While estate planning for private equity and hedge fund partners remains an important and widely addressed topic, the ascendancy of income tax management, in light of higher income tax rates and the Medicare surtax, has inspired a greater focus on charitable planning. Since much of the wealth of these individuals often resides in the funds that they manage, let’s survey their charitable planning options.
By way of background, the universe of private equity funds includes several categories, such as venture capital, leveraged buyout, mezzanine, distressed securities, angel, real estate and geographically targeted.1 The term “hedge fund” also exists broadly and encompasses various strategies involving stocks, fixed income, convertible debt, foreign currencies, exchange-traded futures, forwards, swaps, options and other derivatives.2
While private equity and hedge funds commonly exist as partnerships, the partners’ tax profiles and corresponding charitable planning opportunities differ. Private equity investors experience liquidity (and generally income taxation) when the fund sells its investments. The fund has a fixed life, usually seven to ten years, reflecting the investment term of the underlying portfolio companies.
Private equity funds typically don’t reinvest sales proceeds and, instead, distribute them pursuant to the priorities or “distribution waterfall” prescribed in the partnership agreement.3 Whether private equity partners receive their return of capital on an investment-by-investment or full aggregation basis (that is, the general partner receives carry distributions only after the fund reimburses all invested capital), the distributions typically result in capital gains treatment.
By contrast, hedge fund investors experience liquidity (and potential taxation) by periodic redemption as permitted under the partnership agreement and, in the meantime, pay taxes on their distributive share of the partnership’s taxable income and gain every year, regardless of whether they received a distribution from the hedge fund. Depending on the hedge fund’s strategy, ordinary income may constitute a significant component of hedge fund income. As a result, especially with the Medicare surtax, hedge fund partners may encounter more tax inefficiency annually than private equity partners.
Interests of Fund Managers
The infrastructures of private equity and hedge funds vary widely and can affect the transfer techniques available to the partners.
In a fund’s simplest form, with no separate management entity, the general partnership (GP) entity, owned by the principals who manage the fund, typically receives from the investment fund a:
• management fee (generally 2 percent of a prescribed base),
• return on its invested capital (generally the same as the return on the limited partnership’s (LPs) invested capital), and
• carried interest share of profits (generally 20 percent of the fund’s cumulative net profits, in some cases paid only after surpassing a hurdle rate of return paid to the LPs and a catch-up contribution to the GP). Given the return requirements and hurdle rates that the GP members must clear before receiving their carried interest share of any remaining profits, carried interests have been characterized in commentary as an interest "junior" to the senior interests of the LP investors for purposes of intra-family gifts under Internal Revenue Code Section 2701.4 (One author questions this general assumption, however, and reasons that the transfers of certain profits interests don't necessarily trigger adverse transfer tax results.)5
Often, the principals may form a separate entity to manage the fund and receive the management fee. This segregation may occur due to multiple investment funds managed by a single management company, or for state or local tax planning reasons, among others.
Management fee. As compensation, private equity funds typically pay a periodic management fee to the fund manager equal to a fixed percentage (for example, 2 percent) of the total capital commitments. Once the fund reaches full investment, the base for computing the management fee often shifts to invested capital. As a result, this fee base decreases as the fund disposes of investments.
A hedge fund manager also often receives a 2 percent management fee, but based instead on the fund’s net asset value, which unlike a private equity fund’s committed capital, fluctuates with net contribution or withdrawals.
As compensation for services, this 2 percent management fee constitutes ordinary income for the manager. Since these fees incur higher ordinary tax rates while private equity carried interest (as addressed below) receives more favorable tax treatment as long-term capital gains, private equity fund managers often seek to waive the right to receive service fees in exchange for a higher carried interest. (Both the Internal Revenue Service and New York Attorney General have examined fee waivers in this context as potentially abusive, and the IRS plans to issue guidance on this topic.6)
Carried interest. By far, the issue that’s raised the most scrutiny involves the carried interests that private equity fund managers receive as a performance incentive. The term “carried” derives from the fact that the capital of the other investors initially “carries” the general partner.7 Other synonyms include a “profit override,” a “promote,” an “incentive allocation” or a “profits interest.”8
Private equity perspective. In the private equity context, the majority of the income allocated to general partners with respect to their profits interests in their funds constitutes long-term capital gains when the fund disposes of its portfolio company investments.9 In addition, the IRC currently doesn’t tax private equity fund general partners on the grant of carried interests.10 As a result, managers may defer taxation and benefit from capital gains treatment on amounts that, to many, appear to constitute compensation for services.
