In a prior post, I described some issues related to regulatory severability, that is, a court’s decision to strike or not strike an entire regulation project when it finds that only a portion of it violates the law. In this post, I want to explain how principles of regulatory severability could doom some regulations recently proposed by the Treasury and IRS under Section 707(a)(2)(A) of the tax code. That statute authorizes, but does not require, regulations relating to “management fee waiver” transactions, which private equity firms have engineered to reduce their tax bills.

The tax issue in the proposed regulations is complex, and I will have a subsequent post that walks through the technical tax details. But to understand the severability analysis of this post, you only need to know (or assume) that a key part of the proposed regulations, if finalized, would violate the statute. So, I will generally summarize things like this: The authorizing statute allows the IRS to issue regulations attacking fee waiver transactions only if a private equity firm is allocated special types of payments and those special payments are distributed to the firm.
The IRS freely acknowledges that the statute requires an actual distribution. See Disguised Payments for Services, 80 Fed. Reg. 43652, 43654 (July 23, 2015) (“[S]ection 707(a)(2)(A)(ii) requires both an allocation and a distribution”). However, the agency believes that complying with the statute may be “administratively difficult.” See id. There might be a substantial time gap between the drafting of an allocation provision and the making of any distribution. Consequently, if the IRS complied with the statute, it would have to take a wait-and-see approach.The tax issue in the proposed regulations is complex, and I will have a subsequent post that walks through the technical tax details. But to understand the severability analysis of this post, you only need to know (or assume) that a key part of the proposed regulations, if finalized, would violate the statute. So, I will generally summarize things like this: The authorizing statute allows the IRS to issue regulations attacking fee waiver transactions only if a private equity firm is allocated special types of payments and those special payments are distributed to the firm.

Not wanting to wrestle with this administrative issue, the IRS has said that it will apply its regulations as soon as a private equity firm enters into a fee waiver arrangement, that is, in the year of the income allocation. Prop. Treas. Reg. 1.707-2(b)(2). Thus, the income allocation of a private equity firm may be re-characterized even before it receives a distribution or even if it never receives a distribution.

The IRS’s rule, if finalized, does not fit within the statutory language. The statute authorizes IRS regulations denying tax benefits only when a distribution is made. Administrative concerns can and should play an important role whenever the IRS is acting within its statutory authority and is choosing between permissible interpretations of a statute, but the IRS cannot rewrite a statute to address administrative problems of the agency’s own making. Nothing in Section 707(a)(2)(A)’s text requires the IRS to issue regulations applying the statute to fee waiver transactions, and if the IRS doesn’t want to deal with administrative problems, it can forgo the issuance of regulations and address such transactions through other provisions.

The likely invalidation of an IRS regulation is always interesting, but the stakes could be exceptionally high here. The IRS apparently believes that its elimination of the statute’s distribution requirement is needed to make the regulations workable. Consequently, the particular regulation section that eliminates the distribution requirement might not be severable from the remainder of the regulation project. If that is so, then taxpayers may present a broad pre-enforcement challenge to the final version of Prop. Treas. Reg. 1.707-2(b)(2) and effectively to all the fee waiver regulations.

To address this issue, the IRS might include a severability provision in its fee waiver regulations, stating that if a court invalidates Prop. Treas. Reg. 1.707-2(b)(2), it should not bring down the rest of the regulations. But as I mentioned in my last post, the effect of such provisions remains uncertain, as detailed in an excellent article by recent Yale Law School graduate Charles Tyler and by former Yale Law School Professor Donald Elliott. Also, even putting aside explicit regulatory provisions, the case law on severability seems a bit confused. A court may very well strike down all the fee waiver regulations even if the IRS argues that its error was isolated.

Nonetheless, the IRS probably has little to lose by adding a severability provision. A provision of that sort might ordinarily imply some doubtfulness about a particular regulation’s validity, but the IRS has already candidly acknowledged that its removal of the distribution requirement does not square with the governing statute. So, the IRS may as well include a severability provision, even if courts probably won’t give it much weight.

Regarding private equity firms, they likely have little to lose from presenting a pre-enforcement challenge to the fee waiver regulations. (Well, they might lose some money on legal fees, but they have plenty of cash.) In fact, the optics of a pre-enforcement challenge are probably better vis-à-vis a refund or deficiency challenge, where the machinations of the fee waiver strategy will be on full display. If private equity firms want to litigate the fee waiver regulations, it might be wisest to proceed as soon as the regulations are finalized. Many important issues, including standing, will be messy, but again, there’s little to lose and much to be gained.

If it’s relevant, I’ll also note that I don’t have any special desire to protect tax benefits for private equity firms. In fact, I would happily support a revenue-neutral bill that phased out the capital gains preference for the ultra wealthy. However, IRS overreach should concern everyone, even if the taxpayers affected in a particular instance are not terribly sympathetic and, frankly, should pay more in taxes.