U.S. Income Portfolios: Other Pass-through Entities 
  Portfolio 735-2nd: Private Equity Funds 
  Portfolio Description

Andrew W. Needham
 Cravath, Swaine &  Moore LLP
 New York, NY
 
 Special Consultant to Tax Management

 based on an earlier version by 
 
 Andrew W. Needham
 Cravath, Swaine &  Moore LLP
 New York, NY
 and
 Anita Beth Adams
 Adams &  Adams
 Selmer, Tennessee

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

U.S. Income Portfolios: Other Pass-through Entities 
  Portfolio 735-2nd: Private Equity Funds 
  Portfolio Description

Leonard L. Silverstein, Esq. 
 Advisory Board Chairman
 Technical Director
 
 Gerald H. Sherman, Esq. 
 Deputy Technical Director
 
 Patrick G. Dooher, Esq. 
 Deputy Technical Director
 for U.S. Income

U.S. Income Portfolios: Other Pass-through Entities 
  Portfolio 735-2nd: Private Equity Funds 
  Portfolio Description

PORTFOLIO DESCRIPTION 

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.

Private equity funds are investment vehicles that pool capital in privately-owned businesses at different stages of development.  A recurring theme in this portfolio is that very few fund structures produce optimal tax consequences to every participant or, for that matter, any single participant.  Fund structures instead resolve inherent conflicts by compromise, allowing investors with similar and conflicting tax objectives to coexist within a single fund or fund family.

This portfolio may be cited as Needham, 735-2nd T.M., Private Equity Funds.

U.S. Income Portfolios: Other Pass-through Entities 
  Portfolio 735-2nd: Private Equity Funds 
  Detailed Analysis

I. Introduction 

This portfolio addresses the common U.S. tax issues that arise in the representation of private equity funds.  Its purpose is to provide a source of guidance to tax practitioners who regularly advise private equity funds and their investors.

Private equity funds are investment vehicles that pool capital for investment in privately owned businesses at different stages of development. Like mutual funds and hedge funds, they serve a range of different markets.  Some funds broadly diversify; others focus on particular sectors of the market.  Angel funds invest in start-ups; mezzanine funds invest in more established companies.  Private label or captive funds, although not a discrete investment category, invest on behalf of a single or dominant investor.  LBO funds invest in mature businesses with positive cash flows, with particular emphasis on highly leveraged going private transactions and divisional asset acquisitions.  Funds-of-funds invest in other private equity funds, responding to the special needs of investors who lack the time, resources or expertise to invest in and manage multiple funds.

Obscured in this broad diversity, however, is an overriding similarity among funds that informs much of the basic tax planning.  In particular, the tax structure of most U.S. private equity funds, from the choice of entity at the fund level to the specific economic terms of a portfolio investment, seeks to address three characteristics.  First, an investor in a private equity fund has no liquidity in the short term.  Investors achieve liquidity in stages as the fund disposes of its portfolio investments for cash or marketable securities and distributes the proceeds.  Second, most private equity funds invest for capital appreciation, not current income.  Depending on the particular class of investor, therefore, economic returns of this character may qualify for tax deferral, taxation at reduced rates or even tax exemption.  Third, funds tend to solicit capital from multiple classes of investors, bringing groups of participants with potentially conflicting objectives into a single venture.  This portfolio addresses the tax implications of these characteristics, from the legal structure of the fund, the fund manager and the general partner, to the economic terms of the portfolio investment.  As this portfolio seeks to demonstrate, it is these differences that drive much of the complexity in modern fund structures.

U.S. Income Portfolios: Other Pass-through Entities 
  Portfolio 735-2nd: Private Equity Funds 
  Detailed Analysis 
  II. Fund Prototypes

A. Basic Fund Structures 

1. In General 

Although the investment objectives of private equity funds cover the full spectrum of the market, their organizational structure usually falls within one of four broad prototypes: direct investment funds;funds of funds; hybrid funds; and parallel funds.  Ultimately, however, a fund agreement is no more than a privately negotiated contract among multiple participants.  Any given fund agreement or fund structure will therefore depart from market “norms” as necessary to reflect the specific objectives of its participants.  In addition, the investment philosophy of the fund, the track record of the sponsor and the composition of the investor group each inform fund structure and investment terms.  Nevertheless, because market precedent does tend to define the broad structural and economic parameters of most new funds, this portfolio begins with a summary description of broad fund prototypes.

2. Direct Investment Funds 

Worksheet 1 presents a diagram of a typical “direct investment”fund, including the legal entities that serve as the general partner and fund manager.

a. The Fund 

Typically, the sponsor of a direct investment fund organizes the fund as a limited partnership, a limited liability company (“LLC”)or other form of pass-through entity for U.S. tax purposes, either in the United States or in a low-tax jurisdiction.  The fund has a fixed life, generally seven to ten years, reflecting the expected holding period of its last portfolio investment.  Upon formation, the fund solicits capital commitments from prospective investors and calls on these commitments in stages as it identifies investment candidates or otherwise as necessary to fund management fees and other expenses. Once the fund reaches a targeted level of commitments, the fund manager closes the fund to other investors.  As compensation, the fund pays a periodic management fee to the fund manager equal to a fixed percentage(e.g., 2%) of the total capital commitments.  Once the fund reaches full investment, the base for computing the management fee shifts to “invested capital,” and therefore declines as the fund disposes of investments.  In many cases, the fee percentage itself drops to a lower rate after the fund has invested the entire commitment. The fund pays the management fee either from contributed capital or from the proceeds of sale of its portfolio investments.

During the “investment period,” the fund invests the committed capital in portfolio companies that meet its stated investment criteria. Distributions to investors occur as the fund either sells those investments or converts them to marketable securities.  The general partner will participate in those distributions based upon its “carry percentage,”which usually conveys a fixed percentage of gains over losses on fund investments, computed on an aggregate basis.

b. The General Partner 

The general partner of a private equity fund is usually a passive entity that engages in no business activity, serving as a pure holding company for the carried interest.  The sponsor organizes the general partner of the fund as a pass-through entity for tax purposes, often a domestic LLC or offshore general partnership for funds that operate within the United States.  It usually contributes nominal capital to the fund (e.g., 1% of the aggregate commitments), for which it receives the same return as an investor.  The general partner also receives a special allocation of investment gains, commonly described as a “carried interest” but occasionally as an “override,”an “incentive allocation” or a “profits interest.”The sponsor usually sets the carry percentage at 20%, but with significant variation in how it is computed and when it accrues.  In some funds, the carry percentage may even increase over time as the fund achieves benchmark returns on invested capital.  For tax purposes, the sponsor will structure the carry as a partnership allocation to pass through the character of income at the fund level to the general partner and its members.  Although most general partners operate as independent entities, some share affiliations with commercial or investment banks and others operate as the venture capital arm of a public company. In most cases, the members of the general partner consist in whole or in part of U.S. individuals who qualify for the capital gains preference, allowing them to receive compensation both free of employment taxes and at a reduced rate of federal income taxation.

c. The Fund Manager 

As its name implies, the fund manager manages the fund on behalf of its investors.  On occasion, it provides services not only to the fund, but to the portfolio company investees of the fund.  As compensation, the fund manager receives a periodic management fee, the purpose of which is to defray the cost of managing the fund.  Expressed as a percentage of total capital commitments, the fee usually accrues on a quarterly basis, declining during future periods as the fund approaches full investment.  To avoid entity-level taxes on the management fee, the sponsor usually structures the fund manager as an LLC or other pass-through entity, in many cases as a separate sibling entity to the general partner.  The sponsor bifurcates the fund manager and the general partner into two entities for one of two reasons: to minimize local taxes1 or to facilitate the creation of separate interests in the discrete income streams.
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1 As described more fully in VI, B, 6, below, separating the two entities may allow a fund manager with offices in New York City to avoid unincorporated business taxation of the carried interest distributions.

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3. Funds of Funds 

a. The Fund 

Just as investors in publicly traded securities minimize risk by diversifying their investments, fund investors allocate capital earmarked for private equity among multiple funds, in particular if the specific funds concentrate their investments within narrow sectors of the market.  Some of these investors lack the necessary time, resources and expertise to invest in multiple funds.  A popular alternative for these investors is a “fund of funds” (“FOF”), an entity formed for the sole purpose of investing in other private equity funds.  By investing in an FOF, the investor delegates the ultimate investment decision to a single manager, who operates as a kind of “gatekeeper”on behalf of the FOF investors.  In addition, by pooling its capital with similarly situated investors, an FOF investor is often able to invest in other funds with minimum capital requirements or other investment conditions that the FOF investor could not satisfy directly.

Like a direct investment fund, an FOF calls capital from its investors on a periodic basis to fund investments or other expenses.  The major difference is that the bulk of the capital calls occur as a particular subfund calls capital from its own investors, which includes the FOF. The subfund then invests and distributes proceeds according to its own fund agreement.  As the FOF receives distributions from the subfund, it distributes those amounts to its general partner and its investors. The priority of these distributions will depend primarily upon whether the FOF treats an investment in a subfund as a single investment or “looks through” to the different portfolio investments of the subfund. Although difficult to generalize here, the latter approach is probably the market norm.

b. The General Partner 

For the same reasons as in a direct investment fund, the sponsor organizes the general partner of the FOF as a pass-through entity.  The general partner usually receives a carry as additional compensation for managing the portfolio.  An investor in an FOF therefore bears two carries on its capital, one to the FOF general partner and one to the general partner of each of the underlying direct investment funds.  The carry percentage at the FOF level, however, is usually much lower than the underlying carry due to the more passive role of the general partner and fund manager.  They invest capital in subfunds, the general partner and fund manager of which are responsible for the more time consuming task of identifying and making investments in the ultimate portfolio companies.  The terms of the carry will also tend to vary depending upon the carry percentage of each subfund.  In some cases, the general partner may simply receive one or more “performance allocations”on capital after its investors have received a stated return on their investment.

c. The Fund Manager 

The sponsor usually organizes the fund manager of the FOF as a pass-through entity, with little difference in basic structure from the fund manager of a direct investment fund.  The fund manager, however, will generally charge a lower management fee than its direct investment fund counterpart, reflecting the reduced expenses of managing an FOF.

4. Parallel Funds 

Parallel fund structures chiefly serve the special tax objectives of the tax-exempt or foreign investors.  Except as necessary to accommodate those objectives, therefore, they do not differ from other fund prototypes in basic investment objectives, call rights, distribution priorities, nature of the carried interest, or expected investment period.  As described above, the sponsor organizes the primary fund, the fund manager and the general partner as pass-through entities.  The sponsor forms the parallel entity, which serves as the vehicle through which electing tax-exempt or foreign investors make their investment, in a tax haven jurisdiction.  The parallel entity either “feeds”the primary fund as a single investor or coinvests directly in the underlying portfolio companies with the primary fund.  In the latter case, the general partner holds a separate carry in each entity. When the parallel entity holds the entire investment of the tax-exempt or foreign investors, it often invests any capital earmarked for pass-through portfolio companies through a “blocker” subsidiary.

Worksheet 2 presents a diagram of a typical “parallel fund,”including the legal entities that serve as the general partner and fund manager.

5. Hybrid Funds 

A “hybrid” fund is a fund that merges two or more of the basic prototypes within a single entity.  A direct investment fund, for example, may also invest a portion of its capital in an FOF, or may permit the sponsor to form a parallel vehicle for special investments or for specific types of investors.  The basic investment objectives and distribution priorities in a hybrid fund, although highly variable from one fund to another, tend to reflect a blend of the objectives and distribution priorities of its constituent parts.  Although the hybrid nature of the fund presents few new tax issues, it often introduces economic issues of great complexity that the parties must negotiate and address in the fund agreement.  A hybrid fund, for example, may convey different carry percentages for direct and FOF investments. Without a constant carry percentage, the fund agreement must establish how the fund will aggregate carry distributions on FOF investments with previous or future losses on direct investments and vice versa, and must implement the clawback to reflect those principles.  The agreement must also address whether, for distribution purposes, an investment in an FOF is to be treated as a direct investment in the underlying portfolio company investees of the subfund or as a single investment.  If the hybrid fund “looks through” the FOF, the general partner will participate in distributions by the FOF before the hybrid fund receives a return of its full commitment.  If the hybrid fund instead treats the FOF investment as a single investment, it will distribute investment gains attributable to the underlying investments of the FOF entirely to the investors until the FOF fully reimburses the aggregate commitment.

U.S. Income Portfolios: Other Pass-through Entities 
  Portfolio 735-2nd: Private Equity Funds 
  Detailed Analysis 
  II. Fund Prototypes

B. Basic Fund Categories 

The “private equity” umbrella subsumes a wide-range of fund categories.  This section of the portfolio describes the various categories of private equity funds and their investment objectives.

1. Venture Capital Funds 

Venture capital funds are probably the most conventional form of private equity fund.  These funds invest capital in privately owned businesses during the earlier stages of product or service development.  The businesses often generate losses in the pursuit of revenue growth and market share and therefore lack the necessary cash flows to rely on more conventional financing sources, such as banks or other institutional lenders.  They also lack the maturity necessary to raise equity from the public markets.  On occasion, venture capital funds also invest in more established businesses that seek additional financing to expand or develop a specific line of business.  Venture capital funds usually invest directly in the portfolio company for newly issued shares, diluting rather than “cashing out” the existing shareholders. The portfolio company uses the cash proceeds to develop its business model, either by internal growth or by acquisition.

2. Leveraged Buyout Funds 

Unlike a venture capital fund, a leveraged buyout fund invests primarily in established businesses with substantial borrowing capacity.  In a typical investment, the fund will acquire a controlling interest in the business.  Rather than invest directly in the target company, however, the fund usually organizes a corporate acquisition vehicle, which then acquires the stock or assets of the portfolio company. The existing shareholders often receive all or a substantial portion of the fund investment in a taxable sale of the business.  If the acquisition vehicle acquires stock and the portfolio company is either an 80%-or-greater subsidiary of a corporate seller or an S corporation, the parties will often structure the acquisition as a “qualified stock purchase,” with a joint election under  § 338(h)(10)2 to treat the acquisition as an asset purchase for tax purposes.3 Finally, leveraged buyout funds usually finance most of the purchase price with debt, which the underlying portfolio company will service from existing cash flows.
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2 All section references are to the Internal Revenue Code of 1986, as amended (the “Code”), or the regulations thereunder, unless otherwise indicated.

3 See Regs. § 1.338(h)(10)-1(c)(1) (permitting election when T is member of “selling consolidated group” or “S corporation target”).  For a general discussion of the § 338(h)(10) election, see 788 T.M., Stock Purchases Treated as Asset Acquisitions — Section 338.

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3. Mezzanine Funds 

A mezzanine fund provides financing to more established businesses. In a typical investment, the portfolio company will have already completed one or more rounds of venture capital financing.  Indeed, mezzanine funds tend to target companies on the eve of a sale or public offering, often acquiring a “strip” of securities that may include preferred stock, subordinated debt and warrants.  Because the investment return of a mezzanine fund usually includes a substantial interest or dividend component, its foreign investors bear greater vulnerability to withholding taxes than the foreign investors in other funds.

4. Distressed Securities Funds 

As the name suggests, a distressed securities fund targets public companies that are bankrupt, insolvent or otherwise over leveraged. A distressed securities fund seeks to identify companies with high asset valuations and to gain control of those companies by first acquiring a controlling interest in their debt securities.  These securities usually trade at a steep discount to their accreted values, reflecting the high credit risk of default.  By purchasing these securities in large blocks, distressed securities funds seek to influence the specific terms of the bankruptcy or other reorganization of these companies.

5. Angel Funds 

Angel funds provide seed financing to companies in the earliest stage of development.  A typical investee has yet to generate significant revenues from product sales or even a fully developed business model. These businesses cannot obtain conventional financing from banks or other lenders and cannot raise capital from the public markets.

6. Real Estate Funds 

A real estate fund is a fund that invests in real estate, either directly or through intermediate entities.  Real estate funds usually invest in particular categories of real estate, for example commercial office space, shopping malls, hotels, other retail properties or real estate within specific geographic regions.  Real estate funds commonly hold their portfolio investments not directly, but through joint ventures organized as pass-through entities for tax purposes.  The common use of leverage, coupled with special tax rules that apply to investments in real estate by tax-exempt and foreign investors, raise special tax concerns for these types of funds.

7. Geographically Targeted Funds 

A geographically targeted fund is a fund that invests solely or primarily in businesses within a specific geographic region.  The type, stage of development or particular sector of the market of the portfolio company investees will vary from fund to fund.  If the fund invests outside of the United States, the fund manager will often form the investment vehicle as a foreign entity, both to minimize its U.S. tax compliance obligations and to accommodate the special tax concerns of its U.S. investors.4
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4 See XI, B, 3, below.

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U.S. Income Portfolios: Other Pass-through Entities 
  Portfolio 735-2nd: Private Equity Funds 
  Detailed Analysis 
  II. Fund Prototypes

C. The Investor Participants 

A typical investor in a private equity fund seeks higher returns than those available on publicly traded stocks and securities.  Although some invest in private equity funds because they have higher tolerance for risk, most of them invest in this sector as part of a broad diversification strategy that includes more conservative asset classes.  Their common investment objectives aside, investors in private equity funds have distinctly different tax characteristics.

1. Individual Investors 

Most funds require their investors to invest capital in the fund over a multi-year period.  Due to size and length of these commitments, individuals generally represent only a small percentage of the capital in most funds.  Restrictions under the federal securities laws also limit the ability of the sponsor to solicit individual investors. If an individual is otherwise accredited, however, he or she will often invest in the fund through a special purpose vehicle created by the sponsor to pool capital from similarly situated investors, many of whom may enjoy a special relationship with the sponsor.  Whether or not the fund solicits individual investors, its general partner will almost invariably include individuals as members.  The tax issues of special concern to individual investors therefore receive careful consideration in virtually every private equity fund.

2. Institutional Investors 

Public companies occasionally invest in private equity funds, albeit often for strategic rather than financial reasons.  For example, the investment may provide access to portfolio companies within the same industry, allowing a public company to cultivate operational relationships that benefit its existing business.  A fund investment may also facilitate direct joint venture arrangements between the public company investor and the portfolio companies in new lines of business.  As a general proposition, institutional investors favor investments in portfolio companies organized as pass-through entities, which allow them to benefit currently from the flow through of operating losses that would otherwise shelter taxes during future periods.  As public companies, they tend to avoid investment structures that depress book earnings.

3. Tax-Exempt Investors 

Pension funds are major players in private equity.  Although they invest most of their assets in far less risky, more liquid securities, they usually allocate a very small percentage of their portfolios to aggressive asset classes, including hedge funds and private equity funds.  In absolute dollars, however, these small percentages represent the majority of the capital in the private equity sector.  Tax-exempt entities bear no tax on interest, dividends and capital gains, but do bear tax on “unrelated business taxable income” (“UBTI”). To avoid UBTI, they often restrict the investment discretion of the general partner before committing to invest in the fund.  These restrictions are sometimes severe, occasionally leading to complex investment structures that seek to “neutralize” the effect of these restrictions on the other investors in the fund.

4. Foreign Investors 

Like tax-exempt investors, foreign investors also represent a significant part of the private equity community.  As “investors”for U.S. tax purposes,5 they avoid net basis taxation on interest, dividends and most categories of capital gain.  Foreign investors seek to avoid “effectively connected” income, which, absent treaty protection, attracts U.S. tax at full corporate rates.  Although tax-exempt and foreign investors are subject to tax under separate and distinct provisions of the Code, the operative rules in the fund context tend to overlap in practice, usually leading to very similar investment restrictions in the fund agreement.
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5 See VII, A, 3, below.

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U.S. Income Portfolios: Other Pass-through Entities 
  Portfolio 735-2nd: Private Equity Funds 
  Detailed Analysis 
  III. The Economic Deal

A. Capital Commitments and Funding 

Unlike investors in hedge funds, investors in private equity funds do not invest their entire capital commitment at once.  Instead, they commit to invest a fixed amount of capital in stages, commonly referred to as the “investment period.” The sponsor targets a level of aggregate commitments to reflect the desired size of the fund.  If the fund does not receive sufficient commitments at the first closing, the sponsor may hold one or more additional closings before closing the fund to new investors.  The general partner then calls on these commitments over time, usually to fund investments but occasionally to pay management fees or other fund-level expenses.

The investors usually insist that the general partner fund a small percentage of the total investments of the fund, often 1%.  Although the capital commitment does serve a tax objective,6 that objective is incidental — the investors require the minimum commitment to discourage excessive risk-taking by the general partner.  The implicit assumption is that with its own money at risk, the general partner will be less inclined to exploit the option value inherent in the carried interest in an effort to realize a speculative gain.
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6 Some contend that the capital contribution may avoid the issue of whether the general partner received a “capital interest”for services or is not a “partner” for tax purposes. See VI, A, 4, below, for a discussion of these issues.

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When the general partner calls capital, each investor must contribute its pro rata share.  In practice, however, the process is more complex because some investors will not fund in lockstep with the other investors. For example, the sponsor may have achieved its targeted level of commitments only after multiple closings.  If the general partner calls capital before the final closing, the initial investors will be required to “front” the capital of the later investors. The fund agreement must be flexible enough to accommodate these issues, one of which is valuation.  Because private equity investments are not as susceptible to valuation as investments in hedge funds, the fund agreement must adopt less precise conventions to measure dilution and interim appreciation.  Even if the fund investments have not appreciated, the initial investors will still incur the cost of the “fronted”capital until the later investors fund their allocable share.  To compensate them for this cost, most fund agreements require the later investors to contribute the sum of their pro rata commitment and their allocable share of such appreciation and/or costs, which the fund then distributes to the original investors to restore their original unfunded commitments.7 Akin to the retirement of an advance, these distributions generally bear no preferred or hurdle return.
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7 See III, D, below, for a discussion of the tax consequences of these arrangements.

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The “investment period” terminates after a fixed period, usually five to seven years.  After the investment period, the general partner may not call any remaining unfunded commitments.  This prohibition does not apply, however, to outstanding calls to invest in a portfolio company effective as of the termination of the investment period or to “follow on” investments.  A “follow on”investment is an investment in a portfolio company in which the fund is already a shareholder.  After the investment period, the base for computing the periodic management fee changes from “committed capital” to “invested capital,” which excludes unfunded commitments.  The management fee therefore declines at the end of the investment period.  The management fee also declines as the fund sells its portfolio investments because the sales reduce “invested capital.”

U.S. Income Portfolios: Other Pass-through Entities 
  Portfolio 735-2nd: Private Equity Funds 
  Detailed Analysis 
  III. The Economic Deal

B. The Distribution Waterfall 

The “distribution waterfall” is the economic agreement that governs the distribution of sales proceeds by the fund, whether in the form of cash or marketable securities.  It also governs the distribution of marketable securities after a portfolio company goes public.  Every fund distributes investment proceeds to its investors pursuant to an established 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.

1. Return of Capital 

Investors in private equity funds achieve liquidity as and when the fund sells its investments.  Investors in hedge funds achieve liquidity by periodic redemption.  Unlike investors in hedge funds, therefore, investors in private equity funds rarely allow the general partner to reinvest sales proceeds.  To the contrary, a private equity fund will usually distribute sales proceeds immediately, especially if the carried interest does not bear a preferred or hurdle return. Exactly which capital the fund returns, however, depends upon the distribution methodology.  Return of capital distributions usually follow one of three paradigms: (i) investment-by-investment;(ii) “realized aggregation”; and (iii) full aggregation.

Funds that distribute proceeds “investment-by-investment”reimburse capital and expenses allocable only to the sold investment. In a fund that follows this methodology, therefore, the general partner will participate in any sales proceeds in excess thereof even if the fund has realized an aggregate loss on previously sold investments. If the fund provides for a preferred or hurdle return,8 the general partner will not participate in distributions until the fund achieves that return as well.
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8 See III, B, 2, below, for a discussion of preferred and hurdle returns.

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Example: A fund that provides for a 20% carried interest makes three portfolio investments at a cost of $10 million each in A, B and C.  At the end of the second year, it sells A for $8 million. At the end of the third year, it sells B for $15 million.  Assume no management fee or other expenses.  At the end of the second year, the fund will distribute the entire $8 million to the investors. At the end of the third year, the fund will distribute $10 million to the investors, $1.0 million to the general partner and $4 million to the investors.  The fund therefore distributes 20% of the aggregate$5 million gain on B to the general partner even though it has realized a net gain of only $3 million.

Because this methodology allows the general partner to participate in sales proceeds even if the fund has yet to realize a net gain, few funds follow it.  Rarer still are funds that follow this methodology and do not impose a “clawback” when the fund liquidates.9 If the fund does impose a clawback, the general partner in this example would be required to restore the $1 million distribution upon liquidation if the proceeds from the future sale of investment C are insufficient to recover the loss.
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9 See III, B, 4, below, for a discussion of the clawback obligation.

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In a fund that aggregates gains and losses on realized investments, the fund first distributes sales proceeds to reimburse capital and expenses allocable to the investment and then to reimburse unrecovered losses on prior sales (and, in some cases, built-in losses on retained investments). The general partner will therefore participate in distributions only when current gains exceed the aggregate excess of losses over gains on previously sold investments.  In funds that provide for a preferred or hurdle return, the general partner will not participate in distributions  until the net gains also exceed the preferred or hurdle return.

Example: A fund that provides for a 20% carried interest makes three portfolio investments at a cost of $10 million each in A, B and C.  At the end of the second year, it sells A for $8 million. At the end of the third year, it sells B for $15 million.  Assume no hurdle or preferred return and no management fees or other expenses. At the end of the second year, the fund will distribute the entire$8 million to the investors.  At the end of the third year, the fund will distribute $12 million to the investors, $0.6 million to the general partner and $2.4 million to the investors.  Although the fund has realized a gain of $5 million on B, the gain exceeds previous losses by only $3 million.  To reimburse the investors for the $2 million of loss on A, therefore, the fund will distribute the first$2 million of gain on B to the investors.

In a fund that provides for full aggregation, the general partner will receive carry distributions only after the fund reimburses all invested capital, not merely capital allocable to previously sold investments.  In a fund that adopts this methodology, the general partner may not participate in distributions until late in the life of the fund, even if the fund realizes substantial gains.

Example: A fund that provides for a 20% carried interest makes three portfolio investments at a cost of $10 million each in A, B and C.  At the end of the second year, it sells A for $12 million. At the end of the third year, it sells B for $15 million.  Assume no hurdle or preferred return and no management fees or other expenses. At the end of the second and third years, the fund will distribute the entire $12 and $15 million to the investors even though it has realized a $7 million gain because total invested capital ($30 million)still exceeds total investment proceeds ($27 million).  The fund will then distribute 20% of any sales proceeds on C in excess of $3 million to the general partner in respect of the carried interest.

2. Preferred vs. Hurdle Returns 

In many funds, the investors must also earn a preferred or hurdle return on their capital before the carry participates.  It is important not to confuse the two.  A preferred return is like capital to the general partner: it represents a cost that the fund must recover before the general partner participates in investment gains.  A hurdle return merely subordinates the carry, and therefore discourages premature capital calls and penalizes the general partner for failing to achieve a minimum return.  If the fund pays a hurdle return, the general partner will receive a “catch up” distribution of any remaining proceeds until the amount distributed to the general partner is sufficient to restore its full carry percentage of the pre-hurdle investment gains.  If the general partner earns the full catch-up, it will share in aggregate investments gains as if the fund had provided for no hurdle at all.

Example: A fund that provides for a 20% carried interest, an 8% hurdle, and a “catch up” to the general partner makes three portfolio investments at a cost of $10 million each in A, B and C.  Assume that the fund distributes proceeds on an “investment-by-investment”basis.  At the end of the second year, it sells A for $15 million, distributing $10 million to the investors to reimburse capital allocable to A and $1.66 million to the investors to cover the hurdle return($10 million x 1.08^2 - $10 million). The fund then distributes $0.415 million to “catch up”the general partner and the remaining $2.925 million 80% to the investors and 20% to the general partner in respect of its carried interest. The general partner therefore receives aggregate distributions of$1 million ($0.415 + $0.585), or the same distribution it would have received had the carry borne no hurdle at all (($15 million -$10 million) x 20% = $1 million).  Had the fund provided for an 8% preferred return, the general partner would have received aggregate distributions of only $0.668 million, or 20% of the investment gains in excess of an 8% return to the investors.

Some funds do not allow the general partner to “catch up”to the hurdle return from 100% of any remaining proceeds, the effect of which is to further subordinate the carry.  For example, a fund agreement may provide that the general partner will receive 50% of any remaining proceeds until it receives total distributions equal to 20% of the sum of the hurdle distributions and any “catch up” distributions to the investors.

Example: Assume the same facts as in the preceding example. At the end of the second year, the fund distributes $10 million to the investors to reimburse capital allocable to A and $1.66 million to the investors to cover the hurdle return ($10 million x 1.08^2 - $10 million).  The fund then distributes 50%of the next $1.11 million to each of the general partner and the investors to “catch up” the general partner and the remaining $2.23 million 80% to the investors and 20% to the general partner in respect of its carried interest.  Again, the general partner receives aggregate distributions of $1 million ($0.553 + $0.446), or the same distribution it would have received had the carry borne no hurdle at all.

So when does the hurdle really matter? Assume that the fund had sold investment A for $12 million rather than $15 million.  After paying the hurdle return, the fund would have had only $0.34 million to distribute to the general partner, which is less than 20% of the aggregate investment gains.  Had the fund borne no hurdle, the general partner would have received $0.4 million, or 20% of the $2 million of investment gains. The hurdle, therefore, reduces the carry percentage of the general partner when the fund fails to achieve a minimum level of gain.

3. The Carried Interest 

Regardless of the distribution methodology (i.e., investment-by-investment, realized aggregation, full aggregation), the general partner does not earn its carry until the fund returns aggregate invested capital to its investors.  The reason is that the general partner “earns”the carry only if aggregate gains exceed aggregate losses.  If the fund provides for a hurdle return, the aggregate gains must exceed the aggregate losses by more than the hurdle return.

Despite this uncertainty, funds that distribute either on an “investment-by-investment”or “realized aggregation” basis allow current distributions to the general partner.10 The assumption implicit in such funds is that the retained investments will ultimately command prices at least sufficient to reimburse any remaining unreturned capital (or remaining capital plus the hurdle return in funds that provide for one).  This phenomenon may produce excess distributions to the general partner during periods that precede liquidation of the fund.  The problem of excess distributions is particularly acute if the fund does not escrow any portion of the general partner's carry and ignores unrealized losses in the portfolio.11 The effect of these provisions is to reward the general partner for accelerating the sale of gain investments and deferring the sale of loss investments by providing its members with the interim use of the funds.  To achieve full aggregation of gains and losses, most funds impose a “clawback”obligation.12
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10 Real estate funds usually prohibit non-tax distributions to the carry until the investors have received their full capital contributions (plus a hurdle in many cases), a significant exception to the market norm.

11 Some funds require that investors recover unrealized losses from sales proceeds only if generally accepted accounting principles require the fund to write down the investment or if the general partner deems it appropriate in its reasonable discretion.

12 Alternatively, the fund may escrow all or a portion of any carry distributions to the general partner until the investors receive a minimum percentage of their investment capital or, less frequently, until the fund returns invested capital on an aggregate basis.  Under either approach, the escrow often excludes tax distributions to the general partner.

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4. The Clawback 

To reconcile the aggregate nature of the carry with the market practice of distributing proceeds on an “investment-by-investment”or “realized aggregation” basis, most funds impose a “clawback”obligation.  Assuming that the fund has properly allocated profit and loss,13 a general partner who contributes no capital to the fund should have a negative capital account at liquidation equal to its unearned distributions.  In funds that provide for a clawback, therefore, the general partner and its members must restore those distributions, which the fund will then redistribute to the investors.  In most funds, the fund agreement reduces the maximum clawback by taxes imposed (or deemed imposed) on the unearned distributions, even if the general partner realizes an offsetting capital loss on liquidation.14
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13 See V, below, for a discussion of tax issues in the allocation of profits and losses.

14 See VI, below, for a detailed discussion of the special tax concerns of the general partner and its members.

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The general partner occasionally remits the clawback directly to the investors in an effort to avoid creditors’ claims at the fund level.  In most cases, however, the general partner remits the clawback directly to the fund.  In either case, the general partner should be treated as contributing the clawback to the fund because the payment retires a fund-level liability.  Upon liquidation of the fund, therefore, the general partner should realize a capital loss.15 If the general partner is a pass-through entity, that loss will flow up to the members of the general partner.
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15 § 731(a)(2) (partner recognizes gain or loss on liquidation of partnership if partner receives no property other than cash, inventory or unrealized receivables).

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Example: A fund that provides for a 20% carried interest to the general partner makes three portfolio investments at a cost of$10 million each in A, B and C.  Assume that the fund distributes investment proceeds on a “realized aggregation” basis. At the end of the first year, it sells A for $15 million, distributing$10 million to the investors to reimburse capital allocable to A and the remaining $5 million 80% to the investors ($4 million) and 20%to the general partner ($1 million) in respect of its carried interest. At the end of the second year, it sells B for $12 million and distributes$10 million to the investors to reimburse capital allocable to B and the remaining $2 million 80% to the investors ($1.6 million) and 20%to the general partner ($0.4 million) in respect of its carried interest. At the end of the third year, the fund sells C for $4 million and liquidates.  When it distributes the full proceeds to the investors, the investors will have received aggregate distributions of only $29.6 million ($10 million + $4 million + $10 million + $1.6 million + $4 million), which is less than the $30 million of invested capital. The fund therefore invokes the clawback obligation.  Because the fund realized a net gain of only $1 million ($31 million - $30 million) over the life of the venture, the general partner should have received only $0.2 million, not $1.4 million.  The general partner therefore returns $1.2 million to the fund for redistribution to the investors.

Despite the potential tax benefit from the clawback payment itself, the fund agreement will often reduce the clawback obligation by any taxes paid or deemed paid by the general partner or its members on prior carried interest allocations.  A common formulation is that the general partner must return the lesser of (i) the excess carry distributions and (ii) the aggregate after-tax carry distributions to the general partner.  To justify this formulation, the general partner usually argues that the clawback should not exceed the distributions actually received by the general partner and not remitted to the IRS.  Empirically, however, the facts rarely bear this out.  First, the clawback reduction generally imports the hypothetical assumptions of the tax distribution provisions,16 which rarely reflect actual taxes incurred. Among these assumptions is that the general partner bears tax at the marginal rates of a NYC resident and has no unrelated losses to shelter fund income, an imprecision that the investors tolerate for administrative simplicity because the tax distribution merely reduces future distributions to which the general partner is otherwise entitled. Second, members of the general partner often derive a substantial tax benefit from the capital loss at fund liquidation, either because they participate in the carried interest of other funds or because they otherwise incur unrelated capital gains.  If assumed taxes exceed actual taxes, therefore, the general partner and its members will realize a positive after-tax return even though the investors realize an aggregate loss over the life of the fund.
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16 See III, B, 5, below, for a full discussion of the common assumptions implicit in a typical tax distribution provision of a fund agreement.

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Example: Assume the same facts as in the preceding example and that the members of the general partner bear an effective tax rate on carried interest allocations of 25%.  The members of the general partner will incur aggregate taxes of $0.35 million on their allocable share of the investment gains from A and B ($1.4 million x 25%). At liquidation of the fund, therefore, they will have received $1.05 million in carried interest distributions net of the taxes thereon. If the fund imposes a clawback obligation of $1.2 million, the general partner will bear the $0.15 million difference from its own funds unless it realizes a tax benefit from the capital loss.  If the members of the general partner have no capital gains in year 3, they cannot carry back the capital loss to recover taxes incurred on the capital gain allocations in years 1 and 2.  The general partner therefore returns only $1.05 million to the fund for redistribution to the investors.

Fund investors usually accept the possibility of a windfall to the general partner, perhaps in the belief that the general partner will earn positive returns on invested capital.  Short of requiring a more precise definition of the actual tax burden, however, the investors may propose other limitations on interim carry distributions.  They may, for example, compute tax distributions on a cumulative rather than annual basis.  Alternatively, the fund agreement may reduce tax distributions by any other distributions to the general partner and credit any prior tax distributions against future distributions otherwise payable to the general partner.17 As the purpose of a tax distribution is to address potential timing differences between allocations of income and distributions of cash, the fund agreement is likely to impose these limitations in any event.18 If a fund follows a “realized aggregation”distribution methodology, it may even hedge the risk of clawback exposure by requiring the general partner to mark any depreciated investments to market, treating the write down as a realized loss.19 Even if the fund does mark its investments to market, however, the likelihood of excess carry distributions is still significant due to the imprecision inherent in valuing illiquid securities.
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17 Under this approach, the general partner in the preceding example would have received no tax distribution if the cash otherwise distributable to it was sufficient to cover its tax liability on the allocated gains.  The significance of tax distributions is greatly reduced in funds that distribute investment gains to the general partner on a current basis and that do not allow reinvestment of sales proceeds.  Even in these funds, however, the clawback calculation will typically assume effective tax rates equal to the rates assumed in computing the tax distribution.

18 See III, B, 5, below, for a discussion of tax distributions.

19 Other funds require the general partner to mark all unsold investments to market and to treat the excess of any unrealized losses over gains on such investments as a realized loss.  This formulation is obviously more favorable to the general partner.

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Worksheet 3 provides an example of a typical clawback provision in a fund agreement.

Yet another approach to ensure aggregation is to escrow amounts otherwise distributable to the general partner until the investors have received distributions at least equal to their aggregate capital commitments. Although more secure than a contractual clawback obligation, an escrow may deprive the general partner of distributions until late in the life of the fund, even if the fund realizes substantial gains on earlier dispositions.  A common middle ground, therefore, is to escrow only a percentage of the carry distributions.  Because escrows do not relieve the members of the general partner from tax liability on their allocated gains, funds that adopt this approach usually allow tax distributions to the general partner.

Worksheet 4 provides an example of a typical escrow provision in a fund agreement.

5. Tax Distributions 

Regardless of the distribution methodology (i.e., investment-by-investment, realized aggregation, full aggregation), the members of the general partner will bear tax on their allocable share of the investment gains as the fund sells its investments.  For successful funds that distribute by full aggregation, the members of the general partner may incur enormous tax liabilities well before they receive cash distributions. Liquidity issues of this kind also arise in funds that distribute proceeds “investment-by-investment” if the fund uses investment proceeds to retire debt or receives marketable securities in a taxable transaction.

To address this concern, nearly every fund agreement will provide for a tax distribution that overrides the general distribution priorities. Worksheet 5 provides an example of a standard tax distribution provision. Occasionally, the tax distribution will apply only to the general partner.  The reason is that the tax distribution is intended solely to ameliorate the tax impact of timing differences between allocations of income and distributions of cash, a concern not shared by investors otherwise entitled to priority distributions.  In other funds, the tax distribution applies uniformly to the general partner and the investors, but is reduced to the extent of any previous non-tax distributions to any member.  The purpose of the credit is to limit tax distributions to those participants who have not received sufficient distributions to cover their tax liability.  In practice, therefore, a tax distribution that follows this approach will often apply only to the general partner.

In many funds, tax-exempt and foreign investors will dominate the investor population.  As described more fully below,20 these investors bear little or no tax on their share of the investment gains.  Nevertheless, a typical tax distribution provision will apply, at least in form, to every investor in the fund regardless of its effective tax rate.  Although one might expect the fund agreement to calculate the tax distribution by using each investor's actual tax rate, very few fund agreements do so.  A typical tax distribution provision instead makes the following assumptions, most of which are patently false:
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20 See VII, A, below.

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• Each investor bears a marginal tax rate equal to the highest rate borne by any member of the general partner.

• Each investor resides in the jurisdiction of the investor or member of the general partner that bears the highest tax rate (e.g., New York City, California).
  
• Each investor earns no external income.

A well-drafted tax distribution provision will also give effect to the limitations on “miscellaneous itemized deductions”under  § § 67 and 68, the reduced rate of tax on long-term capital gain under  § 1(h), the deductibility of state and local taxes under § 164 and the limitations on the carryback of capital losses.  See Worksheet 5.

Finally, many fund agreements calculate the tax distribution on a “cumulative”basis.  A common formulation is the taxable income allocable to each member during the current and all prior taxable years multiplied by the hypothetical tax rate, less any prior tax distributions. The effect of a cumulative approach is that gains in any particular year must exceed the excess of losses over gains in all preceding years before a member is entitled to a tax distribution.

Example: A fund that provides for a 20% carried interest to the general partner makes four portfolio investments at a cost of$10 million each in A, B, C and D.  Assume that the highest effective tax rate of any member of the general partner is 25%.  At the end of the first year, the fund sells A for $15 million and distributes the proceeds on an “aggregate” basis, subject to a tax distribution.  The general partner receives a tax distribution of$0.25 million ($5 million x 20% x 25%) and the investors receive the balance.  At the end of the second year, the fund sells B for $8 million and distributes the full proceeds to the investors. The fund allocates $0.4 million of the total loss to the general partner ($2 million x 20%).  At the end of the third year, the fund sells C for $15 million.  If the fund calculates tax distributions on a cumulative basis, the general partner will receive a tax distribution of $0.15 million (($1 million - $0.4 million + $1 million) x25% - $0.25 million).  Had the fund calculated tax distributions on an annual basis, the general partner would have received a tax distribution of $0.25 million ($1 million x 25%).

Even if the fund agreement computes tax distributions on a cumulative basis, it should not net capital losses in later years against capital gains in earlier years.  If it does, the members of the general partner may not receive a tax distribution sufficient to cover their actual tax liability unless they can apply the capital losses to shelter capital gains external to the fund.

In most fund agreements, the computation of the reduction in the maximum clawback obligation for taxes incurred on the carried interest allocations will import the assumptions of the tax distribution provisions.  If the tax distribution is cumulative, therefore, it will increase the maximum clawback obligation by reducing the offset for taxes.

U.S. Income Portfolios: Other Pass-through Entities 
  Portfolio 735-2nd: Private Equity Funds 
  Detailed Analysis 
  III. The Economic Deal

C. Distributions in Kind 

Although funds generally achieve liquidity by selling their investments for cash, they may also receive marketable securities.  If the portfolio company goes public, for example, the fund will probably have exchanged its preferred stock in the company for registered shares of common stock in a tax-free transaction.  Alternatively, the fund may sell the portfolio company to a public acquirer for registered stock in a tax-free “reorganization” under § 368.  In such cases, the fund will have achieved its basic investment objective of achieving liquidity for its investors and will therefore distribute the stock just as it would cash proceeds.  Indeed, most fund agreements require the fund to distribute marketable securities.

As described below, the distribution of securities or other property “in-kind”raises a number of tax issues.

1. General Treatment of Distributions of Marketable Securities 

Section 731(c) treats the distribution of “marketable securities” as a distribution of cash under specified circumstances.  If § 731(c) applies, therefore, the distributee member will recognize gain to the extent that the fair market value of the securities exceeds the distributee's tax basis in the fund.21 This rule does not apply if the security in question was not marketable on the date of acquisition, the issuer of the security had no other marketable securities outstanding at that time, the fund held the security for at least six months before it became marketable, and the fund distributes the security within five years of the date of marketability.22 This rule also does not apply if the fund is an “investment partnership” and the distributee investor is an “eligible partner.”23 Most funds qualify under one or both of these exceptions.  In general, therefore, a fund investor will not recognize gain upon the receipt of marketable securities even if the value of the securities exceeds its tax basis in the fund.  Instead, the investor will take a carryover basis in the distributed securities and reduce its tax basis in the fund by a like amount.24
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21 § 731(a).

22 Regs. § 1.731-2(d)(1)(iii).

23 § 731(c)(3); Regs. § 1.731-2(e).

24 §  732(a).

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

Legal restrictions will occasionally prohibit certain entities (e.g., media companies) from holding marketable securities.  Most funds therefore allow investors to “reject” an in-kind distribution.  When this occurs, the fund sells the securities on behalf of the investor and distributes the cash proceeds.  Had the investor received the distribution in kind, it would have incurred the selling expenses, as well as any interim depreciation or appreciation. To duplicate this economic result, the fund agreement will therefore impose a hypothetical set of assumptions on these arrangements.  For example, the general partner will compute its carry as if the fund had actually sold the securities at the value imputed to them on the date of the in-kind distribution.  The general partner will also ignore the selling costs in the transaction, again to neutralize the cost to itself and the other investors.

For U.S. tax purposes, when a fund sells marketable securities as principal, it must allocate the gain or loss to all of its investors.25 A taxable U.S. investor who receives a distribution in-kind may therefore realize gain not only when it sells the distributed securities under § 1001, but when the fund sells the remaining securities on behalf of the other investors.  Although timing differences of this sort will reverse upon liquidation of the fund, the interim cost remains significant if the general partner sells appreciated securities early in the life of the fund.
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25 Regs.  § 1.704-1(b)(2)(iv)(e)(1).

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In most cases, the parties will prefer to treat the fund as having distributed the securities to the investor subject to the legal prohibition, followed by a sale of the security on the market by the investor. If so characterized, only the electing investor will recognize gain or loss.  This treatment is defensible, however, only if the fund is deemed an “agent” of the electing investor, which may be a difficult characterization given the nature of the legal prohibitions.26 A better approach is for the fund to distribute the securities in question to the general partner, who would then sell the securities on behalf of the electing investor.  The agency characterization is stronger under this alternative because the general partner, unlike the fund, was not the tax owner of the securities before the election.27 Other funds “specially allocate”the gain to electing investors, borrowing a common (albeit somewhat dubious) practice in the hedge fund industry.
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26 But see Gallagher, “Private Equity Funds — Selected Tax Issues,” Tax Club 1, 11-12 (Jan. 16, 2002) (hereinafter cited as “Gallagher”). Gallagher argues that “Court Holding” principles should not apply in this context because, unlike the facts in Comr. v. Court Holding, 324 U.S. 331 (1945), all benefits and burdens of ownership of the securities pass to the investor after the election.  Thus, for example, if the portfolio company pays a dividend on the securities between the date of the election and the date of sale by the fund, the investor would receive the full economic benefit of the dividend.  In addition, as described above, the general partner will compute its carry based upon the assumed value of the securities on the date of distribution to the non-electing investors without regard to the actual sales price.

27 See, e.g., Rev. Rul. 84-111, 1984-2 C.B. 88 (tax consequences to parties of three alternatives for incorporating partnership assets follow form).

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Worksheet 6 provides an example of a provision in a fund agreement purporting to establish an agency relationship between the general partner and an investor who cannot receive a distribution in kind.

U.S. Income Portfolios: Other Pass-through Entities 
  Portfolio 735-2nd: Private Equity Funds 
  Detailed Analysis 
  III. The Economic Deal

D. “Disguised Sales”to Late Investors 

As described in III, A, above, investors in private equity funds commit to invest their capital in stages over an agreed period of time, commonly referred to as the “investment period.”The general partner calls on those commitments to fund portfolio investments. If the investors do not fund their allocable share of each portfolio investment on a timely basis, the general partner will often require the other investors to “front” the late capital.  This can occur either because one or more investors are in default or because the sponsor only achieves its targeted level of commitments after multiple closings.  When these “late” investors ultimately fund their share of the commitment, they will often contribute additional funds to reimburse the other investors for the incremental costs of the fronted capital.  In many cases, the reimbursement will include an allocable portion of the interim appreciation in the portfolio investments.

Example: A fund with aggregate capital commitments of $100 has 10 investors, each with unfunded commitments of $10.  The general partner proposes to invest $20 in portfolio investment A and therefore calls $2 from each investor.  Because Investor X does not contribute its allocable capital, the general partner calls an additional $0.22 from the remaining 9 investors.  Under the fund agreement, “late”investors incur an interest charge of 10%.  If Investor X does not fund its allocable share for nine months, it must contribute $2.15 to the fund ($2 x 1.075), which the fund will then distribute pro rata (i.e., $0.24) to the remaining 9 investors.

What are the federal income tax consequences of this distribution? Do the remaining investors avoid tax because the cash distribution does not exceed their basis in the fund?28 Or have they really received a “guaranteed payment”under § 707 from the fund, or even a payment of interest from the “late”investors?29 Given the passive involvement of the fund and the absence of an underlying “debt,” neither of these characterizations fairly captures the nature of the transaction.30 The distribution is more in the nature of a “disguised sale” under § 707 by the original investors of a portion of their interest in the fund to the late investor.  If so treated, the 9 investors would realize a short-term capital gain of $0.02 ($0.24 - $0.22).  The IRS National Office has treated such a distribution as a “disguised sale” on similar facts, even though it has yet to issue final regulations addressing disguised sales of partnership interests under § 707(a)(2).31
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28 See § 731.

29 See Regs.  § 1.707-1(c).

30 See Gallagher, “Private Equity Funds — Selected Tax Issues,” Tax Club 1, 9 (Jan. 16, 2002).

31 TAM 200301004.

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Nevertheless, some funds do not report these transactions as disguised sales.  Relying upon the absence of final implementing regulations under § 707(a)(2), they treat the distribution like any other distribution, which usually avoids any immediate tax consequence if respected as such.  On the other hand, this approach will leave the late investors with relative capital accounts that exceed the relative capital accounts of the original investors.32 To realign the capital accounts, the fund may specially allocate income to the original investors equal to the portion of the expenses that the fund would have allocated to the “late” investors had they contributed their share of the capital at the same time.
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32 The “disguised sale” regulations reserve guidance on the disguised sale of a partnership interest. Regs.  § 1.707-7; see also Notice 2001-64, 2001-41 I.R.B. 316 (requesting comments on this issue).  In response to the notice, the New York State Bar Association (“NYSBA”) Tax Section submitted a detailed report containing, among other suggestions, a variety of presumptions and safe harbors.  NYSBA Tax Section Report No. 1027, available at BNA TaxCore, Primary Source Material, IRS Comment Letters, February 21, 2003, and at 2003 TNT 44-15.  For a summary of the NYSBA Tax Section's report, see 19 Tax Mgmt. Real Est. J. No. 7 (July 2, 2003).

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In 2004, the IRS issued proposed regulations under §  707(a)(2).33 Under the proposed regulations, these transactions would constitute disguised sales. The proposed regulations recast a transfer of money, property or other consideration, including the assumption of a liability, by a partner to a partnership, coupled with a transfer of consideration by a partnership to another partner, as a full or partial sale between the two partners if, based upon all the facts and circumstances, the transfer by the partnership to the withdrawing partner would not have been made but for the transfer to the partnership by the investing partner. Accordingly, because the existing investors “fronted” the capital on behalf of the defaulting investor and received a corresponding distribution of the contributed capital on the cure date, together with an interest charge, the distribution would not have occurred “but for”the late contribution. They are both proximate in time and occur pursuant to an explicit provision of the fund agreement that conditions one transfer upon the other.
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33 See REG-149519-03, 69 Fed. Reg. 68838 (withdrawn on 1/2/09). These proposed regulations supplemented and generally conformed to the existing regulations relating to disguised sales of property under § 707(a)(2). For an excellent general discussion of the proposed regulations, see Mollerus, “Disguised Sales of Partnership Interests and the Proposed Section 707(a)(2)(B) Regulations,” PLI/Partnerships Vol. 7 (2006). See Regs. §  1.707. For a general discussion of the existing regulations, see 710 T.M., Partnerships—Conceptual Overview.

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But the proposed regulations also applied to a much broader range of transactions. If two transfers do not occur at the same time, their treatment as a disguised sale will depend upon whether the later transfer was subject to the “entrepreneurial risks” of the business.34 The proposed regulations presumed that transfers to and from a partnership within two years constituted disguised sales, and that transfers beyond the two-year interval did not, in each case unless the facts and circumstances “clearly established”otherwise.35 Finally, the proposed regulations required tax return disclosure if a partner transferred consideration to a partnership and the partnership transferred consideration to another partner within a seven-year period and the two partners did not treat the transfers as a disguised sale for tax purposes.36
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34 Prop. Regs. § 1.707-(7)(a)(1), (b)(1) (withdrawn 1/21/09).

35 Prop. Regs. § 1.707-7(c) (withdrawn 1/22/09) (within two years); Prop. Regs. § 1.707-7(d) (withdrawn 1/22/09) (more than  two years apart). The proposed regulations listed a number of non-exclusive “disguised sale” factors. Prop. Regs. § 1.707-7(b)(2) (withdrawn 1/22/09).

36 Prop. Regs. § 1.707-7(k); Regs. § 1.707-8. Neither the two-year presumption nor the requirement to disclose applied to guaranteed payments, preferred returns, or distributions of operating cash flow. See Regs. § 1.707-4. The two-year presumption did not apply to a cash distribution to a selling partner in complete liquidation of the selling partner's interest. See Prop. Regs. § 1.707-7(e) (withdrawn 1/22/09).

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Many criticized the proposed regulations as overbroad.37 According to the original legislative history, § 707(a)(2)(B) is a statutory vehicle designed to curb “deferred or avoided tax on sales of property (including partnership interests) by characterizing sales as contributions of property (including money) followed (or preceded) by a related distribution of partnership property (including money).”38 Nevertheless, the proposed regulations applied to many transfers to and from a partnership that bore no relation to one another other than their proximity in time. For hedge funds, for example, the proposed regulations arguably applied merely because the underlying fund happened to issue shares on the same dates as it redeemed shares of withdrawing investors. For these and other reasons, the IRS withdrew the proposed regulations on January 22, 2009.
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37 See, e.g., New York State Bar Association Tax Section, “Report on Disguised Sales of Partnership Interests Responding to Reg-149519-03,”2005 Tax Notes 78-42 (Apr. 22, 2005) (“[W]e believe the ‘but for' test is simply too susceptible of being read to encompass attenuated chains of causation ... when we should be looking for something that approximates a notion of ‘proximate cause.' For example, in its most literal sense the ‘but for'test is met any time a partnership would not have had sufficient liquidity to make a distribution ‘but for' another partner's contribution”).