Since 2007, legislative proposals have emerged to tax carried interest allocations as compensation. Most recently, President Obama’s Fiscal Year 2016 Budget contains a measure to tax carried interest profits as ordinary income, as in previous years.11
This treatment remains critical to monitor for charitable planning purposes because the donation of a carried interest, if viable for the partner, would result in a deduction only of cost basis (as opposed to fair market value (FMV)) if it became an asset that generates ordinary income under the contribution reduction rules of IRC Section 170(e)(1)(A).
Hedge fund perspective. Hedge fund managers have different income tax concerns with respect to carried interests. Partnership flow-through treatment doesn’t necessarily favor hedge fund managers for several reasons. Many hedge funds elect mark-to-market treatment for securities traded during the tax year and currently recognize ordinary income or loss as a result.12 Even if a hedge fund doesn’t make such an election, a significant portion of its income may constitute short-term capital gains, due to the hedge fund’s short-term trading strategy, or ordinary income, due to the application of IRC Section 1256 and the rules applicable to original issue discount obligations, market discount or short sales.
Alternatively, the portfolio manager may choose to structure the incentive allocation as a service fee. Managers have elected to defer their fee compensation through offshore hedge funds not subject to U.S. taxation. To eliminate this deferral technique, for services performed after 2008, legislation has rendered vested compensation currently taxable to U.S. fund managers and, for services performed before 2009, essentially limited the offshore deferral until the 2017 tax year.13
As a result, 2017 may loom as a year of relatively high income tax liability for hedge fund managers, with a corresponding motivation to benefit from charitable deductions for the same year. In 2017, hedge fund managers may consider both outright donations to a donor advised fund (DAF) (for flexibility in the timing of charitable distributions) and grantor charitable lead annuity trusts, if they wish to benefit their family members as well as charity.14
Hedge fund partners may inquire whether they could assign part or all of their compensation interest to charity (assuming the charity’s willingness to accept it) before 2017, to avoid the corresponding income tax. Several issues arise with this question. First, under the assignment-of-income doctrine, both in the regulations and revenue rulings, the IRS has stated the basic premise that taxpayers may not avoid including compensation in income by assigning their right to receive it to third parties.15 With respect to assignments to charity, the IRS has stated that: “. . . payment directly to an exempt organization, at the direction of the person whose individual personal services earned it, constitutes an assignment of income that is disregarded for Federal income tax purposes.”16
In addition, regulations proposed in 2005 provide that IRC Section 83 (which addresses compensation received in the form of property) would govern the tax consequences of partnership interests issued for services.17 Applying Section 83 to hedge fund interests received as compensation would indicate ultimate income taxation back to the partner for restricted property donated to charity.18
Therefore, instead of focusing on assignments of interests in deferred compensation, I’ll discuss current charitable planning to address income tax liability that hedge fund partners currently bear.
Charitable planning for privately held assets raises issues that don’t apply to donations of cash or marketable securities. Before accepting any privately held assets, charities must examine whether the assets fall within their gift acceptance policies. Charities must also discern a path to liquidity, because they generally have a fiduciary obligation to diversify their investment assets. DAFs may serve as useful vehicles to receive assets with some potential liquidity in the near future and then distribute the sale proceeds to a group of charities recommended by the donors, thereby simplifying the donation process for both the donors and charities involved.
Donors should always review with their tax advisors any limitations on the charitable deduction amount based on adjusted gross income (AGI), state taxes (if any) and the corresponding impact of the Pease limitation on itemized deductions.
Also, to avoid an anticipatory assignment of income from a definitive sale, donors should avoid donating assets too close in time to any liquidity event.19 The suitable time frame for a donation depends on the specific facts and circumstances of the transaction. Donating assets with some level of uncertainty as to the price and timing of the taxable disposition would also result in some valuation discount, as determined by a qualified appraisal secured by the donor.
Private Equity Partners
Private equity partners may consider donating the following to implement their charitable planning:
• Portfolio shares at the partner or partnership level; or
• Partnership interests.
Here are the logistical and tax implications of each route.
Donation of portfolio shares at the partner level. The sale of shares in a highly appreciated portfolio
company reflects a financial success for the private equity fund, as well as a significant tax liability on the recognized gain that flows through to the partners. If allowed by the partnership agreement, a private equity GP may instead elect to distribute company shares directly to the partners, or at least the GP partners, in lieu of distributing cash after the sale of shares.
