognition for the investors.
How Does Cash Create a Diversified Portfolio?
When investors are contributing a mixture of cash and securities to an investment company additional examination will have to be done. For example, if investors A and B each contribute to a partnership, with A contributing $10,000 worth of one security and B contributing $10,000 worth of cash it would appear that the investors have not obtained a diversified portfolio at the time of the contribution. However, if investor B’s contributed cash is part of a plan to purchase assets and create a diversified portfolio, then this later action would be viewed as creating a diversified portfolio under General Counsel Memorandum 39253. As a result investor A would recognize any gain embedded in its contributed security.
As it quickly becomes evident, the pitfalls of IRC Sections 351(e) and 721(b) create some unique circumstances that can complicate tax planning when forming an investment company. In summary, gain recognition occurs if contributions are made to an investment company in exchange for equity and the contributions create a diversified portfolio for the investor. Nevertheless, proper tax planning can allow you to avoid recognition of gain at the time of contribution.
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Robert Traester, MST 212-751-9100 [email protected]
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How Cyber Resilient Are You?
[author-style]By Joseph Fede, CPA[/author-style]
Cybersecurity is the new hot topic in the financial services industry, especially in the wake of several high profile cyber-attacks that have taken place in the United States. These cyber-attacks have ranged from large corporations such as Home Depot and Sony, to the Federal Government. These cyber-attacks are becoming more frequent and more sophisticated. As business and technology become more integrated nearly every transaction in today’s economy is conducted in whole or in part online.
Financial institutions are in a unique position of vulnerability. Not only do they maintain financial information valuable to hackers, but they play a critical role in national and global markets and any data breach could result in severe consequences. Financial firms have used third party service providers to mitigate the risk of cyber-attacks, however recent attacks have proven this method ineffective. With firms relying solely on third parties, any breach in service can cause major issues. As a result, an effective approach to cybersecurity concerns is particularly important and firms are beginning to take a proactive internal approach.
Major financial services organizations such as the Financial Industry Regulatory Authority (FINRA), the Investment Advisory Association (IAA) and the ACA Compliance Group (ACA), have led the way in the fight against cyber-attacks providing research, tips and suggested practices to increase awareness and help firms become less vulnerable. FINRA has recently conducted an assessment of various firms to understand their approach to managing cyber threats. Overall, the purpose was to identify common issues and provide feedback on best practices. Below is a list of some recommendations based upon the assessment.
- Perform cybersecurity risk assessment and include active senior management and board members.
- Assess internal and external threats and areas of vulnerability.
- Increase IT controls which involve data encryption and access management.
- Have a response preparation protocol in place in case of a successful attack.
- Perform thorough due diligence on third party service providers.
- Keep staff informed, well trained in the cyber security area and up to date on recent attacks.
Recently, a survey of 474 financial institutions and advisory firms conducted by the IAA and ACA identify some steps being taken and issues that are arising from recent threats. Below are some results from the survey.
- Nearly 88% of the 474 advisory firms polled identified “cybersecurity/privacy/identity theft” as their top compliance challenge this year.
- About 43% report having a formal, written, standalone cybersecurity program, while another 42% have formal cybersecurity policies and procedures that are incorporated into broader programs.
- The incidence of cyber breaches has jumped, with 15% of advisors reporting being the victim of a cybersecurity breach in the past 18 months, up from 11% last year.
- The advisory firms also reported increased compliance testing in the following areas: cybersecurity/privacy/identity theft (67.9%); advertising/marketing (43%); personal trading/code of ethics (34%); disaster recovery planning (35%), and best execution (32%).
- Nearly half (47%) prohibit the use of personal social networking websites for business purposes, down slightly from 49% in 2013.
This compliance survey comes at a time when more than 3,000 financial institutions have applied for .BANK domain names, which is a new online bank community that uses enhanced security requirements and strict verification standards to provide banks and their customers with a safer place to conduct online business.
The Securities and Exchange Commission (SEC) and Federal Bureau of Investigation (FBI) are lending a helping hand based on what they are learning from the more recent high profile attacks. The SEC recently sponsored a Cybersecurity Roundtable and emphasized the importance of cybersecurity at registered entities to the integrity of the market system and the need for effective cooperation between government and the private sector to respond to increasing cyber threats.
Cybersecurity is a key risk that the financial services industry faces today and that will likely grow in importance in the coming years. The SEC and FINRA have made it clear that they are keeping this a top priority and will use all resources to improve security. FINRA is expecting the same level of concern and proactive approach from firm management hoping they will devote sufficient resources both to understand the current cybersecurity threats and to implement measures necessary to mitigate these risks.
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Joseph Fede, CPA 212-751-9100 [email protected]
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