38 H.R. Conf. Rep. No. 861, 98th Cong., 2d Sess. 860 (1984); S. Rep. No. 369, 98th Cong., 2d Sess. 225 (1984).

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U.S. Income Portfolios: Other Pass-through Entities 
  Portfolio 735-2nd: Private Equity Funds 
  Detailed Analysis 
  IV. Achieving Pass-Through Treatment for the Fund and its Affiliates

A. In General 

Virtually every U.S. private equity fund, with the exception of certain parallel entities, is structured as a pass-through entity for tax purposes.  The sponsor structures the fund as a pass-through entity for a number of reasons, first and foremost to avoid entity-level taxes on investment returns.  In addition, foreign investors benefit from pass-through treatment because it allows the fund to pass through the character of its gains as capital gain, a category of income enjoying broad exemption from U.S. tax; tax-exempt investors benefit from pass-through treatment because it preserves their tax exemption for most categories of investment income; U.S. individual investors benefit from pass-through treatment because it passes through long-term capital gains, which bear tax at lower rates; members of the general partner benefit from pass-through treatment because it facilitates the tax-free issuance of the carried interest and, for U.S. individuals, the pass-through treatment of long-term capital gains; finally, all classes of participants benefit from pass-through treatment because it allows the fund to distribute stock or other marketable securities free of U.S. tax at both the entity and investor levels.39
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39 See III, C, above, for a discussion of in-kind distributions of marketable securities.

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U.S. Income Portfolios: Other Pass-through Entities 
  Portfolio 735-2nd: Private Equity Funds 
  Detailed Analysis 
  IV. Achieving Pass-Through Treatment for the Fund and its Affiliates

B. Classification as a Pass-Through Entity 

1. Before January 1, 1997: The “Kintner” Regulations 

Before January 1, 1997, the effective date of the “check-the-box”(“CTB”) regulations, the IRS distinguished a corporation from a partnership on the basis of whether the entity possessed at least three of the following “corporate” attributes: continuity of life, limited liability, centralized management and free transferability of interest.40 Under this regime, a tax advisor who sought to ensure that the fund would qualify as a pass-through entity often had to graft special provisions onto the fund agreement to defeat one or more of these corporate attributes, many of which served little or no commercial purpose.  On occasion, the legal effectiveness of these provisions depended upon the vagaries of local or foreign law.  The Kintner regulations bred so much uncertainty on the issue of entity classification that investors would routinely demand a formal tax opinion from fund counsel as a condition to closing.
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40 In determining whether an entity was a corporation or a partnership, the former regulations enumerated six “corporate”characteristics: (1) associates, (2) an objective to carry on business and divide the gains therefrom, (3) continuity of life, (4) centralization of management, (5) limited liability, and (6) free transferability of interests.  Regs.  § 301.7701-2(a)(1) (1996).  If the entity possessed more corporate than noncorporate characteristics, these former regulations, often referred to as the “Kintner” regulations, treated the entity as a corporation for tax purposes.  Regs.  § 301.7701-2(a)(3) (1996)(regulations ignored first two characteristics, regarded as common to both corporations and partnerships).

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2. The Current Law: The “Check-the-Box”Regime 

In 1996, the IRS issued new regulations in proposed form that abandoned any effort to classify entities by traditional corporate attributes. Generally referred to as the “check-the-box” regulations(the “CTB regulations”), they simplify the issue of entity classification and eliminate uncertainty. As discussed in detail in 700 T.M., Choice of Entity, the CTB regulations ensure pass-through treatment, either by default or election, for virtually every form of legal entity other than state law domestic corporations and certain foreign entities.

a. State Law General or Limited Partnership 

The CTB regulations treat any general or limited partnership formed under state law as a pass-through entity by default.41 The partners may override the default classification by election.42
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41 Regs. § 301.7701-3(b)(i) (domestic “eligible entity” with two or more members treated as partnership).

42 Regs. § 301.7701-3(c) (“eligible entity” may elect to be classified other than as provided under default rules by timely filing of Form 8832).

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b. Domestic Limited Liability Companies 

The CTB regulations treat a domestic limited liability company as a pass-through entity by default.43 The members may override the default classification by election.44
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43 Regs. § 301.7701-3(b)(i) (domestic “eligible entity” with two or more members treated as partnership).

44 Regs. § 301.7701-3(c) (“eligible entity” may elect to be classified other than as provided under default rules by timely filing of Form 8832).

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c. Foreign Limited Liability Companies 

The CTB regulations treat a foreign entity that extends limited liability to all members as a corporation by default.45 The members may override the default classification by election.46
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45 Regs. § 301.7701-3(b)(2)(i)(B) (foreign “eligible entity” treated as association if all members have limited liability).

46 Regs. § 301.7701-3(c) (“eligible entity” may elect to be classified other than as provided under default rules by timely filing of Form 8832).

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Comment:  If the sponsor forms the fund as a foreign entity with a “corporate” default classification and neglects to file a CTB election, it will convert the fund into a “passive foreign investment company” for U.S. tax purposes, with disastrous consequences to U.S. investors and the general partner.47
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47 For a discussion of the consequences of PFIC status to U.S. investors, see XI, C, below.

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d. Other Foreign Entities 

The CTB regulations treat a foreign entity that does not extend limited liability to all members as a partnership by default.48 As in the case of a domestic partnership or limited liability company, the members may override the default classification by election.49 Although the regulations treat certain foreign entities as per se corporations,50 these entities tend to reside in high tax jurisdictions, making them unappealing candidates to the sponsor in any event.
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48 Regs.  § 301.7701-3(b)(2)(i)(A) (foreign “eligible entity” with two or more members treated as partnership if at least one member has personal liability).

49 Regs. § 301.7701-3(c) (“eligible entity” may elect to be classified other than as provided under default rules by timely filing of Form 8832).

50 Regs.  § 301.7701-2(b)(8).

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3. Publicly Traded Partnership Limitations 

A private equity fund may qualify as a partnership under the CTB regulations and nonetheless be subject to tax as a corporation if it is a “publicly traded partnership” within the meaning of § 7704 (“PTP”).

a. Definition of “Publicly-Traded” 

In general, a private equity fund that otherwise qualifies as a partnership under the CTB regulations will be taxable as a PTP if the partnership interests in the fund are either traded on an “established securities market” or are “readily tradable” on a secondary market or its equivalent.51
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51 § 7704(b); Regs. § 1.7704-1(a)(1).

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Whether a partnership interest is “readily tradable” is a factual question.52 The PTP regulations, however, provide broad safe harbor relief to many transfers, including relief for recurring transfers of any partnership interest originally issued in a “private placement.” Under the private placement safe harbor, any holder of a partnership interest issued in an exempt offering under the 1933 Act may freely transfer the partnership interest during future periods, provided that the issuing partnership has fewer than 100 partners.53 Most private equity funds have far fewer than 100 partners. Of the limited secondary transfers that actually occur on the market, therefore, most of them will qualify under this safe harbor.
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52 See Regs. § 1.7704-1(c)(1) (describing facts and circumstances test).

53 Regs. § 1.7704-1(h)(1). The private placement safe harbor also restricts the use of tiered partnership arrangements to circumvent the “100 partner” limitation. See Regs. § 1.7704-1(h)(3).

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Nevertheless, as described more fully above, the principal tax benefit of investing in a fund depends in the first instance on the status of the fund as a partnership. The transfer provisions of many fund agreements therefore prohibit many transfers of a character that, in the author's opinion, do not and cannot implicate §  7704. It is not unusual, for example, for a fund to prohibit all transfers not within a designated safe harbor unless the general partner consents to the transfer in writing. In such a fund, therefore, the general partner will have the unfettered right to restrict many transfers that bear no resemblance to public trading merely because § 7704 does not unequivocally ignore them, asserting that the transfer may imperil the status of the fund as a partnership. In the author's view, the actual risk that  §  7704 prohibits these transfers is quite small, perhaps even remote.54  For a secondary transfer to actually endanger the underlying status of an entity as a partnership, the entity must offer real liquidity to its investors at regular intervals.55
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54  See Regs. § 1.7704-1(c)(3) (“the fact that a transfer of a partnership interest is not within one or more of the safe harbors... is disregarded in determining whether interests in the partnership are readily tradable on a secondary market or the substantial equivalent thereof”) (emphasis added).

55 See Regs. § 1.7704-1(c)(1) (partners must be  “readily able to buy, sell or exchange ... in a manner that is comparable, economically, to trading on an established securities market”).

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By their very nature, most private equity funds offer nothing of the kind. Instead, they restrict transfers to non-affiliates, do not participate in the establishment of secondary trading markets, and certainly do not list the interests of the fund on any public exchange or other quotation medium. They instead rely on their portfolios to provide liquidity to their investors. On virtually any given day, however, the entire portfolio of the fund will be no more liquid than the outstanding interests in the fund, consisting of large blocks of stock in various privately-held companies and other similar investments. Indeed, the inherent illiquidity of the fund investment is an essential attribute of the basic economic bargain in private equity among the participants: investors subordinate their own liquidity preferences in pursuit of higher expected returns, agreeing to defer the receipt of cash on their investment until the fund sells its portfolio over time in a series of privately-negotiated transactions. When the investor does realize a cash return, it is pursuant to the established distribution provisions of the fund agreement, which require pro rata distributions to every investor in accordance with relative capital commitments.

Moreover, of the limited secondary trades that do occur, many of them take place prior to expiration of the “investment period.”56  A buyer at this stage of the life cycle of a fund must assume the seller's remaining capital commitments. In addition to acquiring a share of the fund's current investments, therefore, a buyer during the investment period will also commit to acquire its pro rata share of any future investments. Moreover, these performance obligations of the buyer to the fund will remain entirely executory even after the buyer completes the secondary purchase of the outstanding interest from the seller. A buyer of publicly-traded stock, to the contrary, will have fully performed its one and only contractual obligation when it tenders the purchase price for the shares. In the author's view, any transfer that would require a buyer to assume a future capital commitment to a fund is ipso facto permissible under § 7704.57 The PTP provisions of the Code are really more germane to hedge funds, a form of perpetual investment vehicle that holds marketable securities, has ready access to cash from a syndicate of lenders, and allows investors to sell at regular intervals by periodic redemption.
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56 For a discussion of the relationship between capital commitments and investment periods, see III, A, above.

57 See Regs. § 1.7704-1(c)(1) (partners must be “readily able to buy, sell or exchange ... in a manner that is comparable ... to trading on an established securities market”). Because liability assumptions of this kind never occur on an established securities market, it should not even matter that a particular fund permits these types of transfers on a recurring basis.

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Note: In spite of these constraints, a fund investor, perhaps suffering from buyer's remorse, may attempt to sell its stake to a third party in an attempt to avoid the future capital calls or to mitigate the risk of future losses. Indeed, one commentator reports that several investor groups have established “online platforms”to facilitate the purchase and sale of interests in other private equity funds.58 Whether the IRS would equate these platforms with the liquidity of an established securities market is not clear. Regardless of any similarity between such a platform and an actual stock exchange, however, an online trading platform cannot imperil the status of a fund as a partnership unless the fund itself either participates in its formation or otherwise recognizes the transfers.59
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58 See Schell, Private Equity Funds: Business Structure and Operations, § 5.01[2].

59 Regs.  § 1.7704-1(d).

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b. The “Qualifying Income” Exception 

The rare fund with “readily tradable”interests will retain its status as a partnership so long as at least 90% of its gross income is “qualifying income” in every taxable year.60 Gross income for this purpose includes any amount includible in income under the mark-to-market rules (e.g., pursuant to a valid § 475(f) election).61 Because § 7704 measures both qualifying and non-qualifying income on a gross basis, it ignores most losses and other items of expense.62
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60 § 7704(c)(2).

61 Regs. § 1.7704-3(b)(2).

62 Regs. § 1.7704-3(b)(1).

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The qualifying income exception does not apply to a partnership that would be described in § 851(a) if it were a domestic corporation.63  Section 851(a) describes a “regulated investment company”(e.g., a mutual fund) as a domestic corporation that has elected under the 40 Act to be treated as a “business development company” or has registered under the 40 Act as a “management company” or “investment unit trust” and meets certain other conditions. In general, therefore, a private equity fund that registers under the 40 Act may not rely on the “qualifying income”exception.64
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63 § 7704(c)(3).

64 See Staff of Joint Committee on Taxation, 105th Cong., 1st Sess., General Explanation of Tax Legislation Enacted in 1997 (Comm. Print 1997) (“a publicly traded partnership that is registered under the Investment Company Act of 1940 generally is treated as a corporation under the provision”); see also Willis, Pennell and Postlewaite, Partnership Taxation at ¶ 3.04[5][a] (6th ed. 1998); McKee, Nelson and Whitmire, Federal Taxation of Partnerships and Partners at ¶ 3.09[7](3d ed. 1997).

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The term “qualifying income” generally includes —
• interest (other than certain interest contingent on profits 65 and interest derived in the conduct of a financial or insurance business66);

• dividends;

• real property rents;

• gain from the sale of real property (including gains earned as a dealer);

• gain from the sale of a capital asset held for the production of qualifying income;67

• income from securities lending activities;

• gain from the sale or other disposition of stock or securities or foreign currencies;

• other income (including but not limited to gains from options, futures, or forward contracts) “derived with respect to its business of investing in such stock, securities or currencies”;68

• income from swaps (but only if the property, income or cash flow that determines the amounts to which the partnership is entitled under the swap would itself give rise to qualifying income if held or received directly by the partnership);69

• income from certain commodities transactions;70
 and
• “other substantially similar income from ordinary and routine investments to the extent determined by the Commissioner”.71

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65 § 7704(d)(2)(B); § 856(f).

66 § 7704(d)(2)(A).

67 § 7704(d)(1).

68 § 7704(d)(4); § 851(b)(2)(A).

69 Regs. § 1.7704-3(a)(1).

70 § 7704(d)(1)(G).

71 Regs. § 1.7704-3(a)(1).

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To the extent that any of these items arise “in the ordinary course of a trade or business” of a partnership, however, they will not constitute “qualifying income”.72
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72 Regs. § 1.7704-3(a)(2).

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Most private equity funds will generate sufficient amounts of qualifying income to avoid § 7704 without regard to the liquidity of the LP interests (or lack thereof) on the market.

U.S. Income Portfolios: Other Pass-through Entities 
  Portfolio 735-2nd: Private Equity Funds 
  Detailed Analysis 
  V. Tax Allocations

A. In General 

As partnership agreements, most fund documents provide for allocations of profit and loss.  The IRS will not challenge these allocations if they have “substantial economic effect” under § 704(b).73 Under the  § 704(b) regulations, allocations have “substantial economic effect” if they satisfy each of two tests.  First, the allocations must have “economic effect.”74 An allocation has “economic effect”for this purpose so long as it is consistent with the underlying economic arrangement of the investors,75 as tested under the various regulatory regimes.  Second, the economic effect of the allocations must be “substantial.”76 An allocation is “substantial”for this purpose if a reasonable possibility exists that the allocation will affect substantially the dollar amounts to be received by the fund investors on a pre-tax basis.77 Even then, the allocation fails the substantiality test if (i) it increases the after-tax economic consequences to at least one investor in present value terms relative to the consequences without the allocation; and (ii) a “strong likelihood”exists that the after-tax consequences to no other investor will be “substantially diminished” in present value terms. In determining after-tax consequences, the regulations consider the relationship between the allocation and the tax attributes of the investors.78 The purpose of this aspect of the substantiality test is to disregard allocations that do not alter the sharing of benefits and burdens among the partners on a present value basis, without regard to their effect in any particular year.
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73 § § 704(a), 704(b)(1); see also Regs. § 1.704-1(b)(1)(i).

74 Regs. § 1.704-1(b)(2)(i).

75 Regs. § 1.704-1(b)(2)(ii).

76 Regs. § 1.704-1(b)(2)(i).

77 Regs. § 1.704-1(b)(2)(iii).

78 Id.

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This portfolio makes no attempt to answer the complex question of how to draft § 704(b)-compliant allocations.  The practitioner should appreciate, however, that a typical private equity fund, as well as its general partner and fund manager, is a pass-through entity and must therefore comply with these regulations.79 In this sense, a fund is no different from any other partnership.  This portfolio instead addresses emerging trends in  § 704(b) compliance in the fund arena.
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79 For an excellent discussion of the § 704(b) regulations, see 712 T.M., Partnerships:Taxable Income; Allocation of Distributive Shares; Capital Accounts.

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The first of these trends is not to liquidate in accordance with capital account balances, which violates a core principle of the capital account maintenance requirements.  The second is to “force”profit and loss allocations, which cedes complete ascendancy to the distribution provisions of the fund agreement.  As described more fully below, each of these approaches reflects an overriding desire not to allow a drafting infirmity by the tax practitioner to infect the intended economic agreement, which is often quite complex.  As many of the investors in a typical fund are a tax-exempt or foreign, these approaches also reflect a decided bias against introducing a regulatory framework that may be wholly alien to a significant percentage of the investor population to define the economic agreement.

U.S. Income Portfolios: Other Pass-through Entities 
  Portfolio 735-2nd: Private Equity Funds 
  Detailed Analysis 
  V. Tax Allocations

B. Not Liquidating in Accordance with Capital Accounts 

In many fund agreements, the allocation provisions seek only to produce capital account balances that reflect the priorities of the distribution waterfall at any given time.  In funds that adopt this approach, the fund agreement will provide that distributions in liquidation of the fund will follow the same order and priority as distributions that precede liquidation.  Thus, if the allocations do not produce the “correct”capital account balances, they will not alter the priority of distributions among the participants.

Although this approach violates the § 704(b) regulations, it avoids what most would regard as a more serious problem, which is to deprive the investors of their intended economic bargain.  Liquidation in accordance with capital account balances is a bedrock principle of the § 704(b) regulations because it establishes the ultimate primacy of the allocations, assuming at least that the partners must restore negative capital account balances upon fund liquidation.  The IRS will respect these allocations because they determine the ultimate economic rights of the parties.  Whether the IRS will respect the allocations, however, is wholly unrelated to the separate question of whether those allocations reflect the intended economic deal.  The practitioner who drafts the allocations incorrectly but does not require liquidations in accordance with capital accounts will at worst misallocate the aggregate tax burden of the economic agreement among the investors.80 The practitioner who drafts the allocations incorrectly and also requires liquidations in accordance with capital accounts may alter the economic agreement itself.  Given the choice, many practitioners cast aside the technical requirements of the regulations and draft the allocations to the best of their ability.
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80 If, as is likely, the fund agreement provides for tax distributions, then improper allocations may alter the economic bargain even if the fund does not liquidate in accordance with capital accounts, at least with regard to the relative timing of distributions among investors.  The magnitude of this departure will depend in part upon how tightly the fund agreement restricts tax distributions. In funds that compute tax distributions on a cumulative basis, reduce tax distributions by previous non-tax distributions, and distribute sales proceeds investment-by-investment, the likelihood that the fund will even make tax distributions is considerably reduced.

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Although the logic of this approach arguably applies to any business entity structured as a partnership, the practice is more prominent in funds for a number of reasons.  First, the economic agreement among the fund investors is often more complex than the agreement in other joint ventures.  In a fund that provides for a hurdle return, variable carry percentages, IRR-dependent distributions or other contingent priorities, it is not so easy to draft “correct” allocations.

Example: A fund provides for a 20% carried interest to the general partner after a 10% preferred return to the investors.  Assume that the fund distributes investment proceeds on a “full aggregation”basis.  The fund makes two portfolio investments at a cost of $10 million each in A and B.  The fund agreement allocates 100% of the profits to the investors until they earn the preferred return and any residual profits 80% to the investors and 20% to the general partner. Upon liquidation, the fund distributes proceeds in accordance with positive capital account balances.  At the end of the first year, the fund sells A for $16 million and distributes the proceeds to the investors.  Immediately after the distribution, the general partner has a capital account of $1 million (i.e., ($16 million -$1 million - 10 million) x 20%).  At the end of the second year, the fund sells B for $11 million and liquidates.  The fund allocates the $1 million of gain entirely to the investors to cover the preferred return and then distributes the proceeds in accordance with capital account balances.  The general partner and the investors therefore receive $1 million and $10 million, respectively.  Over the life of the fund, however, the investors should have received $26.22 million(i.e., ($10 million x 1.10) + ($10 million x1.10^2) + (80% x $3.9 million)).  The problem with these allocations is that they failed to consider the accretion of the preferred return on the unsold investments.  The failure to do so will understate the investors’ capital account if the remaining investments do not generate sufficient gains to cover that return, resulting in a windfall to the general partner.

Second, tax-exempt and foreign investors often dominate the investor population.  Because they bear low effective tax rates on their investment gain,81 a misallocation of profit and loss is unlikely to materially under - or overstate their aggregate tax liability. Third, these investors may not understand the effect of profit and loss allocations on capital accounts and the ultimate link between capital accounts and the economic bargain.  Investors who do not understand this relationship tend to object to contractual provisions that adopt those conventions to define the economic terms of their investment.
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81 For a discussion of the taxation of tax-exempt and foreign investors, see VII, A, below.

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U.S. Income Portfolios: Other Pass-through Entities 
  Portfolio 735-2nd: Private Equity Funds 
  Detailed Analysis 
  V. Tax Allocations

C. Targeted Capital Accounts 

A second trend is to allocate profit and loss to achieve “targeted”capital account balances for each member.  A product of the same concern, targeted capital accounts solve the dilemma described in the preceding section by allocating profit and loss after, rather than before, the fund realizes the profit and loss.  In essence, the approach asks what the investors would receive at any given time if the fund were to sell its remaining investments at book value and distribute the proceeds in accordance with the distribution provisions, taking into account all prior distributions.  That amount becomes the target capital account balance of the investor on the hypothetical liquidation date. Rather than draft specific allocations to reach that target, however, the drafter “forces” the allocation — each investor's allocable share of profit or loss, after adjusting for interim contributions and distributions, “plugs” the change in capital account balances over the relevant period.  Worksheet 7 provides an example of a “forced allocation” provision in a typical fund agreement.

The purpose of this approach is to force “substantial economic effect,” albeit not under § 704(b), by tying capital account balances to actual distributions.  Technically, targeted capital accounts do not comply with the capital account maintenance requirements because capital account balances do not govern distributions either currently or upon liquidation — indeed, distributions govern capital account balances. Nevertheless, they should comply with the alternative “interest in the partnership” test.82
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82 § 704(b)(1); Regs. § 1.704-1(b)(1)(i).

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Practitioners should bear in mind that this approach may forgive many sins but is not a haven for the careless draftsman.  In a fund that admits new investors following formation (e.g., funds that hold multiple closings), the agreement must adjust capital account balances immediately before admission to reflect any unrealized gains or losses.  Otherwise, the change in capital account balances during future periods will overstate overall profit or loss.  If a fund requires any member to restore a deficit balance upon liquidation, the agreement must give full effect to the economic consequences of that obligation. Otherwise, “targeted” allocations may overstate the profit allocable to the investors with such an obligation and understate the profit allocable to the investors with no such obligation.  The agreement should also avoid expressing the restoration obligation in terms of negative capital account balances.  Otherwise, the allocations become circular and produce no result at all.  To avoid this drafting error, the agreement must purge any reference to capital account balances from the distribution and deficit restoration provisions of the document. If the fund incurs nonrecourse debt, the agreement should reduce the target capital account balances of the members to reflect any future “minimum gain” chargebacks.83 These chargebacks represent income that the fund will allocate to the specific members in the future, which will increase capital accounts.  If the agreement does not require all members to restore capital account deficits, the agreement should still provide for the “regulatory” allocations necessary to satisfy the alternative economic effect test under the § 704(b) regulations.84 Finally, targeted allocations in funds with hurdle returns should not give effect to the clawback obligation on unsold investments; otherwise, the fund will allocate profit to the investors attributable to the hurdle return on unsold investments even though the fund distributes the related gains to the general partner.  This adjustment is necessary because the general partner does not bear a current hurdle return on capital allocable to unsold investments until the fund sells them.  If the fund fails to make this adjustment, the general partner may also recognize gain when the fund distributes cash proceeds to the general partner in excess of its basis.85
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83 See Regs. § 1.704-2(f).

84 See Regs.  § 1.704-1(b)(2)(ii)(d).

85 § 731.

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U.S. Income Portfolios: Other Pass-through Entities 
  Portfolio 735-2nd: Private Equity Funds 
  Detailed Analysis 
  VI. Special Tax Issues for the General Partner and Its Members

A. The Grant of the Carried Interest 

In almost every private equity fund, the fund will grant to the general partner the right to an agreed percentage, usually 20%, of the aggregate net gains of the fund. The fund will grant this right as an equity interest, in part for services and in part for capital. Because the capital of the other investors will “carry” the general partner, it has become known in the industry as the “carried interest.”  Others refer to the carried interest as a “profit override,” a “promote,” an “incentive allocation,”or, more generically within the tax profession, a “profits interest.”The general partner will then grant an interest in the underlying carry from the fund to its own members. The carried interest assumes the form of an equity grant at both levels to upstream the benefit of the capital gains preference under § 702(b).

The grant and subsequent allocation of the carried interest present a number of tax issues, beginning with the consequences on the date of grant.

1. The Historical Treatment of a Profits Interest 

Under current law, the grant of a profits interest for services is a tax-free transaction. This was not always so. Until 1971, however, it was widely assumed by the tax bar that the law as it stands today had always been the law, even though neither the IRS nor the courts had ever considered the issue. One prominent commentator at that time described the state of the law as follows:

... it is clear that a partner who receives only an interest in future profits of the partnership as compensation for services is not required to report the receipt of his partnership interest as taxable income. The rationale is two-fold. In the first place, the present value of a right to participate in future profits is usually too conjectural to be subject to valuation. In the second place, the service partner is taxable on his distributive share of partnership income as it is realized by the partnership. If he were taxed on the present value of the right to receive his share of future partnership income, either he would be taxed twice, or the value of the right to participate in partnership income must be amortized over some period of time.86

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86 Arthur B. Willis, et al., Partnership Taxation, 84-85 (1971).

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As further support, others cited the negative inference from Regulations § 1.721-1(b)(1), which provides that the non-recognition rule of § 721 does not apply “[t]o the extent that any of the partners gives up any part of his right to be repaid his contributions (as distinguished from a share in partnership profits) in favor of another partner as compensation for services.”87 The parenthetical language, they contended, evidenced an intent to extend § 721 to the grant of a profits interest for services. In Diamond v. Comr.,88 however, the IRS disavowed any such intent and both the Tax Court and Seventh Circuit agreed. Thus began two decades of litigation that failed to resolve or even clarify matters.89
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87 Emphasis added.

88 56 T.C. 530 (1971), aff'd, 492 F.2d 286 (7th Cir. 1974).

89 For a detailed discussion of the IRS's litigating position during the 20 year period following the Diamond case, see McKee, Nelson & Whitmire, Federal Taxation of Partnerships and Partners at ¶ 5.02[3](3rd ed. 1997); see also Campbell v. Comr., 59 T.C.M. (CCH) 236 (1990) (holding that no provision of the Code exempted the receipt of a profits interest for services from tax), rev'd on this issue, 943 F.2d 815, 823 (8th Cir. 1991) (finding that interest in question was “without fair market value at the time [of receipt] ... and should not have been included in  ... income for the years in issue”);  St. John v. U.S., 53 A.F.T.R.2d 84-718 (C.D. Ill. 1983) (applying a “liquidation analysis” to conclude that the profits interest had no value on receipt); Kenroy, Inc. v. Comr., T.C. Memo 1984-232 (same); Hale v. Comr., T.C. Memo 1965-274 (stating in dicta that profits interest did not constitute taxable income on receipt).

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In Diamond, the taxpayer had entered into a joint venture with another partner to purchase an office building. The taxpayer agreed to arrange for the debt financing on the property and the other partner agreed to fund the equity contribution.  For his service, the taxpayer received a 60% share of the net profits from the joint venture. The purchase closed on February 18, 1962, and three weeks later the taxpayer sold his interest to a third party for $40,000. The taxpayer did not report the grant of this “profits interest”as a compensatory transaction. The IRS, however, contended that the$40,000 represented ordinary income from the performance of services. The taxpayer argued that the receipt of the profits interest was exempt from tax under Regs. § 1.721-1(b)(1) and that the subsequent sale therefore qualified as a short-term capital gain.

The Tax Court held that the grant of the profits interest was a taxable transaction to the taxpayer, reasoning that had the taxpayer received an interest in capital rather than an interest in profits, § 61 would have required the taxpayer to include the value of the capital interest in income.  The Tax Court also found that “a contribution of services is not a contribution of ‘property.’”90 Characterizing the parenthetical language of the regulation as both “obscure” and “opaque,”the Tax Court found nothing in the regulation to suggest that § 721 applied to a partner who received a partnership interest in exchange for services:
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90 Diamond, 56 T.C. at 545.

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[W]e cannot believe that the regulations were ever intended to bring section 721 into play in a situation like the one before us.  The Commissioner disavows such intention, and we agree with him.91

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91 Id. at 546.

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The Seventh Circuit affirmed, finding that the profits interest in question, having been sold for $40,000 three weeks after the date of grant, had a readily ascertainable fair market value.  The court did acknowledge, however, that a profits interest may have only speculative value under different conditions.92
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92 492 F.2d 286 (7th Cir. 1974).

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Following its victory in Diamond, the IRS wisely chose not embark on a crusade to tax every service grant of a profits interest in a partnership as a compensatory transaction. In fact, the IRS even considered a formal pronouncement that it would not follow the Diamond decision when a partner, rather than an employee, receives a profits interest for services.93 Although the IRS never published the guidance, it litigated only four cases over the next two decades.94
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93 See GCM 36346 (July 25, 1977).

94 For a detailed discussion of GCM 36346 and the IRS's position in the two decades following Diamond, see McKee, Nelson, and Whitmire, Federal Taxation of Partnerships and Partners, ¶ 5.02[3] (3d ed. 1997).

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Then, in 1990, the Tax Court followed Diamond in Campbell v. Comr.95 In Campbell, the taxpayer had received certain partnership interests in exchange for services performed in connection with the formation and syndication of three joint ventures.  As a special limited partner, Campbell was entitled to a share of the residual profits after a priority return to the other partners.  As in Diamond, the IRS contended that Campbell should have included the fair market value of the various partnership interests in income.  The Tax Court agreed, holding that no provision of the Code exempted the grant of a profits interest for services from tax.96 In contrast to Diamond, however, the profits interest in Campbell had no readily ascertainable value.
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95 T.C. Memo 1990-162, rev'd on this issue, 943 F.2d 815 (8th Cir. 1991).

96 Id.

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The Eighth Circuit reversed on appeal,97 finding that the interest in question was “without fair market value at the time [of grant] ...and should not have been included in ... income for the years in issue.”98 The court also found that Regs.  § 1.721-1(b)(1) afforded “[s]ome justification ... for treating service partners who receive profits interests differently than those who receive capital interests.”99 Ultimately, however, the court declined to settle the issue as a matter of law, confining its holding to the grant of a profits interest with speculative value.100 Following this decision, the IRS issued Rev. Proc. 93-27.101
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97 943 F.2d 815 (8th Cir. 1991).

98 Id.

99 Id. at 822.

100 See also  St. John v. U.S., 53 AFTR2d 84-718 (C.D. Ill. 1983) (applying a “liquidation analysis” to conclude that the profits interest had no value on receipt); Kenroy, Inc. v. Comr., T.C. Memo 1984-232 (same);and Hale v. Comr., T.C. Memo 1965-274 (stating in dicta that profits interest did not constitute taxable income on receipt).

101 1993-2 C.B. 343. Subsequently, the IRS has issued Rev. Proc. 2001-43, 2001-34 I.R.B. 191, which clarifies certain issues raised in Rev. Proc. 93-27. Rev. Proc. 2001-43 is discussed in VI, A, 3, below. Further, in May 2005 the IRS issued proposed regulations, REG-105346-03, 70 Fed. Reg. 29675 (5/24/05), and Notice 2005-43, 2005-24 I.R.B. 1221, which contains a proposed revenue procedure that would obsolete Rev. Proc. 93-27 and Rev. Proc. 2001-43. These regulations are discussed more fully in VI, A, 4, below.

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2. Rev. Proc. 93-27 

In Rev. Proc. 93-27,102 the IRS announced that it would no longer challenge the compensatory grant of a profits interest as a tax-free transaction. The revenue procedure defines a “profits interest” as any interest in a partnership other than a “capital interest” and a “capital interest” as any interest “that would give the holder a share of the proceeds if the partnership's assets were sold at fair market value and then the proceeds were distributed in a complete liquidation of the partnership.”  To benefit from this self-imposed injunction, therefore, a partnership interest issued for services must have a “liquidation value” of zero on the date of grant. In addition, Rev. Proc. 93-27 does not apply to any profits interest related to a substantially certain and predictable stream of income from the assets of a partnership, such as income from a high-quality debt security or net lease, to a profits interest that the holder sells within two years, or to any profits interest in a publicly-traded partnership.103
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102 1993-2 C.B. 343.

103 The tax-free treatment of a profits interest granted under Rev. Proc. 93-27 was later expanded to include receipt of a profits interest in a partnership even if such interest was subject to a substantial risk of forfeiture and the recipient made no election under § 83(b).  See Rev. Proc. 2001-43, 2001-34 I.R.B. 191, discussed in VI, A, 3, below.

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Although the safe harbor left open a number of questions, it has largely achieved its intended purpose of eliminating longstanding uncertainty in the law.

3. The Vesting Problem:  Rev. Proc. 2001-43 

As described above, the general partner of a private equity fund will usually subdivide the underlying carried interest of the fund by issuing separate grants of an interest therein to each of its partners. Unlike the former, however, the subdivided grants in the general partner will usually bear some form of vesting restriction. In Rev. Proc. 93-27, the IRS failed to address the impact(if any) of a vesting restriction on the initial grant of a profits interest. One explanation for this rather curious omission is that the IRS simply disregards vesting restrictions in the partnership context. If so, the recipient of an unvested profits interest will incur no tax liability upon vesting, even if the value of the profits interest has appreciated in the interim.

The view that § 83 does not apply to the grant of a profits interest is not without merit. In a leading treatise on partnership taxation, for example, McKee once asserted that the principles of § § 61 and 83 should not extend to the grant of a profits interest for services because these provisions of the Code conflict with longstanding principles of partnership taxation, which themselves are “premised on nonrealization concepts.”104 Second, the § 83 regulations have never addressed  the tax consequences of service grants in the partnership context.  Although they have long provided specific rules for the treatment of unvested stock grants in both ‘C’and ‘S’ corporations, they currently provide no guidance on the treatment of unvested grants of a partnership interest for services.105 Finally, the IRS issued the revenue procedure to establish clarity in an area of law once mired in controversy. As the vast majority of profits interests issued for services will bear some form of vesting limitation, a narrow construction of Rev. Proc. 93-27 would provide the desired clarity in only a minority of the cases.
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104 See McKee, Nelson, and Whitmire, Federal Taxation of Partnerships and Partners, ¶ 5.02[6] (3d ed. 1997).  See also GCM 36346 (July 23, 1975)(profits interests not taxable under § 83 because analogous to unsecured promise to pay); Weigel, “Private Investment Fund Interests Held by Employees — Campbell, Section 83(b) and Other Considerations,” Tax Forum No. 543 (June 5, 2000) (citing various theories for and against application of § 83); but see Campbell v. Comr., T.C. Memo 1990-162, rev'd, 943 F.2d 815 (8th Cir. 1991) (rejecting notion that profits interest is not “property” under § 83).

105 See Regs.  § 1.1361-1(b)(3) (holder of restricted stock in S corporation not treated as shareholder absent a § 83(b) election);Regs.  § 1.83-1(a);Regs.  § 1.83-1(f) (Ex. 1) (employer treated as owner of restricted stock issued to employee until property becomes substantially vested; interim dividends and gains characterized as compensation income; but see REG-103580-02, Notice of Proposed Rulemaking, Noncompensatory Partnership Options, 68 Fed. Reg. 2930 (1/22/03) (requesting comment on proper application of § 83 to grant of partnership capital interest for services).

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Nevertheless, most practitioners believe that § 83 applies to the grant of a profits interest for services. If it does, then any vesting restrictions on the date of grant will suspend the application of Rev. Proc. 93-27 until the restrictions lapsed, at least absent a § 83(b) election. Whether the interest in question qualifies as a profits interest, therefore, would depend upon the value of the fund portfolio on the date of vesting, not on the date of grant.  Those subscribing to this view often advised the grantee to make a “protective” § 83(b) election on the date of grant, reporting the interest at a value of zero.106 Although the interest undoubtedly had positive value on the date of grant, the recipient relied upon Rev. Proc.  93-27 and other theories of non-realization to avoid the taxable event.107 Indeed, it would be difficult to reconcile Rev. Proc. 93-27 with § 83 were a § 83(b) election to trigger an immediate tax, given that the election seeks only to accelerate the tax consequences of § 83(a) to the date of grant.108 Having concluded in Rev. Proc. 93-27 that § 83(a) does not trigger an immediate tax upon grant of a fully-vested profits interest, the IRS can hardly impose less favorable consequences to the recipient of an identical interest of lesser value.
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106 See, e.g,, McKee, Nelson, and Whitmire, Federal Taxation of Partnerships and Partners, ¶ 5.09 (3d ed. 1997); Baneman, Roger J., “Selected Tax Issues in Equity-Based Compensation for Partnerships and LLCs,” Tax Club (January 2001).

107 See Willis, et al., Partnership Taxation, 84-85 (1971).

108 See, e.g., Rev. Rul. 83-22, 1983-1 C.B. 17 (property deemed “substantially vested” at time of § 83(b) election, and therefore no longer subject to substantial risk of forfeiture).

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In Rev. Proc. 2001-43,109 the IRS finally weighed in, finding no distinction between the grant of a vested interest and the grant of an unvested interest. So long as the grant otherwise qualifies under Rev. Proc. 2001-43, and the parties report the grantee as a partner on the date of grant, the IRS will not challenge either the grant or vesting of a profits interest as a tax-free transaction.110  Rev. Proc. 93-27 also clarifies that the grantee is not required to file a § 83(b) election.
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109 2001-34 I.R.B. 191.

110 A further condition of Rev. Proc. 93-27 is that neither the partnership nor any partner claim a compensation deduction at any time.

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Comment: If a profits interest is indeed “property”within the meaning of § 83, then the legal basis of Rev. Proc. 2001-43 is not at all clear.111 Indeed, the IRS did not even attempt to articulate one, suggesting a perhaps more pragmatic agenda — the IRS has been besieged with § 83(b) election forms in recent years, due in large part to the surge in popularity of LLCs.  Moreover, unlike a recipient of stock in a corporation, a recipient of a true profits interest has no reason not to make the § 83(b) election.  In view of these stark differences, the IRS may have determined that requiring an affirmative election as a condition of deferral was nothing more than a trap for the unwary.  But if stemming the tide of these elections was its goal, the IRS failed in the endeavor.  Most within the tax bar now advise the grantee of a profits interest to make a “protective” § 83(b) election in the wake of this pronouncement, arguing that the interest in question may not satisfy each and every condition of Rev. Proc. 93-27.112
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111 The IRS has requested comments on the application of  § 83 generally to the grant of a partnership option or an interest in partnership capital for services. See REG-103580-02, 68 Fed. Reg. 2930 (1/22/03).

112 For a discussion concerning “protective”elections under § 83(b), see Kalinka, “Rev. Proc. 2001-43 and the Transfer of a Nonvested Partnership Profits Interest,” 79 Taxes 11(Dec. 2001); see also Mincey et al., “Rev. Proc. 2001-43, Section 83(b), and Unvested Profits Interests — The Final Facet of Diamond?,”95 J. Tax'n 205 (Oct. 2001).

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Note:  In 2009, the House passed a bill that, if enacted, would codify “liquidation value”as the mandatory methodology for valuing the grant of any partnership interest issued for services.113 In addition, the bill would treat the service provider as having made a  §  83(b) election unless it affirmatively elects into § 83(a).114
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113 See H.R. 4213, Tax Extenders Act of 2009, 111th Cong., 1st Sess., §  601. The bill was introduced in the House on December 7, 2009, passed two days later, and referred to the Senate on December 10, 2009.

114 As amended,  §  83(c)(4) would provide that “the fair market value of such interest shall be treated for purposes of this section as being equal to the amount of the distribution which the partner would receive if the partnership sold (at the time of the transfer) all of its assets at fair market value and distributed the proceeds of such sale (reduced by the liabilities of the partnership) to its partners in liquidation of the partnership”and that “the person receiving such interest shall be treated as having made [a  §  83(b) election] ...unless such person makes an election under this paragraph to have such subsection not apply.” See §  601(a) of H.R. 4213.

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4. The Proposed Regulations 

On May 24, 2005, Treasury issued proposed regulations regarding the application of  §  83 in the partnership context, reopening the entire debate after four years of relative peace and quiet. The proposed regulations would apply to all compensatory grants of a partnership interest on or after the date of final regulations.115 Until then, Rev. Proc. 93-27 will remain in effect. As described above, Rev. Proc. 93-27 generally provides for the tax-free grant of a profits interest for services “to or for the benefit of” the issuing partnership.116 Together with the proposed regulations, Treasury also issued a proposed revenue procedure.117 The proposed revenue procedure will obsolete Rev. Proc. 93-27 and Rev. Proc. 2001-43 upon the effectiveness of final regulations.
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115 See REG-105346-03, 70 Fed. Reg. 29675 (5/24/05).

116 See VI, A, 1, above.

117 Notice 2005-43, 2005-24 I.R.B. 1221.

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It is difficult to overstate the significance of the proposed regulations to sponsors of private equity funds. First, the proposed regulations will formally extend § 83  to the grant of a partnership interest,118  resurrecting an issue that the IRS seemed to have interred in 1993: whether the grant of a profits interests for services is a taxable event. In doing so, the proposed regulations will make no distinction between a capital interest and a profits interests.119 Accordingly, absent a timely §  83(b) election, a holder of an unvested partnership interest issued for services will not qualify as a “partner” until the interest vests. If the holder does make a §  83(b) election, he or she will qualify as a partner on the date of grant.120  The proposed regulations therefore reach precisely the opposite conclusion of Rev. Proc. 2001-43. Second, the proposed regulations attempt to resolve fundamental and longstanding discontinuities between §  83 and subchapter K.
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118 Although proposed regulations issued in 1971 would have applied §  83 to the grant of a capital interest for services, the regulations were never finalized. See Prop. Regs. §  1.721-1(b)(1), 36 Fed. Reg. 10787 (6/3/71).

119 See Regs. §  1.83-3(e) (defining ‘property'as “real and personal property other than either money or an unfunded and unsecured promise to pay money or property in the future”);Prop. Regs. §  1.83-3(e) (adding following gloss: “accordingly, property includes a partnership interest”); see also Preamble to the proposed regulations, REG-105346-03, 70 Fed. Reg. 29675 (5/24/05).

120 Id.

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a. “Opting Out” of §  83 

Subchapter K does not readily embrace present value as a measure of economic income. Instead, it measures each partner's relative share of the income and assets of a partnership from year to year by changes in capital accounts balances, reflecting the basic principle that an allocation of profit and loss has “substantial economic effect” only if it increases or reduces a partner's capital account, without regard to when the partner is entitled to it. For example, if a partner invests $100 in a partnership, the partner will have an opening capital account balance in the partnership of $100, regardless of whether his share of the future profits is 10% or 90%. Moreover, the validity of the future allocations to the partner will ignore whether he in fact receives the underlying profits on a current or deferred basis. To validate an allocation, the §  704(b) regulations generally require only that a partner be entitled to his positive capital account on or before a liquidation. If a partner receives a pure profits interest, therefore, subchapter K provides no place within the capital account regime to reflect the present value of the interest on a current basis.

Section 83, on the other hand, taxes the service provider on the date of grant on the fair market value of the property. If the property in question is a profits interest, therefore, traditional §  83 principles would tax the service provider upon grant even though the partnership will deny any capital account credit to the service provider. It is here, therefore, that the two regimes conflict: current fair market value and the right to future profits are inseparable. Nevertheless, §  83 would tax the grantee of a profits interest immediately even though subchapter K would defer the tax until the partnership actually realizes the future profits.121
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121 Subchapter K has been aptly described as a “sealed system.” See NYSBA Tax Section, “Report on the Proposed Regulations and Revenue Procedures relating to Partnership Equity Transferred in Connection with the Performance of Services,”109 Tax Notes 1311 (Oct. 26, 2005) (“As a general matter, subchapter K is an intricate, sealed system in which a seemingly simple transaction can trigger numerous ancillary tax consequences. For example, provisions in § §  704(b), 704(c), 737, and elsewhere are designed to ensure that the taxable income, gain, deduction, and loss will be allocated to the partner who received the economic benefit or burden of the item, and provisions in § §  705, 707, 722, 723, 731, 732, 733, 734, 743, 754, and elsewhere are designed to ensure that income, gains, deductions, and losses will be taken into account only once by the partners”).

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A second, even more deeply-embedded conflict between the two regimes concerns the treatment of an unvested equity grant. By virtue of a §  83(b) election, a service provider becomes a “partner” for tax purposes on the date of grant even though the service provider may forfeit the interest before it vests. The issuing partnership must therefore allocate profit and loss to the service provider before the vesting date. Until the interest actually vests, however, these allocations cannot have substantial economic effect under §  704(b).122  In fact, no allocation can have substantial economic effect before the vesting date because until then, the ultimate beneficiary of the allocations is unknown: if the interest vests, the service provider will actually benefit from the profits previously allocated to his capital account; if the interest does not vest, the same profits will inure to the other partners. The proposed regulations nevertheless validate the “pre-vesting”allocations of profit to the service partner so long as the partnership agreement requires the partnership to make “forfeiture allocations”in the future.123
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122 § §  704(a), 704(b)(1); See also Regs. §  1.704-1(b)(1)(i). The proposed regulations acknowledge this conflict, providing that “if a  section 83(b) election has been made with respect to a substantially nonvested interest, the holder of the nonvested interest may be allocated partnership income, gain, loss, deduction, or credit (or items thereof) that will later be forfeited,” even though “allocations of partnership items while the interest is substantially nonvested cannot have economic effect.” See Prop. Regs. §  1.704-1(b)(4)(xii)(a).

123 Prop. Regs. §  1.704-1(b)(4)(xii)(b). For a fuller discussion of “forfeiture allocations” under the proposed regulations, see VI, E, below.

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b. The SHPI Safe Harbor 

The default rule under the proposed regulations is that §  83 principles govern the grant of a compensatory partnership interest. The grantee of a vested profits interest will therefore report compensation income on the date of grant equal to the full fair market value of the profits interest. Under a safe harbor alternative, however, the parties may instead report the grant at its “liquidation value,” provided that the partnership complies with a number of conditions.124  For all intents and purposes, the safe harbor reinstates Rev. Proc. 93-27, but under a more rigorous set of ground rules.125 In effect, therefore, the proposed regulations concede the intrinsic conflict between §  83 and subchapter K, effectively sanctioning alternative reporting.
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124 Prop. Regs. §  1.83-3(l).

125 Much of the complexity of the proposed regulations is intended to prohibit “whipsaw.”Unlike his corporate counterpart, the grantee of a profits interest has nothing to gain from inconsistent reporting with the service recipient. The grantee will make an §  83(b) election upon receipt of an unvested profits interest because the cost associated with the election in the partnership context is zero. Any incentive to report on an inconsistent basis instead lies with the non-service partners. In particular, although both the service provider and the issuing partnership will report the receipt of a profits interest at its liquidation value, a partner other than the service provider may invoke traditional  principles to claim a “free” compensation deduction. The safe harbor regime therefore amounts to an effective waiver of the right to argue §  83 on the merits by requiring advance consent to the use of liquidation value by all partners.

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The proposed regulations define “liquidation value” as the amount that the service provider would receive if, immediately after the grant, the partnership were to sell all of its assets (including goodwill, going concern value, and any other intangibles associated with the partnership's operations) at fair market value and then liquidate. A true profits interest, therefore, will have a liquidation value of zero. If the service provider instead receives a capital interest, it must report compensation income under §  83 equal to its liquidation value and will receive capital account credit for the amount includible in income.126  The historic partners, on the other hand, will be deemed to have incurred compensation expense, resulting in a corresponding debit to their capital accounts.127  Finally, the timing rules under §  83 will override the timing rules of §  707(c).
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126 Prop. Regs. §  1.704-1(b)(2)(iv)(b)(1).

127 §  83(h).

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Under the proposed regulations, a partnership may make the safe harbor election only under the following conditions:

First, the partnership must prepare and file a document with its tax return stating that the partnership is electing, on behalf of itself and each of its partners, to apply the safe harbor to all partnership interests transferred in connection with the performance of services while the election remains in effect.128
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128 Prop. Regs. §  1.83-3(l).

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Second, either the partnership agreement or a separate document executed by each partner must include “legally binding” provisions authorizing the partnership to effect the safe harbor election and requiring the partnership and each of its partners to comply with all of the requirements of the safe harbor.

Third, the partnership interest granted for services must qualify as a “safe harbor partnership interest”(“SHPI”).129
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129 Notice 2005-43, 2005-24 I.R.B. 1221 (§  3.02 of proposed revenue procedure).

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A SHPI is a partnership interest transferred for services provided to the partnership either before or after its formation, provided that (i) the interest is not related to a substantially certain and predictable stream of income from partnership assets, such as income from high-quality debt securities or a high-quality net lease; (ii) is not transferred in anticipation of a subsequent disposition; and (iii) is not an interest in a “publicly traded partnership” under §  7704(b).130 Absent “clear and convincing” evidence to the contrary, a partnership interest is presumed to be transferred “in anticipation of a subsequent disposition” if the interest is sold or disposed of within two years of the date of grant or is subject to a right to buy or sell regardless of when such right is exercised (other than any such right arising by reason of death or disability).
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130 Id.

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Finally, the safe harbor election will terminate if the partnership fails to satisfy each of these requirements or if any party reports the grant in a manner that is inconsistent with the proposed revenue procedure.131 Once the election is terminated, a partnership may not “reelect” under the safe harbor without the consent of the IRS for five years.132
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131 Notice 2005-43, 2005-24 I.R.B. 1221 (§  3.04 of proposed revenue procedure).

132 Notice 2005-43, 2005-24 I.R.B. 1221 (§  3.05 of proposed revenue procedure). The five-year rule also applies to any “successor partnership,” defined as “any partnership that (1) on the date of termination, is related (within the meaning of §  267(b) or §  707(b)) to the partnership whose Safe Harbor Election has terminated (or, if the partnership whose Safe Harbor Election has terminated does not exist on the date of termination would be related if it existed on such date), and (2) acquires (either directly or indirectly) a substantial portion of the assets of the partnership whose Safe Harbor Election has terminated.” Id.

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c. Compliance Issues for Funds 

The proposed regulations raise a number of compliance issues for fund managers and their members. First, although the proposed regulations would apply only to service grants after the date that they become final, the general partner of an existing fund is likely to effect future grants of an interest in the underlying carry to its own members. As a practical matter, therefore, although the proposed regulations will grandfather the underlying carry of a pre-existing fund, they will not grandfather the post-effective date service grant of an interest in the grandfathered carry. Second, as discussed at VI, A, 6, below, many fund sponsors choose to “split” the carry and fee vehicles into separate entities, one to hold the carried interest and the other to manage the fund. In such a case, if the carry vehicle grants a profits interest to one of its partners, it will have effectively granted the interest in consideration of services to the fund manager, which is merely an affiliate of the carry vehicle. Rev. Proc. 93-27 arguably applies even to funds with “bifurcated” sponsor entities because it refers to compensatory grants “to or for the benefit of” the issuing entity. The proposed regulations, however, apply only if the grantee provides the services “to” the issuing partnership.133 Third, it will be difficult for many funds to comply with the procedural limitations of the safe harbor.
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133 In the preamble to the proposed regulations, the IRS requested comments on the proper tax consequences of transactions involving affiliated entities, including the transfer of an interest in a lower-tier partnership in exchange for services provided to the upper-tier partnership. REG-105346-03, 70 Fed. Reg. 29675 (5/24/05).

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

To achieve pass-through treatment, the general partner and its members must each qualify as “partners” of their respective entities for tax purposes. If they do, they may report their allocable share of the income of the fund in accordance with its underlying character.134
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134 See § 702(a)(1), (2). See generally 711 T.M., Partnerships —Formation and Contributions of Property or Services.

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In general, a person or entity should not fail to qualify as a partner for want of a capital contribution.  Indeed, Rev. Proc. 93-27 itself assumes that a person who receives an interest solely for services may qualify as a partner for tax purposes.135 For two reasons, many practitioners nevertheless advise that the general partner and its members to contribute some quantum of capital. First, a capital contribution tends to clarify the status of a person as a “partner” and not a mere employee. The basis for the concern is that, without capital at risk, the putative partner bears no risk of loss.136 A capital contribution will therefore tend to eliminate ambiguity, in particular, if the tax status of the grantee as a partner is susceptible to alternative characterizations (e.g., employee, independent contractor) or is not consistent with the legal form of the relationship.137 Nevertheless, if a person is a member of the partnership entity under state or foreign law, shares in the profits of the entity and participates in management, he should be respected as a partner for tax purposes whether or not he makes a capital contribution.  Second, the service element of the consideration is arguably more opaque when a partner acquires a partnership interest for a property contribution. Without a clear and dominant service element, the status of the interest as a profits interest rather than a capital interest is less significant because the recipient need not rely upon the vagaries of Rev. Proc. 93-27 to avoid a taxable event. Instead,  § 721 will apply by its terms to the exchange.
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135 See also Diamond v. Comr., 56 T.C. 530 (1971), aff'd, 492 F.2d 286 (7th Cir. 1974) (taxpayer who contributed no capital respected as a partner for tax purposes).

