Private Equity Funds (Portfolio 735)

Tax Management Portfolio, Private Equity Funds, No. 735-2nd, addresses the full range of U.S. tax issues that arise in the representation of private equity funds.  

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Tax Management Portfolio, Private Equity Funds, No. 735-2nd, addresses the full range of U.S. tax issues that arise in the representation of private equity funds. The purpose of this portfolio is to provide a source of guidance to tax practitioners who regularly advise private equity funds and their investors. It includes a description of basic fund prototypes, a discussion of common economic terms and variations thereon, and a comprehensive summary of the principal U.S. tax objectives of the general partner, the fund manager, and the various categories of investors in a typical fund.


Andrew W. Needham

Andrew W. Needham, J.D., Georgetown University Law Center; LL.M. (Taxation), Georgetown University Law Center; M.B.A., The Wharton School; B.A., University of Arizona; Member, Executive Committee, Tax Section of New York State Bar Association, American Bar Association United States Tax Court.

Anita Beth Adams

Anita Beth Adams, J.D., Columbia University School of Law; B.A., University of Mississippi; Member, New York State Bar Association.

Table of Contents

Detailed Analysis

I. Introduction

II. Fund Prototypes

A. Basic Fund Structures

1. In General

2. Direct Investment Funds

a. The Fund

b. The General Partner

c. The Fund Manager

3. Funds of Funds

a. The Fund

b. The General Partner

c. The Fund Manager

4. Parallel Funds

5. Hybrid Funds

B. Basic Fund Categories

1. Venture Capital Funds

2. Leveraged Buyout Funds

3. Mezzanine Funds

4. Distressed Securities Funds

5. Angel Funds

6. Real Estate Funds

7. Geographically Targeted Funds

C. The Investor Participants

1. Individual Investors

2. Institutional Investors

3. Tax-Exempt Investors

4. Foreign Investors

III. The Economic Deal

A. Capital Commitments and Funding

B. The Distribution Waterfall

1. Return of Capital

2. Preferred vs. Hurdle Returns

3. The Carried Interest

4. The Clawback

5. Tax Distributions

C. Distributions in Kind

1. General Treatment of Distributions of Marketable Securities

2. Tax Consequences When Fund Sells Securities "on behalf of" Investor

D. "Disguised Sales" to Late Investors

IV. Achieving Pass-Through Treatment for the Fund and its Affiliates

A. In General

B. Classification as a Pass-Through Entity

1. Before January 1, 1997: The "Kintner" Regulations

2. The Current Law: The "Check-the-Box" Regime

a. State Law General or Limited Partnership

b. Domestic Limited Liability Companies

c. Foreign Limited Liability Companies

d. Other Foreign Entities

3. Publicly Traded Partnership Limitations

V. Tax Allocations

A. In General

B. Not Liquidating in Accordance with Capital Accounts

C. Targeted Capital Accounts

VI. Special Tax Issues for the General Partner and Its Members

A. Carry as a Profits Interest

1. Receipt of a Profits Interest as a Tax-Free Transaction

2. The Historical Treatment of a Profits Interest Issued for Services

3. Rev. Proc. 93-27

4. Should the General Partner and Its Members Contribute Capital?

5. Self-Employment Taxes

B. Special Tax Issues for Members of the General Partner

1. Vesting

a. Pre-Rev. Proc. 2001-43: The Minority View

b. Pre-Rev. Proc. 2001-43: The Majority View

c. Rev. Proc. 2001-43

d. The Proposed Regulations

2. Bifurcation

3. Late Hire/"Catch Up" Solution

4. Grant of Separate Interests in Different Investments

5. Capital Shift on Forfeitures of Appreciated Profits Interest

6. Avoiding Local Taxes on Carry

7. Pass-Through Structure for General Partner

C. Carry as Disguised Management Fee

D. Conversion of Capital Gain to Ordinary Income on CFC Investments

E. Tax Issues Involving the Clawback Obligation

1. Capping the Clawback

2. Hypothetical Taxes on In-Kind Distributions

3. Tax Issues in Renegotiating Contingent Clawback Liabilities

F. Qualified Small Business Stock

VII. The Problem of ECI and UBTI

A. In General

1. ECI


3. Common Exception for Investment Income

B. Typical Categories of UBTI/ECI in Fund Investments

1. Fee Income

2. Investments in Pass-Through Portfolio Companies