Distributing portfolio shares early in the fund’s investment cycle wouldn’t appeal to partners due to their lack of liquidity. However, proportionate in-kind distributions of securities with current or anticipated liquidity may benefit the receiving partners in several ways. In general:
• No gain recognition generally results on a partnership’s distribution of property.20
• The partnership’s basis in appreciated property carries over to the receiving partner.21(In turn, the partner’s outside basis decreases (but not below zero) by the inside basis of any property in a current distribution.)
• The partner may subsequently donate the shares directly to a DAF or other public charity to obtain the optimal tax deduction based on AGI. (By contrast, donations of non-publicly traded shares to a private foundation (PF) yield only a cost-basis deduction.) In addition, contributions of all long-term appreciated assets to a PF remain subject to an annual deduction limit of 20 percent of AGI, as opposed to 30 percent of AGI for public charities.22
The following scenario illustrates the potential benefits of in-kind distributions and subsequent donations of portfolio shares:
Sophia serves as a managing partner of a Silicon Valley venture capital fund, which had invested in a password recovery company named Can’tRemember. After a successful initial public offering and expiration of the lock-up period, Can’tRemember shares continued to appreciate, and the fund made an in-kind distribution of these publicly traded shares to Sophia. Instead of selling these shares, sustaining the income taxes as a California resident and donating some of these proceeds to charity, as she’d done in previous years, Sophia directly donated some of these shares to her DAF. Doing so bypassed any capital gains recognition on the subsequent sale of these shares in the DAF and enabled her to pre-fund her charitable giving for future years through a significant contribution in a high income year.
Factors affecting the viability of an in-kind distribution of portfolio shares include:
• The partnership agreement may impose certain conditions or consent requirements for any distribution of portfolio shares;
• The GP may want to retain the fund’s portfolio shares to avoid any complications that could affect the shares’ market price and corresponding value of its carried interest;
• Securities and Exchange Commission Rule 144 and other sale restrictions may accompany the shares;23
• Trading windows may deter sales during certain periods to comply with insider trading laws;
• Prior to any in-kind distribution, the private equity fund should confirm that none of its employees or board designees possess any material non-public information regarding the portfolio company; and
• Reporting requirements under Form 4, SEC Rules 13D and 13G may apply regarding change of ownership.24
Donation of portfolio shares at the partnership level. If all of the GP partners agree to make a charitable contribution at the partnership level, the GP itself may donate some of the portfolio shares received from the LP to charity or a DAF in the partnership’s name and bypass the administrative steps of distributing the shares to the partners, who would then donate the shares. The partners would report their distributive share of the partnership charitable contribution on their respective individual tax returns.25
Donation of partnership interests. Transferring illiquid assets with high growth potential often occurs in the context of traditional estate planning to shift wealth to descendants with minimal or no gift tax. In general, intra-family wealth transfer benefits from a relatively low valuation of assets during the early stage of its growth in value. By contrast, as an asset grows in value towards a potential taxable sale, it becomes a more appropriate candidate for charitable donation, as a higher value supports a higher income tax charitable deduction.
From a charity’s perspective, the ability to exit out of a donated asset remains critical, because charities often seek liquidity and subsequent diversification from any gift they accept. In general, charities don’t seek to sustain long-term obligations for capital calls or, depending on their comfort level with alternative investments, unrelated business income tax (UBIT) for any unrelated trade or business income flowing through private equity funds or debt-financed income flowing through hedge funds. For this reason, donating a highly appreciated partnership interest before a potential liquidation, redemption or other taxable disposition, as opposed to during its early stage, may benefit both the charity receiving the cash proceeds and the donating partner.
In this manner, partners would bypass any capital gains recognition with respect to the donated partnership
interest, and the charity would encounter liquidity on the subsequent sale. The following checklist of caveats accompanies any donation of a partnership interest:
• Assessing this strategy should also include reviewing the partnership agreement for the possibility and logistics of transferring fund interests to charity.
- To own private equity or hedge fund LP interests, charities generally must meet the criteria of an accredited investor or qualified purchaser, as defined under Securities and Exchange Commission (SEC) rules. Accredited investors includes §501(c)(3) organizations with at least $5,000,000 assets.26 Qualified purchasers include charitable trusts and corporations established by individuals owning at least $5 million in investments. Given these definitions and the corresponding paper work that typically accompanies a transfer of title, the charities most suited to receive fund interests generally consist of those with significant endowments or DAF sponsors with a significant collective asset base (and staff).
