Management fee waivers in investment funds: Tax treatment and regulatory considerations

Editor: Jeffrey N. Bilsky, CPA

Many investment funds employ an economic arrangement in which the general partner receives a carried interest, and the management company, which often shares common ownership with the general partner, is compensated for its services via a management fee. This management fee is intended to cover the operating expenses of the management company, such as legal costs, administrative fees, and salaries. Although many managers collect this fee from the fund periodically, there may be a business reason for the manager to forgo its collection. In these instances, the manager may waive the management fee in exchange for an interest in the fund’s profits (an “additional interest”).

Where the management fee is waived and the management company is issued an additional interest in exchange for services (i.e., the management company is a service provider to the fund), the question arises as to the appropriate treatment of this arrangement for tax purposes.

Potential tax treatments

Under Subchapter K, a transfer from a partnership to a partner in exchange for services is viewed in one of three ways:

1. A distributive share determined under Sec. 704(b);
2. A transaction considered as occurring between the partnership and one who is not a partner under Sec. 707(a); or
3. A guaranteed payment under Sec. 707(c).

In the context of investment partnerships, many managers may prefer to classify the proceeds received from the additional interest as a distributive share since that treatment enjoys favorable tax treatment not only for the manager but also potentially for the fund’s investors.

To understand this preference, first consider the effect on the investors of the unwaived management fee. For investors in a fund that lacks a trade or business, the management fee represents a miscellaneous itemized deduction under Sec. 67. For tax years beginning after Dec. 31, 2017, the fee does not generate a current tax deduction for noncorporate investors. The fee does, however, reduce the investors’ bases in the partnership under Sec. 705. Importantly, the investors’ partnership bases are affected, not the basis of any partnership asset. This reduction in basis will therefore generally result in more capital loss or less capital gain only upon dissolution of the partnership or a transfer of the partnership interest. In effect, the economic outlay of the management fee creates a deferred capital loss rather than a current ordinary deduction. This timing and character disparity may have minimal effects for the investors in a short–lived, single–asset vehicle, but investors in a long–lived, multiasset fund, on the other hand, might not use this tax benefit for several years.

A waived management fee treated as a distributive share, on the other hand, typically results in the investors’ being allocated less capital gain as the fund’s assets are disposed of, since a portion of the gain is likely allocated to the manager’s additional interest. This benefit to the investors can be recognized as assets are disposed of.

Second, if the additional interest is treated as a distributive share, this interest may result in an allocation of capital gain to the manager. The manager would then benefit from a preferential capital gain rate, assuming Sec. 1061 does not force recharacterization. In addition, a distributive–share treatment might also result in deferral of recognition, in comparison to a payment for services. In that case, the manager would benefit not only from the preferential tax rate but also from the delayed tax payment.

For the reasons described above, many fund managers and investors may strive to superficially arrange their affairs to take advantage of distributive–share treatment. Aware of this, Congress added Sec. 707 in 1954 to assist taxpayers with appropriately classifying transactions between partnerships and partners. Notwithstanding the long–standing existence of Sec. 707, Congress also added an anti–abuse rule in 1984 specifically aimed at payments to partner service providers (§٧٣ of the Tax Reform Act of 1984, P.L. 98–369). Sec. 707(a)(2)(A) states that a payment for services is deemed to occur if the performance of services and the resulting allocation, when viewed together, are properly characterized as a transaction occurring between the partnership and a third party. The 1984 amendment deferred to Treasury by applying Sec. 707(a)(2)(A) “under regulations prescribed by the Secretary.”

Treasury provided guidance on the appropriate treatment of management fee waivers under Sec. 707(a)(2)(A) as part of Prop. Regs. Sec. 1.707–2, issued July 23, 2015 (REG–115452–14, 80 Fed. Reg. 43652). Although these regulations have not been finalized, the IRS believes that they are aligned to the statutory provision of Sec. 707(a)(2)(A) (id., preamble).

After the passage of H.R. 1, P.L. 119–21, known as the One Big Beautiful Bill Act (OBBBA), on July 4, 2025, it is clear that Sec. 707(a)(2)(A) is self–executing. Without statutory guidance on how a transfer is “properly characterized,” however, the principles described in the legislative history and Prop. Regs. Sec. 1.707–2 remain as helpful guidance for applying the statutory provision. It is therefore prudent to refer to the proposed regulations when evaluating the differences between a payment for services and a distributive share of income.

The importance of significant entrepreneurial risk

The proposed regulations apply a factor–based model that aims to determine arrangements that are classified as payments for services. Consistent with the legislative history, Prop. Regs. Sec. 1.707–2(c) sets out six factors, including significant entrepreneurial risk, that it identifies as the most important factor and asserts that an arrangement without significant entrepreneurial risk generally constitutes a payment for services. On the other hand, an arrangement possessing significant entrepreneurial risk will generally be considered a distributive share unless the other factors establish otherwise.