136 See Luna v. Comr., 42 T.C. 1067, 1077-8 (extent of capital contributions and obligation to share losses cited as evidence of partner status).

137 See Luna, 42 T.C. at 1078 (taxpayer sought to characterize employment contract as constructive partnership);Weigel, “Private Investment Fund Interests Held by Employees —Campbell,  Section 83(b) and Other Considerations,” Tax Forum No. 543 (June 5, 2000) (capital contribution tends to establish that member is acting in partner capacity).

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Note: In some funds, a general partner may attempt to fund all or a portion of it capital commitment on a notional basis by “waiving” the management fee for the relevant period. If effective, these arrangements allow the general partner to satisfy the commitment with pre-tax dollars.138
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138 For a fuller discussion of this mechanism, see Polsky, “Private Equity Management Fee Conversions,” 122 Tax Notes 743, 751 (Feb. 9, 2009) (“Under a cashless contribution structure, all or a portion of the general partner's capital commitments will be ‘funded' either from previously foregone management fees or from fees that will not be collected in the future. With cashless contributions, the general partner's capital commitments are not technically funded; instead, the obligation to contribute capital is reduced by the amount of the waived fee.”). For a more general discussion of tax issues with fee waivers, see VI, H, below.

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6. Bifurcation 

As described more fully in VI, F, below, if the management activities of the general partner would otherwise attract state or local taxes, the sponsor may choose to split the general partner and the fund manager into separate entities, one to hold the carried interest and the other to manage the fund.  In such a case, the general partner will have effectively granted an interest in the underlying carry in consideration of services performed for an affiliate of the general partner. Because Rev. Proc. 93-27 applies to the grant of a profits interest in exchange for services “to or for the benefit of” the issuing entity, the issue this raises is whether the grant of the profits interest in a bifurcated fund structure nevertheless qualifies as a tax-free transaction.139
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139 A similar question was raised in Banoff, “First IRS Ruling on Unvested Partnership Profits Interest: No Income Recognized but Questions Remain,” 99 J. Tax'n 133 (Sept. 2003) (discussing PLR 200329001, the first letter ruling regarding the tax treatment of a service provider who receives an unvested profits interest in a partnership in exchange for services). It should also be noted that proposed regulations will revoke the revenue procedure and will limit any safe harbor relief to partnership interests issued in consideration of services “to” the issuing partnership. See VI, A, 4, c, above.

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The services to the fund manager by the members of the general partner will certainly benefit the general partner because the services will increase the value of the portfolio company investments; indeed, they are the very quid pro quo for the carried interest. Accordingly, the employees of the fund manager will have received their interest in the general partner in consideration of services performed “for the benefit of” the general partner, complying with the literal language of the revenue procedure.  Some practitioners, however, have construed the “for the benefit of” language as applying only to persons who, like the taxpayer in Diamond, performed the relevant services before the partnership was formed.140 Even if the revenue procedure does not apply, however, the recipient may be able to avoid a taxable event under the common law, arguing that the interest has speculative value or that the grant itself is not a realization event.141
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140 See McKee, Nelson, and Whitmire, Federal Taxation of Partnerships and Partners, ¶ 5.02[7][a](3d ed. 1997) (“[T]he Revenue Procedure clearly leaves open the question whether the receipt of a profits interest for services on behalf of someone other than the partnership is a taxable event”); see also  Campbell v. Comr., 943 F.2d 815 (8th Cir. 1991) (IRS argued, inter alia, that taxpayer rendered services not to partnership, but to his employer).

141 See, e.g., McKee, Nelson, and Whitmire, Federal Taxation of Partnerships and Partners, ¶ 5.02[7][b] (3d ed. 1997).  McKee cites the Campbell, Diamond and Pacheco cases as support for the proposition that the issuance of a “garden variety” profits interest lacks a readily determinable fair market value and therefore is not includible in income.  Campbell v. Comr., 943 F.2d 815 (8th Cir. 1991); Diamond v. Comr., 56 T.C. 530 (1971), aff'd, 492 F.2d 286 (7th Cir. 1974); U.S. v. Pacheco, 912 F.2d 297 (9th Cir. 1990). The argument in support of non-realization is that a partner did not realize income upon the receipt of a profits interest before Congress enacted the 1954 Code, which merely restated the law then in effect under the 1939 Code governing the taxation of compensation for services. See McKee, at ¶ 5.02[6][a] and [b].

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U.S. Income Portfolios: Other Pass-through Entities 
  Portfolio 735-2nd: Private Equity Funds 
  Detailed Analysis 
  VI. Special Tax Issues for the General Partner and Its Members

B. Character of Distributive Share 

1. Current Law 

As discussed above, the grant of a profits interest is not a taxable event.142  In addition, the service provider will qualify as a partner on the date of grant and may therefore report his or her allocable share of the future profits in accordance with its underlying character.143 On these two pillars, the general partner of a private equity fund and its partners avoid immediate tax upon the grant of the carried interest and bear tax on most of the future gains at a 15% rate.
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142 See VI, A, 1, above.

143 §  702(b).

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2. Proposed Carry Legislation 

In 2007, the House introduced a bill that included a proposal to tax the service element of the carried interest in virtually every private equity fund in the market as ordinary income.144 Although the House ultimately dropped this proposal from the bill, it approved a nearly identical proposal in 2008.145  In February 2009, President Obama introduced a similar (albeit broader) proposal.146 On April 2, 2009, the House introduced H.R. 1935.147 Although similar to H.R. 6275 and H.R. 3996, H.R. 1935  modifies these earlier proposals in several respects. Finally, on December 9, 2009, the House passed H.R. 4213 (the “Carry Bill”).148 Although the Carry Bill is substantially similar to H.R. 1935, it differs from each of its predecessors in certain respects.
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144 H.R. 3996, Temporary Tax Relief Act of 2007, 110th Cong., 2d Sess. Congressman Rangel introduced the bill on Oct. 30, 2007, which was passed by the House on Nov. 9, 2007.

145 H.R. 6275, Alternative Minimum Tax Relief Act of 2008, 110th Cong., 2d Sess. Congressman Rangel introduced the bill on June 17, 2008 and the House passed it on June 25, 2008. For a detailed analysis of H.R. 6275, see NYSBA Tax Section, “Report on Proposed Carried Interest and Fee Deferral Legislation” (September 24, 2008).

146 For a narrative description of this proposal, see “General Explanations of the Administration's Fiscal Year 2010 Revenue Proposals” (the “Green Book”), available at http://www.treas.gov/offices/tax-policy/library/grnbk09.pdf. Unlike the other proposals, however, the Green Book proposal would apply to any “services partnership interest,”a term not expressly limited to a partnership interest issued in consideration of investment management services. The Green Book proposal would be effective for taxable years beginning after December 31, 2010.

147 See H.R. 1935, 111th Cong., 1st Sess., §  2(a).

148 See H.R. 4213, Tax Extenders Act of 2009, 111th Cong., 1st Sess., §  602(a) (adding new  § 710 to subchapter K of the Code).

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If the Carry Bill becomes law, it will fundamentally alter current law taxation of the carried interest. In the author's view, the consequences of the Carry Bill to affected taxpayers are so undesirable that many fund managers will restructure the nature of their service compensation in an effort to avoid or mitigate its after-tax impact.

a. Summary of Carry Bill 

Under the Carry Bill, the service provider must report net income with respect to an “investment services partnership interest” (“ISPI”) as ordinary in nature.149 Accordingly, the service provider will no longer bear tax on such income in accordance with its underlying character under §  702(b), but rather at ordinary income rates,150  including self-employment tax.151 Although the service provider must also report a net loss as ordinary, it may deduct the loss only to the extent of the previous allocations of net income.152 If a loss is suspended under this limitation, the service provider may carry the loss forward and treat it as incurred in the following taxable year.153 During the period of suspension, the service provider is not required to reduce its outside basis in the partnership by the suspended loss.154
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149 Proposed §  710(a)(1)(A). Each item of income, gain, deduction, and loss taken into account in the determination of net income is also treated as ordinary. Proposed §  710(a)(1).

150 Effective for taxable years beginning after December 31, 2010, the income will no longer qualify as “qualifying income” under  §  7704(c) to a PTP, subject to an exception if 50% or more of the interests of a PTP are held by a REIT. H.R. 4213, 111th Cong., 1st Sess., § 602(b) (adding new  § 7704(d)(6) to the Code). The Carry Bill would also grandfather any existing PTP as of the date of enactment for 10 years. Id.

151 In the case of individuals, the Carry Bill imposes self-employment tax on the allocations by amending §  1402 of the Code and  §  211 of the Social Security Act. See H.R. 4213, Tax Extenders Act of 2009, 111th Cong., 1st Sess.,  §  602(d) (adding new  § 1402(a)(18) to the Code). Under current law, employment taxes do not apply to carried interest allocations of interest, dividends or capital gains. See §  1402(a)(2) (dividends and interest).

152 Proposed §  710(a)(2)(A).

153 Proposed §  710(a)(2)(B).

154 Proposed §  710(a)(2)(C).

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If the service provider sells an ISPI, it must report the gain as ordinary income as well, notwithstanding any other provision of Subtitle A of the Code.155 Any loss realized on the sale is also ordinary, but only to the extent of the prior income allocations.156
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155 Proposed §  710(b)(1). The Carry Bill does not apply to income allocable to any portion of the ISPI that qualifies as a “qualified capital interest.” For a discussion of this exception, see VI, B, a, (2), below.

156 Proposed §  710(b)(2).

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If the issuing partnership distributes appreciated property to the service provider, it must recognize gain notwithstanding the non-recognition rules of §  731.157 Moreover, the issuing partnership must allocate the gain to the service provider notwithstanding any contrary provision of the partnership agreement.158 Although this special allocation of income would apparently override the “substantiality”requirement under the §  704(b) regulations, the Carry Bill subordinates the §  704(b) violation to facilitate full taxation of the service element. In addition, the service provider must report the in-kind distribution as if he had received cash in an amount equal to the fair market value of the distributed property.159 If the value of the property exceeds the service provider's basis, therefore, the service provider will recognize additional gain in a deemed sale,160  which itself will constitute ordinary income.161  Finally, having fully taxed the service element, the Carry Bill grants the distributee a full fair market value basis in the distributed property.162
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157 Proposed §  710(b)(4)(A).

158 Id. The requirement to specially allocate the gain does not apply, however, if the partnership is otherwise required to recognize gain on the distribution under some other Code provision. See Proposed  §  710(b)(4)(A)(ii) (gain recognition and special allocation rule applies “except to the extent such excess is otherwise taken into account in determining the taxable income of the partnership”). If, for example, a partnership distributes §  704(c) property to a non-contributing partner, the distribution may trigger gain to the original contributing partner. See §  704(c)(1)(B); see also §  737(a) (triggering gain upon distribution of other property to partner who previously contributed built-in gain property); §  707(a)(2)(B) (disguised sales of property).

159 Proposed §  710(b)(4)(B).

160 §  731(a).

161 Proposed §  710(b)(1).

162 Proposed §  710(b)(4)(C). Section 734(b) is applied without regard to this rule. Id.

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In anticipation of efforts to circumvent these limitations, the Carry Bill provides special rules for service grants of an ownership interest other than an ISPI.163 These anti-abuse rules will apply only to a “disqualified interest,” which the Carry Bill defines to include convertible or contingent debt, an option, a derivative and any other arrangement the value of which is “substantially related to the amount of income or gain” from the specified asset.164 Except as provided in regulations, it does not include stock of a taxable corporation165 or stock of an ‘S' corporation.166
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163 See Proposed § §  710(d); 710(d)(2)(A)(ii)(I)(excluding “partnership interest”).

164 Proposed § §  710(d)(1)(C); 710(d)(2)(A).

165 Proposed §  710(d)(2)(A)(ii)(II). For this purpose, a “taxable corporation” includes both a domestic ‘C' corporation and a foreign corporation substantially all of the income of which is either ECI or subject to “comprehensive foreign income tax” within the meaning of §  457A(d)(2). See Proposed §  710(d)(2)(B).

166 Proposed §  710(d)(2)(A)(ii)(III).

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(1) Definition of ISPI 

The Bill defines an ISPI as any partnership interest held by a person if it was reasonably expected (at the time that such person acquired the partnership interest) that such person(or anyone related to such person) would provide, directly or indirectly, a substantial quantity of any of the following services:
• advising on the investment in, purchase of, or sale of any “specified asset;”

• managing, acquiring or disposing of any specified asset;

• arranging financing with respect to acquiring specified assets; or

• any supporting activity related to these services.167

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167 Proposed §  710(c)(1).

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For this purpose, a “specified asset”includes any security (as defined in §  457(c)(2) without regard to the last sentence), any real estate held for rental or investment, any interest in a partnership, any commodity (as defined in §  475(e)(2)), or any option or derivative contract with respect to any of the foregoing.168
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168 Id.

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For many partnerships that do not operate as funds or other pooled investment vehicles, the question of whether and how the Carry Bill will apply to their equity service grants will remain unclear, at least in the absence of future regulations or other guidance. For example, the Carry Bill does not define what quantum of services is a “substantial quantity.” 169 Nor does it specify the period of time over which the service provider must provide these services.170 Indeed, a prior version of the Carry Bill did not even require a partnership to even own the “specified assets.” 171 It is fortunate, therefore, that the statutory language includes an exceedingly broad grant of regulatory authority (far broader than any of its predecessors) to the IRS to issue not only “necessary or appropriate” guidance, but to actually modify the statute “to the extent such modification is consistent with the purposes of this section.”172
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169 Before its amendment in 1984, §  341(b)(1)(A) used the term “substantial part.” When Congress amended  §  341(b)(1)(A) in 1984, it replaced “substantial part” with the fraction “2/3”. See Deficit Reduction Act of 1984 §  65(a), Pub. L. No. 98-369, 98 Stat. 494, 584 (1984).  Some believe that the phrase may capture anything beyond a de minimis amount of the relevant services. See Abrams, “A Close Look at the Carried Interest Legislation,” 117 Tax Notes 961, 969 (December 3, 2007).

170 See Schler, “Taxing Partnership Profits Interests as Compensation,” 119 Tax Notes 829 (May 26, 2008).

171 Compare the version of Proposed §  710(c) under H.R. 6275 (“... a substantial quantity of any of the following services with respect to the assets of the partnership in the conduct of the trade or business of providing such services”)(emphasis added) with Proposed  §  710(c) of H.R. 1935 (“...a substantial quantity of any of the following services...”) As drafted, therefore, H.R. 1935 could be read to have extended to an equity grant by an investment bank organized as a partnership merely because the bank issued the equity in consideration of the employee's expertise as a mergers and acquisitions advisor. In the author's view, it is unlikely that the drafters of H.R. 1935 intended this result. Indeed, in H.R. 4213, the drafters reverted to language similar to the original language in H.R. 6275, referring only to services that relate “to assets held (directly or indirectly)by the partnership.”  Proposed  §  710(c)(1) (emphasis added).

172 Proposed §  710(e).

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To the fund manager of a private equity fund, however, none of these ambiguities is relevant. Regardless of how Treasury opts to resolve them, the grant of an interest in the underlying carry by the general partner of virtually every private equity fund in the market will constitute the grant of an ISPI.

(2) Relief for “Qualified Capital Interests” 

The Carry Bill will not recharacterize any net income allocable to an ISPI that is attributable to the “qualified capital interest” of the service provider.173 The definition of “qualified capital interest” is therefore of great significance.174
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173 Proposed §  710(c)(2)(A).

174 A prior version of the Carry Bill extended more limited relief, limiting the exception to profits allocable to “invested capital” of the service provider, which it defined as the fair market value of any money or other property contributed to the partnership. See H.R. 6275, § 710.

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The Carry Bill defines a “qualified capital interest” at any given time as such portion of a partner's interest that is attributable to the sum of:
•the fair market value of any money or property contributed to the partnership;175

•any income recognized by the service provider under §  83 upon the grant of the ISPI; 176  and

• the service provider's share of any items of income or gain,177

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175 Proposed  §  710(c)(2)(D)(i) (determined without regard to §  752(a) of the Code).

176 Proposed §  710(c)(2)(D)(ii). The Carry Bill would also amend §  83 to expressly sanction the use of “liquidation value” to measure the compensation income attributable to the grant itself. See VI, A, 3, above. As such, the recipient of an ISPI will avoid any risk of double taxation of the service element, first under §  83 on the date of grant and second under the Carry Bill upon the realization of the future profits.

177 Proposed §  710(c)(2)(D)(iii)(I).

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reduced by the sum of:
•any distributions to the service provider; and

•the service provider's share of any items of deduction or loss.178

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178 Proposed §  710(c)(2)(D)(iii)(II).

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The Carry Bill affords no relief under this exception unless the partnership allocates profit and loss to the qualified capital interest of a service provider “in the same manner” as it allocates profit and loss to the qualified capital of the non-service providers.179 Moreover, the allocations to the non-service providers must be “significant” relative to the corresponding allocations to the service provider.180
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179 Proposed §  710(c)(2)(A)(i). In addition, the non-service provider cannot be “related”to the service provider. See VI, B, 2, a, (3), below. For this purpose, “related party” status is determined under § §  267 and 707(b). See Proposed §  710(c)(3).

180 Proposed §  710(c)(2)(A)(ii). The Carry Bill does not define the meaning of “significant”in this context.

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In the rare case in which a service provider is related to all of the significant non-service providers, qualified capital relief will not be available to the service provider except as provided under future regulations or other guidance.181 The legislative history cites as one candidate for regulatory relief any “pro rata allocation” by a partnership to the qualified capital of its partners.182 Accordingly, if a partnership allocates to the qualified capital of the related non-service providers the same return as it allocates to the qualified capital of the service provider, that portion of the return to the service provider should retain its status as an allocation of investment income even though it does not qualify under the statute.
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181 Proposed §  710(c)(2)(B).

182 See Joint Committee on Taxation, Technical Explanation of H.R. 4213, the “Tax Extenders Act of 2009,” as Introduced in the House of Representatives on December 7, 2009 (JCX-60-09), December 8, 2009, available at http://www.jct.gov/publications.html?func=startdown& id=3640 (“It is anticipated that Treasury guidance may provide that [a] pro rata allocation of partnership items to qualified capital interests generally satisfies the special rule in this situation. It is anticipated that the Treasury guidance will take into account whether the partnership agreement provides for proper allocation of the items among the partners and, with respect to a service provider, as between the partner's qualified capital interest and the remainder of the partners interest in the partnership.”).

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(3) Restrictions on Borrowed Capital 

Under the Carry Bill, the service provider will not receive qualified capital credit for any capital contributed to the partnership that represents the proceeds of any loan made or guaranteed by any partner or by the partnership.183 Thus, if a service provider borrows $100 from another partner and contributes it to the partnership to acquire an ISPI, the service partner will receive no credit for the $100 even if the $100 represents the full fair market value of the acquired interest.
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183 Proposed §  710(c)(2)(E). This limitation will also apply to any loan from a lender who is related to the partnership or to any partner of the partnership. For this purpose, “related party” status is determined under § §  267 and 707(b). See Proposed §  710(c)(3).

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The borrowing limitation applies to any loan, regardless of whether the loan is recourse or nonrecourse, arm's length or non-arm's length, or is otherwise commercially reasonable. The purpose of this limitation, however, is to prevent the service provider from exploiting the exception for qualified capital by borrowing money on a subsidized or other non-arm's length basis and then imposing the economic burden of the subsidy on the lending partner or partnership. In effect, a loan of this sort may grant the economic equivalent of a carried interest in favor of the service partner:

Example: GP and LPs form a fund. The LPs contribute $80 of capital and the GP contributes $20 of capital. The GP funds the entire $20 contribution with the proceeds of a 10%non-recourse loan from the LPs.

Because the loan from the LPs is nonrecourse, the capital interest of the GP is economically indistinguishable from a 20% carried interest with no capital contribution, subject to a 10% preferred return. If, for example, the fund were to sell a $100 investment for $200 after one year, the fund would distribute $40 to the GP and $160 to the LPs. The GP would then pay $20 to the LPs to retire the loan, together with $2 of interest, leaving the GP with a pre-tax return of $18 (i.e., $40 - $22). Had the LPs instead funded the entire $100 of capital and granted a 20% carried interest to the GP subject to a 10% preferred return, the GP would also net an $18 pre-tax return (i.e., ($200 - $110) x 20%). Unless the Carry Bill denies qualified capital credit to the GP for the $20 loan, therefore, it would allow the GP to report its entire share of the gain as long-term capital gain even though it bore no greater risk of loss than the grantee of an equivalent profits interest.

(4) Dispositions of ISPIs 

Under the Carry Bill, any gain on the “disposition”of an ISPI is ordinary in nature.184 Loss on a disposition is ordinary as well, but only to the extent it exceeds the aggregate net income allocable to the service provider from prior periods.185 Neither limitation applies, however, to gain or loss on a disposition attributable to “qualified capital”of the service provider.186
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184 Proposed §  710(b)(1).

185 Proposed §  710(b)(2).

186 Proposed §  710(c)(2)(C). For this purpose, the Carry Bill would exempt the same percentage of gain realized on a disposition of an ISPI as would have been allocated to the qualified capital of the service provider following a hypothetical sale of the partnership assets immediately before the disposition. Id.

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A service provider who receives an ISPI and values it at zero cannot avoid ordinary income by simply disposing of it at fair market value on a later date and reporting the gain as capital in nature.187 In this sense, the disposition rule is really just an adjunct to the general rules of the Carry Bill governing allocations of profit and loss. On occasion, however, a service provider may dispose of an ISPI in a purely tax-free transaction. For example, the service provider may transfer an ISPI to a controlled subsidiary in a tax-free transaction under §  351. Even here, the Carry Bill would require the service provider to recognize gain because the disposition rule applies “notwithstanding any other provision of this subtitle.” 188
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187 See § §  741, 1001.

188 Proposed §  710(b)(1).

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Although the drafters could have exempted a §  351 or other non-recognition transfer from the disposition rule, they would have had to “taint”the transferred interest in the hands of the transferee or the equity issued by the transferee to the service provider. Otherwise, the service provider could effectively “close” the service element of the transaction without triggering compensation income:189
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189 The transferred interest is not an ISPI in the hands of a transferee unless the transferee also provides, directly or indirectly, the relevant services to the partnership. See Proposed §  710(c). See also Schler, “Taxing Partnership Profits Interests as Compensation,” 119 Tax Notes 829, 845 (May 26, 2008) (stating that “section 710 [of H.R. 3996] will not apply to the transferee if the transferee does not directly provide services to P and is not considered to indirectly provide services to P through GP's services to P”).

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Example:  GP and LPs form X, a newly formed private equity fund. X grants a 20% carried interest to GP. Assume that the 20% carried interest is an ISPI. GP transfers the ISPI to a wholly-owned S corporation in a transaction that qualifies under §  351. Assume that the S corporation is engaged in a trade or business unrelated to GP or X, and provides no investment management or other services to either entity. Because the 20% carried interest is not an ISPI in the hands of the S corporation, the Carry Bill would not recharacterize any portion of future gains allocable to the S corporation as ordinary income.

Although previous versions of the Carry Bill left open the possibility of non-recognition treatment in this example,190 the current version forecloses it.
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190 Proposed  §  710(b)(1) of H.R. 6275, for example, merely provided that “gain on the disposition of an [ISPI] shall be treated as ordinary income for the performance of services,” without clarifying whether a “disposition”included a tax-free exchange. See H.R. 6275, 110th Cong., 2d Sess. See also Schler, “Taxing Partnership Profits Interests as Compensation,” 119 Tax Notes 829, 845 (May 26, 2008). (“The result under  section 710 of a nonrecognition transfer is not clear. The section states that gain on the disposition of an interest shall be treated as ordinary income, without making clear whether the reference is to gain realized or gain recognized ...This conclusion would create a potential method of avoiding section 710”).

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b. How Will Funds Comply with the Carry Bill? 

For some funds, the primary impact of the Carry Bill will be the one Congress intended:  the conversion of all or substantially all of any income allocations to the general partner and its members from long-term capital gain (or other investment income)into ordinary income. For other funds, however, the mere obligation to report the segmented character of the future allocations of income to the general partner in the manner required under the Carry Bill will reach new heights of complexity. In addition, the literal language of the bill often produces counterintuitive results.

(1) “Disaggregating”Subchapter K 

Much of the complexity in subchapter K originates from its capacity to tolerate (even embrace) virtually any economic arrangement:  it permits the providers of capital and services to “pool”their separate contributions within a single vehicle, yet avoid entity-level tax on the aggregate profits.191  Indeed, it is this “aggregate”feature of subchapter K that many cite as its primary virtue. By extending relief to income attributable to qualified capital,192  however, the Carry Bill will now require affected partnerships to “disaggregate” the undivided interests of their service partners, undermining the very pooling that subchapter K otherwise envisions.
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191 See Regs. §  1.701-2(a) (“Subchapter K is intended to permit taxpayers to conduct joint business (including investment) activities through a flexible economic arrangement without incurring an entity-level tax”).

192 Proposed §  710(c)(2).

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As described above, income attributable to qualified capital of the service provider is exempt from the Carry Bill and is therefore subject to tax in accordance with its underlying character.193 The distinction between income attributable to capital and income attributable to services is perfectly sound:  as a policy matter, a partner who contributes capital to a partnership should bear tax on the same basis as any other partner who contributes capital, even if the contributing partner also contributes services; in practice, however, the process of separating the two is fraught with hidden complexity.
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193 Proposed §  710(c)(2)(A)(ii). A similar exception applies to gain or loss “allocable”to a qualified capital interest on a sale or other disposition. See Proposed § 710(c)(2)(B).

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To actually implement the “qualified capital”exception, the Carry Bill will require an affected partnership to do something that no other partnership has ever been called upon to do, which is to subdivide the distributive share of a single partner under §  704(b) into separate “streams” of service and capital income. In doing so, it will not alter the current law treatment of the grant itself. Accordingly, the recipient of an ISPI may continue to report the grant as a tax-free transaction so long as the ISPI has a liquidation value of zero. Moreover, subject to the rules governing “in-kind”distributions to the service provider,194 it will not alter how an affected partnership allocates profit and loss among its partners under §  704(b) and §  704(c). Accordingly, the Carry Bill will not accelerate the recognition of income to the service provider.195
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194 Proposed §  710(b)(4).

195 In a tax-free disposition of an ISPI, however, the Carry Bill will accelerate income to the service provider. See VI, B, 2, a, (4), above.

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Indeed, for some funds, even the obligation to disaggregate will impose no real complexity:

Example:  LPs invest $900 and GP invests $100 in X, a newly formed private equity fund. Assume that the entire $100 from GP represents “qualified capital.”The LPs and GP are each entitled to the same return per dollar of invested capital. In addition, X grants a 20% carried interest to GP for services. The distribution waterfall of the fund agreement calls for the immediate distribution of all sales proceeds on an “investment-by-investment"basis. Assume that X makes five investments and then sells each one at a gain, distributing the proceeds in accordance with the distribution waterfall.

Under the Carry Bill, the carried interest in this example is an ISPI. Because the GP contributed $100 of capital, however, a portion of the ISPI represents qualified capital. Moreover, because both the GP and the LPs are entitled to the same return on their capital, no portion of the future income allocable to the GP with respect to its capital (as opposed to its carry) is vulnerable to recharacterization. In this particular example, the task of subdividing the aggregate allocations to the GP from year to year into its service and capital components is a simple one because the GP's share of the relative capital in X will remain fixed at a constant 10% throughout the life of the fund.196 In each and every year, therefore, the GP will report only its 20% share of the “excess” gains as ordinary income.

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196 Although the carry allocations of gain will increase the GP's qualified capital, the immediate distribution of the sales proceeds to the GP will generally reduce the GP's qualified capital by a like amount. See Proposed §  710(c)(2)(D).

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But consider the following example:

Example: LPs invest $900 of qualified capital and GP invests $100 of qualified capital in X, a newly formed private equity fund. The LPs and GP are each entitled to the same return per dollar of invested capital, of which GP has contributed 10% and the LPs have contributed 90%. In addition, X grants a 20%carried interest to GP for services. Unlike the previous example, however, the distribution waterfall of the fund agreement requires X to return all invested capital to the LPs and GP prior to making any distributions to the GP with respect to its carry. Assume that X makes five investments, each for $200, sells the first investment at the end of Year 1 for $1000 and then sells the second investment at the end of Year 2 for $500.

In Year 1, X must allocate $160 of gain to GP with respect to its carried interest ($800 gain x 20%) and  $64 of gain to GP (($800 - $160) x 10%) with respect to its capital interest.

In Year 2, X must allocate  $60 of gain to GP with respect to its carried interest ($300 gain x 20%) and  $24 of gain to GP (($300 - $160) x 10%) with respect to its capital interest.

Of the aggregate $224 of gain allocable to GP in Year 1, $160 should constitute ordinary income under the Carry Bill and the remaining $64 should retain its underlying character as capital gain under the “qualified capital” exception. So far, so good.

But what about the $84 of gain allocable to GP at the end of Year 2?  At the end of Year 1, the LPs had $576 of qualified capital in X ($900 + (i.e., $800 x 90% x 80%) - $900) and the GP had $224 of qualified capital in X (i.e., $100 + $160 + (i.e.,$800 x 10% x 80%) - $100). On that date, therefore, the capital of the GP accounted for 28% of the total capital of the fund ($224/$800). In view of these percentages, how much of the $84 should retain its character under the Carry Bill?
• is it 28% of the total gain allocable to the GP, or $23.52 ($84 x 28%)?;

• is it 28% of the total Year 2 gains net of the carry, or $67.02 ($300 x 80% x 28%)?;

•is it the entire $84?  After all, the LPs were allocated$216 of gain in Year 2, or 37.5¢  per dollar of qualified capital at the beginning of Year 2 ($216/$576). Applying the same ratio to the qualified capital of the GP at the beginning of Year 2 would subsume the entire $84 allocation ($224 x 37.5%).

The Carry Bill appears to leave open all three of these possibilities.197

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197 Because X actually deployed only$20 of the GP's capital in the second investment (i.e., 10% of the total capital), perhaps only $24 of the $84 of gain allocated to the GP in Year 2 should retain its character under the “qualified capital” exception. Logically, however, the distribution of 100% of the sale proceeds from the first investment to the LPs should be regarded as an additional economic investment of $160 (i.e., 20%of the gain on the first investment) by the GP in the retained investments of X. See Proposed  §  710(c)(2)(D)(iii)(I) (qualified capital includes “any items of income and gain” allocated to the service provider).

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The basic problem here is that a service provider's relative share of the total qualified capital of a partnership will vary from year to year. Indeed, it may vary within different periods of a single year. These kinds of variations will occur in any fund that reinvests profits or provides for priority returns of capital on unrealized investments. If the Carry Bill becomes law, therefore, the sponsors of these funds will be required to “bifurcate”the income of the service provider in a particular year between services and capital in a manner that properly reflects its relative share of the “qualified capital” in the partnership on the date of each disposition (or other realization event). In this sense, qualified capital is like a “shadow” §  704(b) capital account, but one comprised of only a fraction of the performance results of the underlying fund that will itself vary from year to year. Indeed, even something as commonplace as a tax distribution may alter the general partner's relative share of the aggregate capital of the fund, both from year to year and within a single year.

(2) Taxing Services to Yourself 

It is often said (including by the author) that the general partner of a typical fund earns the same return on its capital as any other fund investor. Strictly speaking, this is not true. The general partner imposes a carry on all capital, and will therefore charge itself a carry or just “waive”the self-imposed portion of the carry as a circular expense. In either case, the general partner is entitled to 100% of the gains on its own capital.

As described above, one condition to relief under the “qualified capital” exception is that the partnership allocate profit and loss to the qualified capital interest of the service provider “in the same manner” as it allocates profit and loss to the money providers.198 The money providers, however, are entitled to only 80% of the gains on their invested capital. Is the general partner therefore taxable at a 35% rate (plus employment taxes) on the “excess” 20% return it derives from its own capital? If so, then the Carry Bill will actually tax the general partner on the value of its own services.199 In the author's view, this portion of the return to the general partner should remain subject to tax in accordance with its underlying character.
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198 Proposed §  710(c)(2)(A)(i).

199 See, e.g., Comr. v. Moran, 236 F.2d 595, 598 (8th Cir. 1956)  (“an individual cannot be his own employee ...”).

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(3) Capital Investments in the GP Entity by Non-Service Providers 

On occasion, a tax-exempt or foreign investor in a fund will acquire an interest in the general partner. In the typical case, it will receive the interest in the general partner as partial consideration for the investor's capital commitment to the fund. The purpose of these arrangements is not to establish a service relationship, but to “buy down” the effective carry percentage for selected investors. Had the same investor acquired a unitary interest in the fund at a reduced carry percentage, the Carry Bill would have exempted the entire acquisition as the investment a pure money provider. Here, however, the investor has acquired an interest in a partnership that holds an ISPI (i.e., the carried interest). By investing in the general partner, the investor must therefore report this portion of its allocable share of the future income in accordance with its “ordinary”character at the partnership level.200
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200 See §  702(b).

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Prior versions of the Carry Bill treated income attributable to an ISPI as service compensation.201 To a foreign or tax-exempt investor, the service characterization probably tainted the income as ECI or UBTI as well. Here, however, the income is merely “ordinary.”Having struck the explicit service characterization, did the drafters of the Carry Bill still intend to tax a foreign or tax-exempt investor in the general partner who provides no services?
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201 The version of Proposed  §  710(a)(1)(A) under H.R. 6275 characterized the income as “ordinary income from the performance of services.” See H.R. 6275, Alternative Minimum Tax Relief Act of 2008, 110th Cong., 2d Sess.

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Although the drafters may have intended to preserve the exempt character of such income to these investors, this is by no means clear from the statutory language, at least in the absence of further guidance. Many categories of income are “ordinary”in nature, including service compensation, interest, dividends, rents and royalties. The status of income as ordinary, however, is not what establishes its character as either UBTI or ECI. Moreover, if an individual investor were to make the same bifurcated investment in both entities, he would be required to report his distributive share from the general partner as service income even though he, like the tax-exempt or foreign investor, provided no actual services.202
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202 See §  702(b). Under a proposed amendment to §  1402, an individual investor who holds an ISPI or an interest in a partnership that holds an ISPI would be required to report his distributive share as “net earnings from self-employment.” See H.R. 4213, Tax Extenders Act of 2009, 111th Cong., 1st Sess., §  602(d)(adding new  §  1402(a)(18) to the Code).

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Under legislative history that does not accompany any of the predecessor proposals, however, it would appear that these allocations will not constitute UBTI or ECI so long as they would otherwise be exempt from U.S. tax as a species of investment income to the tax exempt or foreign investors.  The Technical Explanation, for example, provides that “it is not intended that solely the recharacterization of income as ordinary under the [Carry Bill will]cause income not otherwise treated as unrelated business income of an exempt organization to fail to meet provisions of  section 512(b) that are otherwise satisfied.”203   On similar grounds, it would appear that an allocation of non-FIRPTA capital gain or portfolio interest to a foreign investor in a partnership that holds an ISPI will not generate ECI or income subject to gross basis withholding merely because the Carry Bill characterizes the income as “ordinary.”204
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203 See Joint Committee on Taxation, Technical Explanation of H.R. 4213, the “Tax Extenders Act of 2009,” as Introduced in the House of Representatives on December 7, 2009 (JCX-60-09), December 8, 2009, at 188, available at http://www.jct.gov/publications.html?func=startdown& id=3640.

204 Id.  (“The intent of the provisions is generally not to change the result under[the source, FIRPTA, ECI, foreign tax credit] rules, to the extent that is consistent with not providing an opportunity to avoid the recharacterization of income as ordinary under [the Carry Bill] and not creating an opportunity for exclusion or deferral of otherwise includible amounts.”).

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U.S. Income Portfolios: Other Pass-through Entities 
  Portfolio 735-2nd: Private Equity Funds 
  Detailed Analysis 
  VI. Special Tax Issues for the General Partner and Its Members

C. Late Hires/“Catch Up” Solution 

The general partner will often grant participations in the underlying carry to employees who join the fund after the fund has made substantial investments in underlying portfolio companies.  If those investments have appreciated, the underlying carried interest will not qualify as a profits interest on the grant date.  By extension, therefore, a direct grant of a pro rata interest in the carry will not qualify as a profits interest to the employee.  Indeed, because the new hire had no role in sourcing, structuring or managing those investments, the fund manager may not intend for the new hire to participate in prior appreciation.  To ensure this result, the general partner may “book up” the capital account balances of the existing members to reflect any unrealized appreciation in the carry, granting to the new hire an interest only in future profits or appreciation.  Although the upward adjustment to the capital accounts will generate a book profit, it should not give rise to any actual tax liability.

Previously, the regulations did not specifically authorize a “book up” of capital account balances when a partnership admits a new partner for consideration other than property.205 Technically, therefore, a “book up” of capital account balances after the issuance of a profits interest for services would violate the capital account maintenance requirements of the regulations. Given the purposes of the regulations to ensure that the newly-admitted partner participates solely in future profits, however, it was unlikely that the IRS intended this result. Therefore, in May 2004, the IRS finalized regulations under § 704(b) that permit capital account adjustments to reflect a revaluation of partnership assets in connection with a grant of an interest (other than a de minimis interest) in a partnership for services.206
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205 See Regs. § 1.704-1(b)(2)(iv)(f)(5)(i) (referring to revaluations “in connection with a contribution of money or other property”).

206 Regs. § 1.704-1(b)(2)(iv)(f)(5)(iii). T.D. 9126, 69 Fed. Reg. 25315 (5/6/04). Under regulations proposed in 2005, this rule would be narrowed, permitting capital account adjustments in connection with the transfer or vesting of a compensatory partnership interest but, only if the transfer of vesting results in the service provider recognizing income under § 83 (or would result in such recognition if the interest had a fair market value other than zero). See Prop. Regs. § 1.704-1(b)(2)(iv)(f)(5)(iii), REG-105346-03, 70 Fed. Reg. 29675 (5/24/05).

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In certain cases, however, the general partner may prefer to grant a fungible interest in the carry to the new hire.  If the underlying portfolio has not appreciated, the general partner can do so without tax consequence to the recipient.  Whether it can do so in any particular case will obviously depend on the specific facts and circumstances on the date of grant.  Assuming any meaningful appreciation, however, the grant will constitute a capital interest in the general partner, triggering a taxable event to the recipient.207
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207 See Regs. § 1.721-1(b)(1). Under regulations proposed in May 2005, the IRS has proposed to apply the rules of § 83 to all transfers of partnership interests for services, without distinction between capital and profits interests. Under the proposed regulations, if a partnership interest is transferred in connection with the performance of services and if an election under § 83(b) is not made, then the holder of the partnership interest would not be treated as a partner until the interest becomes substantially vested. If a § 83(b) election is made for such an interest, the service provider would be treated as a partner for federal income taxation. See Prop. Regs. § 1.704-1(b)(4)(xii), REG-105346-03, 70 Fed. Reg. 29675 (5/24/05).

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Comment: Some practitioners may be tempted to “neutralize”the effect of the grant by allocating the resulting compensation deduction to the newly admitted partner.  Such an allocation will not have “substantial economic effect” under § 704(b) absent a corresponding book allocation, which would deprive the new member of his capital interest.  Moreover, if the “capital shift” generates gain at the partnership level, the other partners may realize income with no offsetting compensation deduction.

The general partner should be able to avoid a taxable event by recasting the interest as a profits interest with a “catch up” allocation.

Example: Assume the general partner holds a 20% carried interest in the underlying fund.  Further assume that the portfolio has appreciated by $100 and that the carry has a liquidation value of $20.  The general partner wishes to grant a 25% interest in the carry to A, a new member. If the general partner did so directly, A would receive a capital interest of $5, triggering an immediate tax liability.  If the general partner instead “books up” the capital account balances of the existing members to $20 and then issues a profits interest to A, A avoids a taxable event.  By recasting the grant as a profits interest, however, the general partner deprives A of a 25% interest in the first $20 of unrealized appreciation.  To achieve “ground floor” participation, the general partner could instead issue the same profits interest to A, but with a special allocation of first profits until A's capital account balance accretes to 25% of the aggregate capital account balances of all partners.  Assuming no interim distributions during the “catch up” period, the general partner would allocate the first $6.67 of profits to A.208 The effect of this special allocation is that A will receive the equivalent of a 25% capital interest so long as the underlying carried interest appreciates by at least $6.67. Moreover, it will receive that interest with no difference in tax result from the original members so long as the general partner recognizes capital gain during the catch-up period.  Alternatively, A may achieve the target capital account in a regulatory “book up” for unrealized appreciation, which would have no tax consequences at all.209

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208 $5/(1 - .25) = $6.67.

209 See Regs.  § 1.704(b)(2)(iv)(f).

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If the underlying portfolio fails to appreciate after the grant date, the service provider will receive nothing.  It should be emphasized, therefore, that the service provider who accepts a profits interest with a “catch up” allocation in lieu of a capital interest will bear some economic risk to achieve a more favorable tax result. Had the fund issued a capital interest on the date of grant, the service provider would have received his pro rata share of the existing capital value.  In fact, it is for precisely this reason that a “disguised”capital interest of this kind should qualify as a “profits interest”for tax purposes — its value depends solely upon future profits, not current capital.  Nevertheless, because the catch up allocation applies to profits on the entire carried interest of the general partner, the risk that the service provider agrees to bear is relatively small.  As a practical matter, the failure to “catch up” to the historic partners will often coincide with the failure of the underlying fund to produce positive returns to the investors, in which case the entire carried interest of the general partner is probably worthless anyway.

Comment: In PLR 200329001, the IRS ruled that the common units in a partnership issued to management as part of an equity incentive plan of a REIT qualified as a “profits interests” for tax purposes.  The partnership included an “UPREIT” as one of its partners, which is a type of real estate investment trust that holds its entire interest in REIT-eligible investments through a single partnership.  In a typical UPREIT, the single partnership issues units of partnership interests exchangeable into REIT shares to other outside investors, typically investors who contribute appreciated property rather than cash for their units who seek deferral under § 721.  Although the public filings of the UPREIT described the units as the economic equivalent of REIT common stock, the units were not entitled to liquidating distributions on parity with the REIT common shareholders on the date of grant.  Instead, the units “accreted” to full parity with the common stock over time.  To the knowledge of the author, this is the first occasion on which the IRS has ruled favorably on the treatment of a carried interest with a “catch up”allocation as a “profits interest” for tax purposes.

U.S. Income Portfolios: Other Pass-through Entities 
  Portfolio 735-2nd: Private Equity Funds 
  Detailed Analysis 
  VI. Special Tax Issues for the General Partner and Its Members

D. Subdividing the Carried Interest 

In many cases, the general partner will grant variable sharing ratios in the underlying carry to reflect the relative involvement of its employees in sourcing, negotiating and/or managing specific investments of the fund.  See Worksheet 8.  Assume, for example, that the underlying fund holds investments in three portfolio companies, A, B and C, and that the general partner has a 20% carried interest.  The general partner may choose to grant 5% of the carried interest in A, 10% of the carried interest in B and none of the carried interest in C to employee X, and subchapter K is plainly flexible enough to accommodate such an arrangement.210 But how should this non-linear division of the carried interest affect the relative clawback obligations of the members? In a typical fund, the general partner must refund any “unearned” distributions to the investors upon liquidation.211 Because the general partner may have distributed all or a substantial portion of those distributions to its members, the members usually guarantee the clawback obligation of the general partner on a several basis.  In this particular example, if the fund realizes a loss on C equal to its aggregate gains on A and B but sells C after it sells A and B, the general partner may have to refund all or a substantial portion of its prior carry distributions with respect to A and B.  If X has guaranteed the clawback obligation, it will have to refund its share of the carry distributions even though it had no interest in the C investment.212
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210 See, e.g., Regs. § 1.701-2(a) (purpose of subchapter K to permit “flexible economic arrangement” without incurring entity-level tax); S. Rep. No. 1622, 83d Cong., 2d Sess. (1954); H.R. Rep. No. 1337, 83d Cong., 2d Sess. (1954) (principal objective of subchapter K is “simplicity, flexibility and equity as between the partners”).

211 See III, B, 4, above.

212 On the other hand, had the fund sold its investment in C first, it would have distributed the gains on A and B to its investors to reimburse their losses, in which case X would have received no carry distribution in the first place.

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U.S. Income Portfolios: Other Pass-through Entities 
  Portfolio 735-2nd: Private Equity Funds 
  Detailed Analysis 
  VI. Special Tax Issues for the General Partner and Its Members

E. Forfeitures:the “Capital Shift” Issue 

As described above, unlike the grant of the carried interest in the underlying fund, the grant of the carried interest in the general partner is often subject to a vesting condition.  Before Rev. Proc. 2001-43, the grantee usually made a protective § 83(b) election within 30 days of receipt to avoid the possibility of a taxable event on the vesting date.213 In many of these cases, the grantee makes the election but then forfeits the interest prior to the vesting date. When this occurs, the remaining members will benefit from the resulting “capital shift,” assuming at least that the fund portfolio includes realized or unrealized gains at that time.  Because these forfeitures often occur well into the life of the fund, a substantial capital shift associated with prior allocations of income or intervening revaluations is not unusual in the fund context. The tax issue is whether this sort of capital shift has any immediate consequences to the forfeiting or remaining members.
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213 See VI, A, 3, above.

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In a corporation, a forfeiture of stock by an employee with a § 83(b) election in effect is not a taxable event to the remaining shareholders. The remaining shareholders avoid immediate tax even though the forfeiture increases their collective claim to the remaining assets of the corporation because the forfeiture is not a “realization” event to the shareholders under § 61. The economic consequences of a forfeiture of a partnership interest are no different. Nevertheless, the principles of subchapter K may compel a different result.

The principal legal basis for this concern is Regs.  § 1.721-1(b)(1), the very regulation cited in 1971 by the taxpayer in Diamond as the legal basis for the tax-free grant of a profits interest. This regulation provides that § 721 does not apply if “any of the partners gives up any part of his right to be repaid his contributions (as distinguished from a share of partnership profits) in favor of another partner as compensation for services....” Read literally, the regulation does not apply here because a service partner who forfeits a compensatory grant does not surrender a “contribution” to the partnership; nor does he act to compensate the remaining partners for services.  To the contrary, the forfeiture arises because the service provider has failed to provide the relevant services to the partnership.  Nevertheless, it is this regulation that is the genesis of the “capital shift”theory of subchapter K.214
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214 See generally Schneider and O'Connor, “LLC Capital Shifts: Avoiding Problems When Applying Corporate Principles,”92 J. Tax'n 13 (Jan. 2000); NYSBA Tax Section, “Report on Taxation of Partnership Options and Convertible Securities,”(Jan. 29, 2002), Doc. 2002-2492, 2002 TNT 21-24; Alster, “Shifts of Partnership Capital in the New Service Economy,” Tax Club (Nov. 27, 2000).

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The capital shift theory postulates that at least some capital shifts represent a deemed transfer of assets by the partnership to the transferee partner, followed by a re-contribution of such assets by the transferee back to the partnership in exchange for a capital interest.215 Had the partners actually effected this series of constructive transfers, the resulting capital account balances would have been identical. Having received property for services, however, the transferee partner would also have recognized taxable compensation income under § 61.216
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215 See, e.g., McKee, Nelson, and Whitmire, Federal Taxation of Partnerships and Partners, ¶ 5.08 (3d ed. 1997); Schneider and O'Connor, “LLC Capital Shifts: Avoiding Problems When Applying Corporate Principles,”92 J. Tax'n 13, 16-18 (Jan. 2000).

216 Regs. § 1.721-1(b)(1).

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Whether a capital shift is taxable on these grounds is a source of much debate within the tax bar.  On January 22, 2003, however, the IRS issued proposed regulations under § § 704, 721 and 761 to address the consequences of the grant and subsequent exercise of a noncompensatory option to acquire a partnership interest.217 The proposed regulations would extend non-recognition treatment under § 721 to the exercise of an investment option by the holder, even though the exercise of the option “shifts”partnership capital from the historic partners to the former option holder.218 Although this form of capital shift is perhaps distinguishable from the capital shift associated with a forfeiture of an unvested profits interest, the proposed regulations clearly reject any broad interpretation of the capital shift principle inherent in Prop. Regs. § 1.721-1(b)(1), which would treat any capital shift as a taxable transaction.  Moreover, even before the issuance of these regulations, most fund managers probably relied upon countervailing theories of subchapter K219 to narrowly construe the regulation and did not report forfeiture-driven capital shifts as taxable events.220
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217 REG-103580-02, 68 Fed. Reg. 2930 (1/22/03).

218 Id.

219 See, e.g., St. John v. U.S., 53 AFTR2d 84-718 (C.D. Ill. 1983) (court treated profits interest as without value because taxpayer would not have been entitled to any proceeds upon immediate liquidation); Campbell v. Comr., 943 F.2d 815 (8th Cir. 1991) (interests at issue were too speculative to value); GCM 36346 (July 23, 1975)(profits interests not taxable under § 83 because analogous to unsecured promise to pay).

220 Although it clarifies the treatment of the grant of an unvested profits interest to the grantee, Rev. Proc. 2001-43, 2001-34 I.R.B. 191, does not address the consequences of a forfeiture of such interest to the remaining members.

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On May 24, 2005, however, the IRS issued proposed regulations under § §  704(b) and 83 to address compensatory grants or forfeitures of a partnership interest.221 Under the proposed regulations, a forfeiture of an unvested partnership interest will give rise to immediate tax in the typical case.222 The tax will arise, however, not by any explicit recast of the forfeiture as a constructive sale of assets, but rather from the later “forfeiture allocations” of gross income to the historic partners.223
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221 See REG-105346-03, 70 Fed. Reg. 29675 (5/24/05).

222 For a fuller discussion of the proposed regulations, see VI, A, 4, above.

223 Note that the proposed regulations do not actually describe the gross income allocation as a taxable capital shift. Because the forfeiture allocations shift the pre-existing capital account balance of the service partner to the remaining partners, however, the net effect is the same.

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Under the proposed regulations, a partnership must allocate income or loss to the service partner in the year of forfeiture equal to (a) the excess, if any, of any prior distributions to the service partner (to the extent not taxable under §  731); over the amounts paid for the interest; minus (b) the cumulative net income(or loss) previously allocated to the service partner.224 In effect, the forfeiture allocation achieves retroactive compliance with the “substantiality”requirement of §  704(b) by giving tax effect to the later vesting failure. Having permitted the partnership to allocate income to the forfeiting partner even though the “economic effect” of these allocations had not yet been established,225 the proposed regulations require the partnership to “unwind” the prior allocations in the year of forfeiture to reflect the failure of the interest to vest.226 These reallocations will reverse the intervening accretion in the service partner's tax capital account.
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224 Prop. Regs. §  1.704-1(b)(4)(xii)(c).

225 See Prop. Regs. § 1.704-1(b)(4)(xii)(a)

226 See Prop. Regs. § 1.704-1(b)(4)(xii)(b). The proposed regulations permit “pre-vesting” allocations in spite of their lack of substantiality so long as the remaining material allocations are substantial and the partnership agreement requires the partnership to make future “forfeiture allocations.”

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A typical forfeiture allocation will produce losses to the service provider, not profits. A partnership that issues an unvested profits interest for services is unlikely to have allocated prior losses to the service partner because the losses would only create (or increase) a negative capital account balance that the service partner would have no obligation to restore. Moreover, few partnerships make significant distributions to unvested partners. In a successful fund, therefore, the service provider is likely to have a positive (albeit unvested) capital account balance at the time of forfeiture. Accordingly, forfeiture allocations usually impute net deductions to the service provider and net income inclusions to the remaining partners in the year of forfeiture.227
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227 The preamble to the proposed regulations notes that if a partnership does not have sufficient items of deduction and loss in the year of the forfeiture to “reverse”the prior allocations of income, the service provider may be denied all or a portion of the loss inherent in his/her forfeited tax basis under §  83(b)(1). See REG-105346-03, 70 Fed. Reg. 29675 (5/24/05). The IRS has requested comments on whether final regulations should permit allocations of “notional” items of deduction or loss in this circumstance. Id.

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Example: A and B form XYZ, a partnership for tax purposes, as equal partners. At the beginning of Year 1, XYZ issues an unvested 10% profits interest to C for services. C makes a timely §  83(b) election.228 In Year 1, XYZ earns $100 of taxable income; in Year 2, XYZ generates a $50 taxable loss. In Year 3, C forfeits his profits interest before it receives any distributions. During Year 3, XYZ breaks even, generating $100 of gross income and incurring $100 of deductible expenses. Because XYZ allocated $10 of income to C in Year 1 and $5 of loss to C in Year 2, it must make a $5 “forfeiture allocation” of the deductible expenses to C in Year 3. A and B therefore realize $5 of income even though XYZ broke even for the year.

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228 Note that if H.R. 4213 (passed by the House on 12/9/09) becomes law, C will not be required to make a §  83(b) election. See H.R. 4213, Tax Extenders Act of 2009, 111th Cong., 1st Sess., §  601 (amending  § 83 of the Code). Upon grant, the value of C's unvested profits interest will be zero (liquidation value) and C will be treated as having made a § 83(b) election. See VI, A, 3, above.