- Private equity and hedge funds may utilize offshore feeder structures to effectively "block" their U.S. tax-exempt investors from receiving any UBTI. As a result, fund stakeholders may include an offshore LP, which channels the investments of U.S. tax-exempt investors. Given this bifurcation of vehicles between U.S. taxable and tax-exempt investors, partners should check whether their fund would consent to a transfer of the partner’s U.S. LP interest to a tax-exempt institution.
- If a charity does accept and receive a domestic partnership interest, it should understand its UBIT liabilities for any debt-financed or other type of UBTI during its ownership of the donated interest. UBTI, however, would exclude capital gain from selling or liquidating a fund interest, unless it passed through debt-financed income.27
• Any donations should occur after the partnership interest vests, to preclude any characterization of an incomplete transfer.28
• Because donors benefit most from donating highly appreciated assets, partners should assess with their tax advisor the partnership interests most suitable for donation, as the amount of untaxed appreciation of a partnership interest depends on the partner’s basis amount, as adjusted for previous distributions.29 Hedge fund managers should also confirm whether they have a low or high basis in their fund interests, due to previous years of flow-through taxable income.
• Partners who donate partnership interests subject to liabilities would recognize capital gains to the extent of their shares of liabilities.30 This rule may become relevant for partnerships (particularly hedge funds) that own highly leveraged, debt-financed portfolios.
The transfer of GP carried interests to family members, whether outright or in trust, has raised the specter of IRC Section 2701, which effectively increases the grantor’s gift tax exposure if he also retains certain distribution or extraordinary payment rights. A common response involves the transfer of not only the fund manager’s carried interest, but also a proportionate amount of all other equity interests in the fund owned by the fund manager, under the commonly named “vertical slice” approach.31 Given the lack of appeal of this solution for many fund managers, practitioners have explored alternative strategies with respect to carried interests.32
Section 2701 applies only to transfers to family members and not to public charities, so it wouldn’t apply in the context of outright donations of carried interests.33 However, Section 170 prohibits charitable income tax deductions for partial interests in property not in trust.34 This rule has several exceptions:
• Donors may deduct contributions of a partial interest (for example, an income or remainder interest) that represents their entire interest in the property.35
• They may also deduct contributions of an undivided portion of their entire interest.36 Therefore, under this exception, private equity investors who only own LP interests in a fund may donate and deduct a portion of their LP interests transferred to charity.
As defined in the regulations, an undivided portion for purposes of the partial interest exception “must consist of a fraction or percentage of each and every substantial interest or right owned by the donor in such property and must extend over the entire term of the donor’s interest in such property.”37 In adding another condition, this exception doesn’t apply if the donor “transfers some specific rights and retains other substantial rights.”38 For example, an owner of a working interest in an oil and gas lease who only donates the overriding royalty interest or a net profits interest created out of the working interest, can’t deduct the contribution of these partial interests.39 For this reason, donations of partnership interests by fund managers who own both GP and LP interests in the fund may raise additional issues.
Such language in the regulations appears to evince a similar vertical slice approach for charitable deductions. Arguably, a donation of an undivided portion of a partnership interest should include a pro rata share of all attributes of the interest, such as capital and profits. Certain language in the McCord Tax Court decision reflects some debate over this issue.40
In McCord, the taxpayers had formed a family LP and assigned their LP interests to their children, certain trusts and various charities pursuant to a defined value formula clause. While they assigned their economic interests, they didn’t formally admit the assignees as partners as per the agreement. As a result, the charities, as assignees, lacked certain rights, including the right to vote on partnership matters. (On a side note, charities may consider entering into a joinder agreement, under which an interest transferee is admitted as a member and becomes party to, and bound by, the terms of the partnership or limited liability company agreement.)
Although one Tax Court judge stated that the partial interest rule would have precluded any deduction in the first place for the assignment of only the economic portion of their LP interest, the Tax Court majority allowed the charitable deduction, with an adjustment to the value. The U.S. Court of Appeals for the Fifth Circuit subsequently reversed the Tax Court in accepting the taxpayer’s valuation formula and didn’t raise the partial interest rule.41 Therefore, any requirement of conveying a “vertical slice” with respect to the LP didn’t arise in the final court decision.
As to whether this vertical slice requirement extends to any GP interest in addition to any LP interest owned, the IRS has bypassed this issue in the context of charitable contributions.