3. Investments in Subfund General Partners

a. ECI


4. Investments in Subfund Managers

C. Purging Fee Income from the Fund

1. Potential Treatment of Certain Fees as Capital in Nature

a. Break-Up Fees

b. Transaction Fees

c. Equity Commitment Fees

d. Debt Guarantees

2. "Regularly Carried On" Requirement

3. "Fee Offset" Arrangements

D. Use of "Blocker" Entities to Avoid UBTI/ECI

1. In General

2. Disregarding the Blocker

a. Agency

b. Section 269

3. "Parent Blocker" Structures

4. "Subsidiary Blocker" Structures

5. Pre-Sale Incorporation of Portfolio Company

6. Parallel Blocker Structures

7. "Capital Shift" on Certain Preferred Investments

8. UBTI/ECI "Opt Out" Provisions

E. Use of Option Structures to Avoid UBTI/ECI

1. In General

2. Investments in General Partners and Fund Managers

F. Other Approaches to Avoiding UBTI

1. "Self Funding" by Tax-Exempts

2. Insurance Wrappers

3. Covenant Restrictions

4. General Partner Indemnity

G. Special ECI Issues for Certain Funds

1. Financing Activities Generally as a "U.S. Trade or Business"

2. Lending by Private Equity Funds

3. Lending by "Distressed Securities" Funds

VIII. Special Issues with Convertible Debt Investments

Introductory Material

A. Mandatory Accrual of Interest

B. Qualifying for "Portfolio Interest" Exception

C. Problems with Contingent Debt

D. Ability to Retire without Tax Consequence

IX. Withholding Taxes of Foreign Investors

A. Minimizing Dividend Taxes on Equity Investments Generally

B. Avoiding Dividend Accruals on Preferred Stock Investments

1. Cumulative Preferred Stock

2. Discount Preferred

3. PIK Preferred

4. "Down Round" Adjustments

5. "Double Dip" Preferred Stock

6. Preferred with Change of Control Premium

C. Conversion of Dividend Accretions to Capital Gain

D. Withholding Requirements for Offshore Funds

1. Withholding Foreign Partnerships

2. Nonwithholding Foreign Partnerships

E. Treaty Benefits

F. Fund Agreement Provisions

X. U.S. Tax Objectives of U.S. Individual Investors

A. Minimizing Dividend Taxes

B. Maximizing Deductible Expenses

C. Qualified Small Business Stock

XI. Anti-Deferral Rules for Foreign Investments by Private Equity Funds

A. Introduction

B. Portfolio Investments in CFCs

1. Classification as a CFC

2. Application to Domestic Funds

3. Application to Offshore Funds

4. Imputing Voting Stock to the GP - More than the Carry Percentage?

5. Use of Offshore Parallel Vehicle

6. Mitigating CFC Consequences

a. Section 338(g) Election

b. Use of Hybrid Entities

C. Portfolio Investments in PFICs

1. Classification as a PFIC

a. The Income Test

b. The Asset Test

c. The "Look-Through" Rules

d. Exceptions from the PFIC Provisions

2. Application to Fund Investments

D. Portfolio Investments in FPHCs

1. Classification as a FPHC

a. Foreign Personal Holding Company Income

b. Attribution Rules

2. Application to Fund Investments

XII. Taking the "Private" Out of Private Equity — the IPO

A. Introduction

B. The KKR, Apollo, Fortress & Blackstone IPOs

C. Basic Structure

1. Public Funds: The “Permanent Capital” Vehicle

2. Public Fund Managers: “Monetizing” the Carried Interest

D. The PTP Limitations

E. The "Fungibility" Problem

1. All Distributions Pro Rata

2. The FDAP Withholding Problem

3. §704(c) Compliance

a. The §754 Solution

b. The "Tiered Partnership" Solution

Working Papers

Working Papers

Table of Worksheets

Worksheet 1 Direct Investment Fund Structure

Worksheet 2 Parallel Fund Structure

Worksheet 3 Sample Clawback Provision

Worksheet 4 Sample Provisions for Escrow of Carry Distributions

Worksheet 5 Sample Tax Distribution Provision

Worksheet 6 Sample "Targeted Capital Account" Provisions

Worksheet 7 Sample "Variable Sharing" of Carry Distributions

Worksheet 8 Sample Fee Offset Provisions for Fund Agreement

Worksheet 9 Sample "Blocker" Provision

Worksheet 10 Subsidiary Blocker Structure

Worksheet 11 Sample "Parallel Vehicle" Provision

Worksheet 12 Option Structure for Fund Manager Investment

Worksheet 13 Sample "Best Efforts" Covenant

Worksheet 14 Sample Withholding Tax Provision of Fund Agreement

Worksheet 15 "Qualified Small Businessâ" Representation




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