While “significant entrepreneurial risk” is not explicitly defined, the proposed regulations provide a presumptive model for determining when an arrangement lacks significant entrepreneurial risk. Under Prop. Regs. Sec. 1.707–2(c)(1), the existence of the following five facts and circumstances creates a presumptive lack of significant entrepreneurial risk unless “clear and convincing evidence” to the contrary can be shown:

1. Capped allocations of partnership income;
2. Reasonably certain allocations;
3. Gross income allocations;
4. Allocations that are predominantly fixed in amount, reasonably determinable, or designed to assure that sufficient net profits are highly likely to be available to make the allocations to the service provider; and
5. Arrangements where a service provider waives its right to receive payment for the future performance of services in a manner that is nonbinding or fails to timely notify the partnership and its partners of the waiver and its terms.

The first two factors pertain to the mechanics of the additional–interest allocation. Allocations that are capped at amounts representing the management fee or that are reasonably certain to occur create a presumptive lack of significant entrepreneurial risk. To avoid this presumption, allocations attributable to the additional interest should not be capped and should carry a degree of uncertainty at the time the arrangement is entered into. Additionally, gross income allocations or allocations that are predominantly fixed or subject to manipulation by management create a presumptive lack of significant entrepreneurial risk. According to the proposed regulations, allocations that depend on the long–term future success of the enterprise support a claim of significant entrepreneurial risk. The fifth factor stresses the importance of an economically meaningful fee waiver that is appropriately communicated to all parties to the partnership agreement. Examples (5) and (6) from Prop. Regs. Sec. 1.707–2(d) illustrate “successful” fee waivers that are implemented concurrently with the execution of the partnership agreement. Many waiver arrangements “hardwire” optionality into the partnership agreement and create a notification requirement for when the manager elects into the waiver.

Although not considered in Prop. Regs. Sec. 1.707–2(c)(1), clawback obligations that are reasonably expected to be enforceable are seemingly also an important factor in establishing significant entrepreneurial risk, as noted in Examples (5) and (6) of Prop. Regs. Sec. 1.707–2(d). A clawback obligation is a contractual provision that requires a manager to return previously distributed amounts to the fund or its investors if, at the end of the fund’s life, it turns out that the managers received more than their agreed share of profits. Clawback obligations are common in “American waterfalls” where carried interest accrues on a “deal–by–deal” basis. If the fund as a whole does not earn returns sufficient to justify the earlier deal–by–deal allocations, the carry may be “clawed back” from the manager. In both examples from the proposed regulations, the service partner’s additional interest is subject to a clawback obligation with which the service partner could and would reasonably comply. According to the proposed regulations, clawback obligations support the existence of significant entrepreneurial risk.

Other factors to consider

In addition to significant entrepreneurial risk, the other five factors to be considered under Prop. Regs. Secs. 1.707–2(c)(2) through (6) are:

1. The service provider holds, or is expected to hold, a transitory partnership interest or a partnership interest for only a short period;
2. The service provider receives an allocation and distribution in a time frame comparable to the time frame that a nonpartner service provider would typically receive payment;
3. The service provider became a partner primarily to obtain tax benefits that would not have been available if the services were rendered to the partnership in a third-party capacity;
4. The value of the service provider’s interest in general and continuing partnership profits is small in relation to the allocation and distribution; and
5. The arrangement provides for different allocations or distributions as to different services received, the services are provided either by one person or by persons that are related under Sec. 707(b), and the terms of the differing allocations or distributions are subject to levels of entrepreneurial risk that vary significantly.

According to the proposed regulations, the existence of these factors bears on the determination of an arrangement, but the weight ascribed to any individual factor other than significant entrepreneurial risk depends on the facts and circumstances.

Considering the proposed regulations’ intricate mechanics and the multitude of relevant factors, it is not uncommon for waiver arrangements to erroneously rely on misapplied guidance or fail to consider the implications of other tax principles. One common pitfall is the overreliance on the profits–interest safe harbor of Rev. Proc. 93–27, which states that the grant of a profits interest to a service provider is not a taxable event to the service provider. The proposed regulations intend to explicitly deny the applicability of the Rev. Proc. 93–27 safe harbor to arrangements where a service provider waives the right to a substantially fixed amount. This change would, in effect, cause the grant of the additional interest to be a taxable event to the service provider. Another common pitfall is failing to consider the constructive–receipt doctrine described by Sec. 451 and Regs. Sec. 1.451–2. To potentially be treated as a distributive share, a management fee must be waived before it is earned; otherwise, the manager will be taxed on the management fee as it is constructively received. After going through the difficult tasks of properly arranging the fee waiver, failing to notify the partnership and partners within the applicable window is a common error made by managers. Managers and their advisers should take great care to ensure that notification requirements are met.

Aligning with regulations

Fee waiver arrangements are not simply tax constructs. Fee waivers also carry significant legal, economic, and governance implications — managers and investors should consider not only the tax implications but also the nontax implications of an arrangement. From a tax perspective, whether specific arrangements constitute a payment for services or a distributive share depends on the facts and circumstances. While the presence or absence of entrepreneurial risk is the primary determinant in distinguishing a payment for services from a distributive share, it is important for advisers to know, understand, and consider all relevant factors and ensure that the structure and documentation of fee waivers align with the applicable rules, including the proposed regulations.

Editor

Jeffrey N. Bilsky, CPA, is managing principal, Washington National Tax, with BDO USA, P.C. in Atlanta.

For additional information about these items, contact Bilsky at jbilsky@bdo.com.

Contributors are members of or associated with BDO USA, P.C.