• In one private letter ruling, the taxpayers contributed their LP interests in a real estate partnership to a charitable remainder trust (CRT) and retained their GP interests.42 The IRS noted that any person acquiring the LP interests held by CRTs would likely want to acquire the GP interests as well. The IRS didn’t find any self-dealing in a subsequent sale of the LP interests by the CRT trustee and, with respect to the LP contribution, didn’t raise the issue of partial interests.
• In its own training materials, the IRS identified as potentially abusive a strategy in which the taxpayer retained a GP interest and donated his LP interest to charity, with the plan to have his family reacquire this interest at a much lower price (through a vehicle known as a “Char-FLIP”).43 While the IRS cited this strategy as problematic under Section 170 and other provisions, it didn’t specifically identify the partial interest rule as grounds for denying the charitable deduction, although commentary suggests that it would.44
• Both instances feature the donation of the LP interest and retention of the GP interest, in contrast to the GP carried interest transfer generally targeted under Section 2701.
In reviewing a vertical slice approach for charitable contributions of carried interests, it’s important to consider the respective purposes of Sections 2701 and 170. Section 2701 specifically addresses GP and LP interests in imposing its valuation rules, to prevent undue gift tax avoidance between family members, through an apparently abusive manipulation of value between common and preferred interests in a family entity. Section 170 and its regulations don’t specifically refer to partnerships, but instead reflect the general principle that donating an interest in property, while retaining substantial rights in the same property, doesn’t warrant a charitable deduction. Therefore, while donating just the carried interest and retaining other interests in the GP may potentially raise the issue of a partial interest, the IRS hasn’t specifically targeted such transfers in a charitable donation context.
Whether Section 170 requires partners to convey a proportionate share of the LP interests, as well as their GP interests, may depend on their characterization as separate property. If the GP and LP interests constitute different rights within the same property under state law and the partnership agreement, then donating the GP interest, while retaining the “senior” rights represented by the LP interest, may not necessarily qualify for a charitable deduction under the partial interest rule. If the GP and LP entities constitute separate properties for purposes of Section 170, with their own respective bundle of rights, then the partial interest rule potentially wouldn’t dictate a vertical slice approach to encompass both entities. (On that note, the viability of donating an interest in a separate or special purpose co-investment vehicle formed by a different group of partners also depends on whether it constitutes different property for purposes of Section 170.) In considering partial interests in a partnership, some commentators have cited cases applying section 2703 (which addresses valuation in light of certain rights and restrictions) in suggesting that “each type of partnership interest (for example, preferred or common) is itself a separate property interest rather than a partial interest in some other property.”45
Therefore, in reviewing the strategies below, partners should confirm with counsel whether their GP and LP interests in the fund they manage would constitute partial interests for charitable income tax deduction purposes.
Before the redemption or sale of a partnership interest. In general, the tax consequences of current distributions also apply to liquidating distributions, with several differences, including potential loss recognition.46 Accordingly, to the extent private equity partners receive marketable securities on liquidation, they may potentially qualify under the “investment partnership exception” and defer taxation until their subsequent sale of the distributed securities.47
Private equity investors who seek to cash out of their fund ahead of schedule may encounter interested buyers in an ever-growing secondary market for fund interests. Journalists have cited a significant uptick in secondary sales of stakes in funds—including private equity funds, venture capital funds and real estate funds, in one instance amounting to $47 billion in 2014, an increase of roughly 80 percent from the previous year.48 Depending on the level of market appreciation of LP interests, partners seeking to dispose of these interests may consider donating them as another type of long-term highly appreciated asset to optimize their charitable planning.
During a partnership wind-down of a mature private equity fund. A partner receiving a liquidating cash distribution generally recognizes capital gains or loss to the extent of the difference between the proceeds received and partner’s outside basis.49 For appreciated private equity funds about to wind down (with no set liquidation amount), the partners may consider donating their partnership interests to charity and bypass any capital gains recognition as a result. While hedge funds don’t have a specific end date, they may also terminate for various reasons, including the retirement of the principal manager. However, donating a hedge fund partnership interest may have less appeal as a high basis asset (resulting from years of pass-through partnership income.)
In general, a partnership terminates on the:
• cessation of partnership business activities; or
• sale or exchange of 50 percent or more of the interests in the partnership capital and profits within any 12-month period.50
For tax purposes, the termination date occurs upon the completion of the winding up of the partnership affairs.51 As a result, a private fund termination may occur for tax purposes long after its intended end date.52 The number of private equity funds that have struggled to wind down on schedule has made popular the term “zombie funds” for those with an extended term. Pending fund terminations may present a charitable planning opportunity to partners who can afford to divert part or all of their partnership interests to charity in advance of the termination.