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This is the functional equivalent of a taxable capital shift because A and B will bear tax in Year 3 when they inherit C's capital account balance by way of the forfeiture allocations.

U.S. Income Portfolios: Other Pass-through Entities 
  Portfolio 735-2nd: Private Equity Funds 
  Detailed Analysis 
  VI. Special Tax Issues for the General Partner and Its Members

F. Avoiding State & Local Taxes on the Carried Interest 

Structuring the carried interest as a partnership allocation may also reduce the state and local tax burden on the general partner and its owners.  In many domestic funds, the general partner has offices in New York City (“NYC”).  As an unincorporated entity, a general partner engaged in business in NYC is subject to the unincorporated business tax (“UBT”).  The tax applies to any unincorporated business carried on in whole or in part within the city229 at a rate of 4% of allocable net income after certain adjustments, including a mandatory addback of otherwise deductible payments to partners in exchange for services or the use of capital.230 An unincorporated entity will not be deemed to be engaged in business, however, “solely by reason of the purchase, holding and sale for his, her or its own account of property... . ”231 For this purpose, “property” includes stocks and securities.232 Before 1994, NYC had construed the term “solely”in a strict ‘B’ reorganization sense of the word, prohibiting any other activities not within the trading exception.  That construction produced a cliff effect because any non-exempt income subjected all income to UBT.  Effective July 1, 1994, however, the city tempered the severity of this rule with a $25,000 safe harbor.  So long as an unincorporated business received no more than $25,000 in gross receipts from a non-exempt business, NYC would not impose UBT on its trading income.233
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229 N.Y. City Admin. Code § § 11-502(a), 11-503.

230 N.Y. City Admin. Code § § 11-503(a), 11-505, 11-507(3).

231 N.Y. City Admin. Code § 11-502(c)(2).

232 N.Y. City Admin. Code § 11-502(c)(1)(A).

233 N.Y. City Admin. Code § 11-502(c)(3).

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Until 1996, however, the issue of whether carried interest distributions to a general partner even qualified for the trading exception was not clear.  In Swid-Pearlman Management v. Tully,234 the New York State Supreme Court held that the general partner of two limited partnerships that derived its sole source of income from capital gain allocations did not qualify under the trading exception because the general partner received the carried interest for services.  This interpretation effectively rejected the “look through” treatment of the carried interest at the federal level, not to mention long-standing industry practice. The city later amended the UBT to extend the trading exception to capital gains derived from an incentive allocation, determined without regard to whether the general partner acquired its interest for services and without regard to whether the interest was proportionate to contributed capital.235
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234 413 N.Y.S.2d 239 (3d Dep't 1979).

235 See N.Y.S. Bill No. 3424, 218th Gen. Ass., 1st Reg. Sess. (June 11, 1996); N.Y. City Admin. Code § 11-506(a)(2). The trading safe harbor is not available, however, to payments treated as occurring between an unincorporated entity and one who is not a partner under § 707 of the Code.  Id.

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Nevertheless, UBT continues to apply to carried interest distributions if the general partner also receives the customary management fee from the underlying fund, which will exceed the $25,000 de minimis exception in all but the smallest of funds.  To shelter the carry from UBT, therefore, the sponsor of any fund based in NYC  will usually split the general partner and fund manager into two entities, one to hold the carried interest as a passive conduit and the other to operate the fund, receive the management fee, and incur any associated expenses. Although NYC may attempt to collapse the two entities into a single venture for UBT purposes, the risk of a successful challenge is probably small absent substantial overlapping ownership.236
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236 Even if a single entity receives both carry distributions and nonexempt income (e.g., the management fee), thereby disqualifying it from the trading exception, the entity may be able to allocate a substantial portion of its capital gain outside of the city based upon its “investment allocation percentage,” which generally determines business activity within the city by reference to the underlying portfolio company.  See N.Y. City Admin. Code § § 11-508(a), 11-508(f).

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Note: The 2009-2010 New York budget bill submitted by the Governor on January 7, 2009 as Senate bill 60 and Assembly bill 160 (the “Budget Bill”) included a proposal(later dropped from the legislation) to amend Article 22 of the Tax Law to treat income received by nonresident partners for performing “investment management services” for an investment partnership doing business in New York as New York source income. Specifically, Part N of the Budget Bill would have amended state law to treat certain categories of income derived by a nonresident partner of an investment partnership doing business in New York as New York source income.237 Although the “Memorandum in Support” that accompanied the Budget Bill clarified that the proposal was intended to apply to carried interest allocations(overriding the general source rules governing capital gain),238 the scope of the proposal was unclear in several respects. Under one interpretation, a non-resident member of the general partner of a fund who performed all work on behalf of the general partner outside of New York would be subject to tax in New York on his entire allocable share merely because the general partner itself conducted business in New York. Under another interpretation, the source of the income would depend upon where the non-resident partner actually performed the investment management services. A letter from the Tax Section of the New York State Bar Association described the proposal as “so deeply flawed that it should not be enacted.”239 The proposal was excluded from the final version of the legislation.
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237 The proposed amendments would have applied to all taxable years beginning on or after January 1, 2009.

238 The Memorandum in Support is available at http://www.bcnys.org/inside/documents/2009Revenuebillmemo.pdf.

239 See NYSBA Tax Section, “Report on Tax Provisions of the 2009-2010 New York State Executive Budget Legislation (S.60/A.160),” (March 10, 2009), available at http://www.nysba.org/AM/Template.cfm?Section=Tax_Section_Reports_2009& Template=/CM/ContentDisplay.cfm& ContentID=28972.

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U.S. Income Portfolios: Other Pass-through Entities 
  Portfolio 735-2nd: Private Equity Funds 
  Detailed Analysis 
  VI. Special Tax Issues for the General Partner and Its Members

G. Pass-Through Treatment of General Partner 

Much of the preceding discussion presupposes that the sponsor structures the general partner as a pass-through entity for tax purposes.  If the sponsor structures the general partner as a C corporation, its owners will forego the benefit of the capital gains preference on the underlying carry allocations.  Perhaps worse, its owners will bear two levels of tax on carry-related profits, first at the general partner level and then on distributions by the general partner.  To avoid this result, the sponsor may elect to treat the entity as an S corporation.  Section 1361(b)(1)(D), however, prohibits an S corporation from issuing more than one class of stock.  Under the regulations,240 all outstanding shares of an S corporation must confer identical rights to distribution and liquidation proceeds, taking into account any differences in rights under the corporate charter, articles, bylaws or other binding agreements.  In effect, therefore, subchapter S prohibits any form of equity-based non-linear subdivision of the carried interest.241 So if the sponsor intends to grant anything more than a purely fungible undivided interest in the underlying carry to its members, it should not use a corporate entity.242 The accepted practice is to structure the general partner as a partnership for tax purposes, often a domestic LLC but occasionally an offshore entity with a tax haven domicile.243
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240 Regs.  § 1.1361-1(l)(1).

241 For a discussion of the “one class of stock” limitation, see  730 T.M., S Corporations: Formation and Termination.

242 Although the sponsor could structure participations in the carry as deferred compensation without invalidating the S election, the participants would lose the potential benefit of the capital gains preference.

243 The use of an offshore entity tends to minimize the likelihood that a non-U.S. portfolio company will become a “controlled foreign corporation” under § 957(a), a status that may produce undesirable consequences to U.S. investors.  See XI, B, below.

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U.S. Income Portfolios: Other Pass-through Entities 
  Portfolio 735-2nd: Private Equity Funds 
  Detailed Analysis 
  VI. Special Tax Issues for the General Partner and Its Members

H. “Disguised”Management Fees 

The traditional function of the management fee is to defray the expected expenses of the fund assumed by the fund manager, such as the costs of travel and due diligence, legal and accounting fees and employee salaries.  In some funds, however, the income stream from the management fee also serves as a separate profit center, providing a less volatile source of funds than the carried interest.  In such cases, the members of the fund manager will bear tax on the excess fees at ordinary income rates.

To reduce their effective tax rate, some fund managers may attempt to recast a portion of the management fee in one or more periods as a partnership allocation, assuming that the fund manager and general partners either share common owners or operate as a single entity.  If effective, this approach will allow the general partner to report the compensation as capital gain, based upon the underlying character of the income at the fund level.  The tax-exempt and foreign investors should have no tax objection, as they realize no U.S. tax benefit from the direct payment of the management fee(which at best reduces otherwise exempt capital gain).244 U.S. individuals actually benefit from the allocation by avoiding what would otherwise constitute an “investment expense” under  § 212, which is subject to the 2%limitation for miscellaneous itemized deductions.245 By structuring the fee as a partnership allocation, these investors achieve an effective deduction when the fund allocates income equal to the foregone management fee to the general partner.
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244 See VII, B, 3, below.

245 § 67.

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The problem with this approach, however, is that it exposes the management fee to real economic risk, namely that the fund will not generate sufficient portfolio gains to reimburse the foregone fee.  Timing is also an issue — actual payment of the fee in cash requires the fund to realize the underlying gains.  Without realized gains, the fund may not have sufficient proceeds to fund these amounts at the desired level of frequency.

To minimize the economic risk, the general partner may choose to “waive”the fee in return for an offsetting allocation of existing gains in the fund portfolio.  But if the general partner has already earned the fee and accepts an allocation of future realized gains in lieu of payment, it is probably in constructive receipt of the waived fee.246 If so, the other investors in the fund will incur tax on the gains allocable to the general partner under the agreement, who in turn would be deemed to have received the underlying distribution in payment of the management fee.  Alternatively, if the general partner waives the fee in advance but receives an offsetting allocation of unrealized gains, the allocation may not qualify as a profits interest.
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246 See VII, C, 3, below, for a discussion of the “assignment of income”doctrine as applied to management fee offset arrangements.  For a general discussion of the “assignment of income” doctrine, see 385 T.M., Deferred Compensation Arrangements.

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The better approach is to force the general partner to forgo the management fee before it accrues, with an offsetting right to an allocation of future gains.  Provided that the capital accounts of the investors reflect the net fair market value of the fund investments on the date of grant, the IRS should respect the allocation as a profits interest under Rev. Proc. 93-27.247 To mitigate the risk that the fund will not realize sufficient gains to fund the distribution, the general partner may choose to structure the special profits interest as a priority allocation. Some funds even “hardwire” the fee conversion into the fund agreement from inception. By reducing the optionality associated with future fee waivers, the risk that the IRS would successfully recharacterize the arrangement is probably diminished.248
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247 1993-2 C.B. 343. But see Polsky, “Private Equity Management Fee Conversions,” 122 Tax Notes 743 (Feb. 9, 2009) (arguing that IRS may recharacterize attempted management fee conversion as a “guaranteed payment” under §  707(a)(2)(A)).

248 See Polsky, “Private Equity Management Fee Conversions,” 122 Tax Notes 743, 751 (Feb. 9, 2009) (“In hardwired arrangements, the fee waiver election is made up front, when the fund is initially formed. In those arrangements, the fee waiver and concomitant additional carried interest is automatically built into the fund's origination documents such that the manager technically has no ability to opt out of these  consequences. Therefore, while an elective arrangement explicitly allows the manager to periodically claim future fees in cash or in the form of additional carried interest, a hardwired deal provides no such explicit option. As discussed below, hardwiring a fee conversion arguably bolsters the manager's claim that the fee conversion results in the desired tax consequences.”); but see Sheppard, “Carried Away:  Management Fee Conversion,”116 Tax Notes 532 (August 13, 2007) ( It is fairly simple for a fund manager to waive his fee in exchange for an increase in his distributive share of fund gains. Basically, this turns a stream of ordinary income into a capital asset. Trouble is that managers need that fee income to cover their costs, and funds are not always profitable, especially if they loaded up on mortgage-backed securities, as many did. So advisers need to find ways to get cash to managers to cover those costs without destroying the fiction that the fee has the same risk as the carried interest. Another obstacle is that the fee must be waived before it is earned, and most fees are payable at the beginning of the measurement period.”).

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It may even be possible to structure a portion of the periodic management fee as an allocation of capital gain, but without altering the scheduled payment dates.

Example: A general partner receives an annual management fee of 2.5% on capital commitments of $1000, or $25 per year, and the general partner proposes to restructure $10 as a partnership allocation, but with some degree of assurance that it will receive the full $25 in regular quarterly installments.  The investors pay $25 to the general partner each year, $15 as a fee and $10 as a loan bearing interest at a rate of 8%.  If the fund then grants a special profits interest to the general partner that is entitled to the sum of the first $10 of realized gains and an 8% return thereon, the general partner may be able to retire the loan from future distributions.

Whether this approach in fact converts the management fee to capital gain will first depend upon whether the special allocation qualifies as a “profits interest” under Rev. Proc. 93-27. If the terms of the profits interest minimize the likelihood of default on the loan, for example by providing for a priority allocation of first gains on the entire portfolio, the interest is far less volatile than the underlying carried interest, indeed almost debt-like in certain respects.  The IRS could contend, therefore, that a profits interest of this type is not the sort of “speculative” holding entitled to relief from immediate taxation.

Note: Rev. Proc. 93-27 does not apply to a profits interest that “relates to a substantially certain and predictable stream of income from partnership assets, such as income from high-quality debt securities or a high-quality net lease.”249
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249 1993-2 C.B. 343.

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Even if the IRS respects the priority allocation as a “profits interest,” the structure will fail to achieve its intended purpose unless it also conveys tax ownership of the profits interest to the general partner.  Whether it does so is likely to depend upon the terms of the underlying loan.  Assume, for example, that the “lender”holds the profits interest as security for the loan and has no recourse to the general partner and its owners.  Alternatively, assume that the interest rate on the loan tracks the accretion rate on the profits interest, and that the general partner has no right to prepay the loan.  Under these circumstances, the IRS would probably contend that the lender, not the general partner, is the tax owner of the profits interest.250
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250 See Aiken Industries, Inc. v. Comr., 56 T.C. 925 (1971), acq., 1972-1 C.B. 1; Rev. Rul. 84-152, 1984-2 C.B. 381; Rev. Rul. 84-153, 1984-2 C.B. 381. See also § 7701(1) (regulatory authority to disregard conduit ownership to “prevent avoidance of any tax imposed by this title”).

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Note: In November 2007, the IRS issued a statement listing “areas of possible non-compliance in the reporting of hedge fund and private equity fund investors and managers.”251  That statement cited several “areas of interest,” among them “characterization of income as ordinary or capital.” Based upon informal discussions between the author and IRS officials, management fee conversions of the type described above were the intended target of this particular item.
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251 See “Hedge Fund/Private Equity Fund Statement,” available at http://www.reuters.com/article/businessNews/idUSN0150776420071102.

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U.S. Income Portfolios: Other Pass-through Entities 
  Portfolio 735-2nd: Private Equity Funds 
  Detailed Analysis 
  VI. Special Tax Issues for the General Partner and Its Members

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

The primary reason for structuring the general partner's incentive compensation as a partnership allocation is to pass-through the capital gains preference.  For portfolio investments in “controlled foreign corporations” (“CFC”), however, § 1248 may convert all or a portion of the allocated gain to ordinary income. The potential tax consequences to U.S. investors when the portfolio company in question is a CFC are described in XI, B, below.

U.S. Income Portfolios: Other Pass-through Entities 
  Portfolio 735-2nd: Private Equity Funds 
  Detailed Analysis 
  VI. Special Tax Issues for the General Partner and Its Members

J. Tax Issues Involving the Clawback 

The carried interest usually represents a right to a fixed percentage of the net portfolio gains, computed on an aggregate basis over the life of the fund.252 The general partner participates in these gains either from “first dollar” or after the other investors receive a hurdle return.  In funds that provide for a hurdle return, the hurdle will merely subordinate the general partner's carry, allowing the general partner to “catch up” to the prior hurdle distributions until it receives aggregate distributions equal to the full carry percentage of the total gains.  The general partner will therefore participate from the first dollar of gain unless the investors fail to achieve an aggregate return sufficient to cover the hurdle and the catch up.253 With or without a hurdle, however, the general partner will not “earn” its carry until the fund returns the aggregate invested capital of the investors.
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252 See III, B, 3, above.

253 For example, if the general partner receives a 20% carry and a “catch up”distribution after the investors achieve a hurdle return of 8%, it will receive the same carry distributions with or without the hurdle so long as the fund achieves a net return of at least 10% (i.e., 8% / (1-.20)). For a discussion of the distinction between a preferred return and a hurdle, see III, B, 2, above.

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The clawback is the industry standard for reconciling the aggregate nature of the carry with the common market practice of distributing proceeds investment-by-investment.  In funds that provide for a clawback, the general partner and its members must restore any unearned distributions to the fund for redistribution to the investors.  The following discussion addresses common tax issues that arise when negotiating the terms of the clawback.

1. Capping the Clawback 

As described in III, B, 4, above, most fund agreements limit the maximum clawback obligation to the difference between the aggregate carry distributions and the taxes thereon.  For this purpose, however, “taxes thereon” is a term of art that bears little relation to the actual taxes paid.  For example, the term itself will usually import the hypothetical assumptions of the tax distribution, which tend to maximize the tax payment.254 The underlying rationale for the credit, however, is that the general partner should never be required to disgorge amounts in excess of what it actually received from the fund on an after-tax basis.  If the clawback ignores taxes on the carried interest, the general partner may be forced to do precisely that.
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254 For a discussion of these assumptions, see III, B, 5, above.

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Although the ultimate resolution of these issues is often a function of relative bargaining power, certain terms do depend upon the care and attention of the draftsman.  A practitioner who represents the general partner may propose a tax distribution that computes taxes on a year-by-year rather than a cumulative basis, permitting tax distributions on allocated gains even though they do not exceed allocated losses from earlier periods.  If the clawback calculation also follows that convention, the annual tax distribution may reduce the clawback by amounts that exceed actual cash taxes, sometimes by a substantial margin.  In addition, if the fund agreement prohibits a tax distribution to a partner who has already received non-tax distributions sufficient to fund his tax liability, the clawback must compute “taxes thereon” as if the tax distribution did not so provide.  Otherwise, the members of the general partner may not receive full credit for their actual tax liability.255 Finally, if the tax distribution adopts a cumulative methodology,256 the practitioner must ensure that the fund agreement considers the limitations on capital loss carrybacks when defining “lifetime” taxable income.  If it does not, then allocated losses in later years may reduce tax distributions(and therefore increase the maximum clawback payment) even if the members of the general partner derive no tax benefit from the capital loss.
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255 Indeed, in funds that distribute investment-by-investment or even on a “realized aggregation” basis, the general partner may never receive a tax distribution.

256 For a discussion of “cumulative”tax distributions, see III, B, 5, above.

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From the investors’ point of view, if the clawback applies at all, it usually means that they lost money over the life of the fund. A clawback that leaves the general partner with a positive return net of taxes under these circumstances therefore conveys a windfall. Most fund agreements, for example, assume that each member earns no external income, not because it bears any necessary relation to reality but because it is simple.  So if a member of the general partner applies a “suspended” capital loss to shelter capital gain external to the fund, the reduction in his clawback may exceed his actual taxes.  Should administrative simplicity prevail when the issue is not whether the general partner should receive a tax distribution, but whether the general partner should keep positive after-tax distributions after the investors have realized an aggregate loss? Perhaps not, but is it really practical to submit the tax returns of each of its members to the scrutiny of the investors to determine whether any member derived a tax benefit? In practice, the investors may not have a reliable audit mechanism to police this procedure anyway, in particular if the tax benefit determination extends beyond the year of fund liquidation. On the other hand, investors in a failed fund may prefer administrative complexity to a windfall.

2. Hypothetical Taxes on In-Kind Distributions 

The reduction for taxes should include not only taxes on realized gains, but hypothetical taxes payable on an in-kind distribution of marketable securities.  Why? As described in III, C, 1, above, investors in a fund rarely bear tax on in-kind distributions. The reason is that marketable securities bear deferred taxes, which the investors are likely to incur when they sell them.  If the parties have otherwise agreed to reduce the clawback by taxes, the tax computation should therefore reflect the total taxes borne by the general partner and its members after the sale of all portfolio investments. It is possible, of course, that one or more members of the general partner will never bear this tax, or will bear the tax on a deferred basis or at a higher or lower sales price. Nevertheless, funds that do give credit for the inherent tax on marketable securities usually compute the tax based upon the value of the securities at the time of the distribution and the tax rate in effect at that time.

3. Renegotiating Contingent Clawback Liabilities 

Inevitably, some general partners incur clawback liabilities at fund liquidation.  The archetypical case is the fund that realizes substantial gains during earlier periods and losses in excess of those gains during future periods.  If the fund distributed proceeds either “investment-by-investment”or on a “realized aggregation” basis,257 the general partner will have received carry distributions from the proceeds of the earlier gains.  After the fund allocates subsequent losses to the general partner, the general partner will have a negative capital account balance.  In most cases, the negative balance will roughly correspond to the general partner's clawback liability at fund liquidation.  Faced with the prospect of refunding the distributions, the general partner may attempt to negotiate a settlement of this liability before the fund liquidates, perhaps in exchange for a reduction in future management fees.
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257 For a discussion of the common distribution regimes, see III, B, 1, above.

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Do these settlements trigger any immediate tax consequences? If the arrangement is merely executory, the general partner should be able to fund the clawback liability with pre-tax dollars.  That tax benefit is often without cost to the foreign or tax-exempt investors, who derive no tax benefit for the cost of the management fee anyway. Indeed, U.S. individual investors may actually benefit from the settlement on an after-tax basis.258 It is often possible, therefore, for the parties to negotiate a settlement of a contingent clawback liability without the usual tax “friction” so common in multi-party transactions.
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258 The management fee constitutes a “miscellaneous itemized deduction” to U.S. individual investors under § 67. For a discussion of the limitations on miscellaneous itemized deductions, see X, B, below.

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A possible challenge to the form of these settlements, however, is that they are not arm's length. Specifically, the fund manager, an entity affiliated by common ownership with the general partner, is reducing its compensation as consideration for the forgiveness of an obligation of the general partner.  Yet the consideration for both the management fee and the carried interest is services, indeed services provided ultimately by the same persons.  Because parties are generally free to renegotiate the form of compensation for services to be performed in the future, § 482 would not seem an appropriate basis for challenge, especially when the controlled entities in question are partnerships for tax purposes.  Similarly, the “assignment of income”doctrine should not apply because the service provider is not assigning income to a non-service provider.259
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259 See VII, C, 3, below, for a discussion of the “assignment of income”doctrine.

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Alternatively, the IRS may assert that the investors have relieved the general partner of a liability, akin to making a direct payment.260 But this theory would misconstrue the nature of the clawback, which is merely a contingent obligation to restore a negative capital account balance in the future. Whether the general partner would ultimately incur the clawback will depend upon future events, in particular whether the fund realizes sufficient gains on its remaining investments.  When the investors in a fund release the general partner from its liability to fund a future clawback, they are merely agreeing to alter the sharing of future profits and losses on the remaining investments.  Indeed, professional service partnerships, including law firms and accounting firms, routinely change the sharing of profits and losses at regular intervals, and they are generally free to do so without immediate tax consequence.
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260 See, e.g., Regs.  § 1.61-12(a) (individual who performs services for a creditor, who in consideration thereof cancels the debt, realizes income in the amount of the debt as compensation for services).

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In the fund context, however, these agreements may represent something more.  If a general partner is at risk of incurring a clawback liability, its capital account is probably negative on a fair market value basis, taking into account unrealized losses in the fund portfolio, even if the book value of the capital account is zero or even positive. If the investors forgive the liability, therefore, could they be construed as granting a “capital interest” to the general partner to increase the negative capital account balance to zero? If so, the general partner should bear an immediate tax.261
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261 See Regs.  § 1.721-1(b)(1) (§ 721 does not apply to grant of capital interest for services). See also Prop. Regs. § 1.721-1(b)(1), REG-105346-03, 70 Fed. Reg. 29675 (5/24/05) (providing that, with certain limited exceptions, § 721 would not apply to transfer of partnership interest in connection with performance of services or in satisfaction of obligation).

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Example: A general partner has a 20% carried interest in a fund.  The fund acquires two investments, A and B, at a cost of $100. The fund then sells A for $150 and distributes $10 to the general partner with respect to its carried interest.  Assuming that the general partner invested no capital in the fund, it will have a capital account balance of zero immediately after the distribution (i.e.,$10 profit allocation less $10 distribution).  Assume that B then declines in value to $40.  If the fund were to sell B and then liquidate, it would allocate $10 of the $60 to the general partner, generating a pre-tax clawback obligation of $10.  Assume instead that the investors “forgive”the general partner's potential clawback obligation after the sale of A.  If the forgiveness occurs after the decline in value of B, the investors will have effectively transferred $10 of their capital to the general partner in a taxable transaction.

But what if the fund instead “books down” the capital account balances of the investors and then agrees to allocate the first $10 of book profits to the general partner? The book down would create $60 of book loss, which the fund would allocate $10 to the general partner and $50 to the investors.  The general partner's book capital account then declines to negative $10, but with no immediate tax consequence.  If the fund later sells B for $50, it will realize a book profit of $10 (i.e., $50 - $40) and a tax loss of $50 (i.e., $50 - $100). The agreement to allocate the first $10 of profits should qualify as the tax-free grant of a profits interest under Rev. Proc. 93-27262 because it entitles the general partner to no portion of the current value of B. The fund then allocates the $10 of book profit to the general partner and the entire $50 of tax loss to the investors, leaving the general partner with a book and tax capital account balance at fund liquidation of$0.  Because the general partner has a zero capital account balance, it has no clawback obligation.
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262 1993-2 C.B. 343. The IRS has proposed to apply the rules of § 83 to all transfers of partnership interests for services, without distinction between capital and profits interests. Under the proposed regulations, if a partnership interest is transferred in connection with the performance of services and if an election under § 83(b) is not made, then the holder of the partnership interest would not be treated as a partner until the interest becomes substantially vested. If a § 83(b) election is made for such an interest, the service provider would be treated as a partner for federal income taxation. See Prop. Regs. § 1.704-1(b)(4)(xii), REG-105346-03, 70 Fed. Reg. 29675 (5/24/05). See also Notice 2005-43, 2005-24 I.R.B. 1221, which contains a proposed revenue procedure that would obsolete Rev. Proc. 93-27 and Rev. Proc. 2001-43, 2001-34 I.R.B. 191.

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U.S. Income Portfolios: Other Pass-through Entities 
  Portfolio 735-2nd: Private Equity Funds 
  Detailed Analysis 
  VI. Special Tax Issues for the General Partner and Its Members

K. Qualified Small Business Stock 

If the members of the general partner include U.S. individuals, they may benefit from the treatment of certain portfolio investments of the fund as “qualified small business” stock under § 1202.  The tax advantages of such treatment to U.S. individual investors are described in X, C, below.

U.S. Income Portfolios: Other Pass-through Entities 
  Portfolio 735-2nd: Private Equity Funds 
  Detailed Analysis 
  VII. The Problem of ECI and UBTI

A. In General 

1. ECI 

Foreign persons bear full U.S. federal income tax on income “effectively connected” with the conduct of a U.S. trade or business (“ECI”).263 If a treaty applies, the United States must also establish that the income in question is “attributable to” a U.S. permanent establishment of the foreign person before it may impose taxing jurisdiction.264 Absent treaty protection, foreign corporations also bear “branch profits tax” on deemed repatriations of ECI from the United States to the foreign jurisdiction at a 30% rate.265 Thus, foreign corporations may bear effective U.S. tax on ECI at a 54.5% rate, computed without regard to state and local taxes.266
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263 § § 872(a)(2), 882(a)(1).

264 See, e.g., U.S. Model Income Tax Convention of Sept. 20, 1996, Art. 5.

265 § 884.

266 Section 11 provides for a maximum federal tax rate of 35% on ECI of foreign corporations and  § 884 provides for a branch profits tax on ECI net of such taxes of 30%.  Assuming full application of the branch profits tax, therefore, the effective tax rate on ECI is 54.5% (i.e., (35% + (1 - 35%) x 30%)).

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Foreign persons are subject to tax on ECI even if they engage in no direct business activities in the United States.  If a partnership is engaged in a U.S. trade or business, then each of its foreign partners is deemed to be so engaged.267 This rule applies without regard to the number of tiers interposed between the foreign partner and the operating partnership.268 A foreign investor in an FOF, for example, will be deemed to be engaged in a U.S. trade or business if it invests in a fund that holds a pass-through investment in a single portfolio company that is so engaged.269 When a foreign person or a partnership in which the foreign person is a partner sells an interest in a partnership that is engaged in a U.S. trade or business, the foreign person must treat all or a portion of its gain as ECI.270 Finally, a partnership that generates ECI must withhold each foreign partner's “applicable percentage” under § 704.271
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267 § 875(1); see also § 702(b);Regs. § 1.702-1(b) (character of partnership gains allocated to partner under  § 702(a) determined at partnership level).

268 See, e.g., Johnston v. Comr., 24 T.C. 920 (1955) (individual partner in Canadian partnership that invested in partnership engaged in U.S. business treated as engaged in trade or business).

269 In general, treaties do not protect foreign persons from “partnership-to-partner”attribution if the partnership has a U.S. permanent establishment. See Donroy, Ltd. v. U.S., 301 F.2d 200 (9th Cir. 1962) (office or permanent establishment of U.S. partnership treated as office of each partner for purposes of Canadian treaty); Unger v. Comr., 936 F.2d 1316 (D.C. Cir. 1991) (limited partnership's permanent establishment attributed to limited partner based upon “aggregate” theory of partnerships); Rev. Rul. 91-32, 1991-1 C.B. 107 (gain attributable to permanent establishment in U.S. under applicable income tax treaty, treating partnership as “aggregate”of partners); Rev. Rul. 90-80, 1990-2 C.B. 170.

270 See Rev. Rul. 91-32, 1991-1 C.B. 107.  Some have criticized this ruling as extrastatutory.  See Blanchard, “Rev. Rul. 91-32: Extrastatutory Attribution of Partnership Activities to Partners,” 1776 Tax Notes 1331(Sept. 8, 1997).

271 § 1446(a).

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2. UBTI 

Tax-exempt entities, including U.S. pension funds, enjoy a broad statutory exemption from U.S. federal income tax on all income other than income attributable to an unrelated trade or business.272 Section 511 imposes tax on the “unrelated business taxable income” (“UBTI”) of a tax-exempt entity at regular graduated rates, computed under the same rules that apply to domestic corporations.273 As in the case of foreign investors, the Code imputes the unrelated trade or business activities of a partnership to the tax-exempt partners of the partnership.274 Accordingly, a tax-exempt partner must report its allocable share of any income and deductions attributable to the unrelated trade or business activities of a partnership as UBTI.
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272 § § 511, 512, 513.

273 § 511(a)(1).

274 § 512(c)(1).

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Unlike the rules that apply to foreign persons, the UBTI provisions of the Code also apply to leveraged investments.  Specifically,  § 514 may recast otherwise exempt interest, dividends or capital gains as UBTI if the underlying property is “debt-financed,” whether the tax-exempt entity borrows directly or through a partnership.275 In contrast, foreign investors may usually borrow to fund an otherwise passive investment without “tainting”the investment return.  At the fund level, however, these differences rarely influence structure.  Unlike hedge funds, private equity funds rarely borrow at the entity level.276 Instead, the acquisition debt usually resides in the portfolio company, which brings the creditor closer to the operating assets and allows any otherwise deductible interest expense to shelter operating income.  But if the portfolio company is a pass-through entity, the debt may still “taint” all or a portion of any gain on sale allocable to the tax-exempt investors.277
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275 See Regs. § 1.514(c)-1(a) (Ex. 4).

276 If a fund does permit borrowing, it may provide a mechanism for its tax-exempt investors to “self-fund” an allocable portion of the borrowing to avoid UBTI.  See VII, F, 1, below.

277 See, e.g., TAM 9651001 (applying an “aggregate” theory of partnerships to treat the partner as owning a direct interest in debt-financed property of the partnership).

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3. Common Exception for Investment Income 

Neither tax-exempt nor foreign investors bear net U.S. taxation on interest, dividends or most categories of capital gains, which together comprise the principal return of most funds.  Foreign investors avoid such taxation as “investors,” a profession not regarded as a U.S. trade or business.278 Tax-exempt investors avoid such taxation by statute.279 In funds that limit their investment returns to these categories, therefore, a tax-exempt investor will bear no U.S. tax on any category of income and a foreign investor will bear no U.S. tax on most categories of capital gain.  A foreign investor without treaty protection will bear U.S. withholding tax on U.S. source dividends and certain limited categories of U.S. source interest.280
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278 See, e.g., Higgins v. Comr., 312 U.S. 212 (1941); Liang v. Comr., 23 T.C. 1040 (1955). The case law defines “investing”as the act of buying, holding and selling stocks or securities for current income and long-term capital appreciation and “trading”as the buying and selling of securities with sufficient frequency to profit from short-term market fluctuations. See, e.g., Liang at 1045. See also Shapiro, “Private Securities Partnership –The Trade or Business Issue Examined,” 56 Tax Notes 85, 106 (July 6, 1992) (“if the partnership is engaged substantially in long-term investing (e.g., a venture capital fund or LBO fund), it will find no support in the case law for trader characterization”). Although § 864(b) also grants statutory protection to most “trading” activities, the statute is more commonly invoked by hedge funds, which acquire and often churn publicly traded securities.

279 § 512(b). If the fund investment is “debt-financed,” however,  § 514 may override the statutory exemption. Section 514 will not apply to unleveraged funds unless the investor itself borrows to fund the investment.

280 Interest is generally exempt from U.S. withholding tax under the “portfolio interest”exceptions of § § 871(h) and 881(c).  If the fund owns 10%of the voting stock of the U.S. borrower, however, the portfolio interest exemption will not apply.  See § § 871(h)(3)(A); 881(c)(3)(B).  If the exemption does not apply, the foreign investors will bear withholding tax at a 30% or reduced treaty rate.

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U.S. Income Portfolios: Other Pass-through Entities 
  Portfolio 735-2nd: Private Equity Funds 
  Detailed Analysis 
  VII. The Problem of ECI and UBTI

B. Typical Categories of UBTI/ECI in Fund Investments 

1. Fee Income 

Unlike the passive investor in publicly traded securities, a private equity fund usually acquires newly issued stock or securities.  The fund negotiates the specific terms and conditions of the investment with the issuer and, as a substantial shareholder, achieves a degree of influence and control on management.  The fund manager provides management advice and otherwise assists the portfolio company in the development of broad corporate strategy.  The nature of the relationship between the fund and the portfolio company therefore generates significant potential for fee income.

If a fund renders services to a portfolio company, it must pass through any fees paid or imputed to it as ECI to its foreign members281 and, absent a statutory exemption, UBTI to its tax-exempt members.282 If a fund manager renders the same services, the fund investors will not realize ECI or UBTI, but will also not benefit from the fees.  The potential sources of service income are pervasive, and may include management and monitoring fees, origination and commitment fees, break-up and finder's fees, underwriting commissions and other transaction-related payments.
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281 § 864(b) (assuming fund renders services in the United States).

282 By definition, the services would not qualify as “substantially related” to the exempt purpose of the tax-exempt.  See § 513.

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2. Investments in Pass-Through Portfolio Companies 

As described above, the Code generally imputes the trade or business activities of a partnership to its partners.283 If the partnership is engaged in a U.S. trade or business, its tax-exempt or foreign partners must therefore report their allocable share of the income as UBTI or ECI, respectively. This “look-through” rule applies not only to funds that engage in a U.S. trade or business directly, but to funds that invest in other pass-through entities that engage, directly or indirectly, in a U.S. trade or business.284 Although tax-exempt and foreign investors may prohibit these investments merely to avoid the obligation to file a U.S. tax return, most prohibit them to avoid U.S. tax in a future sale.285
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283 See VII, A, above.

284 § 875(1) (pass-through of ECI to foreign partners of partnership);  § 512(c)(1) (pass-through of UBTI to tax-exempt partners of partnership).

285 On an operating basis, the status of the portfolio company as a pass-through entity merely shifts the incidence of tax from the entity to the investors.  In fact, if the business generates operating losses, status as a pass-through entity may be more efficient even for this group of investors, assuming that they realize other ECI/UBTI subject to U.S. tax on a net basis. See VII, D, 5, below.

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When a fund sells corporate stock, the portion of the gain allocable to tax-exempt or foreign investors is generally exempt from U.S. tax.286 When a fund sells equity in a pass-through entity engaged in a U.S. trade or business, the portion of the gain allocable to tax-exempt or foreign investors is UBTI or ECI,287 limited in the case of tax-exempt investors to the portion of the gain attributable to inventory or “debt-financed property.”288 Although the buyer will “step-up”the tax basis of the portfolio company assets, the tax-exempt and foreign investors are likely to bear incremental taxes on the sale that exceed the buyer's tax benefit, assuming that the parties bear the same effective tax rate.  It is more efficient, therefore, for the tax-exempt and foreign investor to sell corporate stock.
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286 See VII, A, 3, above.

287 See VII, A, 1, above.

288 § § 512(b)(5) (inventory), 512(c) (partnership look-through), 514 (debt-financed property); see also TAM 9651001 (applying an “aggregate” theory of partnerships to treat the partner as owning a direct interest in debt-financed property of the partnership).

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The inefficiency of pass-through ownership is most acute for the corporate foreign investor due to the branch profits tax.  Section 884 imposes a dividend-like tax on deemed repatriations of earnings by U.S. divisions of foreign corporations.289 To achieve a rough parity with the treatment of liquidations of domestic corporations under § 331, § 884 exempts repatriations of earnings that represent the functional equivalent of a liquidation.  Because divisions do not formally “liquidate,” the branch profits tax treats a “complete termination” of the U.S. trade or business activities of the foreign investor as a proxy for a liquidation.290 In many fund structures, however, a sale by the fund of a pass-through investment will not qualify as a “complete termination.”
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289 See  § 884 (imposing tax at a 30% rate on “dividend equivalent amount” of foreign branch for taxable year).

290 Regs. § 1.884-2T(a)(1).

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When a fund sells its interest in a pass-through entity, its foreign corporate investors will terminate their attributive U.S. business activities with respect to that entity immediately after the sale.  But the branch profits exemption does not discriminate between the business activities of multiple pass-through entities, requiring the foreign corporate investor to cease all U.S. trade or business activities.291 So if a fund holds investments in two pass-through entities, one engaged in the hot dog vending business and the other in the manufacture of mainframe computers, a sale of one but not the other does not terminate the U.S. trade or business activities of the foreign investors.  Moreover, as the legal entity liable for branch profits tax, a foreign investor may have little appetite for effecting a “termination” by formal liquidation merely because one of its fund investees has disposed of a pass-through investment.292 Assuming full branch profits tax, therefore, a foreign corporate investor will bear tax on the allocated gain at a 54.5% rate.
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291 See Regs. § 1.884-2T(a)(2)(i). In general, a foreign corporation does not terminate its U.S. trade or business for any taxable year unless, among other things, it has no “U.S. assets” as of the close of the taxable year of termination and generates no ECI for the three year period thereafter. Id.

292 In addition, the liquidation may trigger ECI unrelated to the specific holding if the fund holds other portfolio investments in pass-through form.  § 311(b); Rev. Rul. 91-32, 1991-1 C.B. 107; see also Regs.  § 1.884-2T(a)(2)(B) (use of property attributable to ECI by “related corporation”disqualifies deemed distribution from branch profits relief).

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3. Investments in Subfund General Partners 

A tax-exempt or foreign investor will occasionally acquire an interest both in the underlying fund and in its general partner.  By acquiring the general partnership interest, the investor usually seeks to reduce its effective carry percentage vis-à-vis the other investors. These investments tend to occur most often with FOFs, which exploit the leverage inherent in their substantial capital commitments to extract economic concessions from their subfund investees. When an FOF acquires an interest in the general partner of an underlying fund, it will nominally bear the same carry percentage as the other investors but will “earn back” a portion of that percentage as a member of the general partner. Whether this approach will have the same tax effect as a direct reduction in the carry percentage, however, will depend upon whether the consideration underlying the original issuance of the carried interest — services — “taints”otherwise exempt allocations of capital gain.

a. ECI 

As mere investors in corporate stock, private equity funds do not engage in business.293 When they sell, therefore, their foreign investors do not realize ECI.  But what if the foreign investor participates in the stock gain through its interest in the general partner? May the IRS invoke § 875 to treat the foreign investor as engaged in a U.S. trade or business because the general partner initially received the carried interest in the underlying fund for services? If so, are the carried interest distributions allocable to the foreign investor through its interest in the general partner “effectively connected” with that trade or business?
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293 See VII, A, 3, above.

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In the author's view, this particular species of capital gain is not ECI.  First, § 702(b) determines the character of any item of income included in a partner's distributive share “as if such item were realized directly from the source from which realized by the partnership.” The general partner, and therefore its members, realizes capital gain under  § 702(b) because the underlying fund sold corporate stock.  By treating the members of the general partner as if they had sold stock, the Code preserves the tax-exempt nature of the underlying capital gain.  Second, in most “split entity” fund structures, the sponsor forms the general partner as a conduit holding company.294 If the general partner engages in no business activity, it cannot generate ECI. Third, even if the general partner does engage in a U.S. trade or business, the capital gain allocations are not “effectively connected” with that trade or business.  Under  § 864(c)(2), capital gain is effectively connected only if it is “derived from assets used ...in the conduct of such trade or business” or, if not, the trade or business is a “material factor” in the realization of the capital gain.  Capital gain in a fund investment does not arise from assets used in a trade or business — it arises from investment activity.295 If the capital gain arises from investment activity, how can the business of the general partner ever be construed as a “material factor?” An example in the regulations involving an offshore investment company suggests that it cannot. In the example, an investment company trades in stocks or securities through a principal office in the United States.296 The example concludes that the trading activities are a “material factor” in the realization of the investment gains.297 This conclusion, however, reflects an assumption under prior law that the investment company was engaged in a U.S. trade or business by virtue of its trading activities.298 Under current law, the trading activities of the investment company do not constitute a trade or business under any circumstance.  Unless the trader is a dealer, therefore, the material factor test is irrelevant.299 Indeed, the only distinction between the investment company in the regulations and the general partner of a fund is that the general partner of a fund manages investments on behalf of others.  Thus, unlike the investment company, it performs services for others.  Having concluded that the grant of a carried interest for services is a closed transaction,300 however, the IRS has rejected this distinction.  In any event, the distinction is probably a specious one anyway: once the general partner receives the carried interest, it manages the fund portfolio both for itself as a direct investor and on behalf of others.  Because the tax law does not recognize services performed for oneself,301 the services should not establish an independent basis for taxing the owners.
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294 The fund manager, not the general partner, performs investment advisory services on behalf of the fund.

295 Regs. § 1.864-4(c)(2)(iii).

296 Regs. § 1.864-4(c)(3)(ii) (Ex. 1).

297 Id.

298 In the Taxpayer Relief Act of 1997, Congress repealed the provision of the Code treating U.S. trading activities by a foreign corporation with a “principal office” in the United States as a U.S. trade or business.  P.L. 105-34, § 1162(a).  Before the repeal, effective for taxable years beginning after December 31, 1997, a foreign investor in a fund with a U.S. trading advisor could not rely on the general safe harbor under § 864(b) for trading in stocks or securities unless the fund had its “principal office”outside of the United States.   § 864(b)(2)(A)(ii) (pre-1997). The implementing regulations determined the location of the fund's principal office based upon a ten factor test.  See Regs. § 1.864-2(c)(2)(iii) (listing ten functions to determine site of principal office for foreign corporation);Regs. § 1.862-2(c)(2)(ii) (applying same test to partnerships).  A fund that failed the ten factor test bore U.S. tax on a net basis on its capital gains, interest and dividends.  Because one of the ten factors restricted U.S. marketing activities, many funds adopted parallel “feeder”structures in which only the domestic entity solicited investments within the United States.  Provided that the foreign fund complied with the ten factor test, it was not considered to have a principal office in the United States even if the parallel domestic fund did. See PLRs 8750049, 8846039, 8916004, and 8916005 (“principal office” of lower tier partnership not imputed to upper-tier partnership).  In many parallel feeder structures, the tax advisors would prohibit the two funds from investing in lockstep for fear that the two entities would be deemed engaged in a single joint venture with a U.S. principal office.

299 See  § 864(c)(1)(B), (b)(2)(A)(ii).

300 Rev. Proc. 93-27, 1993-2 C.B. 343.

301 See, e.g., Comr. v. Moran, 236 F.2d 595, 598 (8th Cir. 1956) (“an individual cannot be his own employee ...”).

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b. UBTI 

For tax-exempt investors, the Code is much clearer.  Section 512(c) requires a tax-exempt partner to report its allocable share of the income and deductions of a partnership engaged in an unrelated trade or business as UBTI. Section 512(b)(5), however, excludes gain from the sale or exchange of property from the definition of UBTI unless the property in question is inventory. Because the underlying fund is not a dealer, it does not hold its portfolio investments as inventory.

4. Investments in Subfund Managers 

For the same reason that an investor may acquire an interest in the general partner, it may also acquire an interest in the fund manager:to reduce the effective management fee vis-á-vis the other investors.  When an investor acquires an interest in the fund manager, it will nominally bear the same management fee as the other investors, but will “earn back” a portion of the fee as a member of the fund manager.  For U.S. tax purposes, however, the investment in the fund manager is likely to give rise to ECI to the foreign investors and UBTI to the tax-exempt investors.

U.S. Income Portfolios: Other Pass-through Entities 
  Portfolio 735-2nd: Private Equity Funds 
  Detailed Analysis 
  VII. The Problem of ECI and UBTI

C. Purging Fee Income from the Fund 

1. Potential Treatment of Certain Fees as Capital in Nature 

Not every fee is taxable to tax-exempt or foreign investors.  In substance, the fee must represent, in the case of foreign investors, compensation for services performed in the United States and, in the case of tax-exempt investors, non-exempt compensation for services performed worldwide. As described more fully below,302 the fund must also engage in the fee producing activities on a sufficiently continuous basis to establish a “trade or business” for U.S. tax purposes. Finally, that trade or business must be “regularly carried on” by a tax-exempt investor or carried on through a U.S. “permanent establishment” by a treaty-eligible foreign investor.303 Although some fund agreements flatly prohibit all fees, not every fee gives rise to UBTI or ECI.304 Moreover, other fees may give rise to ECI but not UBTI due to the broader statutory protection available to tax-exempt investors.  The following discussion addresses the status of certain types of fees as UBTI or ECI.
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302 See VII, C, 2, below.

303 § 512(a)(1); Regs. § 1.513-1(c)(1); see VII, C, 2, below.

304 The regulations under  § 731, for example, treat a partnership that receives commitment, break-up, guarantee and similar fees that “are customary in and incidental to any activities of the partnership as an investor ...” as not engaged in a trade or business by virtue of such fees for purposes of determining whether the entity is an “investment partnership.” See Regs. § 1.731-2(e)(3) (emphasis added).  Although it does not address the treatment of fees as ECI per se, the regulatory language is consistent with the view that a fund can receive fees for services without generating ECI so long as the fees do not represent a business “regularly carried on” by the fund.

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a. Break-Up Fees 

Fund investors incur expenses to evaluate, negotiate and close a portfolio investment, including salaries, costs of due diligence, legal and accounting fees and travel expenses.  These costs tend to be incurred before the investment closes.  In a “broken deal,” therefore, the fund investor will incur an immediate loss.  To mitigate its loss, a fund may demand a “break-up” fee from the portfolio company.  Although the size of these fees will vary from one deal to another, the fee will usually exceed the out-of-pocket expenses of the fund, often by a sizable margin.

Under § 61(a), a break-up fee is includible in gross income.  But is it UBTI or ECI to the tax-exempt or foreign investor? Although styled a “fee,”it is more akin to a payment in liquidated damages, not compensation for services.305 In general, the character of a damage payment will depend upon the character of the underlying loss.306 The tax issue, therefore, is whether a break-up fee reimburses the fund for lost profits on a stock investment. If so, then the break-up fee is a surrogate for capital gain, a largely exempt category of income to tax-exempt and foreign investors.307
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305 See, e.g., PLR 200127024 (characterizing break-up fee paid by prospective REIT target to prospective REIT acquirer for breach of merger agreement as settlement in liquidated damages).

306 The Supreme Court first introduced the “origin of the claim” test in U.S. v. Gilmore to distinguish personal from business expenses.  372 U.S. 39 (1963); see also Woodward v. Comr., 397 U.S. 572 (1970);  U.S. v. Hilton Hotels Corp., 397 U.S. 580 (1970). Under the Arrowsmith doctrine, gain or loss in related transactions share the same tax character. Arrowsmith v. Comr., 344 U.S. 6 (1952). Thus, a payment in settlement of a capital claim is itself capital in nature. Raytheon Productions Corp. v. Comr., 144 F.2d 110 (1st Cir. 1944). With respect to securities losses, payments to settle losses generally give rise to either a basis adjustment or capital gain, depending upon whether the recipient holds the securities in question at the time of payment.  See, e.g., Dobson v. Comr., 320 U.S. 489 (1943); Griffith v. Comr., 308 U.S. 355 (1939); Goldsmith v. Comr., 22 T.C. 1137 (1954); Megargel v. Comr., 3 T.C. 238 (1944). Whether the claimant receives the payment in litigation or settlement of the claim is irrelevant. See, e.g., Spangler v. Comr., 323 F.2d 913 (9th Cir. 1963) (“it is immaterial whether taxpayer effected collection amicably or by resolving a dispute through compromise or litigation”).

307 See § 512(b) (tax-exempt investors); § 871(a)(2); Regs. § 1.1441-2(b)(2)(i) (gains derived from sale of property not “fixed or determinable,”subject to certain exceptions).

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In the case of litigation recoveries for losses incurred in connection with the purchase or sale of securities, the injured party typically realizes a loss after having acquired the underlying security.308 A fund that receives a break-up fee incurs its loss by being deprived of that opportunity.  Should that matter? In at least one private letter ruling,309 the IRS opted not to treat a break-up fee paid by one REIT to another for breach of a merger agreement as gain from the sale of stock under an “origin of the claim”analysis, ruling instead that the REIT could exclude the fee from gross income for purposes of the gross income tests of § 856(c)(2) and (3).  Although a somewhat strained construction of the statute, the determination that a break-up fee does not jeopardize the tax status of an entity required to generate passive income as its predominant source of revenue suggests that these fees are a species of investment gain.  In the context of a fund investment, therefore, break-up fees probably do not give rise to UBTI or ECI.310
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308 See, e.g., Dobson v. Comr., 320 U.S. 489 (1943); Griffith v. Comr., 308 U.S. 355 (1939); Goldsmith v. Comr., 22 T.C. 1137 (1954); Megargel v. Comr., 3 T.C. 238 (1944).

309 PLR 200127024 (characterizing break-up fee paid by prospective REIT target to prospective REIT acquirer for breach of merger agreement as settlement in liquidated damages).

310 But see TAM 200438038 (fee paid to spurned buyer for termination of merger agreement by reason of seller's receipt of superior bid treated as “ordinary income”).

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b. Transaction Fees 

In addition to receiving break-up fees, a fund may be reimbursed for expenses incurred in connection with a fully-consummated investment. These fees should not give rise to income at all, so long as the fund would have capitalized the reimbursed expenses into stock basis.311 Upon receipt of the payment, the fund simply reduces its tax basis in the investment. Because these fees are in substance purchase price adjustments, a fund agreement that proscribes the receipt of fee income may exclude these fees without material risk of UBTI or ECI.
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311 See, e.g., Regs. § 1.1012-1(b) (payment by purchaser of property taxes allocable to seller treated as part of cost of property).

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c. Equity Commitment Fees 

Another common type of fee is a commitment fee.  On occasion, funds receive commitment fees for making capital available on a standby basis.  The proper U.S. tax treatment of such fees is not entirely clear.  For lending transactions, the IRS has ruled that a commitment fee does not qualify as “interest” because the fee is not a charge for the use of money.312 This is so even though the Supreme Court defines interest as “compensation for the use or forbearance of money,”313 a definition broad enough to subsume a commitment fee, which may require the lender to “forbear”from lending to others.314 In one context, the IRS required the payor of a loan commitment fee to capitalize the fee over the term of the loan on the basis that the fee was “similar to the cost of an option.”315  Under this analysis, the fee would qualify as option premium, which is neither ECI nor FDAP income to a foreign investor.316 In another context, however, the IRS ruled that a commitment to lend is a “service.”317 For tax-exempt investors, who enjoy exemption from tax on interest, option premium, and fees for “agreement[s] to make loans,”318 these distinctions are of little consequence.
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312 See Rev. Rul. 54-43, 1954-1 C.B. 119; Rev. Rul. 56-136, 1956-1 C.B. 92, revoked by Rev. Rul. 81-160, 1981-1 C.B. 312; Rev. Rul. 70-540, 1970-2 C.B. 101.

313 Deputy v. Du Pont, 308 U.S. 488, 498 (1940).

314 See Kingson, “The David Tillinghast Lecture: Taxing the Future,” 51 Tax L. Rev. (1996).

315 Rev. Rul. 81-160, 1981-1 C.B. 312; see also GCM 39434 (Oct. 25, 1985) (“Rev. Rul. 81-160 revoke[d] Rev. Rul. 56-136 ... and in doing so characterizes the fee not as an interest charge or a service charge, but a charge for the acquisition of a property right ... the credit card holder fee, like the loan commitment fees in Rev. Ruls. 56-136  and 81-160, is a fee for the availability of money”); FHLMC v. Comr., 125 T.C. 248 (2005) (holding that loan commitment fee qualified as option premium).

