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Treatment of Fees Payable to a Removed General Partner

Published by Lisa Pekkala and Tom Stephens on Monday, August 1, 2011

Journal cover August 2011   Download PDF

This article is the second in a series of articles discussing the removal of a general partner (GP) and other associated issues. Last month’s article discussed the various grounds for a GP removal and recommendations for drafting partnership agreements that clearly delineate the partners’ respective expectations with respect to the triggers and consequences of removal. To draw upon the analogy created by our colleague in last month’s article, if the decision to remove a GP is akin to a divorce, the next step, which is to determine how to deal with fees payable to the removed GP and its affiliates, is akin to the settlement. Like removal itself, the treatment of fees is best addressed up front in the partnership agreement, or “pre-nuptial” agreement, so to speak, when the parties are still getting along. These fee issues are the focus of this article and present both economic and tax concerns.

Typical fees payable to the GP or its affiliates include the developer fee, a partnership management fee and/or incentive management fee, and a property management fee. A GP also may have made operating deficit or other similar support loans to the partnership that it may be owed. From an equitable perspective, the partnership likely will not want to pay fees to a GP that was removed for cause, and from an economic perspective, the partnership will need to preserve value for its continuing partners and preserve cash to pay replacement GP fees as a way to provide an incentive for the replacement GP to step into that role.  

Management Fees
With respect to management fees, the partnership should have no obligation to pay the removed GP for unearned fees payable for future services that the removed GP or its affiliates have not yet provided. We recommend that the partnership agreement specifically provide that upon removal of the GP, no further partnership or incentive management fees shall be payable to the GP or its affiliates, and that all agreements with the GP and its affiliates may be terminated at the sole option of the limited partner.

But what about accrued fees payable with respect to services that were earned prior to the GP’s removal? The nonpayment of these fees should have no tax effect if the fees have not been deducted by the partnership. Any tax effect will depend on whether the fees are treated as payments to a partner not acting in his capacity as a partner under Section 707(a) of the Internal Revenue Code (IRC), or as guaranteed payments to a partner determined without regard to the income of the partnership under IRC Section 707(c).

If the payments are treated as 707(a) payments, and the GP or affiliated payee is a cash method taxpayer, certain timing rules under the IRC that are related to the deduction of payments between related parties would require the partnership to defer taking a deduction for the fee until such time as the fee is actually taken into income by the payee, which, in the case of a cash method taxpayer, is upon the receipt of payment. In that case, the nonpayment of the fee by the partnership would not trigger any income to the partnership since the partnership would not yet have deducted an unpaid fee.

If the payment is treated as a 707(c) payment, the IRC requires the payee to take the payment into income, based on the partnership’s method of accounting regardless of whether the payee is a cash or accrual method taxpayer. Given that most partnerships use the accrual method of accounting, the partnership already would have deducted such fees, and the later nonpayment could trigger income to the partnership. In our experience, most partnership management and other similar fees are treated by the partnership as 707(a) payments.

Developer Fees
With respect to developer fees, there is the same potential partnership income issue as with management fees, and the added issue of the effect on eligible basis. Whether the partnership has income will depend on what is happening with the fee: i.e, will it be cancelled, assigned to another party such as the replacement GP or remain outstanding and be paid to the removed GP. Generally, a cancellation of the fee would trigger cancellation of debt (COD) income to the partnership unless a specific exception to the COD rules under the IRC applies. The cancellation shouldn’t affect eligible basis (and thereby the tax credits) if at the time eligible basis was determined, the obligation to pay the developer fee was respected as a true obligation of the partnership.  

However, the cancellation could provide a position for the Internal Revenue Service (IRS), on audit, to argue that the fee should be excluded from basis because, in hindsight, the fee was never paid. This could be a particularly inviting argument for the IRS if cash flow problems at the partnership have resulted in smaller payments on the developer fee than was originally anticipated. While not involving an actual developer fee cancellation, there’s at least one case we know of where the IRS used this “hindsight” argument to exclude an unpaid developer fee from eligible basis.

One way to address this potential issue up front is to provide in the partnership or development agreement that the developer fee is owed in all events, but that the partnership may apply developer fee and any other fee payments owed to the GP or its affiliates to compensate the partnership and the limited partner for damages incurred as a result of the events that gave rise to removal and reasonable expenses related thereto, including the cost of new GP fees that are in excess of the removed GP’s fees.  We would also suggest that the limited partner have a security interest in any unpaid fees to secure the GP’s obligations under the partnership and development agreements. This approach provides a basis for the argument that the developer fee was still paid, since it is only an offset against actual amounts owed by the GP. More importantly, to cancel the fee would require that there be some provision in the partnership or development agreement allowing the cancellation in the event of removal of the GP.  

However, such a provision might be viewed as making the fee contingent on future performance, so that even in the absence of a GP removal situation, the IRS might be able to argue that the fee was not properly accrued by the close of the first year of the credit period because there remained contingencies to the fee payment. The offset against damages approach should help preclude this potential IRS argument as well.

Another approach would be to provide for a transfer of the developer fee to the replacement GP. This might also present a concern that the developer fee is too contingent to accrue and to include in eligible basis, though the counterargument to that is that the fee itself is payable by the partnership in all events in a fixed amount, and the only contingency is to identify the recipient of the fee. However, this approach might be viewed as a reacquisition by the partnership of the developer fee obligation for no consideration, followed by the issuance of a new obligation to the replacement GP for management or other future services yet to be provided, which could trigger COD income to the partnership.

Finally, the partnership could require the removed GP to make a capital contribution to the partnership in the amount of all unpaid installments of the developer fee, which the partnership would then use to pay off the fee. This approach may work, in theory, though in reality may be hard to enforce. Specifically, what does the partnership do if the GP fails to pay? Also, if the GP is removed for cause such as bankruptcy or mismanagement of partnership funds, the likelihood that the GP actually has the cash to make the required capital contribution is pretty remote.

Repayments
The GP may also be entitled to repayment of operating deficit or other support loans, although they are not specifically a fee. Partnership agreements typically provide for the repayment of such GP loans through the cash flow waterfall, with remaining cash flow at the bottom of the waterfall being split between the partners, based on a defined residual sharing percentage. To the extent the removed GP remains entitled to repayment through the waterfall, the residual cash available to the replacement GP and the limited partner is reduced. For this reason, partnership agreements often provide that upon GP removal, the partnership shall have no obligation to repay any such support loans.  Although the cancellation of such loans will result in COD income to the partnership, the partnership will preserve cash and value for the remaining partners, which may outweigh the effects of the COD income. In a similar vein, the partnership agreement should provide that the replacement GP shall redeem the removed GP’s interest for nominal amount (e.g., $100), and that all economic incidents of ownership of the removed GP, including the right to share in any residual value of the property, shall cease.

Conclusion
The options available to the remaining partners with respect to the treatment of fees to the removed GP will ultimately depend on what the partnership agreement does (or does not) say. The only certainties are the need to address these issues carefully and in advance, and the need to consider the economic and tax effects prior to determining a course of action.

Thomas Stephens is a tax partner with SNR Denton and is co-chair of the firm’s tax advantaged investments practice. Lisa Pekkala is a partner and practices in the taxation and tax advantaged investments practices.

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