Hedge Fund Partners
Hedge funds may also make in-kind distributions of securities, which the receiving partner can subsequently donate to charity. Depending on the basis of the securities distributed, their value at the time of distribution and ease of liquidation, the asset may qualify as a suitable candidate for donating to charity. Partners making donations of appreciated securities should also ensure that the holding period (with tacking) exceeds one year to obtain an FMV deduction.53
However, donating securities at the partnership level may not please investors or managers, who don’t want to disrupt the specific trading strategies employed within the hedge fund.
Hedge fund managers often inquire whether they can donate their fund interests to charitable vehicles, most often a PF, which lends to a high degree of their control over the investment composition. Doing so raises several potential issues, including:
• PF excise taxes for:
• jeopardy investments,54
• self-dealing if the manager donates encumbered assets or receives management fees from the PF. In the latter case, the manager may demonstrate the fee as a reasonable arm’s-length amount, pursuant to several PLRs,55 or simply choose to waive his fees,
• fiduciary duty to diversify under the Uniform Prudent Management of Institutional Funds Act or the Uniform Prudent Investment Act, and
• UBIT for any debt-financed income.
Alternatively, hedge fund managers may donate LP interests held in other hedge funds that they invest in, or simply cash, which may constitute a significant component of their wealth.
—The author gratefully acknowledges the guidance of Jennifer Reynoso, Simpson Thacher & Bartlett LLP, N. Todd Angkatavanich, Withers Bergman LLP, Kevin Matz, Kevin Matz & Associates PLLC, Daniel H. McCarthy, Wick Phillips Gould & Martin, LLP and Ryan Boland and Jacqueline Valouch, Fidelity Charitable.
—Credit Suisse Securities (USA) LLC (CSSU) does not provide tax or legal advice. This information is for educational purposes only. CSSU makes no representation as to the accuracy or completeness of and accepts no liability for losses arising from the use of the material presented.
1. Andrew Needham, BNA Portfolio 735-2nd: Private Equity Funds, II. Fund Prototypes, Basic Fund Categories
2. Andrew Needham, BNA Portfolio 736-1st: Hedge Funds, Introduction, A. What Is a Hedge Fund?
3. The “distribution waterfall” governs the fund’s distribution of sales proceeds and any marketable securities after a portfolio company goes public and sets forth a set of priorities. The first priority is usually invested capital, whether invested to fund portfolio investments or an allocable portion of the management fee. In most cases, the second priority is a preferred or hurdle return on that capital. If the fund provides for a hurdle return, the third priority is a catch-up distribution to the general partner. The fund then distributes any remaining proceeds, which represent residual investment gains, to the investors and the general partner with respect to its carried interest. Kevin Matz, "Estate Planning Strategies for Private Equity Fund Managers," Estate Planning Journal, Vol. 34, Number 11 (November 2007).
5. Richard L. Dees, Profits Interests Gifts Under Section 2701: 'I Am Not a Monster' By, Tax Notes, May 11, 2009, page 707; Richard L. Dees, Is Chief Counsel Resurrecting The Chapter 14 'Monster'? Tax Notes, December 15, 2014, p. 1279.
6. Lydia Beyoud, “Legislation on Carried Interest Wouldn’t Affect Fee Waiver Guidance, IRS Official Says,” BNA Weekly Report: News Archive (June 16, 2014) Current Developments 33 TMWR 776 Business Entities; Amy S. Elliott, “IRS Is Studying Fee Waivers,” Tax Notes Today (May 1, 2013); Victor Fleischer, “What’s at Issue in the Private Equity Tax Inquiry,” New York Times, Dealbook (Sept. 4, 2012), http://dealbook.nytimes.com/2012/09/04/whats-at-issue-in-the-private-equity-tax-inquiry/.
7. Andrew W. Needham, BNA Portfolio 735-2nd: VI. Special Tax Issues for the General Partner and Its Members, A. The Grant of the Carried Interest.
9. Internal Revenue Code Section 751. Ordinary income may result if the fund directly invested in a portfolio company that operated as a flow-through entity with unrealized receivables or inventory. Internal Revenue Code Section 751.
10. Rev. Proc. 93-27, 1993-2 C.B. 343; Rev. Proc. 2001-43, 2001-2 C.B. 191.
11. H.R. 3996, Temporary Tax Relief Act of 2007, 110th Cong., 2d Sess.; Treasury Department News Release, “FACT SHEET: Administration’s FY2016 Budget Tax Proposals,” TDNR JL-9753, Treasury Department (Feb. 3, 2015).