316 See Regs. §  1.1441-2(b)(2)(i) (option premium not FDAP); see also §  865(a) (income from sale of personal property by nonresident is foreign source income). In addition, gain derived by the writer upon lapse of an option qualifies as gain from the sale of a capital asset. See §  1234(b)(1).

317 See Rev. Rul. 54-43, 1954-1 C.B. 119; Rev. Rul. 56-136, 1956-1 C.B. 92, revoked by  Rev. Rul. 81-160, 1981-1 C.B. 312; Rev. Rul. 70-540, 1970-2 C.B. 101.

318 § 512(b)(1); see also §  512(b)(5) (excluding gains from lapse of option to buy or sell securities from definition of UBTI).

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In the fund context, however, most commitment fees arise not from lending, but from equity investing.  The IRS has ruled that a commitment fee paid by a U.S. borrower to a foreign lender with no permanent establishment in the United States represents foreign source income.319 Although characterizing the commitment to lend as a service, the IRS treated the fee as foreign source income and therefore not ECI because the lender provided the relevant “service” from abroad.  If a commitment to fund an equity investment is also a service, a commitment fee received in consideration for that service will generate ECI to the foreign investors unless the fund can establish that the relevant services occurred outside of the United States.320 This may be a difficult burden for funds managed principally within the United States.  For tax-exempt investors, where the services are performed is not even relevant.
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319 PLR 7808038.

320 See also Bank of America v. U.S., 680 F.2d 142 (Ct. Cl. 1982) (while sourcing by analogy to source rules for interest, court characterized commissions received for accepting letters of credit as fee for “services”).

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In spite of the obvious economic similarity, none of the equity commitment fee authorities consider whether the recipient of the commitment fee has merely written an option.  Yet, when a fund commits to invest equity capital for a fee, it has done precisely that.321 Anyone who writes an option “commits”to invest capital.  Here, however, the IRS chooses to ignore the alleged service element in the transaction.322 Instead, the writer of the option reduces its tax basis in the acquired stock by the option premium upon exercise of the option323 and recognizes gain upon the lapse of the option.324 If the IRS were to characterize a commitment fee as an option premium, therefore, a foreign or tax-exempt investor would bear no tax upon receipt of the fee, upon exercise or lapse of the option, or upon a sale of the underlying stock.325 In addition, option premium is not FDAP income and is therefore exempt from withholding to a foreign investor.326.
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321 See, e.g., Rev. Rul. 81-16, 1981-1 C.B. 312 (requiring payor of loan commitment fee to capitalize fee over term of loan because fee was “similar to cost of an option”).

322 See, e.g., Rev. Rul. 58-234, 1958-1 C.B. 279.

323 Id.

324 § 1234(a)(1). In addition, gain derived by the writer of an option upon its lapse constitutes gain from the sale of a capital asset. See §  1234(b)(1).

325 § 512(b)(5) (excluding gains from lapse of option to buy or sell securities from definition or UBTI); Regs. § 1.864-2(c)(2) (trading safe harbor includes trading in “options to buy or sell stock or securities”).

326 See Regs. §  1.1441-2(b)(2)(i) (option premium not FDAP); §  865(a); §  1234(b)(1).

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d. Debt Guarantees 

Occasionally, the lenders to the portfolio company will require the fund to guarantee debt or to provide other forms of credit support. The debt in question may be preexisting debt or debt incurred to finance the actual investment.  Assuming sufficient borrowing capacity to withstand a Plantation Patterns challenge,327 the IRS should respect the portfolio company as the obligor of the debt.328 Even if it does, however, the tax-exempt or foreign investors may realize UBTI or ECI if the portfolio company pays a guarantee fee, assuming at least that the fee is construed as a payment for services. Although a loan guarantee is similar to a put option329 and has been analyzed as such in the financial literature,330 the IRS has yet to accept this characterization.331
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327 Plantation Patterns v. Comr., 462 F.2d 712, 722-23 (5th Cir. 1972) (“the guarantee enabled [the shareholder] to create borrowing power for the corporation which normally would have existed only through the presence of more adequate capitalization of New Plantation”).

328 If the nominal borrower is adequately capitalized and otherwise able to borrow funds on an independent basis, the courts will respect the form of the arrangement as a guarantee.  See, e.g., Murphy Logging Co. v. U.S., 378 F.2d 222 (9th Cir. 1967) (shareholder guarantee respected where corporate borrower adequately capitalized); Santa Anita Consolidated Inc. v. Comr., 50 T.C. 536 (1968).

329 A guarantee is similar to a put option contract in the sense that it vests in the original creditor the right to put its claim at “par” to the guarantor upon an event of default.

330 See, e.g., Ashoka Mody &  Dilip K. Patro, Methods of Loan Guarantee Valuation and Accounting, at 7 (1996), available at http://www-wds.worldbank.org/external/default/WDSContentServer/WDSP/IB/1995/11/01/000009265_3970701165809/Rendered/PDF/multi_page.pdf  (“A guarantee is a put option on the assets of the firm with an exercise price equal to the face value of its debt”) (last visited Aug. 16, 2007).

331 See CCA 003530 (Aug. 22, 1994)(treating guarantee fee as FDAP income); FSA 200031005 (Apr. 3, 2000) (same); FSA 200147033 (Aug. 14, 2001) (same); But see Blessing, 905 T.M., Source of Income Rules, at XV, B, 1, b (“a taxpayer could reasonably take the position that guarantee fees should be sourced by reference to the residence of the guarantor ...on the theory that a key element in earning the fee is the credit standing of the guarantor”).

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In many cases, however, the portfolio company does not pay a fee to the shareholder guarantor. The question in such a case is whether the absence of an explicit fee will preclude the IRS from imputing one.  On its face, § 482 would seem to provide ample authority, assuming at least that the fund controls the portfolio company and that an unrelated third party would have charged a fee under similar circumstances.332 Perhaps surprisingly, however, the authorities involving shareholder guarantees suggest otherwise.
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332 See Regs. § § 1.482-1(a),-2(b).

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In Seminole Thriftway, Inc. v. U.S.,333 for example, the Court of Federal Claims denied a deduction for the payment of a guarantee fee to the shareholder guarantors, treating the fee as a constructive dividend.  Although the decision turned in part upon the shareholders’ failure to impose the fee at the time of the guarantee, the court also assigned substantial weight to two other criteria: whether a separate charge for a guarantee was “customary” in the particular industry and whether a fee was “necessary” to induce the shareholders to act as guarantors.334 Given the relationship of the parties, the court's emphasis on these criteria is peculiar. First, an unrelated third party who guarantees debt invariably charges a fee for exposing its own assets to credit risk.  It may be “customary”for a controlling shareholder to waive a fee but that is because the fee will not increase its aggregate assets.  The question is not whether the charge is customary, but whether it is arm's length.  Second, a payment by a shareholder of a corporate expense is a constructive capital contribution.335 Shareholders routinely provide capital to their controlled corporations to preserve the value of their stock investment, including capital to fund otherwise deductible expenses.  Nevertheless, the implication of these cases is that an explicit guarantee fee is a constructive dividend, at least in certain circumstances.336 If so, the IRS cannot logically impute a guarantee fee to a shareholder who fails to charge one under the same circumstances.337 So long as the fund is acting in accordance with “custom” in the industry in waiving the fee, therefore, it is unlikely that a court would impute a fee to the fund.338
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333 99–1 USTC ¶ 50,155 (Fed. Cl. 1998).

334 Id. Because the case involved a motion for summary judgment, the court was required to assume that a guarantee fee was customary in the plaintiff's particular business.

335 See, e.g., Regs.  § 1.83-6(d)(1) (transfer of property by shareholder to an employee in consideration for services performed for the corporation treated as contribution to corporation by shareholder followed by payment of compensation by corporation to employee).

336 See also Tulia Feedlot, Inc. v. U.S., 513 F.2d 800 (5th Cir. 1975); Olton Feed Yard, Inc. v. U.S., 592 F.2d 272 (5th Cir. 1979); Tulia Feedlot, Inc. v. U.S., 3 Cl. Ct. 364 (1983); Fong v. Comr., T.C. Memo 1984-402.

337 As the “earnings-stripping”limitations of § 163(j) implicitly acknowledge, foreign shareholders often guarantee debt of their U.S. subsidiaries.  Yet in the author's experience, the shareholders rarely charge a fee for exposing their assets to credit risk.  Assuming that the fee would avoid U.S. withholding tax as “foreign source”income, the IRS would have little incentive to impute a fee under § 482. Note that IRS Form 8926, Disqualified Corporate Interest Expense Disallowed Under Section 163(j), is designed to obtain  information about application of § 163(j), specifically about the determination of the taxpayer's debt-to-equity ratio, net interest expense, adjusted taxable income, excess interest expense, total disqualified interest, and the amount of interest deduction disallowed under § 163(j). This form was proposed in response to a Congressional mandate in the 2004 American Jobs Creation Act, P.L. 108-357, § 424, that Treasury study the effectiveness of Code provisions applicable to earnings stripping. See Announcement 2007-114, 2007-50 I.R.B. 1176.

338 In each of the cited cases, the deduction minimized the aggregate tax liability of the parties.  In a fund investment, the deduction will maximize the aggregate tax liability of the parties if the portfolio company has operating losses.

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But what if the portfolio company does pay a guarantee fee? If construed as a dividend under Seminole Thriftway, the foreign and tax-exempt investors will still avoid ECI or UBTI. If construed instead as a fee for services, the foreign investors may realize ECI.  For tax-exempt investors, however, the fee may not constitute UBTI even if construed as a payment for services.339 Section 512(b)(1) exempts fees “for agreements to make loans” from UBTI.  A guarantor of a loan usually has a state law right of subrogation, allowing it to assume the rights of the original lender when it funds the guaranty.340 In that sense, therefore, the fee is really consideration for an agreement to make a loan, albeit on a contingent basis.
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339 See § 512(b)(1) (excluding amounts received “as consideration for entering into agreements to make loans).

340 See Gallagher, “Private Equity Funds — Selected Tax Issues,” Tax Club 1, 21 (Jan. 16, 2002).

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2. “Regularly Carried On” Requirement 

Although its incentive to do so is not clear, the IRS may seek to impute UBTI or ECI to the fund investors by recasting a “fee offset” provision as an assignment of income earned by the fund to the fund manager.341 Alternatively, a fund may inadvertently receive a fee in violation of explicit covenants in the fund agreement.  In either case, foreign investors may incur U.S. tax on such income under  § 864, which treats most categories of income from the performance of services in the United States as ECI.342 Moreover, the added protection of a treaty will only rarely shield the investor from tax if the fund has a U.S. office, which will generally constitute a “permanent establishment” of the investor.343 The tax-exempt investor, however, may still avoid U.S. tax by establishing that the trade or business giving rise to the fee was not “regularly carried on” by the investor.
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341 See VII, C, 3, below, for a discussion of the assignment of income doctrine as applied to tax fee offset arrangements.

342 § 864(b).

343 A foreign investor who is eligible to claim treaty benefits may be able to avoid U.S. tax on ECI under a treaty equivalent of the “one bite”rule.  See, e.g., Rev. Rul. 58-63, 1958-1 C.B. 624; Rev. Rul. 60-249, 1960-2 C.B. 264; Rev. Rul. 70-543, 1970-2 C.B. 172; Rev. Rul. 85-4, 1985-1 C.B. 294 (domestic corporation that operates race track not required to withhold under treaty where racetrack owner knows that owner of horse will race only once during year); see also Rev. Rul. 67-321, 1967-2 C.B. 470 (foreign corporation producing theatrical shows that contracted to present floor show in hotel did not have permanent establishment because “it did not have an office or other permanent facility in the United States and ... the contract involved [was] for a relatively short period of time”).  The rationale for the “one bite” rule is that merely temporary activities in the United States do not create a permanent establishment.  See TAM 8526005.  Many funds have permanent offices in the U.S. through which the fund manager regularly manages the investments of the fund.  A typical treaty, however, defines a permanent establishment as an office in which the “business”of the treaty party is carried on, not an office through which the entity conducts investment activities.  See, e.g., U.S. Model Income Tax Convention of Sept. 20, 1996, Art. 5.

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Section 512(a)(1) defines UBTI as “the gross income derived by any organization from any unrelated trade or business regularly carried on by it.”344 For the fee to attract taxation, the activities of the fund must constitute a trade or business, the fund must regularly carry on that trade or business, and the trade or business must not be substantially related to the investor's exempt purpose.345 Section 513 imports the § 162 definition of the phrase “trade or business.”346 The phase therefore subsumes most activities carried on for the production of income from the sale of goods or services.  In determining whether the tax-exempt “regularly carries on” the trade or business, however, the UBTI regulations also consider both the frequency and continuity of these activities and the manner in which they are conducted.347 Although the precise quantum of activity that the statute requires is not clear, any such determination must give due regard to the statutory purpose.  The “regularly carried on” requirement seeks to place the bona fide commercial activities of tax-exempt entities on the same playing field as competing activities of other taxpayers, denying tax exemption only to those activities ordinarily conducted by taxable entities.348 The IRS, therefore, should not impose taxing jurisdiction until the business activities of a tax-exempt “manifest a frequency and continuity, and are pursued in a manner, generally similar to comparable commercial activities of non-exempt organizations.”349
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344 See also Regs. § 1.513-1(a), (c).

345 Regs. § 1.513-1(c)(1). This portfolio assumes that any fee income imputed to a tax-exempt investor in connection with a private equity investment is not “substantially related”to the exempt purpose of the investor.

346 Regs. § 1.513-1(b).

347 Regs. § 1.513-1(c)(1).  Thus, the regulations exempt activities that occur over “only a few weeks,” even though the same activities of a foreign person would probably establish the conduct of a U.S. trade in business. Regs. § 1.513-1(c)(2).

348 Regs. § 1.513-1(c)(1). The “regularly carried on” requirement is therefore broader than the “regular and continuous” requirement.  See, e.g., Pinchot v. Comr., 113 F.2d 718 (2d Cir. 1940) (“regular and continuous activity of the kind of which is commonly concerned with the employment of labor; the purchase of materials; the making of contracts; and many other things that come within the definition of business”).  The IRS has ruled, for example, that the entry of a race horse in a single race is a trade or business.  See, e.g., Rev. Rul. 58-63, 1958-1 C.B. 624; Rev. Rul. 60-249, 1960-2 C.B. 264.  See also GCM 18835, 1937-2 C.B. 141 (“any activities beyond the mere receipt of income from property, and the payment of organization and administration expenses incidental to the receipt and distribution thereof” are sufficient to give rise to a “trade or business”).

349 Regs. § 1.513-1(c)(1).

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Assume, for example, that neither the tax-exempt investor nor the fund generates “bad” income on a regular basis and that any such income is incidental to investment activities that themselves do not constitute a trade or business (e.g., guarantee fees, equity commitment fees).  Should the tax-exempt entity be viewed as engaged in a separate service business distinct from its investment activities merely because it receives these fees? The regulations do provide that even intermittent or periodic business activities may be considered “regularly carried on,” but they treat such activities as “regularly carried on” only if conducted with “the competitive and promotional efforts typical of commercial endeavors.”350 In making that determination, the regulations compare the activities of the tax-exempt with similar commercial activities normally pursued by non-exempt organizations.351 Thus, if the fee-generating activities of the fund are both infrequent and incidental to its investment activities,352 they should not be viewed as generating UBTI even if a fully taxable enterprise generates similar fees as part of an active service business.
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350 Regs. § 1.513-1(c)(2)(ii).

351 Id.

352 For example, if the fund derives all of its fee income from portfolio company investors, the tax-exempt investor may construe the fees as incidental to its investment activities. Although the UBTI provisions do not explicitly exempt “incidental”fees, their status as such may tend to negate the necessary business “continuity”that the regulations require.

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3. “Fee Offset”Arrangements 

Although not every fee is taxable to tax-exempt and foreign investors, some fees are, in particular fees received for the performance of services.  The sponsor cannot anticipate the nature of every service that a portfolio company investee may require over the life of the fund.  To protect the tax-exempt and foreign investors, therefore, the sponsor will usually adopt some form of prophylactic strategy to purge “bad income” from the fund.  The most common of these strategies is to separate, both under the fund agreement and in practice, the activities of the fund manager as a provider of investment advisory services from the activities of the fund as a passive investor.  As is so often the case, however, this effort to delineate the activities of the two entities to achieve a tax objective tends to conflict with the primary non-tax objective of the fund investors, which is to maximize portfolio returns.  In the typical fund, therefore, although the fund manager will capture 100% of most categories of fee income, the fund investors will receive some form of compensating adjustment to the periodic management fee.  Less frequently, the fees will reduce future carried interest distributions to the general partner.

Worksheet 9 provides an example of a typical fee offset provision in a fund agreement.

Whether the IRS will respect these arrangements depends upon whether their form is consistent with their substance, which the offset mechanism tends to obfuscate.  If the fund is providing the services, the IRS should treat the fund as having received the fee and then assigned it to the fund manager in satisfaction of the management fee.  The fountainhead of this doctrine is Lucas v. Earl.353 In Lucas v. Earl, a husband and wife entered into a binding contract providing for co-ownership as joint tenants of all property owned or subsequently acquired “in any way, either by earnings ... or any rights by contract or otherwise” during their marriage.  Relying upon this agreement, the wife included half of her husband's earnings in income. The Supreme Court held that the husband remained fully liable for tax on the income even after the attempt to assign it to his wife, whether or not he entered into the contract to reduce taxes:
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353 281 U.S. 111 (1930).

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“There is no doubt that the [Code] could tax salaries to those who earned them and provide that the tax could not be escaped by anticipatory arrangements and contracts however skillfully devised to prevent the salary when paid from vesting even for a second in the man who earned it.  That seems to us the import of the statute before us and we think that no distinction can be taken according to the motives leading to the arrangement by which the fruits are attributed to a different tree from that on which they grew.”354

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354 Id. at 114-15.

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Since Lucas v. Earl, the courts have applied the assignment of income doctrine to prohibit many “anticipatory”assignments of income.  A recent example is United Parcel Service of America, Inc. v. Comr.,355 a Tax Court case involving U.P.S. In this case, U.P.S. had restructured its insurance marketing program to divert insurance premiums to its Bermudan subsidiary, the intended effect of which was to shift insurance income from U.P.S., a fully taxable U.S. corporation, to a lightly taxed affiliate.  The Tax Court analyzed the transaction under the “economic substance”doctrine, holding that the restructuring lacked both real economic effect and a non-tax business purpose.  The Tax Court also found that U.P.S., rather than its affiliate, had earned the premiums in question and was therefore fully taxable on the income under the assignment of income doctrine.  On appeal, the Eleventh Circuit reversed the Tax Court's finding on economic substance but did not address the assignment of income issue.356
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355 T.C. Memo 1999-268, rev'd, 254 F.3d 1014 (11th Cir. 2001).

356 United Parcel Service of America, Inc. v. Comr., 254 F.3d 1014 (11th Cir. 2001).

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At the heart of the assignment of income doctrine is the attempt to assign the service provider's legal right to earned income to another.357 If the party reporting the income in fact provided the services, the doctrine does not apply.358 In funds with fee offset provisions, the fund agreement usually prohibits the fund not only from receiving the fees, but from performing the services that generate those fees.  The fund manager is the only entity authorized to provide the services.  As the provider of those services, it both reports the income and receives the fees. To the author's knowledge, no court has ever applied the assignment of income doctrine to impute income from one who earned it to one who did not.
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357 Courts have also invoked the assignment of income doctrine to defeat putative transfers of income-producing property by assignors who retain control of the corpus.  See, e.g., Helvering v. Horst, 311 U.S. 112 (1940) (transfer of coupon payments on retained bond).  This line of cases, which addresses the taxation of earnings from property, should not apply to fee offset arrangements.

358 See, e.g., Lucas v. Earl, 281 U.S. 111 (1930); Seyburn v. Comr., 51 T.C. 578 (1969); American Savings Bank v. Comr., 56 T.C. 828 (1971).

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Nevertheless, many tax advisors fear that the IRS will impute the fee to the fund because the fee reduces the fund's liability for the management fee.  Whether the fund benefits from the foregone fees is certainly relevant to the analysis.  In both Lucas and U.P.S., the assignee was affiliated with the assignor, ensuring that the assignor would continue to benefit from the assigned income. Similarly, the investors in a fund that provides for a management fee offset may still benefit from fees they do not receive because the fees will reduce a liability that they would otherwise incur. But a mere benefit is not sufficient — the assignment of income doctrine still requires that the assignor earn the income; otherwise, it has no property right to assign.  Implicit in this concern, therefore, is that the fund must have earned the fee if the fee discharges a fund liability.

An alternative theory for challenging a management fee offset is that the arrangement is, in substance, a joint venture to share fees between the fund and the fund manager.359 This line of argument effectively recasts the fund as a disguised equity investor in the fund manager.  Yet the fund and its investors are not in form entitled to receive any fees from the portfolio company investees and, at least in the more common offset arrangements, are not assured of receiving the full economic benefit of the fees.  As described above, whether the fund will benefit from fee income will depend on the size and timing of the fees relative to the management fee.  Indeed, unless the fund imposes a carryforward on any unrecovered fees to absorb future management fees and “clawbacks”any unrecouped difference at liquidation, the investors cannot be said to participate in any known percentage of the fee income.  Although the law in this area is unsettled, many believe that the lack of economic parity between direct payment of the fee and the common market practice of indirect payment by offset lends substance to these arrangements for tax purposes.360
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359 See Sicular, “Selected Current Effectively Connected Income Issues for Investment Funds,”56 Tax Law. 719 (Summer 2003).

360 See Sicular, “Selected Current Effectively Connected Income Issues for Investment Funds,” 56 Tax Law 719, 777 (Summer 2003) (“market activity suggests that the economic distinction is significant and should be given tax significance”). See also Karig, “Taxation of Tax-Exempt and Foreign Investors in U.S. Private Investment Funds,”533 P.L.I. 89, 99 (2002) (“the better view (at least with respect to offset structures prevalent today) is that the arrangement should not be recharacterized”); Gallagher, “Private Equity Funds — Selected Tax Issues,” Tax Club 1, 15, (Jan. 16, 2002) (“strong arguments” for respecting form in typical fee offset arrangements).

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The interpretation that most clearly supports respecting form is that the offset is simply the quid pro quo for reduced services to the fund.  If X contracts for services from Y at a fixed fee, but then reduces the fee by all or a portion of any compensation paid to Y for services performed for Z over the same period, is X in substance performing the services for Z or is X merely receiving reduced services from Y? Is it significant that X is a shareholder of Z? Alternatively, the offset may serve only to penalize the fund manager for performing services to third parties that do not directly inure to the benefit of the fund investors.

As described above, the most common approach to ensuring investor participation in fee income is to reduce the periodic management fee by all or a portion of any fees earned by the fund manager from portfolio company investees.  These arrangements rarely assure the investors of receiving the full benefit of the foregone fees.361 Instead, some funds will reduce the management fee by a percentage of the fees received by the fund manager (e.g., 50%) or will limit the offset to 100%of the maximum management fee payable in any particular year.  In the latter case, the excess, if any, of the annual fees over the periodic management fee may or may not carryforward or carryback against future or earlier management fees.  Even if the fund agreement provides for a first dollar offset with a full carryover, it may not require the fund manager to disgorge fees in excess of the aggregate reduction in the management fee over the life of the fund.  Whether the assignment of income doctrine does not apply, or merely does not apply to the extent that the investor does not receive a full offset, is not clear. If the fund reduces the management fee by the full amount of any fee income, however, the issue is probably academic — the fund manager will have little incentive to extract fees from the portfolio company in the first place.362
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361 A leading treatise characterizes the application of the doctrine as “obvious” in full offset cases.  See Schell, Private Equity Funds: Business Structure and Operations, § 5.04[2].  Yet, as described above, the assignment of income doctrine presupposes that the fund performs the services. The doctrine will not apply if the right of full offset merely discourages the fund manager from deriving fee income that does not directly benefit the fund or reflects a reduction in compensation for diminished services.

362 Even in full offset scenarios, the fund manager may have some incentive to extract fees if the resulting reduction in the management fee increases the internal rate of return to the investors.

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An alternative albeit far less common approach to this problem is to reduce carried interest distributions to the general partner by all or a percentage of any fees paid to the fund manager.  The assignment of income doctrine is less likely to apply because the fund has no legal right to the fee and, unlike a management fee offset, no fixed legal right to an offsetting cash payment.  Whether the investors recapture the foregone fee will depend entirely upon whether the fund realizes sufficient portfolio gains.  Indeed, it is for precisely this reason that carry offsets are so rare: they reward the general partner for achieving lower-than-expected returns.  General partners also tend to disfavor carry offsets because they have the undesirable effect of converting capital gain to ordinary income.  Finally, debiting carry distributions is an approach that presupposes that the general partner and fund manager operate as a single legal entity.  If they do not, then the carry offset is not a viable mechanism to recover the fees because separate constituencies participate in fee income and carry distributions in different ratios.363
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363 See VI, B, 2, above.

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U.S. Income Portfolios: Other Pass-through Entities 
  Portfolio 735-2nd: Private Equity Funds 
  Detailed Analysis 
  VII. The Problem of ECI and UBTI

D. Use of “Blocker”Entities to Avoid UBTI/ECI 

1. In General 

As discussed in VII, A, above, if a fund invests in a pass-through entity, its tax-exempt or foreign investors may realize UBTI or ECI if the entity is engaged in a trade or business.  To avoid this particular brand of UBTI or ECI, most funds interpose a corporate “blocker”entity (a “Blocker”) between the investors and the portfolio investment.364 As a distinct taxpayer, the Blocker will “trap”the operating profits of the portfolio company within a separate entity, preventing the trade or business activities of the entity from tiering up to its tax-exempt or foreign shareholders.  Although the shareholders of the Blocker will still bear an indirect tax burden on the Blocker's share of the profits, that tax will roughly approximate the tax that the portfolio company itself would have borne if organized as a corporation. The equity holders, however, will not assume the concomitant obligation to file a U.S. tax return.  If the Blocker is a domestic entity, it will bear U.S. tax on 100% of its income.365 If the Blocker is an offshore entity, it will bear U.S. tax on its “effectively connected” income.366
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364 With no statutory analogue to  § 875 for corporate entities, the IRS cannot impute the trade or business activities of a corporation to its shareholders unless it disregards the corporation under an agency or other common law theory.  Seealso De Vegvar v. Comr., 28 T.C. 1055 (1957); Banac Est. v. Comr., 17 T.C. 748 (1951).

365 § 11.

366 § 11(d); § 882(a)(1).  If the Blocker resides in a treaty jurisdiction and is otherwise eligible to claim treaty benefits, the United States will not tax ECI of the Blocker unless the income is “attributable to” a permanent establishment. See U.S. Model Income Tax Convention of Sept. 20, 1996, Art. 5.

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Blocker entities may reside above, below or parallel to the fund. In most cases, however, the fund owns the Blocker shares. In that event, the fund will invest any and all capital earmarked for pass-through entities through a Blocker, imposing potential entity-level taxation on all investors.  Alternatively, the fund may bifurcate its capital between electing tax-exempt or foreign investors and other investors, investing only the capital of the electing investors through a Blocker. Finally, the fund may organize a parallel Blocker for the tax-exempt or foreign investors.  In a parallel structure, a special purpose entity will either coinvest with the fund in the pass-through entity or invest in the entity through the fund as a “feeder.”In some funds, the fund does not participate in the Blocker strategy at all, leaving the tax-exempt and foreign investors to fend for themselves. If the fund opts not to use a Blocker, the tax-exempt or foreign investors may choose to interpose a Blocker between themselves and the fund, either with respect to their entire commitment or only the portion thereof earmarked for pass-through investments.

Worksheet 10 provides an example of a broad grant of authority to the general partner to employ a Blocker structure.

The U.S. tax consequences of holding a pass-through investment through a Blocker depends entirely upon the chosen structure, in particular whether the Blocker is domestic or offshore, whether the Blocker holds all or only a subset of the fund investments, and whether the Blocker resides above, below or parallel to the fund.  In a sale or other disposition, the U.S. tax consequences also depend upon whether the fund or a subset of its investors has the right to force a sale of the Blocker shares.  In many cases the fund has no such right, typically when the purpose of the Blocker is to isolate the tax return filing obligation within a separate entity.  In other cases, the Blocker structure imposes tax inefficiencies upon the other investors, who must forgo the ability to convey a tax-efficient basis step-up to future buyers even though they share none of the tax concerns of their tax-exempt or foreign coinvestors.  A threshold question in virtually every Blocker structure, however, is whether the IRS will respect the Blocker as the tax owner of the particular investment.  If not, then the Blocker will fail to achieve its intended purpose as a repository for ECI or UBTI.

2. Disregarding the Blocker 

To disregard the Blocker entity as the owner of the fund investment, the IRS is likely to assert one of two theories.  First, it may assert that the Blocker is merely an agent of its shareholders, who own the Blocker shares as principals.  Second, it may assert that the shareholders formed or acquired the Blocker for “tax avoidance” purposes under  § 269. As described below, neither theory is likely to prevail in a typical Blocker structure.

a. Agency 

When the IRS invokes agency, it seeks to disregard the Blocker's legal ownership of the fund investment.  If it succeeds, ownership of the investment for tax purposes will pass to the shareholders of the Blocker as “principals.” To establish agency, however, the IRS must overcome the presumptive recognition of a corporation for tax purposes if the corporation is organized for or in fact engages in substantial business activity.367 As described below, the standards for sustaining such a showing are de minimis.
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367 Moline Properties v. Comr., 319 U.S. 436 (1943); see also Nat Harrison Associates, Inc. v. Comr., 42 T.C. 601 (1964).

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In Bass v. Comr.,368 for example, the taxpayer, a U.S. citizen, established a Swiss corporation (“SwissCo”) and then sold it a 25% interest in certain oil and gas leases.  Although SwissCo earned significant revenues from the leases during the years following the sale, it claimed exemption from U.S. tax under the tax treaty then in effect between the United States and Switzerland.  The IRS sought to impute the income of SwissCo to the taxpayer, contending that the sole purpose of the entity was to avoid taxes.  The Tax Court rejected this argument, citing the general principle of Moline Properties and National Carbide Corp. v. Comr.369 that the tax laws will respect the separate existence of a corporate entity either formed for a substantial business purpose or engaged in substantial business activity.370
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368 50 T.C. 595 (1968).

369 336 U.S. 422 (1949).

370 50 T.C. at 600.

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In Ross Glove Company v. Comr.,371 the taxpayer, also a U.S. citizen, formed a Bahamian corporation(“BahamaCo”) to hold and operate a manufacturing facility in the Philippines.  BahamaCo manufactured gloves in the Philippines and sold them to Ross Glove Company, a U.S. corporation controlled by the taxpayer.  Although BahamaCo had acquired beneficial ownership of the property pursuant to a deed of trust, the taxpayer did not record the deed in the Bahamas, the Philippines or the United States. In the Philippines, local records and filings reflected the taxpayer, rather than BahamaCo, as the registered owner of the Philippine business and its related facilities.  As a foreign corporation not engaged in a U.S. trade or business, BahamaCo did not file a U.S. tax return. The IRS, however, sought to recast the entire Philippine operation as a sole proprietorship owned directly by the taxpayer and his wife. If treated as the direct owner of the Philippine business, the taxpayer would have borne full U.S. tax on the income of BahamaCo. The Tax Court rejected this theory on much the same grounds as in Bass.
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371 60 T.C. 569 (1973).

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From these and other cases, it is possible to distill the following general principles: First, an explicit shareholder purpose to avoid taxes by transferring or holding assets through a Blocker is not itself a sufficient basis for disregarding the Blocker entity.  In Bass, the Tax Court states that “the test .... is not the personal purpose of a taxpayer in creating a corporation.....[but] whether that purpose is intended to be accomplished through a corporation carrying out substantive business functions.”372 In Ross Glove, the Tax Court dismissed the personal tax motivation of the shareholder as “not a basis for ignoring what is otherwise a viable business entity.”373 In Nat Harrison, the Tax Court even goes so far as to cite shareholder tax avoidance as a valid business purpose for the formation of a corporation, so long as the corporation actually conducts business.374 Second, the status of the Blocker as a “dummy” subject to the unfettered direction and control of the shareholder is of no relevance whatsoever.  In Bass, the Tax Court conceded that the taxpayer directed the actual business activities and decision making of SwissCo “down to the minutest detail,” finding that this relationship nevertheless afforded no basis for disregarding SwissCo as a separate entity.375 In Ross Glove, the Tax Court even dismissed the failure of the taxpayer to disclose BahamaCo's beneficial ownership of the Philippine business to third parties, characterizing the taxpayer as a “nominee” of BahamaCo for Philippine reporting purposes.376 Third, and perhaps most critically, domicile has no bearing on the question of agency, even if a foreign domicile is essential to the shareholder's tax objectives. In both Bass and Ross Glove, the taxpayer would have achieved no deferral of U.S. tax had it operated the relevant businesses through domestic corporations.  In Siegel v. Comr., a case in which the IRS asserted both agency and § 269, the Tax Court stated that “the question before us is not to be clouded by the use of a foreign corporation, rather than a domestic corporation, to escape U.S. taxation, except as it may bear on the question of whether that corporation was in fact formed for a substantial business purpose or was engaged in substantive business activity.”377 Funds frequently employ foreign Blockers to avoid entity-level taxes on sources of income other than ECI.  Based upon the foregoing, therefore, a showing that the Blocker has legal title to the fund investment and otherwise possesses the necessary tax indicia of ownership should suffice to rebut any IRS challenge predicated upon an agency theory.  The requirement that the Blocker conduct “substantive business activity” should impose no further burden because the only “business” at issue is the holding of a fund investment, which the Blocker conducts in the same fashion as any other investor in the fund.378
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372 50 T.C. 595, 601 (1968).

373 60 T.C. 569, 588 (1973).

374 42 T.C. 601, 618 (1964).

375 Id.; see also National Carbide Corp. v. Comr., 336 U.S. 422, 433 (1949) (“undoubtedly, the great majority of corporations owned by sole stockholders are “dummies”in the sense that their policies and day-to-day activities are determined not as decisions of the corporation but by their owners acting individually.”).

376 60 T.C. 569, 592 (1973).

377 45 T.C. 566, 576 (1966). For a discussion of the facts of Siegel, see VII, D, 2, b, below.

378 The IRS has privately ruled on several occasions that a tax-exempt entity that invests through a blocker in an otherwise “tainted”investment does not realize UBTI. See, e.g., PLRs 200251016, 200251017, 200251018, 200315028, 200315032, 200315034, and 200315035.

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b. Section 269 

Weaker still is the theoretical basis for disregarding the Blocker under § 269. Section 269 authorizes the IRS to disallow any “deduction, credit or other allowance”if any person or persons acquire control of a corporation and “the principal purpose” of that acquisition is the evasion or avoidance of U.S. tax by securing the benefit of such deduction, credit or other allowance.379 For this purpose, § 269 defines “control”as the ownership of 50% of the vote or value of the stock of a corporation.380
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379 § 269(a).

380 § 269(a) (flush language).

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In many Blocker structures, the tax-exempt and foreign investors will invoke one or more of the garden variety defenses under  § 269.  First, the Blocker may serve sufficient non-tax objectives of the investors to negate the required finding of “principal purpose.” Second, the shareholder base of the Blocker may be sufficiently dispersed, either among similarly situated persons or otherwise, to avoid the threshold requirement that one or more persons acquire “control” of the Blocker entity.  Third, the Blocker structure may achieve only marginal savings to the shareholders, serving instead either to downstream the administrative requirement to file a U.S. tax return and/or to facilitate a later sale of stock of the Blocker entity.  As a separate corporation, the Blocker will always bear full corporate tax on its ECI or worldwide income, depending upon its domicile.  Although the shareholders avoid corporate level tax when they sell the Blocker shares, the portfolio company will retain its historic tax basis in the business.  In any event, § 269 affords no authority for the IRS to recast a sale of stock as a deemed sale of assets.

Even absent one of the typical defenses, however,  § 269 will not apply unless the remedial language of the statute authorizes the IRS to disregard the Blocker entity. On this issue, the classic hedge fund example is instructive:In a hedge fund, tax-exempt investors will often invest through an offshore corporation formed in a tax haven jurisdiction.  The purpose of the structure is to avoid § 514, which treats certain leveraged investments in stocks and securities as “debt-financed” property.  If a tax-exempt entity invests directly in a hedge fund, it may realize a portion of its gains as UBTI, assuming that the hedge fund borrows to fund investments.  If the entity instead invests in the hedge fund through a Blocker, the Blocker will earn the leveraged returns.  The Blocker will not bear U.S. tax, however, unless those returns represent ECI.  Because the trading safe harbor under § 864(b) subsumes most borrowing activities,381 the Blocker should avoid ECI on most hedge fund gains.  Moreover, when the Blocker distributes sales proceeds to its tax-exempt shareholders, the shareholders will report the distribution as tax-exempt under § 512(b). In summary, therefore, a Blocker structure will often allow a tax-exempt entity to avoid UBTI at no incremental tax cost.
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381 See Regs. § 1.864-2(c)(2)(i) (buying securities on margin and obtaining credit both subsumed under trading safe harbor).  For a discussion of the potential application of the various U.S. anti-deferral regimes to U.S. investors, see XI, below.

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Although the use of leverage at the fund level is less common in private equity funds, the hedge fund example is instructive because it represents the extreme use of a Blocker to avoid U.S. tax on a fund investment. So long as the taxpayer is able to establish the separate corporate existence of the Blocker and its tax ownership of the fund investment, § 269 provides no independent basis for taxing the income of the Blocker to its shareholders.  In Siegel v. Comr.,382 for example, the taxpayer, a resident of Florida, acquired a 20% interest in a Cuban joint venture to sell vegetable produce to third parties.  The taxpayer held its interest in the joint venture through a Panamanian corporation (“PanamaCo”). During the years in question, PanamaCo derived substantial profits from the joint venture, which it did not remit to the taxpayer.  Following termination of the joint venture, however, the taxpayer liquidated PanamaCo and reported the proceeds in excess of basis as long-term capital gain.383
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382 45 T.C. 566 (1966).

383 The years in question preceded the enactment of Subpart F and PFIC legislation, which would probably have precluded any significant deferral by the taxpayer.

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The IRS assessed deficiencies in tax for the years preceding the liquidation, contending that PanamaCo was a sham and, in the alternative, that § 269 applied to the taxpayer's acquisition of the Panamanian corporation.  In rejecting the § 269 argument, the court observed that the IRS had not disallowed any “deduction, credit or other allowance” claimed by the taxpayer, which the statute empowers it to do, but had instead “added to petitioner's reported income.”384 By its terms, therefore, § 269 did not apply.  Based upon Siegel,  § 269 provides no independent basis for imputing income earned by one entity to another entity, regardless of its particular tax effect.
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384 45 T.C. 566, 578 (1966).

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3. “Above-the-Fund” Blocker Structures 

If the fund does not participate in the Blocker structure, the tax-exempt or foreign investors may choose to contribute all or a portion of their fund investment to a Blocker (an “Above-the-Fund”Blocker).  The Above-the-Fund Blocker will assume direct liability for any U.S. taxes associated with the pass-through investment, as well as the attendant tax return filing obligations.  The typical domicile of an Above-the-Fund Blocker is a tax haven jurisdiction. By choosing a tax haven, the investors will avoid U.S. taxes on fund investments that do not give rise to ECI and, in the case of foreign investors, U.S. withholding taxes on distributions by the Blocker.385 The investors will avoid any income and withholding taxes at the local level.  In contrast, a domestic entity will attract full U.S. tax on all Blocker income, including the portion thereof that would have avoided U.S. tax if earned directly by the shareholders.386
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385 See IX, below.

386 § 11.

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One of the major infirmities of the Above-the-Fund Blocker structure is its lack of flexibility.  Because these entities reside above rather than below the fund, they fail to protect investors from corporate level tax in a sale. The reason is that the investor, as a mere shareholder of the Blocker, cannot dispose of its interest in the underlying portfolio company by selling the Blocker shares.  Dispositions instead occur at the fund level, with each Blocker receiving its allocable share of the proceeds.  When the fund sells its interest in the portfolio company, the Above-the-Fund Blocker will realize ECI on its allocable share of the gain.387 Although the fund may extract a sales premium for the resulting basis step-up in the portfolio company assets, the Blocker shareholders will still receive less on an after-tax basis than they would have realized in an otherwise exempt sale of corporate stock.
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387 See VII, A, 1, above.

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The specter of the “branch profits” tax only compounds the tax inefficiency of these structures.  A sale of a pass-through investment generates not only ECI to the Above-the-Fund Blocker, but a reduction in “U.S. net equity” under § 884.  This reduction will attract branch profits tax unless the Above-the-Fund Blocker “terminates”its U.S. trade or business activities immediately after the sale.388 If the Above-the-Fund Blocker holds the entire fund investment, however, the U.S. trade or business activities of other pass-through investees will “tier up” to the Above-the-Fund Blocker under § 875. A sale of a single investment by the fund, therefore, may not terminate the U.S. trade or business activities of the Above-the-Fund Blocker in the year of sale.389 Without treaty relief, the Above-the-Fund Blocker will bear a combined rate of tax on the gain of up to 54.5%, excluding state and local income taxes.
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388 Regs.  § 1.884-2T(a)(2).

389 See Regs.  § 1.884-2T(a)(2); see VII, B, 2, above.

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To solve this problem, some sponsors permit their tax-exempt or foreign investors to “balkanize” their capital commitments among multiple Above-the-Fund Blockers.  This alternative has two advantages. First, it allows the investors to dispense with the Blocker entity for any capital allocable to a “corporate” portfolio investment. Second, it allows them to avoid the branch profits tax in a sale by assigning each pass-through investment to a separate entity.  So long as each entity holds no other assets, the sale will “terminate”its U.S. trade or business when the fund disposes of the underlying pass-through investment.

In funds that permit this approach, however, the IRS may seek to impose the branch profits tax under a “constructive partnership”theory.  In virtually every fund, the investors recover prior losses from subsequent gains before the carry participates.  The returns to any single Blocker, therefore, will depend upon whether the affiliated Blockers have unrecovered losses on prior dispositions.  The right of each Blocker to participate in gains on a specific investment therefore depends upon whether the gains must reimburse prior losses of another Blocker owned by the same investor.  If this sharing of gains and losses is a “partnership” for tax purposes, a sale of a single investment by the fund may not “terminate” the U.S. trade or business activities of the Above-the-Fund Blocker.390
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390 For an excellent article on the potential recharacterization of various economic arrangements as constructive partnerships, see Brannan, “Recent Developments in the Law on Constructive Partnerships (and Constructive Non-Partnerships),”Tax Club (April 11, 2006).

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A final problem with these structures is unique to the foreign investor:Depending upon its home jurisdiction, the foreign investor may bear a higher rate of non-U.S. tax on the receipt of sales proceeds in the form of a dividend or liquidating distribution from an Above-the-Fund Blocker than on the receipt of a direct distribution of sales proceeds from the fund.  Accordingly, it must weigh that additional cost against any U.S. tax savings of the Blocker structure.

Tax-exempt investors generally avoid foreign taxes by holding their interest in the fund through an Above-the-Fund Blocker domiciled in a tax haven jurisdiction.

4. “Below-the-Fund”Blocker Structures 

In funds with significant tax-exempt or foreign capital, the general partner usually agrees to exercise “reasonable best efforts”to avoid UBTI or ECI,391 coupled with a flat prohibition on pass-through investments. The practical effect of these restrictions is to compel the fund to invest in pass-through entities through a corporate Blocker (a “Below-the-Fund”Blocker) or, less frequently, to invest in pass-through entities through a parallel vehicle.392 As described below, Below-the-Fund Blocker structures provide much more flexibility to the fund, avoiding many of the problems endemic to Above-the-Fund Blocker structures.
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391 If the fund is an FOF, the investors may prohibit the general partner from investing in subfunds that invest in pass-through entities.

392 For a discussion of Parallel Blocker structures, see VII, D, 6, below.

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In its simplest incarnation, the fund assigns the entire investment to a Below-the-Fund Blocker.  The portfolio company itself remains a pass-through entity, allowing the other equity holders to avoid the inefficiencies of the Blocker structure.  In a sale, the direct equity holders therefore preserve the ability to convey a basis step-up without incurring two levels of tax, allowing them to capture a potential sales premium from the buyer.393 If the entity goes public, of course, the parties must incorporate the business before the IPO.  Here, the fund must ensure that the incorporation either eliminates the Blocker entity or uses the Blocker itself as the public vehicle.  If, for example, the holders incorporate the portfolio company, the public vehicle will issue stock to the Below-the-Fund Blocker rather than its shareholder, with potentially disastrous consequences to the fund. In most cases, the fund and the other holders will avoid this problem by forming a holding company as the public vehicle, exchanging the stock of the Below-the-Fund Blocker and the direct equity interests for newly issued stock of the holding company.394 The receipt of stock in the holding company should qualify as a tax-free exchange under § 351.395
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393 See § § 754, 743.  On occasion, the fund will insist that the direct equity holders share any premium tied to the value of the basis step-up in a sale.  By participating in these premiums, is the fund engaged in a constructive partnership for tax purposes, exposing its foreign investors to ECI? See Rev. Rul. 91-32, 1991-1 C.B. 107.  Given that the fund shares only in gains on disposition and does not share in losses at all, the arrangement is probably more akin to the grant of a put option on the Blocker shares.

394 If the direct equity holders merely contribute their interests to the Subsidiary Blocker, they will incur an immediate tax unless they, together with any other transferors, “control” the Subsidiary Blocker immediately after the exchange.  See § § 351, 368(c).

395 If the portfolio company has aggregate losses that exceed the aggregate equity contributions at the time of incorporation, the equity holders may recognize gain in the exchange to the extent of the excess losses.  See § 357(c) (liabilities in excess of basis).  This type of “boot,” however, merely reverses a favorable timing difference to the holders.

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More efficient, however, is for the fund to invest only the tax-exempt and foreign capital through the Below-the-Fund Blocker.  This variation on the structure requires the formation of two entities rather than one: a Below-the-Fund Blocker, which is a wholly owned subsidiary of the fund, and a pass-through entity as a jointly owned subsidiary of the fund and the Below-the-Fund Blocker (the “SPV”). The fund contributes the tax-exempt and foreign capital to the Below-the-Fund Blocker and the capital of the other investors to the SPV.  The Below-the-Fund Blocker then downstreams its capital to the SPV, leaving the SPV with the full capital commitment of the investors.  Finally, the SPV uses the proceeds to acquire either newly issued equity from the portfolio company or outstanding equity from the selling members.  Thus, although the fund holds two separate investments, it invests in the portfolio company through a single entity.  The general partner participates in the investment through the SPV and not through the Below-the-Fund Blocker.

Worksheet 11 provides a diagram of a typical Below-the-Fund Blocker structure.

If the SPV sells the portfolio investment, it will first distribute the tax-exempt and foreign investors’ share of the proceeds to the Below-the-Fund Blocker.  The Below-the-Fund Blocker will then liquidate, distributing the after-tax proceeds to the fund for further distribution to these investors.  The SPV will distribute the remaining proceeds to the fund for further distribution to the general partner and other investors.  More likely, however, the fund will not structure the transaction as a sale by the SPV of the portfolio investment. Instead, the fund will “bifurcate” the sale, avoiding the burden of corporate level tax to the tax-exempt and foreign investors without prejudicing the other investors or the general partner.  In a bifurcated sale, the SPV liquidates, distributing the equity interests in the portfolio company to each of the Below-the-Fund Blocker and the fund.396 Immediately after the liquidation, the fund sells the shares of the Below-the-Fund Blocker and the direct equity interests in the portfolio company to the buyer.  In both cases, the general partner realizes its carry through a direct sale of equity in the portfolio company, allowing it to bypass the corporate level tax on the tax-exempt and foreign capital.  See Worksheet 11.
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396 The liquidation of the SPV should qualify as a tax-free transaction under § 731.

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Tax-exempt and foreign investors tend to prefer a bifurcated structure because it avoids U.S. tax in a sale.397 Without adequate covenant protection in the fund agreement, however, they cannot be assured of avoiding this liability because the fund may simply force the SPV to sell its direct investment.  The investors would have no recourse to the general partner in such a case, who promised only to avoid UBTI and ECI, because the Below-the-Fund Blocker would bear the corporate-level tax rather than the tax-exempt and foreign investors.
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397 See § 512(b) (tax-exempt investors); § 871(a)(2); Regs. § 1.1441-2(b)(2)(i) (gains derived from sale of property not “fixed or determinable,”subject to certain exceptions).

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Comment: Investors seeking to ensure a tax-efficient exit should compel the general partner not only to use “reasonable best efforts” to avoid UBTI and ECI, but to structure any sale of the underlying business as a disposition of the shares of the Below-the-Fund Blocker.398
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398 Because a buyer may be reluctant to acquire a legal entity with unknown liabilities, it may insist upon an indemnity from the fund or its investors.

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In a bifurcated structure, the other investors derive the same benefit of pass-through ownership as the direct members of the portfolio company in the generic Below-the-Fund Blocker structure.  Similarly, the general partner bears none of the tax inefficiency of the Blocker structure. As a member of the fund, it recognizes capital gain on its carried interest whether the SPV sells the entire equity investment in the portfolio company or instead liquidates immediately before a sale of the equity investment by the fund.399
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399 See  § 741; but see § 751 (gain on sale of partnership interest attributable to “hot assets” recharacterized as ordinary income).

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But what if the fund requires the general partner to refund the carry distribution at a later date? Assume, for example, that the fund realizes losses on subsequent investments, requiring the general partner to recontribute all or a portion of its carry distributions to the fund pursuant to its clawback obligation.  Under the Arrowsmith doctrine,400 do the tax-exempt or foreign investors realize UBTI or ECI upon receipt of the clawback? Not unless the proceeds of the clawback represent gains realized on the sale of the pass-through entity that would have been treated as UBTI or ECI if allocated to the tax-exempt or foreign investors.  But that characterization betrays a basic misunderstanding of the clawback.  The clawback is not, in substance, an obligation to refund earlier distributions.  It is merely an agreement by the general partner to bear losses on remaining investments until the fund has fully reimbursed the funded capital commitments of the investors.  The allocation of these losses to the general partner creates a negative capital account, which the general partner restores to the fund in retirement of the clawback obligation.  So long as these losses do not arise from equity investments in pass-through entities, they should not create UBTI or ECI to the tax-exempt or foreign investors.401
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400 Arrowsmith v. Comr., 344 U.S. 6 (1952) (taxpayer who returned portion of proceeds from sale of stock previously reported as capital gain required to treat payment as capital loss).  The “Arrowsmith doctrine” stands more generally for the proposition that if subsequent and earlier events are integrally related, they share the same tax character. The doctrine is most commonly invoked to establish the nature of an expense as capital or ordinary.

401 In fact, the receipt of the clawback often has no income tax consequence to the other investors.  If paid to the fund upon liquidation, the clawback will usually generate a capital loss to the general partner and a distribution to the other investors that does not exceed their tax basis.

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If the fund agreement does authorize the fund manager to implement a “bifurcated” Below-the-Fund Blocker structure, the practitioner should draft the profit and loss allocations to reflect the economic consequences of Blocker ownership to each class of investor.  For example, if the SPV sells the entire fund investment, the fund should allocate a portion of the aggregate gain equal to the sum of the carry and non-Blocker percentages to the fund and the remainder to the Below-the-Fund Blocker.402 The fund should then allocate 100% of any gains realized upon liquidation of the Below-the-Fund Blocker to the tax-exempt and foreign investors and 100% of any gains allocated to it by the SPV to the general partner and other investors, with the general partner receiving a portion of that allocation equal to its full carry percentage. Alternatively, if the fund “bifurcates” the sale to avoid corporate level tax to the Below-the-Fund Blocker, it should allocate all gains attributable to the disposition of the shares of the Below-the-Fund Blocker to the tax-exempt and foreign investors.
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402 These allocations assume that the investors do not have unrecovered losses on prior investments, which may reduce or even eliminate the carry distribution.

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The IRS should respect these allocations.  First, each of the allocations described above corresponds to each investors’ special rights to distributions of proceeds from the SPV and Below-the-Fund Blocker entities.  Accordingly, they have “economic effect.” The economic effect of these allocations should also satisfy the “substantiality”requirement.  “Substantiality” requires a reasonable possibility that the allocation will affect substantially the dollar amounts to be received by the fund investors on a pre-tax basis.403 Whether the fund causes the SPV to sell the entire equity interest in the portfolio company or liquidates the SPV and sells the shares of the Below-the-Fund Blocker, the investors who do not invest through the Blocker should receive more per equity unit than the investors who do.  In the first case, the tax-exempt and foreign investors will receive only the after-tax proceeds of their equity investment.  In the second case, the buyer will pay less for an interest in a portfolio company that resides below a Blocker than it would pay for a direct interest, either because it must forgo a basis step-up in the portfolio company assets or because it will discount the purchase price to reflect the costs associated with assuming unknown Blocker liabilities.  Even then, the allocation is not substantial under the regulations, if (i) it increases the after-tax economic consequences to at least one investor in present value terms relative to the consequences without the allocation; and(ii) a “strong likelihood” exists that the after-tax consequences to no other investor will be “substantially diminished”in present value terms.404 The purpose of this aspect of the substantiality test is to disregard allocations that do not alter the sharing of benefits and burdens among the partners on a present value basis, without regard to their effect in any particular year.  Described by one commentator as the “no losers” rule,405 it should not be construed to override allocations of profit and loss on investments in different entities, in particular if those investments yield different expected returns. Although the special tax attributes of tax-exempt and foreign investors do influence these structures, the stated allocations of profit and loss give full economic effect to the imbedded costs of these structures to the various classes of investors.  Moreover, the structures themselves merely duplicate the tax consequences of direct investment by the tax-exempt and foreign investors outside of the fund.
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403 Regs.  § 1.704-1(b)(2)(iii)(a).

404 Id.

405 See Leder and Richard, “Tax-Driven Partnership Allocations with Economic Effect: The Overall After-Tax Present Value Test for Substantiality and other Considerations,”54 Tax Law. 753, 754 (Summer 2001); see also McKee, Nelson, and Whitmire, Federal Taxation of Partnerships and Partners, ¶  10.02[2][b][iv] (3d ed. 1997).

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5. Pre-Sale Incorporation of Portfolio Company 

The principal objective of many tax-exempt and foreign investors who seek to avoid UBTI or ECI is to minimize their substantive tax liability, most of which is incurred when the fund sells the investment.  Tax-exempt or foreign investors with no institutional aversion to filing a U.S. tax return, therefore, may accept a covenant from the general partner that the fund will incorporate its pass-through investments before a sale in lieu of a covenant to hold all such investments through Blockers.  During the intervening period, the portfolio company may generate operating losses, producing no tax liability to the tax-exempt or foreign investors and possible tax benefits to the other fund investors and direct equity holders.  Even if the business is profitable, the aggregate tax liability of the investors will usually approximate the entity-level taxes otherwise payable by a corporate portfolio company.  In an IPO, of course, the fund will have to incorporate the entity before the offering.  The incorporation should qualify as a tax-free transaction under  § 351,406 subject to potential branch profits tax to the foreign corporate investors under § 884.
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406 But see § 357(c) (liabilities in excess of basis).  Pass-through entities usually incorporate in one of three ways: First, they may contribute their assets to a corporation in exchange for stock and then distribute the stock to the fund and the other members in liquidation.  Second, they may distribute their assets in liquidation to the fund and the other members, who then contribute the assets to a corporation in exchange for stock.  Third, their members may contribute their equity interests in the entity to a corporation in exchange for stock.  The tax consequences to the parties in each instance should follow the chosen form.  Rev. Rul. 84-111, 1984-2 C.B. 88.  In limited cases, however, the chosen form may yield different tax consequences to the parties under § 351.  For example, if the portfolio company members have a high outside basis and receive both cash and stock in the corporation, the third method could reduce the portion of the cash characterized as “boot” to the members.  Alternatively, the second method could trigger gain to members who receive cash in excess of their basis in the portfolio company even if they contribute the cash and other assets to the corporation solely in exchange for stock.  See § 731(a).

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If the incorporation precedes a sale, however, the incorporation will avoid UBTI or ECI only if it qualifies as a tax-free transaction under § 351.  If it does, then the fund may usually sell the newly issued stock without recognizing UBTI or ECI.  If it does not, the IRS will treat the fund as having transferred the portfolio company to the newly incorporated entity in a taxable sale.407 Whether the pre-sale incorporation of the portfolio company will qualify under § 351 will depend upon whether the fund and the other equity holders satisfy the “control”requirement of  § 368(c). As described below, however, that determination is subject to the vagaries of the “step transaction” doctrine.
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407 The IRS has ruled that a transfer of assets to a corporation in exchange for 100% of the stock will not qualify as a tax-free contribution under § 351 if, at the time of such transfer, the transferor has a binding obligation to sell more than 20% of the stock to a third party. In such a case, the transfer is a sale of the contributed assets to the corporation for federal income tax purposes. See, e.g., Rev. Rul. 79-194, 1979-1 C.B. 145; see also Hazeltine Corp. v. Comr., 89 F.2d 513 (3d Cir. 1937); Intermountain Lumber Co. v. Comr., 65 T.C. 1025 (1976).

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A leading authority on the application of this doctrine in the context of § 351 is Rev. Rul. 70-140.408 In this ruling, a taxpayer transferred assets to a wholly owned corporation in a putative § 351 transaction, followed by a transfer of the newly issued stock to the buyer in a ‘B’reorganization.  The two transfers occurred “pursuant to an agreement” between the taxpayer and the buyer.  The IRS concluded that the two transfers occurred as part of a prearranged plan pursuant to which the taxpayer transferred assets to a corporation merely to facilitate the subsequent transfer to the buyer in a tax-free transaction. Because it was “transitory and without substance,” the incorporation failed the “control” requirement of § 368(c).
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408 1970-1 C.B. 73.

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A major failing of this ruling, however, is that the IRS does not state which facts were essential to its conclusion.  Most critically, it does not state whether the prior “agreement” to transfer the stock was itself dispositive.  Instead, the ruling speaks more broadly of a “prearranged integrated plan” and of tax-avoidance motives.  Still, it is tempting to seize upon the reference to the agreement as an implicit check on the step transaction doctrine as applied to § 351 transactions.409 At least one commentator has expressed this view, citing the ruling for the proposition that the step transaction question depends upon whether the taxpayer is “contractually committed” to sell the stock at the time of the asset transfer.410 Others, however, cite the ruling as endorsing the far broader “end result” test.411 So construed, the ruling would seem to imperil just about any transaction in which a further step is contemplated.412
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409 The step transaction doctrine has three formulations. First, the IRS may collapse multiple steps into a single transaction only if the taxpayer has a binding commitment before an earlier step to complete the later ones (the “binding contract” test). Second, the IRS may collapse multiple steps if the steps are deemed so interdependent that the preceding steps lack a business purpose or “economic substance” on their own and therefore would have been fruitless without the subsequent steps (the “mutual interdependence” test).  Third and most broadly, the IRS may collapse multiple steps if the taxpayer intended each step as part of a single transaction aimed at a single result (the “end result”test).  See, e.g., McDonald's Restaurants of Ill. v. Comr., 688 F.2d 520 (7th Cir. 1982); Weikel v. Comr., T.C. Memo 1986-58;Kahn and Lehman, Corporate Income Taxation, § 7.4(4th ed. 1994).

410 770 T.M., Structuring Corporate Acquisitions — Tax Aspects; Cf. 771 T.M., Corporate Acquisitions — (A), (B), and (C) Reorganizations (Rev. Rul. 70-140 cited for principle that “preexisting commitment” to dispose of stock acquired in § 351 transfer will invalidate transaction; unclear whether authors would construe ruling more broadly on appropriate facts); Bittker and Eustice, Federal Income Taxation of Corporations and Shareholders (6th ed. 1994), at ¶  3.09[2], n. 171 (cited as ruling “of like import”with case in which attempted § 351 transfer was invalidated because transferors had “agree[d] beforehand”that they would transfer enough stock to lose control), ¶  3.14[4], n. 295 (called “an elaborate variation on the facts” of another ruling wherein § 351 transfer was invalidated because transferee corporation “was organized merely for the purpose” of enabling the taxpayer to avoid recognition of gain), ¶  3.17[6], n. 335, (cited as illustration of rule that purported  § 351 transfer may be disregarded if done “with no purpose other than”to facilitate a ‘B’ reorganization).

411 Kahn and Lehman, Corporate Income Taxation (4th ed. 1994), at § 7.4, Ex(5) and n. 39.  The authors offer no explanation of what exactly Rev. Rul. 70-140 means other than to quote the ruling's own language that the two steps “were part of a prearranged integrated plan” in which the first step was undertaken “for the purpose of enabling” the second.

412 But see Rev. Rul. 2003-51, 2003-21 I.R.B. 938. In this ruling, W transferred assets to a newly formed corporation (the “first corporation”) in exchange for 100% of the stock and then transferred the stock to another corporation(the “second corporation”) simultaneously with the transfer of assets to the second corporation by its other shareholder. The IRS ruled that the transfer by W to the first corporation qualified under  §  351 even though the second transfer occurred pursuant to a prearranged agreement in which W lost “control” of the first corporation. The IRS distinguished Rev. Rul. 70-140 on the basis that “no alternative form of transaction that would have qualified for nonrecognition treatment” was available to the taxpayer in Rev. Rul. 70-140.

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In Weikel v. Comr.,413 the Tax Court only added to the confusion. There, the taxpayers had incorporated a business and then exchanged the stock of the newly formed corporation for stock of Johnson & Johnson, again in a purported ‘B’ reorganization.  The Tax Court declined to apply the step transaction doctrine, choosing instead to distinguish Rev. Rul. 70-140 on factual grounds.  First, while the taxpayer and the buyer had “an agreement” in the ruling, the taxpayer in Weikel incorporated the business during contract negotiations and before execution of a definitive document. Any agreement between Johnson &  Johnson and the taxpayer was “uncertain”or at best “tentative” at the time of incorporation. Second, the taxpayer had “independent valid business purposes for incorporating” the business, which allowed Johnson & Johnson to report the acquisition as a “pooling” for accounting purposes and allowed the taxpayer to obtain the tax benefits of operating in corporate form.  This, we are told, imbued the incorporation with economic substance wholly apart from the later exchange of stock. Finally, the newly formed corporation engaged in business for nearly three years following the reorganization as a separate entity, belying the IRS's claim of conduit.
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413 T.C. Memo 1986-58.

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As a strictly logical matter, the Tax Court's effort to distinguish the ruling is unconvincing.  First, the Tax Court seeks to differentiate the nature of the two agreements, even though it knew only that an agreement in Rev. Rul. 70-140 existed.  Second, the Tax Court cites the continuous operation of the business in corporate form after the reorganization as evidence that the incorporation was real, even though Rev. Rul. 70-140 does not state whether the acquiring entity liquidated the target corporation after the purported ‘B’ reorganization.  Given that a typical corporate buyer would file a single tax return whether it liquidates the target or treats it as an “includible corporation”in its consolidated group, it is not clear why the court would assign any significance to this factor anyway.

How then does one reconcile Rev. Rul. 70-140 with Weikel? The author's interpretation is that Weikel endorses a pre-sale incorporation of a portfolio company that serves an independent business purpose unrelated to a later sale even if it occurs after the parties commence negotiations to sell the business, provided that the agreement is not definitive at that time.  The facts of Rev. Rul. 70-140 are said to have failed this test because the acquired corporation served “solely as a conduit” for the transfer of the assets on a tax-free basis.414 This interpretation is also consistent with the Tax Court's earlier decision in Intermountain Lumber Co. v. Comr.,415 which involved a sale of 50% of the stock of a newly incorporated entity by the transferor pursuant to a binding obligation. In dicta, the Tax Court stated that, absent a binding obligation, “it is immaterial how soon thereafter the transferee elects to dispose of stock or whether such disposition is in accord with a preconceived plan.”416
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414 GCM 37274 (Sept. 28, 1977); see also GCM 37540 (May 18, 1978)(identical phrase); GCM 39053 (Nov. 7, 1983) (identical phrase); PLR 9137003 (identical phrase); GCM 37443 (Mar. 6, 1978) (threshold transfer “undertaken solely to avoid tax”on disposition of assets).

415 65 T.C. 1025 (1976).

416 65 T.C. 1025, 1031-32.

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Note: A cautious seller may also insist upon a covenant from the buyer to maintain the corporate existence of the entity, given the Tax Court's lip service to these facts in the decision.

A final issue to consider in evaluating the pre-sale incorporation approach is the branch profits tax. Section 884 imposes second level withholding tax on foreign corporations engaged in business in the United States.  The base for the tax is the “dividend equivalent amount” (“DEA”)of the entity, which is the foreign corporation's “effectively connected earnings and profits” for the year, reduced by any increase in “U.S. net equity” and increased by any decrease in U.S. net equity, in each case subject to certain adjustments and limitations.417 The statute defines “U.S. net equity” as the excess, if any, of the assets over liabilities of the U.S. trade or business.418 As a general matter, therefore, neither the reinvestment of earnings in the business nor the use of such earnings to retire debt of the business will attract branch profits tax.  If a foreign corporate investor engaged in business through a pass-through entity incorporates the entity before a sale or public offering, however, the incorporation may give rise to a DEA because the stock of the newly formed entity will not qualify as an “asset” used in the investor's U.S. trade or business.  The incorporation of the business therefore reduces U.S. assets, which in turn reduces U.S. net equity and increases the DEA.419
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417 See  § 884(b).

418 See § 884(c).

419 See  § 884(b)(2).

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The fund and its foreign investors will avoid branch profits tax if the U.S. business has no “effectively connected” earnings and profits on the date of incorporation, or at least no such earnings in excess of prior DEA inclusions.420 Thus, if the portfolio company has historic operating losses before the sale, the fund may incorporate the business without tax consequence even if the investment itself has appreciated. The fund will also avoid branch profits tax if the increase in the DEA occurs as part of a qualifying termination of the U.S. trade or business of the foreign corporate investor.421 As described earlier in this portfolio, however, this exception will apply only if the foreign corporate investor has no U.S. assets as of the close of the taxable year and generates no ECI for the three year period thereafter.422 Finally, § 884(g) grants regulatory authority to the IRS to reduce the DEA in connection with a transfer of U.S. assets to a controlled corporation in a transaction that otherwise qualifies under § 351.  Under the regulations, however, a foreign corporate investor avoids immediate tax only if it agrees to pay the tax so avoided upon a subsequent disposition of the corporate stock.423 Moreover, this relief is only available if the foreign corporate investor satisfies the “control”requirement under § 368(c) without regard to the percentage of stock acquired by any other transferors.424 For all intents and purposes, therefore, the exception is unavailable to fund investors.425
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420 See § 884(b)(2)(B).

421 Regs. § 1.884-2T(a)(1).

422 Regs. § 1.884-2T(a)(2)(i). For a discussion of the exception to the branch profits tax for deemed terminations, see VII, B, 2, above.

423 See Regs. § 1.884-2T(d)(5).

424 Regs.  § 1.884-2T(d)(1).

425 If the incorporation immediately precedes a sale of the corporate stock, of course, the exception would provide no tax benefit to the foreign investor even if it otherwise applied.

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6. Parallel Blocker Structures 

a. In General 

While more common in hedge funds, many private equity funds employ parallel structures to avoid or minimize the pass-through of UBTI and ECI to their tax-exempt and foreign investors.426 In funds that employ parallel structures, the fund manager will form a separate and distinct vehicle for these investors.  The parallel vehicle may invest directly in the fund as a “feeder” holding company or “side-by-side”with the fund as a coinvestor in each of the portfolio companies.
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426 Before 1997, parallel fund structures in this sector were pervasive, but for an entirely different reason. At that time, the “feeder” entity was required to maintain its “principal office” offshore to comply with the § 864(b)(2) trading safe harbor. In 1997, Congress amended §  864(b)(2) to eliminate the “principal office”requirement. See P.L. 105-34, §  1162(a).

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Funds usually adopt these structures with one of two strategies in mind. First, the fund manager may form the parallel fund to facilitate the grant of a special “opt out” right to the investors for any portfolio investment that is likely to generate UBTI or ECI. In an “opt out” vehicle, therefore, the tax-exempt and foreign investors will commit to fund their entire investment in the fund through the parallel entity, but will not commit to participate in every portfolio investment of the fund. If and when an investor opts out at any stage of the investment period, the general partner will call the additional capital from the other investors on a pro rata basis. Second, the fund manager may form a “blocker”underneath the parallel vehicle (a “Parallel Blocker”)as a special funding vehicle for any investment in an operating partnership. With Parallel Blocker vehicles, therefore, the tax-exempt and foreign investors have no opt out right at all. Instead, the parent entity funds the ECI investment through the Parallel Blocker and the Parallel Blocker bears the direct U.S. tax and filing obligations.427
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427 The sponsor will usually form the two entities in a jurisdiction that imposes no entity-level or withholding taxes (e.g., Bermuda). The parent entity will elect to be taxed as a foreign partnership and the subsidiary entity will elect to be taxed as a foreign corporation.

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Worksheet 2 provides a diagram of a typical Parallel Blocker structure. Worksheet 12 provides an example of a provision authorizing the general partner to implement such a structure.

Parallel Blocker structures suffer from the same infirmities as Blocker structures that reside above the fund.428 First, if the Parallel Blocker holds multiple ECI investments, its shareholders cannot dispose of any single ECI investment by disposing of the Blocker shares, which would otherwise avoid U.S. tax entirely.429 Second, the direct sale of a single ECI investment by the blocker will attract both corporate and branch profits tax because the retained investments of the blocker will disqualify the subsequent dividend distribution to the parallel vehicle from “termination”relief under §  884.430
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428 For a discussion of “Above-the-Fund”blocker structures, see VII, D, 3, above.

429 Foreign investors bear no U.S. tax on capital gain from the sale of stock in a domestic corporation unless §  897 (FIRPTA)applies. See §  871(a)(2); Regs. §  1.1441-2(b)(2)(i) (gains derived from sale of property not “fixed or determinable,”subject to certain exceptions).

430 For a discussion of the “complete termination” exception to the branch profits tax, see VII, D, 3, above.

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In a related infirmity, the objective of the fund manager to isolate 100% of the ECI within the blocker entity will be frustrated if the economic aggregation of gains and losses under the fund agreement creates a “constructive” partnership between the parallel and blocker entities.431 For example, assume that the parallel vehicle realizes a loss on a non-ECI investment and that the blocker subsidiary then realizes a gain on an ECI investment. Under these conditions, the distribution provisions of the fund agreement may require the fund to distribute a portion of the sales proceeds from the ECI investment to the parallel vehicle in reimbursement of its prior loss on the non-ECI investment before it makes any distribution to the blocker or general partner. If this contingent participation of the parallel vehicle in the separate investments of the blocker is tantamount to a partnership for U.S. tax purposes,432 then the foreign investors in the parallel vehicle will be deemed to be engaged in the U.S. trade or business of the underlying portfolio company.433
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431 For a fuller explanation of the “aggregate” nature of the carried interest in most funds, see III, B, above.

432 For an excellent article on the potential recharacterization of various economic arrangements as constructive partnerships, see Brannan, “Recent Developments in the Law on Constructive Partnerships (and Constructive Non-Partnerships),”Tax Club (April 11, 2006).

433 See §  875.

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Finally, if the parallel vehicle coinvests with the fund in each portfolio company, it will likely grant a separate carried interest to the general partner to reflect its right to a percentage of the future gains derived by the parallel vehicle. Unlike the main fund, however, the blocker subsidiary of the parallel vehicle will bear entity-level tax on the sale of its ECI investments, reducing the after-tax proceeds available for distribution to the parallel vehicle.434 The general partner may therefore insist upon a “gross up” for the portion of any reduced carry distribution directly attributable to the entity-level taxes imposed at the blocker level. As an alternative, however, the general partner may propose to circumvent this additional tax by interposing an intermediate partnership (“SPV”)between the blocker and each ECI investment.435 By interposing an SPV, the parallel vehicle may now grant the carried interest to the general partner at the SPV level. Because the later sale of the ECI investment will also occur at the SPV level, the SPV may allocate the general partner's 20% share of the gain away from the blocker member to avoid the corporate level tax.436
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434 The after-tax proceeds available for distribution to the parallel vehicle will be reduced because the blocker subsidiary must retain sufficient cash from the sale to pay the corporate level tax.

435 This structure is identical to the “SPV” structure described in VII, D, 4, above.

436 Id.

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Worksheet 13 provides an example of a provision in a fund agreement that would “gross up” the general partner for any reduction in carry distributions attributable to the use of a blocker.

b. The “Series”LLC or “Cell Company” Alternative 

To address at least some the foregoing concerns, the fund manager may opt for a “series” LLC or “cell” entity as the funding vehicle. Under this approach, the fund manager will form two entities, the first a partnership and the second a wholly-owned series LLC or cell subsidiary (a “Series Blocker”) of the partnership. The Series Blocker will then fund all investments on behalf of the tax-exempt and foreign investors without regard to the status of a particular portfolio company as a corporation or a partnership for tax purposes, issuing a separate series or class of equity to the parent to reflect each investment.

Although the IRS has yet to issue definitive guidance on this question, each “series” or “cell”of the Series Blocker should qualify as a separate entity for U.S. tax purposes.437 Accordingly, each series or cell should remain free to elect its own status as either a partnership or a corporation without regard to the separate elections of any other series or cell of the Series Blocker. For portfolio investments in corporations, the parent will elect to treat the corresponding class of equity in the Series Blocker as a partnership interest. For portfolio investments in partnerships, the parent will elect to treat the corresponding class of equity as stock.
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437 See PLR 200803004 (each separate “series”of series LLC is entitled to choose its own entity classification independent of classification of other series); Rev. Rul. 2008-8, 2008-5 I.R.B. 340 (when income, expense, assets, liabilities and capital of each cell in cell insurance company are accounted for separately for each cell and X owns all stock of single cell, purported insurance arrangement is “akin to” arrangement between parent and wholly owned subsidiary and therefore does not qualify as “insurance”in the absence of third party risk transfer); Notice 2008-19, 2008-5 I.R.B. 366; NYSBA Tax Section, “Notice 2008-19 and Protected Cell Companies Outside of the Insurance Arena,” (May 2, 2008), available at http://www.nysba.org/AM/Template.cfm?Section=Tax_Section_Reports_2008& Template=/TaggedPage/TaggedPageDisplay.cfm& TPLID=29& ContentID=12619.

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In a Series Blocker structure, therefore, the identity of the future seller will depend upon the current tax status of the underlying portfolio company on the date of investment. If the portfolio company is a corporation, the Series Blocker will exit the investment by selling the stock of the portfolio company. If the portfolio company is a partnership, the parent entity will exit the investment by selling the corresponding class of equity of the Series Blocker. Having sold “stock” in either case, the tax-exempt and foreign investors in the parent entity should avoid both corporate level tax and branch profits tax even though the Series Blocker will have funded every investment and will hold the entire portfolio of the fund.438
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438 Foreign investors bear no U.S. tax on capital gain from the sale of stock in a domestic corporation unless §  897 (FIRPTA) applies. See §  871(a)(2); Regs. §  1.1441-2(b)(2)(i) (gains derived from sale of property not “fixed or determinable,”subject to certain exceptions).

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Worksheet 14 provides a diagram of a Series Blocker structure.

7. “Capital Shift”on Certain Preferred Investments 

As described in IX, B, 6, below, some funds demand a fixed multiple on their investment in a sale, for example a right to receive a minimum of three times their cash investment in any sale or other liquidity event.  If the investment in question is corporate stock, the right should not implicate § 305.439 But what if the investment is a partnership interest? A partner that acquires a newly issued partnership interest for cash in an arm's length transaction ordinarily has an opening capital account balance equal to the cash investment, which presumptively represents the fair market value of the interest.  But if the specific investment entitles the fund (or a Blocker intermediary) to a sales multiple, does an opening capital account equal to the cash investment accurately reflect the partner's share of the business? Partnerships usually adjust the capital account balances of the existing partners immediately before they admit a new partner to reflect the amount that each partner would receive in a hypothetical sale of the partnership assets.440 Under that assumption, therefore, the existing partners would receive less in a sale immediately before the fund investment than immediately after the fund investment. Should the opening capital account balance of the fund therefore exceed its cash investment? If so, is that “capital shift” a taxable event to the fund? To the other partners?
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439 See IX, B, 6, below.

440 See Regs. § 1.704-1(b)(2)(iv)(f).

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Most practitioners would probably advise that it is not, based upon a fundamental principle of taxation that a buyer of an asset in an arm's length transaction should not realize income.  The technical analysis in support of this conclusion is elusive, however, in part because subchapter K provides no clearly defined rules for taxing “capital shifts,” at least in the non-service context.441 Of some significance is that the partners have not experienced any form of a realization event, but rather an adjustment to capital account balances to reflect an effort to comply with the  § 704(b) regulations.
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441 On January 22, 2003, the IRS did issue proposed regulations on the taxation of the issuance and exercise of noncompensatory options to acquire a partnership interest, whether in the form of warrants, convertible debt or convertible equity.  REG-103580-02, 68 Fed. Reg. 2930 (1/22/03). The proposed regulations generally apply § 721 to defer the recognition of gain to a partnership and its partners upon the exercise of an option to acquire a partnership interest.  Issued in response to comments received in Notice 2000-29, 2000-1 C.B. 1241, the proposed regulations represent the first clear statement from the IRS that a “capital shift” is not a taxable event in every circumstance.

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So what is the appropriate opening capital account? If limited to the cash investment, should the portfolio company specially allocate profit (or gain on sale) to the fund to “build” the capital account to the agreed multiple over time? Given the business deal, the validity of this approach is questionable because it would deprive the fund of its economic bargain if the portfolio company realizes sales proceeds in excess of the cash investment but without sufficient “profit”to produce the correct capital accounts. To avoid an inadvertent conflict with the economic agreement, one might attempt to allocate gross income or to construct a “guaranteed payment” as and if necessary to produce the required capital account balances, or even to avoid liquidating in accordance with capital account balances.  But this approach may deprive otherwise eligible fund investors of the capital gains preference, assuming that the fund invests directly and not through a blocker.  Ultimately, however, the problem with any of these approaches is that they mask the true nature of the transaction, which is a shift of capital from the existing partners to the newly admitted partners.  A more intellectually honest approach, in the author's view, is to reflect the premium in the opening capital account but not report the premium as a taxable capital shift.

8. UBTI/ECI “Opt Out” Provisions 

Yet another approach to the problem of UBTI and ECI is to provide tax-exempt and foreign investors with a direct right of “opt out” on pass-through investments.  The fund may offer this right either as part of a broader strategy that includes one or more “blocker”solutions or as the sole remedy to these investors.  In funds that adopt this approach, the tax-exempt and foreign investors may opt out of the investment entirely if the fund cannot or will not interpose a Blocker.

The virtue of this approach is that it eliminates the need for a parallel vehicle and its associated complexities.  For all its simplicity, however, the opt out solution is not without its deficiencies.  First, in funds with opt out mechanisms, the general partner may have to call additional capital from the non-electing investors.  The fund agreement must therefore convey the concomitant right to compel these investors to fund a larger percentage of any fund investments in pass-through entities.  If tax-exempt or foreign entities represent most of the investor population, the opt out right may materially increase the contingent participation of other investors in pass-through investments. Second, any investment in a pass-through entity by a fund with an opt out provision will reduce the effective size of the fund unless the general partner has the right to call the “opt out”capital of the tax-exempt and foreign investors for other investments. Without this right, the opt out provision reduces the option value of the carried interest, as well as the size of the management fee. Finally, the distribution provisions in the fund agreement will not reflect pro rata investment in each portfolio company, requiring a hedge fund-style computation of loss recovery and the carried interest for each investor.

Nor does the opt out solution avoid the obligation to file a U.S. tax return for foreign investors.  Section 875 treats a foreign investor as engaged in a U.S. trade or business if a fund in which it is a member is so engaged, without regard to whether the foreign investor participates in the particular investment giving rise to ECI.  If a foreign corporation is engaged in a U.S. trade or business at any time during the taxable year, it must file a tax return even if it has no effectively connected income.442 By contrast, tax-exempt entities must file a return only if their total gross income included in the UBTI computation is at least $1,000.443 Thus, an investment by a tax-exempt investor in a fund that is engaged in a trade or business will not trigger a tax return filing requirement if the investor opts out of all UBTI investments.
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442 § 6012(a)(2); Regs. § 1.6012-2(g)(1)(i).

443 Regs. § 1.6012-2(e).  The tax-exempt entity must report UBTI on Form  990-T for each taxable year that the gross income of the entity included in the computation of UBTI equals or exceeds $1000.  Id.

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U.S. Income Portfolios: Other Pass-through Entities 
  Portfolio 735-2nd: Private Equity Funds 
  Detailed Analysis 
  VII. The Problem of ECI and UBTI

E. Use of Option Structures to Avoid UBTI/ECI 

1. In General 

On occasion, a tax-exempt or foreign investor may seek to avoid UBTI or ECI not by investing through a Blocker but by structuring the portfolio investment as convertible debt, as straight debt coupled with warrants or as an “in-the-money” warrant.  The basic tax objective of these structures is to avoid status as a “partner”for tax purposes. If the investor is not a partner of the portfolio company, it will not be deemed to be engaged in the trade or business of the portfolio company.444
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444 § § 875(1) (foreign investors), 512(c)(1) (tax-exempt investors).

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Any tax structure predicated on the status of a portfolio investment as debt requires that the portfolio company possess borrowing capacity. For many portfolio companies, this threshold condition will eliminate the creditor alternative as a viable strategy.  Similarly, the IRS may equate “in-the-money” warrant structures as direct ownership of the underlying equity.445 But if the portfolio company does have borrowing capacity, the fund may be able to achieve equity-like returns without generating UBTI or ECI to its tax-exempt or foreign investors.  By investing as a creditor, the fund will realize a current return in the form of interest and a deferred return in the form of capital appreciation in the warrant or other conversion right. Neither form of return should give rise to UBTI or ECI.446 These structures assume, however, that the fund will not exercise its right to acquire the underlying equity.  If, for example, a fund were to convert debt in a pass-through entity immediately before a sale, it would carry over its basis in the debt investment.447 When it then sells the acquired equity to the buyer, it would recognize gain as a partner, creating ECI to its foreign investors.448 If the fund instead sells the convertible debt to the buyer, it would recognize gain not as a partner, but as a creditor.  The buyer would than convert the debt into equity, leaving it in the identical economic position.449
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445 See, e.g., Rev. Rul. 82-150, 1982-2 C.B. 110 (payment of $70,000 for option to acquire stock with a value of $100,000 for $30,000 treated as current purchase of shares).

446 See  § 512(b)(1) (interest not UBTI), (b)(5) (gains from sale of non-inventory property not UBTI); see also VII, A, 3, above, for a discussion of the treatment of investment activities as not giving rise to ECI.

447 § 721;Prop. Regs. § 1.721-2(a) (§ 721 generally applies to exercise of non-compensatory option).

448 Rev. Rul. 91-32, 1991-1 C.B. 107.

449 With a § 754 election in effect, the buyer should still receive a full basis step-up in the portfolio company assets because its tax basis in the acquired equity will include the liability of the portfolio company for the convertible debt.  § 752.  Alternatively, if a single buyer acquires 100% of the equity, it should receive a full basis step-up as a direct purchaser of assets.  See Rev. Rul. 99-6, 1999-6 I.R.B. 6.

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On January 22, 2003, the IRS issued proposed regulations under § § 721, 704 and 761,450 which address the treatment of the issuance and exercise of a noncompensatory option to acquire a partnership interest. Although merely proposed, the regulations are noteworthy because they represent the first occasion in which the IRS has formally attempted to reconcile longstanding tax principles governing investment options generally with the principles of subchapter K, in particular with regard to the proper tax effect of a “capital shift.”In addition, the regulations would appear, if only tacitly, to affirm the viability of option structures by funds as effective mechanisms to avoid UBTI and ECI to their tax-exempt and foreign investors.
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450 REG-103580-2, 68 Fed. Reg. 2930 (1//22/03).

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First, the proposed regulations acknowledge the general rule that a mere option to acquire a partnership interest is not itself a partnership interest until the holder exercises the option.451 The general rule does not apply to any option that provides the holder with rights that are substantially similar to the rights afforded to a partner, assuming that, as of the date of issue, modification or transfer of the option, “there is a strong likelihood that the failure to treat the holder of the noncompensatory option as a partner would result in a substantial reduction in the present value of the partners’ and the holder's aggregate tax liabilities.” 452 In making this determination, the regulations consider all facts and circumstances, including whether the option is reasonably certain to be exercised as of such time and whether the option holder possesses sufficient “partner attributes.” 453 Whether the option is “reasonably certain” to be exercised depends upon a number of factors, including the spread between the strike price of the option and the fair market value of the underlying partnership interest, the term and volatility of the option, and the anticipated distributions by the partnership during the option term.454 Whether the option holder possesses “partner attributes” depends upon the extent to which the holder participates in the benefit of partnership profits and losses during periods preceding exercise and any contractual rights to restrict the activities of the partnership during those periods.455
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451 Prop. Regs. § 1.721-2(b) (§ 721 does not apply to issuance of a “noncompensatory option”).

452 Prop. Regs. § 1.761-3(a).

453 Prop. Regs. § 1.761-3(c)(1).

454 Prop. Regs. § 1.761-3(c)(2).

455 Prop. Regs. § 1.761-3(c)(3).

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Although these structures do seek to achieve equity-like returns without the attendant consequences, this is inherent in any option and is clearly not a sufficient basis for recasting the investment under the proposed regulations.  Moreover, if a fund invests as a creditor at a conversion price that is not in-the-money, the IRS will have difficulty establishing that the fund is reasonably certain to convert the debt, in particular given the risks inherent in most private equity investments.  Thus, a tax-exempt or foreign investor in a fund that acquires a partnership option should generally avoid UBTI and ECI that would otherwise result from an investment in a partnership engaged in a trade or business.

Second, the proposed regulations do not “bifurcate” debt convertible into a partnership interest into straight debt and a separate option.  Instead, they extend the rule of Regs.  § 1.1273-2(j) that subsumes the value of the conversion right within the issue price of a single security to include convertible partnership debt.456 Thus, the fund will not realize additional interest income attributable to the conversion right as an incremental cost of these structures.
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456 Prop. Regs. § § 1.1272-1(e), 1.1273-2(j), 1.1275-4(a)(4).

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2. Investments in General Partners and Fund Managers 

Sometimes, a foreign investor will invest not only in the fund, but in the general partner or fund manager.  In spite of the form of the investment, the foreign investor tends to view the acquired interest as reducing its effective share of the carry or management fee rather than as a discrete investment.  Indeed, sponsors grant these interests with this very purpose in mind.  Of course, the sponsor is free to discriminate among investors by simply reducing the management fee or carried interest on the capital of specific investors in the fund agreement.  In many cases, however, the sponsor prefers to “mask”the preferential terms from other investors, allowing it to market equity interests in the fund as a single class of investment.

As described previously,457 the holding of an interest in the general partner should not generate ECI, provided that the entity limits its returns to investment income.  The interest in the fund manager enjoys no such protection.  As a service provider, the fund manager will receive the management fee and, in many cases, fee income from the portfolio companies.  The foreign investor will therefore incur U.S. tax during the pre-sale period on the portion of the management fee it effectively pays to itself.  Many foreign investors accept this inefficiency as a frictional cost of the structure, in particular if they derive a non-U.S. tax benefit on the payment of the gross management fee to the fund.  Upon a sale of the equity interest, however, the foreign investor may also incur a substantial U.S. tax liability.458
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457 See VII, B, 3, above.

458 Rev. Rul. 91-32, 1991-1 C.B. 107; see VII, A, 1, above. If so, then the foreign investor has also acquired an interest in the management contracts and/or goodwill or going concern value of the fund manager, achieving much more than a mere reduction in its share of the management fee.

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To minimize its liability in a sale, the foreign investor may opt to bifurcate its ownership of the equity investment in the fund manager. Assume, for example, that the fund manager issues equity to a U.S. subsidiary of the foreign investor and that the U.S. subsidiary then grants a call option on that investment to the foreign investor at a negotiated strike price.  During the holding period, the U.S. subsidiary will include its allocable share of the profits of the fund manager as the holder of the equity interest, consolidating those profits within its U.S. tax group.  The unrealized appreciation on the equity interest, however, will inure to the foreign option holder.  The foreign option holder will capture that appreciation free of U.S. tax by conveying the call option to the buyer, who would then exercise the option against the U.S. subsidiary.459 To ensure the effectiveness of this strategy, the foreign investor may prohibit any direct sales of the business by the fund manager, which would require the entity to allocate gain realized in the sale to the U.S. subsidiary.
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459 With a § 754 election in effect, the buyer should receive a full basis step-up in the assets of the fund manager because the basis of the acquired equity will include the purchase price of the option.  Alternatively, if a single buyer acquires 100% of the equity of the fund manager, it should receive a full basis step-up as a direct purchaser of assets.  See Rev. Rul. 99-6, 1999-6 I.R.B. 6.

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Worksheet 15 provides a diagram of a fund manager option structure.

U.S. Income Portfolios: Other Pass-through Entities 
  Portfolio 735-2nd: Private Equity Funds 
  Detailed Analysis 
  VII. The Problem of ECI and UBTI

F. Other Approaches to Avoiding UBTI 

The principal tax distinction between the rules governing tax-exempt and foreign investors in private equity funds is the effect of leverage on the taxation of investment income.  For foreign investors, leverage does not generally “taint” the character of investment income as non-ECI.  For tax-exempt investors, leverage can implicate § 514.460 Although most funds do not borrow at the fund level, some seek the flexibility to do so, but without excluding tax-exempt entities as a potential source of capital. This section of the portfolio addresses two additional strategies to avoid UBTI in funds that employ leverage: (i) “self-funding”by tax-exempts; and (ii) variable annuity “wrappers” with insurance intermediaries.
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460 See VII, A, 2, above.

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1. “Self Funding”by Tax-Exempts 

Funds that allow “self-funding” do not prohibit borrowing. Instead, they allow their tax-exempt investors to “front”their allocable share of the borrowing by advancing additional capital to the fund as equity. In funds that adopt this approach, the general partner will usually notify the tax-exempt investors of the proposed borrowing and allow them to “opt out” by funding their allocable share with an additional capital contribution.  Unless the borrowing merely bridges a later capital contribution, a tax-exempt investor who self-funds will effectively increase its capital commitment to the fund.  Because the tax-exempt investors do not bear any of the expenses of the borrowing, the fund will allocate those costs to the other investors.

In Rev. Rul. 76-95,461 a tax-exempt organization with an undivided interest in real estate subject to a mortgage prepaid its allocable share of the mortgage debt and received a release from the lender from any further personal liability. The other co-owner also released the tax-exempt organization from personal liability. The lien on the entire property remained in place, however, until retirement of the entire principal balance of the loan. Although the regulations provide that indebtedness secured by a mortgage is considered indebtedness of the tax-exempt incurred in acquiring such property even if the tax-exempt does not assume it,462 the IRS nevertheless ruled that this series of arrangements effectively retired the tax-exempt's share of the debt. In PLR 9723025, the IRS applied the principles of this ruling to treat a tax-exempt partner in a partnership that owned property subject to mortgage debt that entered into a similar arrangement to conclude that the tax-exempt partner had not incurred “acquisition indebtedness” within the meaning of § 514.463
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461 1976-1 C.B. 172.

462 Regs. § 1.514(c)-1(b)(1).

463 See also  PLRs 9719041, 8426128.

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Based upon these authorities, § 514 should not apply to taint the tax-exempt investors in a leveraged fund so long as the tax exempt investors “self-fund” their allocable share of the borrowing. Although the tax-exempt investor is a partner in a partnership that has incurred debt to fund acquisitions, it derives no benefit from the leverage. Analytically, therefore, self-funding is more akin to a direct borrowing by the other investors followed by an equity contribution. This view is also in harmony with the principles of § 752, which allocate partnership debt to the partners who bear risk of loss. A fund that allows its tax-exempt investors to pre-fund their allocable share of any borrowings would not allocate any portion of the borrowing to the tax-exempt investors under § 752.464
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464 See, e.g., TAM 9651001 (applying § 752 to determine portion of partnership debt allocable to tax-exempt partner).

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2. Insurance Wrappers 

Section 818(a) defines a pension plan contract to include virtually any investment product issued by a life insurance company to a qualified plan. Under § 817(e), most pension plan contracts qualify as contracts that provide for “the payment of annuities”for purposes of § 817(d). Section 512 excludes payments on “annuities”from the definition of UBTI and § 514(c)(5) excludes an “annuity”from the definition of “acquisition indebtedness.” Completing the analysis, § 817(d) defines a “variable contract” issued by a life insurance company to include a contract that provides for the allocation of payments to a segregated account that provides for “the payment of annuities.”

Thus, if a pension plan acquires a variable annuity in a life insurance company that mimics the returns of a leveraged fund, it should not realize UBTI even though it would have realized UBTI had it invested directly in the fund. This is so even though the issuer of the variable annuity will invest directly in the fund to hedge its liability. Although § 514(g) grants regulatory authority to the IRS to prevent tax-exempts from circumventing the debt-financed property limitations through “segregated asset accounts,”the IRS has not issued regulations under this grant since 1984.

Insurance “wrappers” usually come in two types:
Fund of funds: a fund available only to insurance company investors that invest in other funds. The portfolio manager, rather than the policyholder, has and regularly exercises the discretion to vary the investment among several sub-funds. The sub-funds solicit capital from “qualified purchasers”or “accredited investors” under the federal securities laws (“eligible investors”).

Clone funds: a fund offered only to insurance companies with investment objectives and strategies that mimic those of a fund managed by the same portfolio manager and available to eligible investors.

If form is respected, the fund will allocate the acquisition debt to the life insurance company investor, not the pension plan behind it. The life insurance company will therefore report its allocable share of the profit and loss of the fund, but will deduct additions to reserves under § 817 to reflect its future obligations under the annuity. The pension plan, on the other hand, will derive exempt income under the annuity that tracks the economic performance of the fund, but without incurring the adverse tax consequences associated with direct investment.

The life insurance company will hedge its exposure under the contract by investing in the underlying fund. In March 2005, the IRS amended the regulations under § 817(h) to limit the ability of life insurance companies to offer these products as alternatives to direct investment in a hedge fund or private equity fund.465 Section 817(h)(1) provides that a variable contract based on a segregated account will not qualify as an annuity unless it is “adequately diversified” in accordance with Treasury regulations. For this purpose, a segregated asset account may treat a pro rata portion of each asset held by the fund as an asset of the segregated asset account. So long as the underlying fund is “adequately diversified,” therefore, the variable contract will be adequately diversified. Effective March 1, 2005,466 however, this “look-through”rule no longer applies to nonregistered partnerships467 unless all of the beneficial interests in the fund are held by one or more segregated asset accounts of one or more insurance companies and public access to the fund is available exclusively through the purchase of a variable contract.468 If a variable contract does not meet the diversification requirements, the policyholder will be taxed as the owner of the fund investment. Under published rulings, the mere availability of the same fund to the public may suffice to establish tax ownership.469  Many funds that allow life insurance companies to invest therefore prohibit direct investment by pension plans.
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465 Regs. § 1.817-5(f)(2), (g) Ex. 1, (h)(6), (i)(2)(v), T.D. 9185, 70 Fed. Reg. 10319 (3/3/05) (Regs. § 1.817-5(f)(2)(ii) and (g), Ex. 3 were removed; Regs. § 1.817-5(f)(2)(iii) and (g), Ex. 4 were redesignated as Regs. § 1.817-5(f)(2)(ii) and (g), Ex. 3, respectively). The amended regulations make it more difficult for the underlying assets of a nonregistered partnership to support the qualification of a variable contract as an annuity or life insurance contract.

466 Arrangements already in existence on Mar. 1, 2005, will be considered to be diversified adequately if: (i) the arrangements were adequately diversified within the meaning of § 817(h) prior to Mar. 1, 2005, and (ii) by Dec. 31, 2005, the arrangements are brought into compliance with the amended regulations. Regs. § 1.817-5(i)(2)(v).

467 A nonregistered partnership is a partnership that is not registered under a federal or state law regulating the offering or sale of securities.

468 See Regs. § 1.817-5(f)(2)(i) (unchanged by T.D. 9185).

469 See, e.g., Rev. Rul. 82-54, 1982-1 C.B. 11 (contract holder not treated as owner of mutual fund accounts when, inter alia, mutual funds not available for sale to general public).

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The purpose of § 817(h) is “to discourage the use of tax-preferred variable annuity and variable life insurance primarily as investment vehicles.” 470 Section 817(h) therefore denies annuity or life insurance treatment to investments that are publicly available for direct investment by the public. According to the preamble to the proposed regulations471 which were adopted as the final regulations in March 2005, a “qualified purchaser” or “accredited investor” in a private investment partnership is part of the general public for purposes of § 817(h), even though investment in the partnership is exempt from registration under the federal securities laws. If the investment partnership is available to these investors, therefore, the regulations deny the benefit of “look through” treatment to a wrapped investment by a life insurance company.
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470 See H.R. Conf. Rep. No. 861, 98th Cong., 2d Sess. 1055 (1984).

471 See REG-163974-02, 68 Fed. Reg. 44689 (7/30/03).

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Comment: Although perhaps unintended, the final regulations appear to deny “look through” treatment even to a fund that only admits insurance company investors if the general partner structures its carried interest as a partnership interest. Under the old regulations, a life insurance company (a) could “look through” the fund to the underlying investments if the fund limited investment to accredited investors,472 and (b) could disregard the general partner's equity interest in the fund as an interest available to the public only if the return to the general partner “is computed in the same manner as the return on an interest held by a segregated asset account.” 473 The current regulations strike rule (a), but do not adjust (b). Although the removal of the “eligible investor” exception drew a great deal of attention,474 it was really the retention of(b), which requires the general partner to hold a fungible equity interest in the fund, that eliminated the viability of insurance wrappers as alternatives to direct fund investment for most policies. As described more fully in III, B, 3, above, the typical carried interest in a private equity fund conveys the economic right to 20% of the portfolio gains to the general partner in exchange for services and a nominal capital contribution. The carried interest therefore reflects economic terms that materially differ from those of any other interest in the fund. Under the current regulatory regime, therefore, a “wrapped”fund with a carried interest cannot qualify for “look through”treatment under §  817(h) even if every other investor in the fund is an insurance company.475
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472 Former Regs. § 1.817-5(f)(2)(ii). For a discussion of the “look through” rule and the application of Regs. § 1.817-5(f)(2) as it existed before March 2005, see PLR 200443029.

473 Regs. § 1.817-5(f)(3)(ii).

474 See Neufeld, “New Guidance on Investor Control Rule:  Road Map or Roadblock?”100 Tax Notes 1191 (Sept. 1, 2003); see also Luke, “Beating the “Wrap”:  The Agency Effort to Control Wraparound Insurance Tax Shelters,” 25 Va. Tax Rev. 129, 174 (2005).

475 Although the general partner could opt to recast the carried interest as a fee to avoid this limitation, it would forego the capital gains preference on its share of the underlying income of the fund.

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Even if a wrapped investment does satisfy the § 817(h) diversification requirements, it will not avoid UBTI to a pension investor if the pension plan retains too much dominion and control over the investment. For example, if the pension plan has the right to vote, to direct investment and to otherwise act on behalf of the insurance company investors in the fund, the IRS may assert that the insurance company is acting as an agent of the pension plan rather than the true owner of the fund investment.476
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476 See Christoffersen v. U.S., 749 F.2d 513 (8th Cir. 1984); Rev. Rul. 81-225, 1981-2 C.B. 13, clarified and amplified by Rev. Rul. 2003-92, I.R.B. 2003-33; Rev. Rul. 80-274, 1980-2 C.B. 27; Rev. Rul. 77-85, 1977-1 C.B. 12.

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Until recently, it was not entirely clear whether excessive “investor control” provided an independent basis from § 817(h) for denying annuity treatment to an insurance wrapper. According to the legislative history, the purpose of § 817(h) is to deny annuity treatment to “investments that are publicly available to investors and investments which are made, in effect, at the direction of the investor,”477 suggesting statutory preemption of the investor control issue.478 Although the ABA once endorsed this view,479 the IRS has long maintained that investor control remains an independent theoretical basis for denying tax ownership to the life insurance company.480
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477 Joint Committee on Taxation, General Explanation of the Revenue Provisions of the Deficit Reduction Act of 1984, at 608.

478 See 546 T.M., Annuities, Life Insurance, and Long-Term Care Insurance Products for a discussion of “investor control” issues with variable annuities generally.

479 See ABA Section of Taxation, Committee on Insurance Companies, “A Roadmap to the Federal Income Taxation of Non-Qualified Annuity Contracts,” 45 Tax Law. 123(1991).

480 See 51 Fed. Reg. 32664 (9/15/86) (preamble to proposed regulations stating that future regulations or rulings would provide guidance on this issue).

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In two rulings in 2003, the IRS reaffirmed its position that the policyholder may be treated as the owner of the wrapped investment under common law principles without regard to whether the contract satisfies the § 817(h) diversification requirements. In Rev. Rul. 2003-92,481 a separate asset account of an insurance company had 10 sub-accounts, each of which invested in a private investment partnership. Investment in the partnership was available to investors other than insurance companies and managed by an independent investment manager. Under the terms of the contract, the policyholder had the right to allocate the premium among the available sub-accounts. The IRS ruled that the policyholder rather than the insurance company was the owner of the underlying investment. In contrast, in Rev. Rul. 2003-91,482 the insurance company was respected as the owner of the underlying investment under similar facts because investment in the sub-accounts was available solely through the purchase of an insurance wrapper. These rulings appear to establish that the IRS will apply common law ownership principles more restrictively for investments in private equity and hedge funds that admit non-life insurance company investors. It should be noted, however, that neither ruling addresses a case in which the policyholder did not have the right to control the allocation of invested amounts among different funds.
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481 2003-33 I.R.B. 350. See also PLR 200443029.

482 2003-33 I.R.B. 347. See also PLRs 200443029, 200701016.

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In Rev. Rul. 2007-7,483 the IRS amplified Rev. Rul. 2003-92. Under the facts of Rev. Rul. 2007-7, access to segregated asset accounts was available only to variable annuity or life insurance contract holders and to the limited classes of investors specified in Regs. § 1.817-5(f)(3). The IRS concluded that the general public does not include investors under Regs. § 1.817-5(f)(3) for purposes of determining whether the investor has control of the segregated accounts. Therefore, the holder of the variable contract was not treated as the owner of the investment.
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483 2007-7 I.R.B. 468.

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3. Covenant Restrictions 

In a fund with tax-exempt and foreign investors, the general partner often agrees to exercise “reasonable best efforts” to avoid UBTI and ECI. The effect of this covenant is to prohibit most investments in pass-through entities, as well as both the borrowing of money at the fund level484 and the receipt of fee income. The risk that the IRS will impute UBTI or ECI to the fund by disregarding the form of the management fee offset likely will remain with the tax-exempt and foreign investors, who can assess this risk before investing.485 Worksheet 16, below, provides an example of such a covenant.
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484 But see VII, F, 1, above, for a discussion of “self-funding” by tax-exempt investors in leveraged funds.

485 See VII, C, 3, above, for a discussion of the tax issues associated with fee offset arrangements.

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A covenant approach to UBTI or ECI assumes that the general partner of the fund has the right to control investment structure at the portfolio company level. For the vast majority of funds, this is a reasonable assumption. In an FOF, however, the type of investing most susceptible to tax risk occurs at the subfund level, the responsibility for which devolves to the subfund general partner. As a passive investor, the FOF has no more right to direct investment policy than any other investor in the subfund. For this reason, the FOF investors often will agree to relax the tax covenant at the FOF level to reflect the delimited responsibilities of the FOF general partner. The fund agreement, for example, may presume the exercise of “reasonable best efforts”to avoid UBTI or ECI if a subfund agreement provides (or is amended to provide) substantially equivalent protections to its direct investors. If the subfund generates UBTI or ECI in breach of a subfund covenant, the tax-exempt or foreign investors in the FOF must pursue their claim of indemnity against the subfund general partner.

4. General Partner Indemnity 

At the other extreme, the fund may allow unrestricted investment in pass-through entities, subject to the treatment of any UBTI or ECI taxes incurred along the way as “notional” fund expenses. If the investors incur UBTI or ECI taxes, the fund will effect a priority distribution equal to those taxes before the general partner participates in investment gains.  This approach seeks to recognize the disparate tax incentives of the parties and then realign them by contract.  The members of the general partner, on the one hand, have a decided bias in favor of investing in pass-through entities, which allows the fund to convey a basis step-up to future buyers while preserving all or substantially all of the capital gains preference to the U.S. individuals.486 The tax-exempt and foreign investors, on the other hand, favor investing through Blockers, which avoids entity-level taxes (and possibly branch profits taxes) at the price of a foregone basis step-up of far lesser value.  To realign these incentives, the fund agreement “socializes”these taxes, forcing the general partner to bear their economic cost to the extent of its carry percentage.  Having internalized these costs, the argument goes, the general partner will serve the interests of the tax-exempt and foreign investors even when acting in its own self-interest.
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486 But see  § 751 (gain on sale of partnership interest attributable to “hot assets”recharacterized as ordinary income).

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U.S. Income Portfolios: Other Pass-through Entities 
  Portfolio 735-2nd: Private Equity Funds 
  Detailed Analysis 
  VII. The Problem of ECI and UBTI

G. Special ECI Issues for Certain Funds 

As a rule, foreign investors do not bear net basis taxation on interest, dividends or most categories of capital gains because they are “investors,”a profession not regarded as a U.S. trade or business.487 Foreign investors also avoid net basis taxation even if their investing activities constitute “trading”rather than “investing” in stocks or securities for tax purposes.488 While few funds “trade” in the common law sense,489 the trading safe harbor remains an important statutory backstop for funds that buy and sell liquid stocks and securities.
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487 See VII, A, 3, above.

488 A partnership that “trades” for its own account in stocks or securities is not engaged in a U.S. trade or business regardless of the domicile or location of its principal office unless it is a “dealer.” § 864(b)(2)(A); Regs. § 1.864-2(c)(2)(ii).

489 Under Regs. § 1.864-2(c)(2)(i), “the volume of stock or security transactions effected during the taxable year shall not be taken into account in determining ...whether the taxpayer is engaged in trade or business within the United States.” (emphasis added).

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As described below, however, the status of the activities of certain funds that acquire debt securities as either “trading”or “investing” is not entirely clear.