12. IRC Sections 475(f); Seth H. Poloner, “Structuring Hedge Fund Manager Compensation: Tax and Economic Considerations,” Journal of Taxation, Vol. 112 (May 2010). Beginning in 2013, individuals with modified adjusted gross incomes in excess of a specified amount became subject to an equivalent 3.8% previous Medicare surtax under on their "net investment income" (NII), IRC Section 1411. This tax does not apply to any income derived from an exempt trade or business. Because the activities of a hedge fund do not qualify as exempt trade or business activities, the interests in the fund cannot qualify as exempt property from the Medicare surtax. IRC Section 1411(c)(4).
13. IRC Section 457A; Notice 2009-8, Q&A-22. For purposes of §457A, the rights of a person to compensation are subject to a substantial risk of forfeiture only if such person's rights to such compensation are conditioned upon the future performance of substantial services by such person. The addition of any risk of forfeiture after the legally binding right to compensation arises, or any extension of a period during which compensation is subject to a risk of forfeiture is disregarded for purposes of determining whether such compensation is subject to a substantial risk of forfeiture. Section 457A(d)(1)(A); Notice 2009-8, Q&A-3(a).
14. See Julia Chu, “Managing CLAT Investments,” Trusts & Estates (January 2011), at p. 52 for information on optimal charitable lead annuity trust asset allocation.
15. Treasury Regulations Section 1.61-2(c); Revenue Ruling 77-290, 1977-2 C.B.26; amplified Rev. Rul. 79-132; 1979-1 C.B. 62 and Rev. Rul. 80-332, 1980-2 C.B. 34.
16. Revenue Ruling 72-542, 1972-2 C.B. 37.
17. REG-105346-03, 70 Fed. Reg. 29675 (May 24, 2005). Notice 2005-43, 2005-1 C.B. 1221. Currently, Revenue Procedures 93-27, 1993-2 C.B. 343 and 2001-43, 2001-2 C.B. 191 address the treatment of the grant of a partnership capital and profits interest in exchange for services.
18. Treas. Regs. Section 1.83-1(a)(1); PLR 9737015 (June 13, 1997); PLR 9737016, (June 13, 1997).
19. See Julia Chu, “Charitable Planning for Executives,” Trusts & Estates (October 2014) at 46.
20. IRC Section 731(a), (b); Treas. Regs. Section 1.731-1(a), (b). The IRC treats the distribution of marketable securities (that is, actively traded property on an established financial market) as a distribution of money under specified circumstances. IRC Section 731(c). If this provision applies, the receiving partner would recognize gain to the extent that the fair market value of the securities exceeds his tax basis in the fund. Section 731(a). However, this rule generally doesn’t apply to private equity fund distributions under the investment partnership exception or due to the initial classification of the distributed shares as non-marketable when acquired. Section 731(c)(3); Treas. Regs. Section 1.731-2(e).
The “mixing bowl” rules require a contributing partner to accelerate gain or loss recognition when another partner receives the contributed property within seven years of the original contribution. IRC Section 704(c). Private equity funds often solicit capital commitments from prospective investors and call on these commitments in stages as they identify investment candidates, or otherwise as necessary to fund management fees and other expenses. Given this common pattern of funding with cash, as opposed to appreciated assets, the mixing bowl rules typically don’t apply to private equity fund distributions
21. IRC Sections 732(a), 733(2).
22. See supra note 19.
25. IRC Section 702(a)(4); Treas. Regs. Section 1.702-1(a)(4). The partnership’s taxable income doesn’t account for charitable contributions. Sections 702(a)(4), 703(a)(2)(C). Each partner determines the deduction based on their respective adjusted gross income-based limitations.
26. Regulation D, Regs. Section 230.501(a)(3); Section 2(a)(51), Investment Company Act of 1940; Goldman Sachs Asset Management, L.P. No-Action Letter dated March 13, 2007, available at http://www.sec.gov/divisions/investment/noaction/2007/gsam031307-3c7.htm.
27. IRC Sections 512(b)(4), (5), 514. The Code also applies a 125% excise tax on a donor, donor advisor, or related person who gives advice to have a sponsoring organization make a distribution from a donor-advised fund, which results in such person receiving, directly or indirectly, a more than incidental benefit as a result of such distribution. IRC Section 4967. DAFs should examine whether accepting a fund interest with a corresponding capital call obligation could trigger such a penalty.
28. Rev. Rul. 98-21, 1998-18 I.R.B. 7.
29. IRC Section 733(a); Treas. Regs. Section 1.733-1.
30. Rev. Rul. 75-194, 1975-1 C.B. 80.
31. Supra note 4.
33. Attribution rules under Section 2701 may attribute a preferred senior interest transferred to a grantor CLAT to the grantor. Treas. Reg. Sections 25.2701-6(a)(4)(ii)(C) and 25.2701-6(a)(5)(i). Accordingly, transfers of fund interests to charitable split interest trusts warrant careful planning.
34. IRC Section 170(f)(3)(A); Treas. Regs. Section 1.170A-7(a)(1).
35. Treas. Regs. Section 1.170A-7(a)(2)(i).
36. IRC Section 170(f)(3)(B)(ii).
37. Treas. Regs. Section 1.170A-7(b)(1).
39. Rev. Rul. 88-37, 1988-1 C.B. 97.
40. McCord v. Commissioner, 120 T.C. 358 (2003). Specifically, Judge Swift cited the analogous rule of IRC Section 2522(c)(2), which bars gift tax charitable deductions for the transfers of partial interests.
41. Succession of McCord v. Commissioner, 461 F.3d 614, (5th Cir. 2006), rev’g and rem’g McCord, 120 T.C. 358 (2003).
42. Private Letter Ruling 9114025 (Jan. 7, 1991).
43. IRS, 2001 EO CPE Text, Topic G, 6. “Charitable Family Limited Partnerships.”
44. Steve Leimberg’s Estate Planning Newsletter # 617, www.leimbergservices.com, Charitable Family Limited Partnerships.
45. N. Todd Angkatavanich, Jonathan G. Blattmachr & James R. Brockway, Coming Ashore - Planning for Year 2017 Offshore Deferred Compensation Arrangements: Using CLATs, PPLI and Preferred Partnerships and Consideration of the Charitable Partial Interest Rules, ACTEC LAW JOURNAL , Volume 39 Number 1 and 2 Spring 2013/Fall 2013 103, 136.
46. IRC Section 706(c)(2)(A); Treas. Regs. Section §1.706-1(c)(2)(i). Liquidating distributions terminate the distributee partner’s entire interest in a partnership, whether through one distribution or a series of distributions. IRC Section 761(d); Treas. Regs. Sections 1.731-1(a)(1)(i), 1.761-1(d). For a series of liquidating payments, each one constitutes a liquidating (as opposed to current) distribution, even though the interest doesn’t liquidate until the final payment. Treas. Regs. Section 1.761-1(d).
47. For purposes of partnership distributions, marketable securities don’t constitute cash in the case of distributions of securities that weren’t marketable when acquired by the fund; and distributions of securities from an “investment partnership” to an “eligible partner.” IRC Section 731(c)(3)(A)(ii) and Treas. Regs. Section 1.731-2(d)(3); Sections 731(c)(3)(C)(i) and 731(c)(3)(A)(iii).
49. IRC Section 731(a)(1), 731(c)(3)(A)(ii) and Regs. § 1.731-2(d)(3); 731(c)(3)(C)(i) and 731(c)(3)(A)(iii).
50. IRC Section 708(b).
51. Treas. Regs. Section 1.708-1(b)(3)(i).
52. For instance, when partners agree on April 30, 2015 to dissolve their partnership but carry on the business through a winding up period ending Sept. 30, 2015, when all remaining assets, consisting only of cash, are distributed to the partners, the partnership doesn’t terminate because of cessation of business until Sept. 30, 2015. Treas. Regs. Section 1.708-1(b)(1). Private Equity’s Long Tail: Considerations for Private Equity Managers and Investors Facing Fund Life Extensions (2015), Michael D. Custar, Credit Suisse Securities (USA), LLC, Kenneth T. Latz, Conway MacKenzie, Jeremy A. Duksin, Credit Suisse Securities (USA), LLC, David J. Schwartz, Debevoise & Plimpton, LLP, Andrew M. Ahern, Debevoise & Plimpton, LLP.
53. Section 735(b).
54. Treas. Regs. Section 53.4944–1(a)(2)(i). By contrast, donor advised fund sponsors typically seek to diversify out of donated securities to align with their own investment policies.
55. IRC Section 4941(d)(2)(A); Regs. §53.4941(d)-3(c)(2), Ex. (2); PLR 200102055 (Oct. 13, 2000); PLR 199905025 (Feb. 8, 1999); ; PLR 9619049 (Feb. 7, 1996).