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

Under Regs.  § 1.864-4(c)(5)(i)(b), a foreign person is considered to be engaged in the active conduct of a banking, financing, or similar business in the United States if its activities consist of, among other things, “making personal, mortgage, industrial, or other loans to the public.” The Tax Court cited this regulation as a basis for determining when the financing activities of a foreign corporation will constitute the conduct of a U.S. trade or business.490 If a fund is treated as engaged in a “banking, financing, or similar business” in the United States, then its foreign investors are subject to tax on any U.S. source interest, dividends and capital gains “effectively connected” to that business, assuming that the income is attributable to a U.S. office.
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490 InverWorld Inc. v. Comr., T.C. Memo 1996-301. Technically, however, the regulation presumes that the foreign person is engaged in a U.S. trade or business and then identifies whether that U.S. trade or business is a “banking, financing or similar business.” See Sicular, “Selected Current Effectively Connected Income Issues for Investment Funds,” 56 Tax Law. 719, 749 (Summer 2003).

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A fund that invests in newly issued debt securities of a portfolio company is lending money. Indeed, even a foreign person that acquires funded debt securities will inherit the rights of the original lender, and therefore become a lender in some sense.  Yet the mere acquisition of a debt security, whether or not publicly traded, cannot constitute the business of “making loans to the public”in and of itself.  If it did, then the “trading” safe harbor for debt securities and the withholding tax on U.S. source interest, each of which presupposes that the foreign lender is not engaged in a U.S. trade or business, would rarely apply.

An important distinction between “investing” in outstanding debt securities and “lending” is that a buyer of previously issued debt neither advances funds to the lender nor negotiates the terms of the debt.  Indeed, the act of “origination” appears to be a necessary (albeit not sufficient) condition to the trade or business of “lending.” A typical hedge fund, for example, is not engaged in a U.S. lending business because it does not originate loans.  It acquires publicly traded debt securities on the market. But assuming that a foreign person does indeed originate a loan, at what point does the origination activity rise from mere investment to a full-blown lending trade or business?

Although not the subject of this portfolio, many issuers of collateralized debt obligations (“CDOs”) scrupulously avoid “origination”for fear that the activity would constitute a financing business for U.S. tax purposes, subjecting them to net basis taxation in the United States.  In a typical CDO transaction, an offshore vehicle (the “CDO issuer”) raises cash from investors and acquires a portfolio of debt securities from one or more companies.  The sellers of the portfolio, however, are not the original borrowers, even when the debt in question is of recent vintage.  For newly issued debt, the CDO issuer usually acquires the securities after funding from the original lenders.  Indeed, the lending syndicate often enters into forward sales of participations in the loans to the CDO issuer and other buyers before it advances any funds.  By not acting as the original lender, the CDO issuer does not technically “originate”any of the acquired loans, and therefore contends that it is not engaged in the trade or business of making loans to the public.  Although its relationship with the original lender may bear many of the hallmarks of agency, the CDO issuer does not negotiate directly with the borrower and does not acquire the securities from the original syndicate of lenders for a period of time (e.g., 48 hours).  Moreover, the parties endeavor to structure the loan participation as a sale by the original syndicate to the CDO issuers, rather than as a joint venture or direct issuance by the borrower.

Whether these types of activities constitute “origination”and, if so, a lending trade or business of the CDO issuer is not clear, and the subject of debate among practitioners.491 Even when the CDO issuer does participate in the syndication group, its role is often no more active than that of an initial purchaser of debt securities in a registered public offering, with much of the actual negotiations confined to the issuer and the lead lender.492 For funds that lend to portfolio companies in their capacity as equity investors, however, the market practice in the CDO industry suggests little cause for concern.
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491 See, e.g., Humphries, “The Way (Securitization) Things Ought To Be,” Tax Forum No. 561 at 16, 37 (Nov. 4, 2002) (noting that line between two activities is “sometimes murky” and that practitioners “tend to be conservative” in establishing permissible scope of activities by CDO issuers due to high stakes of being wrong); Mullin, “The Impact of the ’97 Tax Act on Private Investment Funds,”15 J. Tax'n Investments 91 (trading safe harbor under § 864 not intended to protect funds that enter into loan syndications); Sicular, “Selected Current Effectively Connected Income Issues for Investment Funds,”56 Tax Law. 719, 761 (Summer 2003) (extensive origination and negotiation by CDO issuers creates “risk” of net basis taxation; but distinction between lending trade or business and trading/investing activities “far from clear”).

492 See Humphries, “The Way(Securitization) Things Ought To Be,” Tax Forum, No. 561, at 16 (Nov. 4, 2002).

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In the domestic context, the issue of whether lending is a trade or business arises not in the context of U.S. jurisdiction to tax, but in the context of whether a U.S. lender may deduct its expenses. For example, an individual lender may not deduct a “bad debt”as an ordinary loss under § 166 if the debt is a “nonbusiness debt.” Section 166 defines a “nonbusiness debt” as debt other than debt created or acquired “in connection with a trade or business of the taxpayer.”493 The regulations provide that the status of debt as a nonbusiness debt is a question of fact.494 As a general proposition, however, merely sporadic lending activity is not a trade or business.495
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493 § 166(d)(2)(A).

494 Regs. § 1.166-5(b).

495 See Sicular, “Selected Current Effectively Connected Income Issues for Investment Funds,” 56 Tax Law. 719, 750-51 (Summer 2003):

The Tax Court and the IRS consistently have held that a trade or business of money lending is limited to those ‘exceptional situations’where the taxpayer's lending activities are so extensive and continuous as to rise to the level of a separate trade or business. Specific relevant factors include the number and frequency of loans made by the taxpayer over the years, the amount of time and effort spent on lending activities, the maintenance of an office for purposes of engaging in a money lending business, the employment of employees or other dependent agents, and the maintenance of books and records detailing the taxpayer's money lending activities.

(citations omitted).  For a general discussion of the trade or business requirement under § 166, see 538 T.M., Bad Debts.

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2. Lending by Private Equity Funds 

As describe above, private equity funds will occasionally lend to their portfolio company investees.  For example, a mezzanine or LBO fund may acquire both debt and equity securities of a portfolio company. Alternatively, a fund that generally invests in equity securities may advance funds to a portfolio company during periods of declining valuations, seeking to protect its prior equity investment and/or limit its risk should the financial condition of the portfolio company further deteriorate. Another example is convertible debt, an investment strategy that may allow the fund to circumvent a restriction in the articles of incorporation but still achieve an equity return.496
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496 See VIII, below.

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In none of these cases should the fund be deemed engaged in the lending business.  First, portfolio companies of a fund are neither “customers”of the fund nor part of the “public” at large, but rather companies with whom the fund enjoys a shareholder relationship.  The fund does not hold itself out to unrelated parties as a lending institution. Second, funds do not generally derive fee income when they originate portfolio company loans, any more than they would derive fees by advancing the funds as equity.497 Third, the fund's primary motivation in making the loan is not the fixed return, but the protection of a prior equity investment.  In Whipple v. Comr.,498 for example, the Supreme Court declined to treat loans from a substantial shareholder as incurred in a trade or business of the shareholder when the purpose of the purported lending “services”was to procure investment income.
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497 The receipt of fee income is occasionally cited as evidence that the recipient is engaged in the trade or business of “promoting” corporations.  See, e.g., Milsap v. Comr., 46 T.C. 751 (1966); Whipple v. Comr., 373 U.S. 193, 202-03 (“the promotion of more than one corporation might lend support to the finding that the taxpayer was engaged in ... promoting corporations for a fee ... but in such cases there is compensation other than the investor's return, income received directly for his own services rather than indirectly through the corporate enterprise”).

498 373 U.S. 193 (1963).

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When the only return is that of an investor, the taxpayer has not satisfied his burden of demonstrating that he is engaged in a trade or business since investing is not a trade or business and the return to the taxpayer, though substantially the product of his services, legally arises not from his own trade or business but from that of the corporation.

In the domestic context, a controlling shareholder seeking to claim an ordinary deduction under § 166 for advances to corporate borrowers will usually fail to establish a trade or business separate and apart from the trade or business of the corporate borrower.499 Finally, investments in the form of convertible debt bear many of the hallmarks of investments in convertible preferred stock, including the expectation of capital appreciation, a senior claim to common shareholders, and substantially equivalent economic terms.  It is difficult to conceive how purchasing a convertible instrument, a pure “investment” activity for U.S. tax purposes if structured as equity, becomes a “lending business” when recast as debt.500
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499 See, e.g., Kelly v. Patterson, 331 F.2d 753 (5th Cir. 1964) (loan by controlling shareholder and president treated as nonbusiness debt because shareholder not engaged in separate trade or business); Milsap v. Comr., 46 T.C. 751 (1966) (shareholder loans to protect equity investment in controlled corporation constitute nonbusiness debts).

500 See Sicular, “Selected Current Effectively Connected Income Issues for Investment Funds,”56 Tax Law. 719, 773 (Summer 2003) (“nothing in the context [of a convertible debt financing] suggests a distinction that should be relevant to the tax treatment of the fund for ECI purposes”).

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3. Lending by “Distressed Securities” Funds 

As described in II, B, 4, above, a “distressed securities”fund targets public companies that are bankrupt, insolvent or otherwise financially troubled.  The debt securities of these companies usually trade at a steep discount to their accreted values, reflecting an increase in default risk since the date of original issue.  By purchasing these securities in large blocks, a distressed securities fund seeks to participate in the bankruptcy or other reorganization of the issuer.

Unlike most other funds, therefore, these funds do not acquire newly issued securities.  Because they do not originate the loans, they are not “lenders” in the “trade or business”sense and certainly do not acquire the securities to earn a traditional lender's return. Indeed, these investments bear tremendous risk, not unlike an investment in illiquid stock.  What may distinguish their activities, however, is the process by which a distressed securities fund seeks to achieve its returns.  After the fund acquires a substantial block of securities, it uses the controlling position to extract more favorable terms, whether by participation on creditors’ committees or by exercising rights under the governing indenture.  Those negotiations may lead to a cash payment, a change in payment terms or, in certain cases, an actual exchange of the securities for stock in the reorganized company.  Although the fund's return will still consist of interest and capital gains, the fund will not generate that return by “trading”in the common law sense.  Should that matter?

In the author's view, it should not.  First, the form of the return as investment income arguably controls the characterization of the underlying activity as exempt from net basis taxation unless the underlying activity is a U.S. financing business.  The trading safe harbor defines trading to subsume virtually all non-dealer transactions in stocks and securities, including activities “closely related thereto.”501 Second, the ability to influence the restructuring process is purely derivative, flowing from the rights conveyed through ownership of the debt securities.  It is the securities themselves, therefore, that permit the kinds the activities that produce the financial gain.
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501 Regs. § 1.864-2(c)(1), (2).

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It is possible, however, that a distressed securities fund may be deemed to “originate” loans, at least in a technical sense. One commentator, for example, observed that the restructuring process itself will often trigger a “reissuance” of the debt securities under § 1001.502 If the fund is deemed to have received newly issued debt because the restructuring produces a “significant modification”of the old debt, it has indeed “originated” a new loan in a sense.  Does a constructive origination change the nature of the fund's activities from investing to a lending trade or business?
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502 See Sicular, “Selected Current Effectively Connected Income Issues for Investment Funds,” 56 Tax Law. 719, 771 (Summer 2003); Regs. § 1.1001-3(b) (definition of “significant modification”).

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Although a fund that exchanges an old debt security for a new debt security, either in form or for tax purposes, does “originate”a loan, it does not lend any money to the borrower — the issuer borrowed the money from the original buyer of the old debt security. The lending authorities clearly involve the lending of money.503 Indeed, the IRS has accepted this distinction in other contexts.  Prior to January 1, 2005, for example, a FASIT was subject to a “prohibited transactions” tax under  § 860L if it originated loans.504 The proposed FASIT regulations under the now-repealed § 860L define “origination,” however, to exclude the exchange of an old loan for a new loan of the same obligor.505 Because distressed securities funds do not originate funded debt, they should not be viewed as engaged in a lending business.
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503 See, e.g., Eberhart v. Comr., T.C. Memo 1977-155 (record did not justify finding that taxpayer was in “business of lending money”); Imel v. Comr., 61 T.C. 318 (1973) (rejecting taxpayer's assert that he was in trade or business of “lending money”); Baker v. Comr., T.C. Memo 1995-385 (taxpayer must establish that he was in “trade or business of lending money”).

504 The 2004 American Jobs Creation Act, P.L. 108-357, § 835(a)and (c), repealed § 860L and other special rules for FASITs, effective on Jan. 1, 2005; however, the repeal generally does not apply to any FASIT in existence on Oct. 22, 2004 to the extent that regular interests issued by the FASIT before that date continue to remain outstanding in accordance with their original terms.

505 Prop. Regs. § 1.860L-1(a)(4). The proposed regulations also define “origination” to include “making any offer to lend funds to any person.” Prop. Regs. § 1.860L-1(a)(3) (emphasis added).

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U.S. Income Portfolios: Other Pass-through Entities 
  Portfolio 735-2nd: Private Equity Funds 
  Detailed Analysis 
  VIII. Special Issues with Convertible Debt Investments

As described above, private equity funds typically invest as shareholders, in most cases acquiring preferred stock convertible into common stock. An alternative form of investment is convertible debt, which provides substantially equivalent equity participation and a more senior preference. Indeed, convertible debt is often the more tax-efficient security in other contexts because it conveys an interest deduction to the portfolio company at no incremental cost to the tax-exempt or noncorporate U.S. holder.506 In the private equity arena, however, debt financing at the portfolio company level introduces many potential problems, even assuming that the portfolio company has sufficient borrowing capacity to withstand a § 385 challenge to the character of the investment.
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506 § 163. With the passage of the 2003 JGTRRA, individual holders now bear a higher tax rate on interest than on dividends, effective for taxable years from 2003 to 2010, assuming that the dividends constitute “qualified dividend income.” For a further discussion of the reduced rate of taxation on “qualified dividend income,” see X, A, below.

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U.S. Income Portfolios: Other Pass-through Entities 
  Portfolio 735-2nd: Private Equity Funds 
  Detailed Analysis 
  VIII. Special Issues with Convertible Debt Investments

A. Mandatory Accrual of Interest 

The first problem is the common phenomenon of losses at the portfolio company level, which precludes any immediate tax benefit from the interest deduction.  Instead, the interest deduction merely increases the net operating loss, which the portfolio company will carry forward to future periods.  Upon a sale or IPO of the portfolio company, § 382 may even limit the benefit of the interest deduction during those periods.  As a lender, however, the fund will report the yield on the debt as interest income to its investors on a current basis, regardless of whether it is paid currently or merely accrues over the term of the security.  If the instrument defers the payment of interest, the fund will report the interest as “original issue discount” (“OID”), which accrues on a constant yield to maturity basis.507 On a preferred stock investment, the fund would report dividend income, if at all, only to the extent of the current or accumulated earnings and profits of the portfolio company.508 If the preferred stock merely accretes the dividend or pays the dividend in the form of stock, the dividend will accrue for tax purposes only to the extent required under § 305. Finally, as described above, the ultimate payment of the accrued dividend may qualify as capital gain to the fund and its investors.509
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507 See § § 1272(a) (current accrual of OID), 1273(a)(2) (interest not payable at least annually added to “stated redemption price at maturity,” creating OID).  Under § §  871(a)(1)(C) and 881(a)(3), a foreign investor in the fund will incur the withholding tax liability on accrued OID when the borrower pays the OID or when the fund disposes of the instrument, assuming that the OID does not otherwise qualify as “portfolio interest” under § §  871(h) and 881(c).

508 See § § 301(a) and (c), 316(a)(1) and (2).  If the dividend constitutes “qualified dividend income,” then an individual investor in the fund will also bear tax on the dividend at a lower rate.  For a further discussion of the reduced rate of taxation on “qualified dividend income,”see X, A, below.

509 See Rev. Rul. 69-130, 1969-1 CB 93; Rev. Rul. 69-131, 1969-1 CB 94. For a discussion of these rulings, see IX, C, below.

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Because the fund is itself a pass-through entity, the relative significance of these differences will depend upon the tax status of its investors. As a general matter, tax-exempt investors care little about character and deferral because they do not bear U.S. tax on most categories of interest, dividend and capital gains anyway.510 Foreign investors may be less indifferent, depending upon whether the interest is exempt from U.S. withholding tax as “portfolio interest” or pursuant to an applicable treaty.  The relative treatment of convertible debt and convertible preferred stock in the home jurisdiction of the foreign investor is also relevant.  In most cases, U.S. individuals, whether investors in the fund or members of the general partner, bear much of the incremental tax cost of debt financing because they forego both tax deferral and the capital gains preference.  After passage of the 2003 JGTRRA, U.S. individuals also bear tax at a higher rate on interest income than on “qualified dividend income.” For a further discussion of the reduced rate of taxation on “qualified dividend income,” see X, A, below.
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510 See § 512(b).

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U.S. Income Portfolios: Other Pass-through Entities 
  Portfolio 735-2nd: Private Equity Funds 
  Detailed Analysis 
  VIII. Special Issues with Convertible Debt Investments

B. Qualifying for the “Portfolio Interest” Exception 

A second problem with convertible debt is that the interest allocable to foreign investors in the fund may not qualify as “portfolio interest” under § § 871(h) and 881(c).  These provisions exclude from the definition of portfolio interest any interest paid to a “10-percent shareholder” of the portfolio company.511 Interest that fails to qualify as “portfolio interest” is generally subject to withholding at a 30% or reduced treaty rate.512 In contrast, many forms of dividend accretion on preferred stock avoid U.S. withholding tax, either because the portfolio company has no current or accumulated earnings and profits or because the accretion itself will qualify as exempt capital gain upon payment.513
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511 § § 871(h)(3)(A), 881(c)(3)(B).

512 § § 871(a), 881(a).

513 For a discussion of the taxation of accretion on various types of preferred stock investments, see IX, B, below.

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In the case of a corporate debt obligation, a 10% shareholder is any person who holds stock in the issuer representing 10% or more of the total voting power.514 For this purpose, a lender is deemed to own any stock subject to an option, including stock it may acquire by converting the debt claim.515 In the case of a debt obligation issued by a partnership, a 10% shareholder is any person who owns 10% or more of the capital or profits interest in the partnership.516 For purposes of determining whether a partner is considered a 10% shareholder of such a partnership, the regulations provide that attribution rules similar to the attribution rules governing corporate borrowers shall apply.517 Therefore, any partnership interest owned directly, indirectly or constructively under the relevant §  318 attribution rules will be taken into account for this purpose.
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514 § 871(h)(3)(B)(i).

515 See § § 871(h)(3)(C) (incorporating § 318 attribution rules with certain modifications), 318(a)(4) (options deemed exercised); see also Rev. Rul. 68-601, 1968-2 C.B. 124 (convertible debt treated as “option”under § 318(a)(4)).

516 §  871(h)(3)(B)(ii);Regs. §  1.871-14(g)(2)(i)(B).

517 Regs. §  1.871-14(g)(2)(ii)(B).

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Prior to the issuance of regulations in 2007, whether the statute measured 10% ownership at the partnership or partner level was not clear.518 In 2007, however, Treasury issued regulations to clarify that the portfolio interest rules “look through”a partnership for purposes of determining whether a foreign partner of the partnership is a 10% shareholder of a portfolio company borrower. Specifically, the 2007 regulations provide that if interest is paid to a partnership and included in the distributive share of a foreign partner, the status of such partner as a 10% shareholder of the issuer will be determined solely at the partner level.519  They further provide that the withholding agent must make this determination when it would otherwise be required to withhold the underlying tax under § §  1441 and 1442.520 Thus, if a fund partnership receives a payment of U.S. source interest from one of its portfolio companies, it must determine whether any of its foreign partners is a 10% shareholder of the portfolio company on the date that the partnership distributes the interest to its partners.521 If the interest is not distributed on a current basis, the determination is made on the earlier of the date on which the Form K-1 is due or the date on which the Form K-1 is mailed or otherwise delivered to such partner.522
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518 The Code defines a “person” to include both a U.S. and a foreign partnership. See § 7701(a)(1). Accordingly, a “10% shareholder” literally includes a domestic or foreign partnership that owns 10% of the voting stock of a U.S. borrower. On the other hand, a partnership lender does not bear substantive liability for U.S. withholding taxes.  Only its foreign partners do, and they would be deemed to own voting stock of the portfolio company based upon their relative beneficial ownership of the partnership.

519 Regs. §  1.871-14(g)(3)(i). These rules apply to interest paid after April 12, 2007. Taxpayers may choose to apply these rules to interest paid in any taxable year not closed by the period of limitations as of April 12, 2007, provided they do so consistently for all relevant partnerships during such years. Regs. §  1.871-14(i)(1).

520 Regs. §  1.871-14(g)(3)(ii).

521 Id.

522 Id.

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Accordingly, if a fund partnership holds convertible debt representing 10% or more of the total voting power of a corporate borrower on an “as-converted” basis, a foreign partner in the fund partnership may nevertheless claim the portfolio interest exemption on its allocable share of the interest so long as its attributive share of such voting stock is less than 10%. By the same token, equivalent relief is available for payments of interest on nonconvertible debt when the fund partnership owns 10% or more of the voting stock of the borrower.

U.S. Income Portfolios: Other Pass-through Entities 
  Portfolio 735-2nd: Private Equity Funds 
  Detailed Analysis 
  VIII. Special Issues with Convertible Debt Investments

C. Problems with Contingent Debt 

1. In General 

As described above, one inefficiency of convertible debt is that the lender must report the accrual of interest payable in the future on a current basis without regard to whether the borrower will derive an immediate tax benefit from the deduction. In the private equity sector, however, a more serious concern at the holder level is the potential treatment of the instrument as “contingent debt”for tax purposes.

When a fund manager opts to structure a particular investment in a portfolio company as convertible debt, it rarely intends to alter the basic economic terms of the investment. In most cases, the purpose is to achieve some form of benefit not available to a holder of convertible preferred stock. For example, the relevant bylaws may allow a portfolio company to issue debt securities without the prior consent of its shareholders but not to issue a senior class of equity. Alternatively, the status of the holder as a creditor may reduce the fund's exposure to further losses following a “down round.” Finally, the fund may just prefer a more leveraged capital structure, which will reduce the corporate tax base of the portfolio company by “pushing down” a larger interest deduction. In each of these examples, the economic terms of the debt instrument will tend to track the economic terms of an equivalent preferred stock investment, which often include other forms of equity participation features.

An equity “kicker” may assume one of many forms. For example, the fund may demand a reduction in the conversion price after a “down round,” increasing the number of shares issuable to the fund upon conversion of the instrument. Or the fund may demand that junior shareholders subordinate their claims to a minimum level of gain on the new investment, for example three times the initial cash investment of the fund in a future sale or IPO.523 A convertible instrument may even retain its preference in the capital structure on the conversion date, entitling a fund to both a fixed liquidation preference (payable in cash or stock) and additional common shares equal to its “as-converted”ownership of the remaining assets of the portfolio company. The effect of each of these equity kickers is to increase the fund's claim to the assets and earnings of the portfolio company after a specified event. In a debt investment, however, these same provisions will often implicate the “contingent debt” rules of the Code.524
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523 If the value of the underlying common shares were to exceed the liquidation preference, the fund would simply convert the instrument to common stock immediately before the sale to capture the surplus value.

524 See Regs. §  1.1275-4.

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One condition to the treatment of any debt instrument as “contingent debt” for tax purposes is that the instrument provide for one or more contingent payments that are neither “remote”nor “incidental.”525 A contingency is “remote”if the likelihood that it will occur (or not occur) is remote.526 A contingency is “incidental”if, under all reasonably expected market conditions, the size of the contingent payment is insignificant relative to the total expected amount of the other payments on the instrument.527 Beyond this, the contingent debt regulations provide few other guideposts or safe harbors.  In the case of most “private equity” convertible debt investment, however, the lack of precision in these definitions adds no real uncertainty to the tax analysis—the payments in question will reflect a fundamental economic attribute of the instrument.
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525 See Regs. § 1.1275-4(a)(1) and (5).

526 Regs. § 1.1275-2(h)(2).

527 Regs.  § 1.1275-2(h)(3)(i).

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In a cash borrowing transaction, both the issuer and holder must account for the investment under the “noncontingent bond method.”528 The noncontingent bond method requires the issuer to first construct a hypothetical payment schedule on the date of issue to estimate the expected debt service on the investment,529 which itself must produce a yield-to-maturity equal to the “comparable yield” of the issuer.530 The “comparable yield”of the issuer for this purpose is the issuer's cost of borrowing on a noncontingent basis under terms and conditions otherwise similar to the terms of the actual investment.531 On the basis of this payment schedule, the issuer and holder then report the accrual of OID under the general rules governing noncontingent debt, subject to later adjustment if the actual contingent payments on the investment differ from the projected ones.532
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528 Regs. § 1.1275-4(b)(1).

529 Regs.  § 1.1275-4(b)(2) and (3).

530 Regs. § 1.1275-4(b)(4)(ii)(C).

531 Regs. § 1.1275-4(b)(4)(i)(A). In making this determination, the issuer must consider the term, level of subordination and timing of the payments on the instrument.

532 See generally Regs. § 1.1275-4(b)(3).

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In Rev. Rul. 2002-31, the IRS ruled that the “comparable yield” of convertible debt that provides for contingent payments is the comparable yield of the same issuer on equivalent nonconvertible debt, rather than the comparable yield of the issuer on equivalent convertible debt.533 The IRS further ruled that the right to convert, when coupled with any other contingent payment on the debt that “is neither remote nor incidental” is also a contingent payment.534 For convertible debt bearing a nominal yield below the issuer's fixed rate borrowing cost, the effect of this ruling is to convert future appreciation in the issuer's stock into deductible interest, both in the projected payment schedule and upon a sale or conversion of the debt.
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533 Rev. Rul. 2002-31, 2002-22 I.R.B. 102.

534 Id. Thus, for example, the mere right to receive dividends on an “as-converted” basis will convert gain on sale or conversion of the bond to ordinary income whenever the likelihood of these payments is not “remote or incidental,” even though they may represent only a small portion of the expected return on the instrument.

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The tax accounting for convertible debt under the contingent debt rules favors the issuer because it accelerates the interest deduction and recharacterizes the stock appreciation as deductible interest. For these same reasons, the tax accounting disfavors the lender. First, the lender will be required to report the projected payments before they accrue on a modified accrual basis, triggering tax without cash. Second, the lender will be required to report any further gain on sale as additional interest,535 converting capital gain into ordinary income.  Finally, should the lender exercise the conversion right in an exchange that would otherwise qualify as a tax-free transaction,536 it will be required to report the stock as an additional contingent payment if and to the extent that the total return to the lender on the conversion date exceeds the issuer's comparable yield, again triggering tax without liquidity, also at ordinary income rates.
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535 Regs.  § 1.1275-4(b)(8)(i). This rule does not apply if the debt instrument has no remaining contingent payments at the time of the sale or exchange.  Regs. § 1.1275-4(b)(8)(iii)(A).

536 Rev. Rul. 72-265, 1972-1 C.B. 222.

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In summary, therefore, the treatment of a portfolio investment as contingent debt is undesirable to any taxable investor in the fund, including members of the general partner with respect to the carried interest. Moreover, any foreign investor in the fund who is a “10%shareholder” of the portfolio company will bear U.S. withholding tax at a 30% or reduced treaty rate on its entire return, including the portion thereof that represents capital appreciation attributable to the stock even though such gain would otherwise avoid U.S. tax entirely.537 Had the fund held the identical instrument as a stock investment, the foreign investor would have avoided these consequences as long as  § § 301 and 305 did not recast any portion of the contingent payments as a dividend.538
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537 See  § 871(h)(3).  Although gain attributable to the conversion right on contingent debt is treated as interest under the contingent debt rules, it should not constitute “contingent interest” under the separate “portfolio interest”rules of §  817(h). See § 871(h)(4)(A)(i).  The IRS has yet to exercise its regulatory authority to expand the statutory exclusions to the definition of “portfolio interest” to include other types of contingent payments. See § 871(h)(4)(A)(ii) (grant of regulatory authority).

538 For a discussion of the potential application of  §  305 to various types of preferred stock, see IX, B, below.

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2. Self-Help and Other Avenues of Relief 

Must a fund either forgo the contingent payments or restructure the instrument as an equity investment to avoid these rules?  Perhaps not. A debt instrument will not be deemed to provide for contingent payments “merely because it provides for an option to convert into the stock of the issuer.”539 Accordingly, if every payment on the instrument other than those related to the stock is fixed, then the more favorable rules governing the taxation of “plain vanilla” convertible debt should apply. These rules effectively suppress the true amount of interest on debt by including the value of the conversion right in the issue price.540 Moreover, they respect the payment of any actual conversion premium as a capital transaction.541 One alternative, therefore, is to embed the desired contingent payments within the underlying equity security. Although most debt is convertible into common stock, the “option to convert” exception also applies to debt convertible into preferred stock.542 Thus, if a debt instrument is convertible into preferred stock that is itself convertible into common stock, and if only the preferred stock is entitled to the contingent payments, the instrument should avoid the contingent debt regulations entirely. Although the fund will be forced to forgo its senior claim as a creditor in the future in order to capture the underlying contingent payments, it would presumably do so only on the date of sale or other liquidity event.
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539 Regs. § 1.1275-4(a)(4).

540 See Regs. §  1.1273-2(j) (issue price of convertible debt includes amount paid for option to convert).

541 See Rev. Rul. 72-265, 1972-1 C.B. 222 (no gain realized upon exchange of convertible debenture for stock of obligor corporation).

542 See Regs. §  1.1275-4(a)(4) (referring only to “stock” of the issuer).

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Finally, even under the contingent debt rules, if a substantial percentage of the fund investors (together with the other holders) consists of “tax indifferent” persons, the issuer may use the AFR in lieu of its fixed rate borrowing cost as the presumptive yield of the instrument.543 This will temper the severity of these rules at the holder level for periods preceding actual sale or conversion. The lower rate applies to instruments sold in substantial part to persons for whom the inclusion of interest is not expected to have a substantial effect on their U.S. tax liability. Because a tax-exempt investor bears no U.S. tax on income from a debt investment,544 the AFR exception should respect these investors as “tax indifferent” persons. Moreover, once Treasury clarified in the 2007 amendments to the §  871 regulations that the portfolio interest rules “look through” a partnership for purposes of determining whether a foreign partner of the partnership is a “10%shareholder” of the portfolio company borrower,545 most foreign investors in a fund should qualify as well. Accordingly, the lower rate should apply to any fund investment in contingent debt so long as the tax-exempt and foreign investors of the fund comprise a substantial percentage of the total capital. Under these conditions, the remaining taxable investors in the fund will therefore avoid phantom income for periods preceding conversion or retirement of the instrument so long as the coupon rate exceeds the AFR.546 In a later sale or conversion, however, the taxable investors will be required to report the full amount of any additional gain (whether or not realized) as taxable interest.547
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543 See Regs. §  1.225-4(b)(4)(i)(B). The issuer is not required to use the AFR if it is able to establish by “clear and convincing” evidence that a higher rate should apply. Id.

544 §  512(b); but see §  514 (debt-financed property exception).

545 See Regs. §  1.871-14(g)(3)(ii). For a fuller discussion of the impact of the 2007 amendments on foreign investors in a private equity fund, see VIII, B, above.

546 If the coupon rate exceeds the AFR, the excess will be subject to the CPDI rules governing “positive adjustments” to the projected payment schedule. See Regs. §  1.1275-4(b)(6)(ii).

547 See Regs. §  1.1275-4(b)(8)(i). This rule does not apply if the instrument has no remaining contingent payments included in the projected payment schedule on the date of sale or retirement. See Regs. §  1.1275-4(b)(8)(iii).

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U.S. Income Portfolios: Other Pass-through Entities 
  Portfolio 735-2nd: Private Equity Funds 
  Detailed Analysis 
  VIII. Special Issues with Convertible Debt Investments

D. Ability to Retire without Tax Consequence 

One nearly universal advantage of debt financing for shareholder-funded debt is that it allows a shareholder to offset its basis in the debt against any retirement proceeds whether or not the shareholder retains any stock of the borrower. The right to offset basis is a significant tax advantage to fund investors.  First, a fund investor may agree to commit more capital to a portfolio company if it expects to refinance a portion of the investment shortly after the closing with a bank, institutional lender or other third party.  Second, the fund may plan to extract a significant percentage of its investment in a later IPO of the portfolio company, improving the IRR of the fund when it sells the remaining stock at a gain.  If a portfolio company with earnings and profits retires preferred stock from a shareholder that continues to hold a substantial equity interest, the shareholder may be required to include up to the entire proceeds as a dividend under §  301, depending upon whether the redemption avoids “dividend equivalency” under any of the various tests under § 302(b).

For example, assume that a fund contributes $1,000 to a portfolio company with $500 of earnings and profits for more than 50% of the stock, $100 of which represents “straight” preferred stock that the fund intends to retire in a subsequent third party financing. Because the redemption is likely to fail each of the tests under § 302(b), the fund will recognize dividend income of $100 even though it has merely received a return of its economic investment.  Although the fund will increase its basis in the retained shares,548 the additional basis will either reduce capital gain or increase capital loss in a later sale.  For the foreign investor in the fund who incurs U.S. withholding taxes on the dividend, the additional basis may produce no U.S. tax benefit, either currently or in the future.  For U.S. individual investors, the additional basis will at best reduce a future capital gain that would have borne tax at a lower rate.549 Had the fund instead contributed the $100 as debt, it would have been permitted to offset its full basis against the retirement proceeds.550
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548 Regs. § 1.302-2(c) (providing for “proper adjustment of the basis of the remaining stock” when redeemed stock is treated as § 301 distribution).

549 If the amount treated as a dividend constitutes “qualified dividend income,”however, the U.S. investor will bear the same rate of tax on the dividend. See X, A, below.

550 If the retired debt is convertible, the fund will also lose the benefit of the conversion right in the transaction.  To avoid this result, the fund will often structure the investment as straight debt with warrants, retaining the warrants after the debt is retired.  Although the fund will recognize a gain on retirement of the debt to the extent of the initial warrant value (less any portion thereof representing accrued OID as of the date of retirement), the issuer may have assigned a low value to the warrants on the issue date.  See  § § 1271, 1273(c)(2) (requires issuer to allocate proceeds to “investment unit” based upon relative fair market values).

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U.S. Income Portfolios: Other Pass-through Entities 
  Portfolio 735-2nd: Private Equity Funds 
  Detailed Analysis 
  IX. Withholding Taxes of Foreign Investors

A. Minimizing Dividend Taxes on Equity Investments Generally 

The Code imposes U.S. withholding tax on several categories of non-effectively connected fixed and determinable income derived from U.S. sources.551 Foreign persons bear these taxes whether they derive such income directly or through a partnership.552 The tax rate on this income is 30% unless the foreign person can claim a reduced rate of withholding under an applicable treaty.553 If organized as a U.S. entity, the fund will bear the primary obligation to withhold from payments considered to be made to its foreign members.554 For foreign funds, the Code imposes the withholding obligation on the portfolio company or other U.S. withholding agent, unless the fund is a withholding foreign partnership.555 In either case, the obligation to withhold applies whether or not the fund or portfolio company distributes property to its owners.556
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551 § § 871(a), 881(a).

552 § 702(b).

553 § § 871(a), 881(a), 1441(a), 1442(a). See Regs. §  1.1441-6 for rules relevant to claims for reduced withholding based on tax treaties. See also Regs. §  301.6114-1(c)(6) (effective for taxable years ending after December 31, 2004, reporting under §  6114 is not required in certain circumstances where the payment is properly reported on Form 1042-S, “Foreign Person's U.S. Source Income Subject to Withholding,” and the withholding agent is a withholding foreign partnership).

554 See Regs. § 1.1441-5(b)(2)(i).

555 See Regs.  § 1.1441-5(c).

556 For a discussion of special withholding procedures for “withholding foreign partnerships,” see IX, D, 1, below.

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Private equity funds invest primarily as shareholders. Because capital gain is generally exempt from withholding,557 foreign investors in private equity funds are most likely to incur U.S. withholding tax on dividend income.  For funds that invest in common stock, therefore, withholding is rarely a concern for the simple reason that growth companies rarely pay cash dividends. As a rule, however, private equity funds demand a preference on their investment, usually in the form of preferred stock.  In addition, the investment is usually convertible into common stock, and may provide for one or more variable claims to the earnings or assets of the business. Depending upon the terms of those claims, the fund may realize taxable dividends under § 305.
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557 See § 871(a)(2); Regs. § 1.1441-2(b)(2)(i) (gains derived from sale of property not “fixed or determinable,”subject to certain exceptions).  Although non-ECI capital gains realized by a nonresident individual are subject to withholding taxes if such individual is present in the United States for 183 days or more during the taxable year, the Code generally treats such persons as U.S. residents. See § 7701(b). Foreign investors generally bear U.S. tax on capital gains only if those gains represent ECI or attract taxation under  § 897.

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The immediate significance of § 305 for fund managers is that the withholding obligation on dividends applies without regard to whether the dividend coincides with any actual transfer of cash or other property.558 Sections 871(a)(1)(A) and 881(a)(1) impose a 30% tax on non-ECI dividends from U.S. sources “received” by a foreign person during the taxable year.  The obligation to withhold applies to the “payor” of the dividend,559 whether it pays the dividend annually or at other regular intervals.560 The regulations, however, construe the term “payment” to subsume many taxable accruals that do not coincide with an actual transfer of cash or property.561 Instead, the regulations impute “payment”at the time that the dividend is “includible in the income of the beneficial owner under the U.S. tax principles governing the cash basis method of accounting.”562 The touchstone for withholding, therefore, is not the receipt of the property, but the accrual of the tax liability. These rules represent a gross departure from the rules governing withholding for original issue discount, which defer the substantive tax liability until the foreign investor either receives payment or transfers the debt instrument.563 Although § 305 requires the holder to accrue “redemption premium” on preferred stock under the same principles,564 the regulations accelerate both the liability for tax and the withholding obligation.
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558 The preamble to the regulations provides that withholding is required under the § 1441 regulations “at the time of the deemed distribution even if the income from the distribution is prorated over time (such as a redemption premium under section 305(c))”.  See T.D. 8734, 1997-2 C.B. 109.

559 See § 1441(a), (b).

560 Regs. § 1.1441-2(b)(1)(ii).

561 The regulations generally excuse any withholding agent who is unrelated to the recipient or beneficial owner if the agent has no control of or custody over money or property of the recipient or beneficial owner.  See Regs.  § 1.1441-2(d)(1).  Relief from withholding does not apply, however, to “distributions with respect to stock.” Id.

562 Regs.  § 1.1441-2(e)(1).

563 § § 871(a)(1)(C), 881(a)(3); Regs. § 1.1441-2(b)(3).

564 § 305(c).

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Accreting dividends often represent a significant portion of the fund's return.  Yet the dividend is rarely paid in cash, at least on a current basis.  The obligation to withhold therefore poses a serious funding issue for many investments.  The regulations do provide a measure of relief for portfolio companies that have no current or accumulated “earnings and profits” at the time of investment and anticipate none during the accrual period by allowing them to “elect to not withhold on a distribution (actual or deemed) to the extent it is not paid out of accumulated earnings and profits or current earnings and profits, based on a reasonable estimate.”565 If the parties cannot safely assume that this relief provision will apply, however, they must either provide a mechanism to fund the withholding or structure the instrument to avoid the substantive liability.
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565 Regs.  § 1.1441-3(c)(2)(i)(C). The regulations define a “reasonable estimate” as “a determination made by the distributing corporation at a time reasonably close to the date of payment of the extent to which the distribution will constitute a dividend, as defined in section 316,” based upon “the anticipated amount of accumulated earnings and profits and current earnings and profits for the taxable year in which the distribution is made, the distributions made prior to the distribution for which the estimate is made and all other relevant facts and circumstances.” See Regs.  § 1.1441-3(c)(2)(ii).

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U.S. Income Portfolios: Other Pass-through Entities 
  Portfolio 735-2nd: Private Equity Funds 
  Detailed Analysis 
  IX. Withholding Taxes of Foreign Investors

B. Avoiding Dividend Accruals on Preferred Stock Investments 

1. Cumulative Preferred Stock 

Preferred stock often provides for a cumulative dividend at a fixed rate, payable “when, as and if” declared by the board of directors.  If the company fails to declare the dividend, it will accrue like interest on debt until ultimate payment, either by formal declaration or upon redemption, conversion or liquidation.  Unpaid dividends on cumulative preferred stock are not subject to § 305 even though they will increase the holder's claim to the earnings and assets of the business.566 If the issuer defers the dividend until the redemption date, however, the holder will realize an economic return on the instrument that will mimic the return on a “zero coupon” preferred security issued at discount to its redemption price.  In spite of the similarity, the latter security is subject to § 305. Thus, the legislative history authorizes the IRS to promulgate regulations to treat cumulative preferred stock as issued at a “disguised”redemption premium in appropriate cases.567 The IRS has failed to issue any regulations under this grant and it is the view of most practitioners that, absent extreme facts (e.g., debt covenants that prohibit dividends if debt matures beyond likely redemption date, economic penalty if issuer pays current dividends), any such regulations will not apply to cumulative preferred stock.568 A substantive reason is that such an instrument, although similar, is not identical to zero coupon preferred stock.  For example, if the issuer is free to pay the dividend if legally able, it may choose to do so in a declining interest rate environment, requiring the holder to reinvest the cash at lower market rates.  Due to the reinvestment risk, therefore, the security has less value than a “zero coupon”security that compounds the accrued dividend at the coupon rate.
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566 See § 305(c) (no redemption premium).

567 H.R. Rep. No. 881, 101st Cong. 2d Sess. 348 (1990).

568 See, e.g., Ginsburg & Levin, Mergers, Acquisitions and Buyouts, A Transactional Analysis of the Governing Tax, Legal and Accounting Considerations, Vol. 3, ¶  1309.3.3(6) (June 2002) (“any treatment of cumulative dividends on such preferred stock as “disguised”preferred OID would appear to represent a significant and unwarranted change in IRS position”).

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Rather than bear any risk of a constructive dividend, however, the parties will often modify the terms of the investment. Under  § 305, a redemption premium triggers a constructive dividend if it is payable on “preferred stock.”569 The regulations define preferred stock to exclude stock that “participate[s] in corporate growth to any significant extent.”570 Stock is deemed to so participate if it participates with the common stock on dividends and in liquidation on an “as converted” basis.  In most private equity investments, these changes will not materially alter the fundamental economic bargain. First, few companies at the venture capital stage of their existence pay dividends on common stock.  Thus, a right to participate in any such dividends will not increase the expected yield of the preferred stock.  Second, the fund investor already has the right to participate in liquidation on an “as converted” basis — it can simply convert to common stock immediately before a liquidation to capture the surplus value in the unlikely event that the conversion right is “in-the-money” at that time.  Although the regulations disregard the conversion right in measuring participation, it is the very existence of this right that should eliminate the issuer's objection to extending the right to participate in liquidation on a pre-conversion basis.571
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569 See  § 305(c).

570 Regs. § 1.305-5(a).

571 See Regs. § 1.305-5(a) (“the determination of whether stock is preferred for purposes of section 305 shall be made without regard to any right to convert ...”).

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2. Discount Preferred 

Although portfolio companies rarely issue preferred stock at an explicit discount, they often issue preferred stock as part of an investment unit.  When a corporation issues an investment unit, it must allocate the cash proceeds received for the unit between the stock and the other property (e.g., warrants, common stock) in accordance with their relative fair market values.  Any portion of the proceeds allocable to the other property therefore creates discount on the preferred stock, which, assuming that the stock is either mandatorily redeemable or redeemable at the option of the holder, the holder must accrue under § 305 as a constructive distribution.572
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572 See § 305(c)(1), (c)(3); Regs. § 1.305-5(b)(1) (redemption premium); Regs.  § 1.305-5(b)(2) (mandatory redemption or holder put); § 316(a) (earnings &  profits limitation).  In addition, the holder must accrue any discount on preferred stock that is redeemable at the option of the issuer if the exercise of the option is “more likely than not” to occur.  Regs. § 1.305-5(b)(3).  This rule does not apply if the optional redemption right is intended to penalize the issuer for redeeming the stock prematurely. Id.

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One simple remedy to this problem is to assign de minimis value to the other property, but that requires empirical evidence that supports a low valuation. Funds will often cite the illiquidity of the other property or its subordination to senior claims as evidence of a low valuation, which reduces the discount on the preferred stock.  Because the issuer derives no tax benefit from stock discount, it will usually cooperate with the holder on issues of this sort.573 Another remedy is to modify the terms of the investment to include sufficient participation rights to avoid the definition of “preferred stock,” which is a necessary condition to the application of the § 305(c) regulations.  As described in IX, B, 1, above, the nature of the participation rights already inherent in the investment will often neutralize the pre-tax significance of these modifications to the issuer.
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573 In fact, if the fund is not a domestic entity, the issuer may share the fund's objective of minimizing the discount to avoid the withholding obligation. See IX, A, above.

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3. PIK Preferred 

One of the more complex securities under  § 305 is convertible preferred stock that provides for a dividend payable in additional shares (“PIK Preferred”).  If the issuer has sufficient earnings and profits, PIK Preferred may attract a constructive distribution under three distinct provisions of § 305. First, under § 305(b)(4), any stock distribution on “preferred stock,” other than certain limited categories of conversion ratio adjustments, is treated as a dividend.  Second, under § 305(b)(2), any distribution that has the result of the receipt of property by “some”shareholders and an increase in the proportionate interests of “other”shareholders in the assets or earnings and profits of the issuing corporation is treated as a dividend.  Third, under § 305(b)(5), any distribution of convertible preferred stock is treated as a dividend unless the taxpayer establishes to the satisfaction of the IRS that the distribution will not have the result described in § 305(b)(2).

In assessing the viability of any structural solution to this problem, one must be mindful of a fundamental economic difference between PIK Preferred and cumulative preferred stock.  PIK Preferred conveys two discrete economic rights: the right to the cash dividend, as reflected in the liquidation preference of the newly issued share, and the right to additional common shares, as reflected in the conversion right of that share.  Thus, the substitution of a cumulative dividend for a PIK dividend to avoid a taxable distribution will produce an inferior economic security to the holder, who must surrender the embedded conversion right.  Moreover, a periodic adjustment to the conversion ratio to compensate the holder for the foregone shares will give rise to a distribution under § 305(b)(4) (and possibly § 305(b)(2)).

Sections 305(b)(4) and 305(b)(5) apply only to “preferred stock.” As described above, it is often possible to avoid that characterization without materially altering the economic terms of the investment.574 But § 305(b)(2) applies to all classes of stock, focusing only on the question of whether “some”shareholders receive property and “other” shareholders increase their proportionate interest.  Although the statute does not define the required nexus between the two events, it does require both a stock dividend and a property distribution.  Section 305(b)(2) will not apply, therefore, if the issuer has no convertible debt outstanding575 and pays no dividends on any other class of stock.  Because many portfolio companies do not pay dividends and have insufficient debt capacity to borrow, many PIK investments will fit within this seemingly narrow corridor.  A far more likely impediment is other classes of preferred stock that pay explicit or constructive dividends under § 305.
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574 See IX, B, 1, above.

575 Section 305(d) treats a holder of convertible debt as a holder of stock.  Thus, any interest paid or accrued on convertible debt may satisfy the taxable “distribution” requirement of the statute for purposes of imputing a dividend to the “other”shareholders.

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But what if the issuer does pay a common dividend? Then the answer will depend upon whether the two transactions have sufficient nexus and, if so, whether the right of the PIK Preferred to participate in common dividends has any independent bearing on the analysis. The textbook case under § 305(b)(2) is the issuer with two classes of common stock:one paying dividends in cash, the other in shares.576 Because the stock dividend directly compensates one class of shareholders for cash dividends to the other, § 305(b)(2) taxes the stock dividend.  Yet the actual reach of the statute is considerably broader, seeming to permit any dividend on another class of stock to supply the property distribution.577 But as one leading commentator observed, “one should not focus so intently on the hole as to miss the doughnut.”578 First, the statute requires some causal connection, however attenuated, between the property distribution to the other shareholders and the increase in proportionate interest to the holder of the PIK Preferred.579 The PIK dividend, however, has no causal connection —the issuer must declare it whether or not it declares a cash dividend on the common stock.  Second, the statute applies only if “some”shareholders receive the property distribution and “other”shareholders increase their proportionate interest.  If the PIK Preferred participates in common dividends, then all of the shareholders receive the distribution, not “some” of the shareholders. Unless “some” subsumes “all,” therefore, the statute does not apply.
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576 Regs. § § 1.305-3(a), 1.305-3(e) (Ex. 1).

577 Regs. § § 1.305-3(b)(2), 1.305-3(b)(4).

578 See Bittker and Eustice, Federal Income Taxation of Corporations and Shareholders (6th ed. 1994)at ¶  8.14[2][e].

579 See  § 305(b)(2) (“if the distribution ... has the result of”).

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While that argument is not without merit, it is not entirely persuasive either.  First, § 305 is hardly the model of clarity on nexus.  While the statute seems to require a causal connection, the regulations do not require a plan to achieve the prohibited result.580 If no such plan exists, the regulations presume that the distribution fails to achieve the prohibited result only if the stock dividend occurs more than three years before or after a taxable dividend.581 If the absence of a plan is not dispositive, one struggles to discern exactly what causal link will suffice to establish nexus.  Perhaps the statute presumes causation whenever two transactions occurring within a stated interval achieve the prohibited result, in which case causality is irrelevant.  Second, the holders of PIK Preferred in fact increase their proportionate interest in the issuer and the issuer in fact pays a cash dividend to the other shareholders, including the PIK Preferred shareholders.  To interpret the word “some” to exclude “all” would allow any cash dividend on the PIK Preferred, whether or not the conversion right is in-the-money and whether or not the cash dividend is paid on a fully-converted basis, to “cleanse” the PIK dividend even though the PIK dividend compensates the holder for not fully participating in common dividends.  Is the PIK dividend really so different from the stock dividend in the textbook case?
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580 Regs. § 1.305-3(b)(2) (“It is sufficient if there is an actual or deemed distribution of stock ...and as a result of such distribution ... some shareholders receive cash ... and other shareholders increase their proportionate interest”).

581 Regs. § 1.305-3(b)(4).

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4. “Down Round”Adjustments 

A modern trend in private equity investing is to demand price-based anti-dilution protection.  Like any holder of convertible securities, fund investors will receive standard anti-dilution protection for stock dividends, stock splits, partial liquidations and other changes in the issuer's capital structure that would otherwise diminish their percentage claim to the assets of the business.  Price-based anti-dilution protection addresses are an entirely different phenomenon, applying not when the issuer alters its capital structure, but when the issuer sells stock at a lower price, commonly known as a “down-round.”

Formulas for adjusting the conversion price of preferred stock will incorporate specific pricing assumptions and other conventions, many of which are heavily negotiated.  Most frequently, the formula will provide for a “full ratchet” or “weighted-average”adjustment to the conversion price.  The adjustment may be contingent upon whether the shareholder participates in the down-round (i.e., “pay-to-play”)and may or may not include options, warrants, convertible debt or other equity equivalents in the equity base.  Regardless of the variations, however, the adjustment seeks to compensate the earlier investors for all or portion of the unrealized loss in their investment, as implied by the down-round.

Example (“Full Ratchet”): A fund invests in a portfolio company with 100 shares of common stock outstanding at a pre-money valuation of $1000.  The fund acquires 100 shares of preferred stock for $1000, convertible on a one-for-one basis into common stock. The portfolio company later raises $750 in a “down-round”at a pre-money valuation of $1500, or $500 below the $2000 post-money valuation of the portfolio company immediately after the first round of financing.  If the terms of the preferred stock provide for a “full ratchet” adjustment to the conversion ratio, the fund should be entitled to common stock upon conversion with a value of $1000 immediately after the second round of financing, or the dollar amount invested by the fund in the first round.  The conversion ratio would therefore increase from 1.00 to 1.5582 and the portfolio company would issue 125 shares of preferred stock to the new investor, assuming an initial conversion ratio of 1.00.583

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582 1.00 (initial conversion ratio)/($1000 (initial investment)/$1500 (pre-money valuation before second round of financing)).

583 750 /($1500/250).

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Example (“Weighted Average”): Assume the same facts as in the preceding example, but that the preferred stock calls for a “weighted average” adjustment to the conversion ratio. With a “weighted average” adjustment, the formula must weight the adjustment to reflect the total dollar investment in each round.  After the adjustment, therefore, the fund would still receive common stock upon conversion with a $1000 value, but measured as if the portfolio company raised capital in the second round at the weighted average price of the stock over the first and second rounds, not the actual share price.  The weighted-average price is therefore $8.75 per share,584 increasing the conversion ratio from 1.00 to 1.1429.585 The portfolio company would issue 107.14 shares of preferred stock to the new investor.586

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584 2000/200) + ($1500/200))/2.

585 1.00/0.875.

586 750/$1500/((100 x 1.1429) + 100) = $750/$7 per share = 107.14 shares.

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“Pay-to-play” is a condition precedent to the price adjustment, whether the adjustment occurs on a full ratchet or weighted-average basis.  A portfolio company may insist on this condition for fear that if its existing shareholders were to receive full or partial price protection in a down-round whether or not they invested, it would reduce their incentive to do so, which in turn may diminish the likelihood of raising capital from anyone.  To benefit from the anti-dilution adjustment, therefore, an investor who holds “pay-to-play”preferred stock must invest in the down-round.

Under § 305, an increase in conversion ratio that “represents an adjustment of the price to be paid by the distributing corporation in acquiring property ... is not within the purview of section 305.”587 Although the precise contours of this exception are not clear, the purpose of the exception is: to exempt from § 305 any change in conversion ratio or other adjustment that represents a purchase price adjustment, which under general tax principles is not a taxable event so long as the recipient of the compensating payment continues to hold the subject property.588 Most forms of price-based anti-dilution protection seek to do precisely that.  Thus, § 305 should not apply to these types of adjustments.589
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587 Regs. § 1.305-1(c).

588 See, e.g., Dobson v. Comr. 320 U.S. 489 (1943); Griffith v. Comr., 308 U.S. 355 (1939); Goldsmith v. Comr., 22 T.C. 1137 (1954); Megargel v. Comr., 3 T.C. 238 (1944).

589 The point is often academic after a “down-round” because the issuer will have no current or accumulated earnings and profits.  Down-round financings often coincide with poorer-than-expected financial performance, and therefore correlate negatively with profitability.

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5. “Double Dip”Preferred Stock 

In an environment of scare capital, a fund investor may seek to increase its share of the equity not only by demanding price-protection, but by subordinating the junior equity to a minimum level of gain.  In a typical preferred stock investment, for example, the holder will surrender its liquidation preference when it exercises the conversion right.  Thus, the holder will convert the security only when the value of the underlying common exceeds the sum of the liquidation preference and any accrued but unpaid dividends.  A modern trend, however, is to retain the liquidation preference upon conversion.  With this type of instrument, the investor “double dips” on conversion, receiving both the liquidation preference (often payable in common shares) and additional common shares equal to the “as-converted”percentage of the residual assets.  As an economic matter, therefore, the instrument resembles an investment unit consisting of straight preferred stock and penny warrants.

Because the actual number of common shares issuable on conversion will depend in part upon the value of the common on the conversion date, the conversion price of this type of preferred stock investment is not fixed, at least with respect to the number of common shares necessary to retire the liquidation preference.  Nevertheless, the investment should fall beyond the purview of § 305.  Section 305 is intended to tax conversion ratio adjustments that compensate the holder for taxable distributions to other shareholders or that increase the holder's interest in the earnings or assets of the business,590 the two principal hallmarks of a dividend.  This type of preferred stock entitles the holder to a fixed dollar return plus a constant percentage of the residual assets.  To impute a distribution under § 305, therefore, the IRS would have to bifurcate the investment into its component parts and allocate a portion of the cash investment to the “embedded”warrants.591 Even then, § 305 would only apply if the preferred stock provided for mandatory redemption or was redeemable at the option of the holder.592 Given the absence of any clear legal basis for bifurcation,593 it is unlikely that § 305 would apply to this type of investment.
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590 See Regs. § 1.305-7(a), (b).

591 See IX, B, 2, above, for a discussion of the tax treatment of preferred stock issued at a discount to its stated redemption price.

592 Regs. § 1.305-5(b)(2).

593 See, e.g., Rev. Rul. 70-108, 1970-1 C.B. 78 (convertible preferred stock treated as two securities because stock incorporated right to purchase additional shares for cash consideration); Regs.  § 1.1275-2(g)(3) (Ex. 3: anti-abuse rule permitting bifurcation of debt instrument inapplicable to convertible debt even if purpose of issuing unitary security is to avoid discount).

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6. Preferred with Change of Control Premium 

When a fund sells an investment, it may realize a small dollar return even when the investment produces a high internal rate of return (“IRR”).

Example: A fund makes an investment of $100 in two portfolio companies and sells the first investment for $150 in 6 months and the second investment for $500 in three years.  The first investment generates an IRR of 100% and the second investment generates an IRR of 71%.  In absolute dollars, however, the first investment produces a 50% return and the second investment a 500% return.

As this example illustrates, an investor's IRR depends not only on its dollar return, but on the holding period of the investment. A short holding period increases IRR, but not the dollar return. Fund managers measure fund performance by both criteria.

To protect the dollar return, some funds demand a fixed multiple on sale above the typical downside protection, which is the fund's initial cash investment.  For example, the certificate of designation may provide that the fund will receive three times its cash investment upon liquidation, broadly defined to include any merger, sale of control or other liquidity event.594 Like price-based anti-dilution adjustments,595 these provisions increase the fund investor's ownership of the assets and earnings of the portfolio company after a specified event.  However, the right does not raise the same tax concern.  First, the mere existence of the contingent participation right may disqualify the investment as “preferred stock”for tax purposes.596 Even if the IRS were to construe the right as a disguised “redemption premium,” therefore, the regulations would not impute a constructive distribution under § 305(c).  Second, because the premium is only payable in a sale or liquidation, the stock is not mandatory redeemable “at a specified time.”597 Without a fixed redemption date, the holder cannot accrue the premium in accordance with the principles of § 1272(a), as the statute clearly requires.598
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594 If the value of the underlying common shares were to exceed the liquidation preference, the fund would simply convert the instrument to common stock immediately before the sale to capture the surplus value.

595 See IX, B, 4, above.

596 See IX, B, 1, above.

597 See  § 305(c)(1); Regs.  § 1.305-5(b)(2).

598 § 305(c)(3); Regs. § 1.305-5(b)(1).

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U.S. Income Portfolios: Other Pass-through Entities 
  Portfolio 735-2nd: Private Equity Funds 
  Detailed Analysis 
  IX. Withholding Taxes of Foreign Investors

C. Conversion of Dividend Accretions to Capital Gain 

As described above, many types of preferred stock provide for returns based in whole or in part on time value of money principles, yet without the concomitant inclusion of dividend income.  If the fund investor is able to avoid the accrual, it will recognize income when the issuer pays the accrued return.  Moreover, if the fund is able to recognize the accrual as a capital gain, its U.S. investors will achieve both deferral of tax during the holding period and a reduced rate of taxation on payment.599 Foreign investors will usually achieve complete tax exemption.600
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599 For a discussion of the reduced rate of taxation on “qualified dividend income” for U.S. individual investors, see X, A, below.

600 See  § 871(a)(2); Regs.  § 1.1441-2(b)(2)(i) (gains derived from sale of property not “fixed or determinable,”subject to certain exceptions).  Although Congress reduced the highest marginal rate on dividends with respect to “qualified dividend income” for U.S. individual investors to 15%, the lower rate does not apply to dividends subject to withholding under § 871 or  § 881. See X, A, below.

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In Rev. Rul. 69-130,601 a corporation declared a quarterly dividend on preferred stock to shareholders of record as of a specified date.  A few days before that date, the corporation called the preferred stock effective as of the specified date, offering to pay the holders the par amount plus the previously declared dividend in exchange for the stock.  The IRS treated a portion of the redemption proceeds as a dividend under § 301, characterizing the declared amount as a separate property right akin to a debt obligation.  Because the corporation declared the dividend before taking any action to call the preferred, the amount paid to the holders “could not be said to be paid in cancellation or redemption of the stock”to the extent allocable to this separate obligation.
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601 1969-1 C.B. 93.

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In Rev. Rul. 69-131,602 a corporation called preferred stock for redemption.  Although the preferred stock provided for a 6% compounding dividend, the corporation never declared it.  Under the terms of the preferred stock, however, the redemption price included not only the par amount, but any accrued but unpaid dividends through the date of redemption.  Thus, the holder would receive the same cash proceeds upon redemption whether or not the corporation declared the dividend under state law.  The IRS nevertheless ruled that the full amount of the price paid to redeem the stock, including the portion thereof allocable to the accrued dividend, qualified as an exchange under  § 302(a).603
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602 1969-1 C.B. 94.

603 If the certificate of designation prohibits common dividends before the payment of accrued dividends on a senior class of stock, then any dividend on the common stock in violation of the certificate will create a legal obligation to pay the accrued dividend, whether or not the issuer declares it.  Under the principles of Rev. Rul. 69-130, therefore, a subsequent redemption of the preferred stock that compensates the holder for the accrued dividend will give rise to a § 301 distribution.  See Rev. Rul. 75-320, 1975-2 C.B. 105; Crown v. Comr., 58 T.C. 825 (1972), aff'd, 487 F.2d 1404 (7th Cir. 1973).

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Based upon these rulings, therefore, preferred stock that provides for any form of time-based accretion (e.g., cumulative dividends, participating preferred stock issued at a discount, certain types of PIK Preferred) but nevertheless avoids the constructive distribution rules of § 305 may achieve not only deferral to the holder, but character conversion, provided in certain cases that the portfolio company dispenses with the corporate formality of declaring the dividend.  By altering the tax character of the dividend, the foreign and U.S. investors achieve both deferral of tax during the fund holding period and, upon actual payment, either tax exemption (foreign investors) or a reduced rate of tax (U.S. individual investors and members of the general partner).

Note: If the dividend in question is “qualified dividend income,” a U.S. individual investor would bear tax on the dividend at the same rate as long-term capital gain, but without the benefit of deferral.  For a further discussion of the reduced rate of taxation on “qualified dividend income” under the 2003 JGTRRA, see X, A, below.

The investors should derive these tax benefits whether the fund sells the preferred stock to a third party, sells the preferred stock back to the portfolio company in a sale or exchange transaction,604 or exchanges the preferred stock in an acquisitive reorganization.605 In contrast, a holder of convertible debt with substantially identical terms must accrue these returns at ordinary income rates, regardless of when the holder actually receives the cash.606
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604 See § 302(b).

605 In an acquisitive reorganization, the receipt of shares in the acquiror should qualify for rollover treatment whether or not attributable to accrued but unpaid dividends on the shares of the portfolio company.  Rev. Rul. 82-158, 1982-2 C.B. 77.  In contrast, if the portfolio company itself acquires preferred stock with dividend arrearages for newly issued stock with a preference sufficient to cover the arrearage, the exchange may not qualify as tax-free to the extent of the arrearage.  See Regs.  § § 1.305-7(c)(1); 1.305-5(d) (Ex. 1); 1.368-2(e)(5).

606 For a discussion of special tax issues with convertible debt, see VIII, above.

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U.S. Income Portfolios: Other Pass-through Entities 
  Portfolio 735-2nd: Private Equity Funds 
  Detailed Analysis 
  IX. Withholding Taxes of Foreign Investors

D. Withholding Requirements for Offshore Funds 

1. Withholding Foreign Partnerships 

In 1997, the Treasury Department issued comprehensive regulations, effective January 1, 2001, setting forth the withholding and reporting obligations pursuant to § § 1441 and 1442 for payments by foreign partnerships to their partners.607 These regulations establish withholding and reporting obligations for two types of foreign partnerships:nonwithholding foreign partnerships (“Non-WPs”) and withholding foreign partnerships (“WPs”).  To qualify as a WP, a foreign partnership must enter into a withholding foreign partnership agreement(a “WP Agreement”) with the IRS.608 If a foreign partnership does not enter into a WP Agreement, it is subject to the withholding and reporting requirements that apply to Non-WPs.609
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607 See T.D. 8734, 1999-1 C.B. 455, modified, T.D. 8881, 2000-1 C.B. 1158.

608 See Regs. § 1.1441-5(c)(2).

609 For a detailed discussion of the withholding and reporting requirements applicable to Non-WPs, see IX, D, 2, below.

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A Non-WP must submit withholding statements allocating each payment, by income type, to each partner.  A WP may provide the withholding agent with a Form W-8IMY on behalf of the foreign partnership.  Although a WP has a separate obligation to collect the appropriate Forms W-8 and W-9 from each of its partners, it is not required to provide this information to the withholding agent.  Instead, the WP may receive payments from the withholding agent free and clear of withholding and then withhold and pay over any taxes due based on the documentation received from each of its partners.610
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610 See Regs. § 1.1441-5(c)(2).

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On May 22, 2002, the IRS published Notice 2002-41,611 which provides guidance to foreign partnerships seeking to enter into a WP Agreement.  The IRS stated in the notice that it would defer publication of a model WP Agreement as a revenue procedure until it first considered comments on the proposed guidance.  Until that time, therefore, a foreign partnership could not qualify as a WP.  The IRS did, however, extend transition relief to all foreign partnerships for calendar year 2002.  Initially granted to foreign partnerships after publication of regulations, the relief provisions now allow a foreign partnership to provide withholding agents with a withholding statement based on “withholding rate pools,”along with Forms W-9 for all U.S. non-exempt recipients.612 The foreign partnership may provide documentation to the withholding agent with respect to its foreign partners and U.S. exempt recipients at any time during the calendar year.
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611 2002-24 I.R.B. 1153.

612 A “withholding rate pool” is a payment of a single type of income, determined in accordance with the categories of income reported on Form 1042-S or Form 1099, as applicable, that is subject to a single rate of withholding.”

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On July 11, 2003, the IRS issued Rev. Proc. 2003-64.613 The revenue procedure includes the model WP Agreement and the application procedures for entering into those agreements.  A WP Agreement entered into during the calendar year may be made effective as of the first day of the calendar year.  Upon the issuance of the revenue procedure, therefore, the relief provisions described above became obsolete.
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613 2003-32 I.R.B. 306. See also Rev. Proc. 2004-21, 2004-14 I.R.B. 702, modifying Rev. Proc. 2003-64 (amending Section 10.01 of WP Agreement to eliminate the $200,000 cap); Rev. Proc. 2005-77, 2005-2 I.R.B. 1176, modifying Rev. Proc. 2003-64 (amending Section 10.02 of WP Agreement to eliminate the “relatedness requirement”).

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To become a WP, a foreign partnership must submit an application that includes the following information:

• a statement identifying the partnership as a foreign partnership that requests to enter into a WP Agreement;

• the name, address and employer identification number of the partnership, if any;

•the country in which the partnership was created or organized and a description of the partnership's business;

• a list of the persons, including names, titles, addresses and telephone numbers, serving as the responsible parties for the partnership's performance under the WP Agreement;

• a list setting forth, as of the application date,(i) the types of partners by category (e.g., domestic, foreign, treaty-eligible, etc.); (ii) within each category, the number and percentage interest of each partner in partnership capital, profits and losses (including any special allocations); and (iii) the estimated value of the U.S. investments to which the WP Agreement will apply;
  
• a completed Form SS-4 for WP reporting and filing purposes;614 and
  
• two executed copies of the WP Agreement.

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614 A partnership that has already obtained an employer identification number for other purposes must still apply for a special WP employer identification number.

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Under the model WP Agreement, a WP may receive payments from the withholding agent in gross and then withhold from its partners based upon the Forms W-8 or W-9 that it receives from its partners.  The WP must withhold on the date that it makes any distribution to a direct foreign partner that includes an amount subject to withholding.  The model WP Agreement also includes a provision that would allow the WP to determine how much to withhold from a distribution based upon a reasonable estimate of the partner's distributive share of income subject to withholding for the year.  A WP Agreement generally continues in force indefinitely unless the WP does not keep appropriate documentation on file with respect to its partners and fails to cure the defect after a stated period.  A WP Agreement also terminates following a deemed termination of a foreign partnership under  § 708(b)(1)(B).

2. Nonwithholding Foreign Partnerships 

Under the regulations, a Non-WP must provide a Form W-8IMY to each withholding agent on behalf of the partnership, along with appropriate documentation(i.e., the appropriate Forms W-8615 or W-9) from its partners.616 The W-8IMY must allocate the payments to each such partner by type of income.617 A Non-WP must update the withholding statement “[a]s often as required to keep the information ... correct prior to each subsequent payment.”618
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615 In general, a fund investor will provide the fund with a W-8BEN, in the case of any payments not “effectively connected” to a U.S. trade or business, or a W-8ECI, in the case of any payments “effectively connected” to a U.S. trade or business.

616 See Regs.  § 1.1441-5(c)(3)(iii).

617 See Regs. § § 1.1441-5(c)(3)(iv) and 1.1441-1(e)(3)(iv).

618 Regs.  § 1.1441-1(e)(3)(iv)(B).

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As the IRS implicitly recognizes, the rules that govern Non-WPs impose a greater compliance burden.  Most significantly, unless the general partner maintains an “evergreen” withholding statement that reflects the appropriate allocations of each payment, the withholding agent may withhold too much or too little.  This will often leave a foreign partner with no simple remedy.  If an agent overwithholds, the partner may have to file for a refund with the IRS.619 Conversely, if an agent underwithholds, the partner may have to file a U.S. tax return to report and pay the remaining amount due.620 The IRS therefore expects that the majority of foreign partnerships with substantial reportable income will seek to enter into a WP Agreement.621
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619 Under § 1464, the IRS will refund the overpayment to the withholding agent unless the withholding agent actually withheld the excess amount. If the withholding agent withheld the excess amount and remitted it to the IRS, the IRS will refund the remitted amount directly to the foreign person.  Regs.  § 1.1464-1(a).  A withholding agent that overwithholds may instead repay the excess withholding to the foreign person from its owns funds, claiming a credit equal to the repayment on its next deposit of withholding tax.  See Regs. § 1.1461-4(a)(1). Alternatively, the withholding agent may reimburse the foreign person by applying the excess amount against withholding taxes on future payments.  See Regs.   § 1.1461-4(a)(2).

620 Under certain circumstances, a withholding agent that underwithholds may assess the shortfall against future payments, or even satisfy the tax from property of the foreign person otherwise in its custody, provided that the agent does so before the due date of the Form 1042 for the calendar year in question.  See Regs.  § 1.1461-2(b).

621 Rev. Proc. 2003-64, 2003-32 I.R.B. 306, § 2.10.

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U.S. Income Portfolios: Other Pass-through Entities 
  Portfolio 735-2nd: Private Equity Funds 
  Detailed Analysis 
  IX. Withholding Taxes of Foreign Investors

E. Treaty Benefits 

Under § 894(c), a foreign person is not entitled to a reduced rate of withholding under an otherwise applicable treaty on any item of income that is “derived through an entity which is treated as a partnership” if (i)such item is not subject to tax in the foreign jurisdiction; (ii)the treaty does not include provisions addressing the treatment of items of income derived through a partnership; and (iii) the foreign jurisdiction does not impose tax on a distribution of such item of income.  This provision is often perceived as an anti-abuse rule directed at foreign CTB entities in non-treaty jurisdictions formed for the purpose of claiming treaty benefits on payments from domestic entities, even though the payments are not subject to tax in the treaty jurisdiction of the shareholder.  For example, § 894(c) prohibits a Bermuda entity owned by a treaty resident that receives a dividend from a U.S. corporation from claiming treaty benefits merely because the treaty resident elects to treat the Bermuda entity as a CTB entity for U.S. tax purposes.

In limited cases, however, § 894(c) also limits treaty benefits with respect to dividends or other amounts paid by U.S. entities to a domestic pass-through entity.  Assume, for example, that a U.S. private equity fund organized as a Delaware LLC receives a dividend from a U.S. portfolio company. If the laws of the jurisdiction in which a foreign investor in the fund is resident treat the LLC as a corporate entity, the foreign investor may not qualify for treaty benefits on its allocable share of the dividends.  Under the regulations, treaty benefits do not apply to any item of income earned by a pass-through entity unless the item of income is “derived by” the treaty resident, regardless of where the entity is organized.622 An item of income is “derived by”a treaty resident only if the fund is fiscally transparent under the laws of the treaty jurisdiction and the treaty resident is not.623 An entity is “fiscally transparent” in a jurisdiction if the jurisdiction requires the holder to report the item of income on a flow-through basis as if realized directly by the holder, whether or not the entity distributes it to the treaty resident.624 Thus, if a foreign jurisdiction treats a fund organized as a domestic LLC or limited partnership as a separate taxable entity, the fund must withhold at the full 30% rate on any dividends payable to fund investors in that jurisdiction, even if the relevant treaty provides for a lower rate.625 For example, prior to a recent treaty amendment, Canada treated a U.S. LLC as a corporation for Canadian income tax purposes.626 A Canadian investor who invested in a fund organized as a domestic LLC therefore bore a 30% withholding tax on its allocable share of any dividends from a U.S. portfolio company, even though the Canadian treaty provides for a 5 to 15% withholding rate on dividends.627
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622 Regs. § 1.894-1(d)(1).

623 Id.

624 See Regs. § 1.894-1(d)(3)(iii).

625 To avoid the potential loss of treaty benefits, the sponsor may choose to organize the fund entity as either a state law limited partnership or as a foreign partnership in a low-tax jurisdiction—despite the growing popularity of LLCs as joint venture vehicles.

626 See R.S.C. 1985 (5th Supp., C.1), ITA  § 248(1); Interpretive Bulletin IT-343.

627 See Article X of Canada-U.S. Income Tax Treaty (prior to amendment by Fifth Protocol). Effective February 1, 2009, the treaty was amended to extend reduced withholding rates to domestic LLCs and other fiscally transparent entities. See Fifth Protocol to Canada-U.S. Income Tax Treaty.

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U.S. Income Portfolios: Other Pass-through Entities 
  Portfolio 735-2nd: Private Equity Funds 
  Detailed Analysis 
  IX. Withholding Taxes of Foreign Investors

F. Fund Agreement Provisions 

The withholding obligation is derivative, a collection mechanism for funding the substantive tax liability of the investor.  If a fund withholds from an investor, therefore, it should treat any amounts so withheld as if the fund had distributed such amounts to the investor. On occasion, however, the withholding will exceed amounts otherwise distributable to an investor during the period in question.  The “excess”withholding will usually reduce subsequent distributions to which the investor is otherwise entitled.  In some funds, however, the fund agreement will characterize the excess portion as a demand loan. Finally, if the general partner fails to withhold from a distribution, most fund agreements will require the investor to indemnify the general partner for any taxes or other penalties.

Worksheet 17 provides an example of a typical withholding provision in a fund agreement.

U.S. Income Portfolios: Other Pass-through Entities 
  Portfolio 735-2nd: Private Equity Funds 
  Detailed Analysis 
  X. U.S. Tax Objectives of U.S. Individual Investors

A. Minimizing Dividend Taxes 

Like foreign investors, U.S. individual investors prefer equity investments that do not generate actual or constructive dividends for U.S. tax purposes.  For foreign investors, avoiding the dividend prevents imposition of U.S. withholding taxes on income otherwise exempt from U.S. tax.628 For U.S. individual investors, avoiding the dividend preserves both deferral of tax and the capital gains preference upon ultimate realization.629 Thus, the preceding discussion concerning the application of § 305 to common types of preferred stock investments is also relevant to U.S. individual investors.630
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628 See  § 871(a)(2); Regs.  § 1.1441-2(b)(2)(i) (gains derived from sale of property not “fixed or determinable,”subject to certain exceptions).

629 § 61(a)(6) (dividends).

630 See IX, B, above.

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The Jobs and Growth Tax Relief Reconciliation Act of 2003 (the “Act”or the “2003 JGTRRA”)631 reduced the maximum marginal tax rate for individuals from 38.6% to 35%,632 effective for taxable years 2003 through 2010.633 The Act also reduced the maximum marginal tax rate for long-term capital gains for individuals from 20% to 15%,634 effective for sales or exchanges on or after May 6, 2003 and on or before December 31, 2010.635 Finally, the Act reduced the maximum marginal tax rate on dividends for individuals from 38.6%to 15%,636 effective for taxable years 2003 through 2010.637 The reduced rate on dividends applies only to “qualified dividend income.” For this purpose, “qualified dividend income”generally includes any dividends received from a domestic corporation or from a “qualified foreign corporation.”638 A qualified foreign corporation is any foreign corporation (i) incorporated in a possession of the United States, (ii) eligible for benefits under a comprehensive income tax treaty with the United States that contains an exchange of information program and which the IRS determines “is satisfactory” for purposes of the reduced rate on dividends;or (iii) a foreign corporation the stock of which is readily tradable on an established securities market in the United States.639 For this purpose, a share of stock will be treated as “readily tradable” on an established securities market if the entity issues readily tradable American Depository Receipts (“ADRs”) that reflect ownership of its shares.640 Even if a foreign corporation otherwise qualifies under one these categories, it will not be treated as a qualified foreign corporation if, during the year the dividend was paid, or the preceding year, the foreign corporation is a “passive foreign investment company.”641
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631 P.L. 108-27, § 302(a).

632 § 1(i)(2).

633 Act § § 105(b) and 107.

634 § § 1(h)(1)(C), 55(b)(3)(C).

635 Act § § 301(d) and 303, as amended by the 2005 TIPRA, P.L. 109-222, § 102. In the case of a pass-through entity, the reduced rate applies to gain and loss taken into account by the entity on and after May 6, 2003.

636 § 1(h)(11).

637 Act § § 302(f)and 303, as amended by the 2005 TIPRA, P.L. 109-222, § 102.

638 § 1(h)(11)(B)(i).

639 § 1(h)(11)(C). In PLR 200752029, the IRS explained that whether a mutual fund was a “corporation” for § 1(h)(11)(C) purposes depended on whether the fund was treated as a corporation for U.S. (not foreign)tax purposes, but that whether the fund was a § 1(h)(11)(C) “qualified foreign corporation” depended on whether it was a “resident”of the foreign country within the meaning of the applicable income tax treaty and a “qualifying person” under the treaty, without regard to the fund's entity classification for U.S. tax purposes.

640 H.R. Conf. Rep. No. 108-126, at 42 n. 41 (2003).

641 § 1(h)(11)(C)(iii), as amended by the 2004 American Jobs Creation Act, P.L. 108-357, § 413(c)(1)(B), effective for taxable years of foreign corporations beginning after Dec. 31, 2004, and to taxable years of U.S. shareholders with or within which such taxable years of foreign corporations end. Pre-2004 ACJA § 1(h)(11)(C)(iii)provided that a foreign corporation was not treated as a qualified foreign corporation if, during the year the dividend was paid, or the preceding year, the foreign corporation was: (1) a “foreign personal holding company;” (2) a “foreign investment company;”or (3) a “passive foreign investment company.” See also Notice 2004-70, 2004-44 I.R.B. 724 (providing guidance for treatment as qualified dividend income under § 1(h)(11) of distributions, inclusions, and other amounts from foreign corporations subject to certain anti-deferral regimes).

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A taxpayer will generally qualify for the reduced rate on dividend income only if it holds the stock for 60 days during the 121-day period beginning 60 days before the ex-dividend date and the taxpayer is not required to pay to another person the amount of the dividend (or otherwise required to make “substitute dividend payments”)with respect to the stock or substantially similar property.642
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642 § 1(h)(11)(B)(iii), as amended by the 2004 Working Families Tax Relief Act, P.L. 108-311, § 402(a)(2).

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U.S. Income Portfolios: Other Pass-through Entities 
  Portfolio 735-2nd: Private Equity Funds 
  Detailed Analysis 
  X. U.S. Tax Objectives of U.S. Individual Investors

B. Maximizing Deductible Expenses 

Unlike tax-exempt and foreign investors, U.S. individual investors in private equity funds bear full net basis taxation on their fund returns, albeit in large part at long-term capital gains rates.  Their principal objective, therefore, is to maximize the deductibility of their allocable share of the fund expenses.  Other than the capitalized costs of the portfolio investments themselves, which reduce gain (or increase loss) on sale, the carried interest and the periodic management fee represent the most significant of these expenses.  If the investors borrow to fund all or a portion of their capital commitment, then the carrying cost of the debt represents an additional expense.

If the fund is not engaged in a trade or business, then none of its expenses will be deductible by individual U.S. investors under  § 162.  Instead, these costs will pass through to the investors as “investment expenses”under  § 212.643 Section 67(b) classifies these expenses as “miscellaneous itemized deductions.” Under § 67(a), a taxpayer may deduct miscellaneous itemized deductions only the extent that they exceed 2% of the taxpayer's adjusted gross income.  Any amount so deductible then bears a further “haircut” under § 68, which caps the deduction at the excess of the itemized deductions over 3% of adjusted gross income above a specified base or 80% of the total itemized deductions of the taxpayer, whichever is lower.644  Finally, the alternative minimum tax disallows any tax benefit for miscellaneous itemized deductions.645
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643 See Regs. § 1.702-1(a)(8)(i). Section 212 includes “fees for services of investment counsel, custodial fees, clerical help, office rent, and similar expenses” as deductible investment expenses, provided that they are “paid or incurred by the taxpayer for the production or collection of income or for the management, conservation, or maintenance of investments held by him for the production of income; and ... are ordinary and necessary under all the circumstances.” See Regs. § 1.212-1(g).

644 § 68(a).

645 § 56(b)(1)(A)(i).

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As intrinsically passive entities, private equity funds do not pass through “trade or business” deductions to their U.S. individual investors. The net effect of § § 67 and 68, therefore, is to increase the effective tax rate of these investors on their portfolio gains.  Given these limitations, U.S. individual investors usually share the general partner's desire to structure the carry as a partnership allocation. For the general partner, the allocation converts the character of the income; for the investors, it converts what would otherwise constitute a nondeductible expense to the equivalent of an income exclusion. By reducing allocated income to exclude the general partner's incentive compensation, therefore, the investors do not need the separate deduction.  Had the general partner instead received the carry as a fee, § 704(b) would have required the fund to allocate 100% of the gains to the fund investors, including the portion thereof allocable to the general partner.646
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646 Expenses incident to a sale generally reduce the seller's “amount realized” for purposes of computing gain or loss. See, e.g., Wilson v. Comr., 49 T.C. 406 (1968), rev'd on another issue, 412 F.2d 314 (6th Cir. 1969). See also Prop. Regs. § 1.263(a)-1(d)(1), (2), REG-168745-03, 73 Fed. Reg. 12838 (3/10/08) (re-proposed regulations that would require, except in case of dealers in property, commissions and other transaction costs paid to facilitate sale of property to be capitalized and treated as reduction in amount realized). Because the fund pays the carry not as a selling commission but in consideration for managing the investments of the fund, the carry would not qualify as a selling expense even if cast as a fee.

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Deducting the management fee is a more difficult proposition.  Based upon a percentage of committed capital, the management fee usually represents the largest potentially nondeductible expense to U.S. individual investors.  In some cases, the general partner will structure a portion of the management fee as a partnership allocation, allowing its members to report the fee based upon the underlying character of the income at the fund level and to avoid employment taxes.647 If effective, the shift in character will also achieve an effective deduction of the fee for the U.S. individual investors by reducing their allocable share of the portfolio gains. Management fee offsets to reimburse fund investors for portfolio company fees paid to the fund manager achieve similar results, provided that the IRS does not treat the fund as having assigned the fees to the fund manager in partial satisfaction of the management fee.648
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647 See VI, H, above. If the fee is treated as a partnership allocation, the income will be excluded from the definition of “net earnings from self-employment”under § §  1402(a)(2) (dividends and interest) and 1402(a)(3)(A) (gain from sale of capital asset).

648 See VII, C, 3, above, for a discussion of fee offset arrangements and the related tax issues.

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Finally, although private equity funds rarely borrow to fund acquisitions, some investors do.  U.S. individual investors who borrow all or a portion of their capital commitments will incur “investment interest” on the debt, which is deductible only to the extent of their “net investment income.”649 “Net investment income” is the excess of investment income over investment expenses.650 Absent a special election, investment income does not include long-term capital gain or “qualified dividend income.”651 Taxpayers who make the election, however, bear tax on any sheltered capital gain or “qualified dividend income” at ordinary income rates.652 For investors in most funds, therefore, the deduction for investment interest will only shelter income otherwise subject to tax at a 15% or lower rate.653
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649 § 163(d).

650 § 163(d)(4).

651 § 163(d)(4)(B)(iii). See Regs. § 1.163(d)-1(b), T.D. 9191, 70 Fed. Reg. 13100 (3/18/05), for guidance on making the election and filing Form 4952, Investment Interest Expense Deduction.

652 Id.; see also Regs. § 1.163(d)-1(a); § 1(h)(3).

653 § 1(h)(1)(C).

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U.S. Income Portfolios: Other Pass-through Entities 
  Portfolio 735-2nd: Private Equity Funds 
  Detailed Analysis 
  X. U.S. Tax Objectives of U.S. Individual Investors

C. Qualified Small Business Stock 

If the fund has U.S. individual investors, or if the general partner of the fund has U.S. individual members, the fund may bear a reduced effective tax rate on gains attributable to fund investments in “qualified small business” (“QSB”) stock within the meaning of  § 1202. Section 1202 grants an exclusion to noncorporate taxpayers of 50%, 60%, or 75%654 of any gain recognized on the sale or exchange of QSB stock with a holding period of more than five years. Enacted prior to the reduction in the maximum capital gains rate for noncorporate taxpayers,655 § 1202 does not allow a taxpayer to both take the exclusion and apply the 15% rate to the balance.656 Thus, for example, an individual taxpayer in the highest tax bracket and who is entitled to a 50% exclusion will incur an effective tax rate on gains with respect to QSB stock of 14%, based upon the 28% capital gains rate. Such a taxpayer will therefore bear tax on gains with respect to QSB stock at a rate that is only one percentage point lower than the 15% rate under the 2003 JGTRRA.657
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654 For stock held more than five years and acquired on or before February 17, 2009, or on or after January 1, 2011, the exclusion is equal to either 50% or 60%. See §  1202(a)(1) (general rule of 50% exclusion) and §  1202(a)(2) (60% exclusion for stock of certain empowerment zone businesses). However, for stock held more than five years and acquired after February 17, 2009, and before January 1, 2011, the exclusion is 75%. § 1202(a)(3).

655 Revenue Reconciliation Act of 1993, P.L. 103-66, § 13113; § 1(h)(1) (enacted as part of Taxpayer Relief Act of 1997, P.L. 105-34).

656 §  1(h)(4).  The Code prevents taxpayers from taking advantage of both benefits by excluding § 1202 gain from the definition of “adjusted net capital gain,” which is gain subject to the reduced 15% rate(10% in the case of taxpayers in the 15% or lower bracket). § 1(h)(3).

657 For a further discussion of the reduced rate of taxation on long-term capital gain under the 2003 JGTRRA, see X, A, above.

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Section 1202 imposes a number of special limitations.  First, a taxpayer must hold QSB stock for more than 5 years.658 If the holder converts QSB stock into another class of stock of the same issuer, the newly acquired stock will also qualify as QSB stock with a tacked holding period.659 Section 1202 only applies to “eligible gain,” which is gain from the sale or exchange of QSB stock held for more than 5 years.660 For any single taxpayer, the maximum amount of eligible gain is the greater of $10 million or 10 times the taxpayer's basis in the stock of the issuing corporation.661
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658 § 1202(a)(1).

659 § 1202(f). Convertible debt does not itself qualify as QSB stock.  The holding period of the debt, therefore, will not tack to the QSB stock received upon conversion, even though the conversion itself is not a taxable event.

660 § 1202(b)(2).

661 § 1202(b)(1). This limitation applies for purposes of determining the amount of gain eligible for the exclusion. The effective ceiling is therefore only a percentage of the statutory amount.

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A further benefit of QSB stock is that noncorporate holders may reinvest the cash proceeds of a sale in new QSB stock without recognizing gain, provided that the holder satisfies certain conditions.662 In funds that require the immediate distribution of sales proceeds, this condition may preclude any rollover benefit unless the fund investor reinvests in QSB stock directly.663 To qualify for rollover treatment under § 1045, the taxpayer must satisfy a number of conditions, including that it hold the old QSB stock for at least six months before the sale and that it affirmatively elect rollover treatment under the Code.664
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662 § 1045. Regulations under §  1045 were finalized on August 14, 2007.

663 The investor could also receive the benefits of § 1045 if replacement QSB stock is purchased by a partnership in which the investor is a partner. See Regs. § 1.1045-1(c)(1)(i).

664 See § 1045(a). See also Regs. § 1.1045-1(b)(1) and (c)(1), which provides that for entities classified as partnerships, the election to defer gain under § 1045 can be made at the partnership level, the partner level, or both if the partnership replaces some QSB stock and the partner replaces some QSB stock.

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To qualify as QSB stock, an equity investment by the fund must satisfy the “original issuance” requirement and the portfolio investee must satisfy (i) the “C corporation” requirement;(ii) the QSB requirement and (iii) the “active business”requirement.665
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665 See § 1202(c)(1) and (2).

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To satisfy the C corporation requirement, the portfolio company must be a domestic C corporation during substantially all of the fund's holding period.666 To satisfy the “original issuance” requirement, the fund must acquire the stock at original issue.667 Although the rule itself is straightforward, the statute polices attempts to circumvent the purpose of this rule by contemporaneous redemptions.668 Specifically, stock held by a fund will lose its status as QSB stock if the portfolio company purchases any of its own stock (directly or indirectly) from either the fund or persons related to the fund within a four year period beginning two years before the date of the issuance,669 subject to a regulatory de minimis exception.670 In addition, any “significant”redemptions from any person within one year before or after the issuance of stock, as well as certain constructive redemptions under  § 304, will also disqualify the investment.671
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666 § 1202(c)(1), (c)(2)(A) and (d)(1).

667 § 1202(c)(1)(B).  Certain exceptions to the original issuance requirement apply to stock acquired upon conversion of QSB stock and stock acquired in certain tax-free exchanges.  See § 1202(f), (h).

668 § 1202(c)(3). See H.R. Rep. No. 213, 103d Cong., 1st Sess., 523 (1993) (redemption provisions intended to “prevent evasion”).

669 § 1202(c)(3)(A).  For this purpose, a “related person”means any person treated as a related person under § 267(b) or § 707(b).

670 See Regs.  § 1.1202-2(a)(2).  For this purpose, stock acquired from the taxpayer or a related person exceeds a de minimis amount only if the aggregate amount paid for the stock exceeds $10,000 and more than 2% of the stock held by the taxpayer and related persons is acquired. Id.

671 § 1202(c)(3)(B), (C).

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In the case of a partnership distribution of QSB stock to an eligible partner,672 the eligible partner is treated as having acquired such stock in the same manner as the partnership and having held such stock during any continuous period immediately preceding the distribution during which it was held by the partnership.673 The amount of gain eligible for deferral upon the later sale of such stock, however, cannot exceed the distribution nonrecognition limitation. For this purpose, the distribution nonrecognition limitation is equal to the partner's § 1045 amount realized, reduced by the partner's § 1045 adjusted basis.674 Further, the regulations provide rules for determining the partner's § 1045 amount realized and the partner's § 1045 adjusted basis in the case of a liquidating distribution, a nonliquidating distribution of all of the QSB stock (of the same type), and other nonliquidating distributions.675
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672 The regulations define an eligible partner as a non-corporate partner who held an interest in the partnership at all times that the partnership held the QSB stock or a non-corporate partner who acquired an interest in a partnership from an existing eligible partner by gift or death. Regs. § 1.1045-1(g)(3).

673 See Regs. § 1.1045-1(e)(1) (effective August 14, 2007).

674 See Regs. § 1.1045-1(e)(3)(i).

675 See Regs. § 1.1045-1(e)(3)(ii), (iii).

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To satisfy the QSB requirement,676 the “aggregate gross assets”of a domestic C corporation must not exceed $50 million at any time on or after August 10, 1993 and immediately before and after the date of issuance.677 Future appreciation above $50 million does not affect the status of the investment as QSB stock.  For this purpose, the statute defines “aggregate gross assets”as the amount of the cash and the aggregate adjusted bases of other property,678 treating contributed property as having a fair market value basis on the date of the contribution.679 For purposes of determining whether a corporation is a QSB, the statute treats all corporations within the same parent-subsidiary controlled group as a single corporation.680
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676 § 1202(d)(1).

677 § 1202(d)(1)(A) and (B).

678 § 1202(d)(2)(A).

679 § 1202(d)(2)(B).

680 § 1202(d)(3)(A).

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To satisfy the “active business” requirement681 for any period, the corporation must use at least 80% of its assets, measured by value, in the active conduct of one or more qualified trades or businesses and must be an “eligible corporation.”682 In general, the term qualified trade or business means any trade or business other than certain excluded trade or businesses.683 For purposes of measuring asset values, a corporation is deemed to own its ratable share of the assets of any subsidiary and to conduct its ratable share of the subsidiary's activities.684
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681 § 1202(c)(2)(A).

682 § 1202(e)(4) (the definition of “eligible corporation”excludes DISCs,  § 936 corporations, RICs, REITs, REMICs and FASITs).

683 See § 1202(e)(3)(A) through (E) (listing statutory exclusions).

684 § 1202(e)(5)(A).

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Worksheet 18 provides a sample QSB representation for a stock purchase agreement between a fund investor and a QSB.

U.S. Income Portfolios: Other Pass-through Entities 
  Portfolio 735-2nd: Private Equity Funds 
  Detailed Analysis 
  XI. Anti-Deferral Rules for Foreign Investments by Private Equity Funds

A. Introduction 

For funds that invest offshore, the practitioner must consider the potential application of various U.S. anti-deferral regimes to the taxable U.S. investors.  The primary targets of these regimes are U.S. shareholders in “controlled foreign corporations”(CFCs),685 “passive foreign investment companies” (PFICs),686 and, prior to 2005, “foreign personal holding companies”(FPHCs).687 If applicable, these provisions may subject U.S. shareholders to a number of undesirable consequences, among them loss of the capital gains preference and loss of tax deferral.  Although a detailed discussion of the CFC and FPHC rules is beyond the scope of this portfolio, practitioners who advise private equity funds that invest offshore should be familiar with the basic rules.688 As described more fully below, funds commonly adopt a range of strategies to avoid or at least temper the severity of these rules.
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685 See § § 951-965.

686 See § § 1291-1298.

687 See former § § 551-558, repealed by the 2004 American Jobs Creation Act, P.L. 108-357, § 413(a), effective for taxable years of foreign corporations beginning after Dec. 31, 2004, and taxable years of U.S. shareholders with or within which such taxable years of foreign corporations end.

688 See generally 926 T.M., Subpart F — General; 923 T.M., PFICS; 922 T.M., Foreign Personal Holding Companies  (Foreign Income Series) for a detailed discussion of the CFC, PFIC and FPHC rules.

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U.S. Income Portfolios: Other Pass-through Entities 
  Portfolio 735-2nd: Private Equity Funds 
  Detailed Analysis 
  XI. Anti-Deferral Rules for Foreign Investments by Private Equity Funds

B. Portfolio Investments in CFCs 

1. Classification as a CFC 

In general, a foreign corporation is a CFC if one or more “U.S. Shareholders” own more than 50% of the total combined voting power of all classes of voting stock or more than 50% of the total value of all classes of stock on any day during the taxable year.689 For this purpose, a “U.S. Shareholder” is any U.S. person who owns, either directly or by attribution, 10% or more of the total combined voting power of all classes of voting stock.690 A “U.S. person” includes not only a domestic corporation, but a domestic partnership, even if the partnership has no U.S. partners.691
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689 § 957(a);Regs. § 1.957-1(a)(1).

690 § 951(b).

691 § 7701(a)(30).

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In determining whether a U.S. person is a “U.S. Shareholder,” § 958(a)(2) imputes stock owned by a foreign corporation, partnership, or trust to its shareholders, partners or beneficiaries on a proportionate basis.  A person's “proportionate”interest for this purpose depends upon the facts and circumstances, taking into account the purpose for which the interest is being ascertained.692 Although the attribution rules generally adopt modified § 318 principles to establish stock ownership, they do so with a bias in favor of U.S. ownership.  Accordingly,  § 958(a)(2) attribution does not extend beyond the first U.S. person in the chain of ownership.693
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692 Regs. § 1.958-1(c)(2).

693 Regs. § 1.958-1(b).

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In addition to § 958(a)(2) attribution, § 958(b) applies the constructive ownership rules of § 318(a) to the extent that such attribution would treat a U.S. person as a U.S. Shareholder or a foreign corporation as a CFC.  Section 958(b) also modifies § 318 in a number of respects.  First, it does not attribute ownership from a nonresident alien individual to a U.S. citizen or resident except in limited circumstances.694 Second, for the purpose of attributing stock owned by a partnership, trust or corporation to its owners, an entity that owns more than 50% of the voting stock of a corporation is deemed to own all of the voting stock.695 Third, for purposes of attributing stock owned by a corporation to its shareholders under § 318(a)(2)(C), the attribution rules reduce the required ownership by the corporation from more than 50% to more than 10%.  Finally, § 958(b) does not allow “downward attribution”under § 318(a)(3) to the extent such attribution would cause a U.S. person to own stock otherwise owned by a foreign person.696
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694 See § 958(b) and Regs. § 1.958-2 for the constructive ownership modifications applicable in the CFC context.

695 § 958(b)(2).

696 § 958(b)(4).

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2. Application to Domestic Funds 

A fund organized as a U.S. partnership is a “U.S. person,”regardless of the domicile of its investors.697 If a domestic fund owns more than 50%of the stock of the foreign corporation (by vote or value), therefore, the foreign corporation is a CFC.698 A domestic fund is also a U.S. Shareholder if it owns, directly or by attribution, 10% or more of the voting stock of the foreign corporation, again without regard to the domicile of or relative ownership of the fund by its investors.  Thus, even if a domestic fund is merely a U.S. Shareholder that owns less than 50% of the stock, the foreign corporation may be a CFC if the fund investment, when aggregated with the investments of other U.S. Shareholders, exceeds 50% of the stock.699
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697 § 7701(a)(30).

698 § 957(a).

699 Id.

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Example: A domestic fund owned entirely by foreign investors but with a general partner that has U.S. members acquires 51% of the stock of a foreign portfolio company.  The foreign portfolio company is a CFC because a “U.S. person” owns more than 50% of the stock.

If a domestic fund invests in a CFC and is a U.S. Shareholder, then its U.S. investors, as well as the U.S. members of its general partner, will bear tax under the CFC rules.  Under § 951(a), a U.S. person that is a U.S. Shareholder for an uninterrupted period of 30 days or more during the taxable year must include in gross income its pro rata share of (i) any subpart F income of the CFC, including interest, dividends, and capital gains from the sale of stocks and securities;700 (ii) amounts deemed attributable to the CFC's investments in U.S. property;701 and (iii) any ordinary gain arising from the disposition of CFC stock.702 As a partnership, the fund does not bear these taxes directly.  Instead, it reports each U.S. investor's allocable share of the foregoing categories of income on Schedule K.
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700 § 951(a)(1)(A) (pro rata share of subpart F income);  § 952(a)(2) (subpart F income includes “foreign base company income”); § 954(a)(1) (foreign base company income including “foreign personal holding company income”); § 954(c)(1) (foreign personal holding company income includes interest, dividends and excess of gains over losses on property that generates interest and dividends). Note that the 2004 American Jobs Creation Act, P.L. 108-357, § 413(a), repealed the rules applicable to foreign personal holding companies (§ § 551-558), effective for taxable years of foreign corporations beginning after Dec. 31, 2004, and taxable years of U.S. shareholders with or within which such taxable years of foreign corporations end. See XI, D, below.

701 § § 951(a)(1)(B); 956.

702 § 1248(a).

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Example: A fund with no U.S. investors owns 10% of the stock of CFC, which it acquired at a cost of $100.  The general partner has a 20% carried interest.  The general partner has 20 U.S. members, each with a 5% interest in the general partner.  The portfolio company generates $50 of earnings during the fund holding period, none of which constitutes subpart F income.  The fund then sells the stock for $200, allocating $20 of the gain to the general partner (i.e.,$200-$100 x 20%).  The fund reports $10 of the $20 of gain as a dividend under  § 1248(a) (i.e., 50/100 x $20).  Each member of the general partner therefore reports $0.5 of his $1 allocable share of the gain as a dividend, even though his economic ownership in the portfolio company is only .01% (i.e., 10% x20% x 5%).

Comment: Section 1248 recharacterizes gain on the sale of stock in a CFC as a dividend to the extent of the full untaxed earnings and profits of the CFC, not just subpart F income.703 If the CFC is a “qualified foreign corporation,” then U.S. investors may qualify for the reduced 15% rate on the deemed dividend, assuming that they realize the gain before 2011. In the private equity context, dividends from a foreign portfolio company will generally qualify for the reduced rate only if the company is eligible to claim the benefits of a comprehensive income tax treaty with the United States.  For a further discussion of the reduced rate of taxation on “qualified dividend income”under the 2003 JGTRRA, see X, A, above.
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703 § § 1248(a); 952(a).

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3. Application to Offshore Funds 

On the same portfolio of investments, a fund organized as an offshore entity has a far better chance of avoiding the CFC rules than a fund organized as a domestic entity.704 As described above, a domestic fund is a U.S. person.  If a domestic fund owns 10% or more of the voting stock of a foreign portfolio company, therefore, it will qualify as a U.S. Shareholder of the company under the CFC rules, without regard to the number or relative concentration of its U.S. investors. A foreign fund, however, is not a U.S. person. Here, the  § 958(b) attribution rules determine the CFC status of the underlying portfolio company by “looking through” the foreign fund to determine the attributative ownership of its U.S. investors. For this reason, the U.S. investors of a widely held or foreign-controlled offshore fund will rarely qualify as U.S. Shareholders.  To minimize CFC risk, therefore, many fund sponsors of foreign-targeted funds organize the fund entity as an offshore vehicle.
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704 § 7701(a)(30).

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Comment: The general partner of an offshore fund with a controlling interest in a foreign portfolio company (e.g., an LBO fund) may itself be a U.S. Shareholder by virtue of the 20% carried interest, assuming that the sponsor organizes the general partner as a domestic entity.  The sponsor may therefore organize the general partner as an offshore entity as well.

Comment: Section 7701(a)(4) authorizes the IRS to issue regulations that would treat a partnership as domestic or foreign without regard to its legal domicile.  According to the legislative history, any such regulations “will be based only on material factors such as the residence of the partners and the extent to which the partnership is engaged in business in the United States or earns U.S. source income.”705 Based upon this language, future regulations should respect the foreign domicile of a fund that invests in offshore portfolio companies and generates no ECI.  Even if they do not, the regulations will not apply retroactively to existing partnerships.706
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705 S. Rep. No. 33, 105th Cong., 1st Sess. 210(1997).

706 H.R. Rep. No. 220, 105th Cong., 1st Sess. 3451(1997). Regulations finalized in 2006 reiterate that a business entity is domestic if it is created or organized as any type of entity (including, but not limited to, a corporation, unincorporated association, general partnership, limited partnership, and limited liability company) in the United States, or under the law of the United States or of any State. Regs. §  301.7701-5(a). These regulations provide that a business entity that is created or organized both in the United States and in a foreign jurisdiction is a domestic entity. Id. These regulations do not, however, provide any additional guidance with respect to whether, in certain circumstances, the IRS will look past legal domicile to determine whether an entity should be considered domestic or foreign.

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

Less clear, however, is whether the §  958 attribution rules impute the ownership of voting stock in a foreign portfolio company to the general partner based upon the general partner's unilateral right to vote the shares rather than upon its proportionate economic interest in the fund.  In the author's view, they do not.  When a general partner votes the shares of a fund portfolio company, it acts both in its own capacity and as a fiduciary on behalf of the fund and the other investors.  The attribution rules, to the contrary, require “ownership”of voting power.707 The naked ability of a person to direct the vote, whether by proxy, trust arrangement, status as general partner or other contractual agreement, is not “ownership”of voting power within the meaning of § §  957(a) or 958.
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707 § 957(a);Regs. § 1.957-1(a)(1).

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To establish “ownership” of voting stock, §  958(b) incorporates the attribution rules of §  318, subject to certain modifications.  In particular, §  318(a)(2)(A) provides that “stock owned, ... by or for a partnership ...shall be considered as owned proportionately by its partners.”708  The rule therefore imputes ownership of voting stock held by a partnership not on the basis of a partner's ability to vote the shares on behalf of the partnership, but on the basis of each partner's economic interest in the partnership.709 Accordingly, a general partner with a 20% interest in profits and a 0% interest in capital of a partnership should not be attributed more than 20% of the voting shares held by the partnership even though, by virtue of its status as the general partner, it may possess the right under state law to direct 100% of the vote.710
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708 See also Regs. § 1.958-2(c)(1)(i).

709 In 1958, an advisory group recommended that Congress clarify the meaning of “proportionate interest”to reflect such partner's interest in profits or capital, whichever is greater. See “Revised Report on Corporate Distributions and Adjustments of the Subchapter C Advisory Group,” 85th Cong., 2d Sess. (1958).  Although Congress never amended the statute, the recommendation presupposes attribution of stock to a partner on the basis of its economic interest in, not its effective control of, the partnership.

710 Although § 318(a) does not refer to voting power, § 958 applies § 318(a) to the voting power analysis.

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The CFC anti-abuse rules also support this construction. These rules ignore illusory shifts of formal voting power to non-U.S. shareholders to avoid CFC status. In particular, they provide that “the mere ownership of stock entitled to vote does not by itself mean that the shareholder owning such stock has the voting power of such stock for purposes of section 957.”711  The regulations therefore disregard the nominal possession of voting power by a non-U.S. owner of the voting stock if the shareholder has agreed not to vote the stock or to vote it in a specified manner.712  For example, if such a shareholder were to grant a voting proxy to a third party, the regulations would probably disregard its nominal right to cast the vote even though the shareholder continues to own the stock itself.713  It does not follow, however, that the proxy holder “owns” the voting stock. Absent a purpose to avoid CFC status, ownership of voting power resides with the owner of the voting shares, as determined under attribution rules that reflect economic rather than voting rights.
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711 See Regs. § 1.957-1(b)(2).

712 Id.

713 See, e.g., Rev. Rul. 72-72, 1972-1 C.B. 104 (where target shareholder received voting stock in purported ‘B'reorganization but granted acquiring corporation's shareholder irrevocable right to vote shares for five years, IRS ruled that such stock was tantamount to nonvoting stock that converted into voting stock in five years).

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The anti-abuse rules also impute voting power associated with a separate class of stock with disproportionate voting rights away from its shareholder to the person “on whose behalf it is exercised,” but only if the shareholder who casts the vote does not act independently and with a “principal purpose”to avoid the CFC rules.714  When a general partner votes the shares of a portfolio company, to the contrary, it is merely exercising the rights and obligations of a general partner under state law.715
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714 Regs. § 1.957-1(b)(2).

715  It should also be noted that Congress enacted §  318 in 1954. At that time, virtually every partnership was either a general or limited partnership. Under state law, the general partner has the right to control the partnership and therefore the right to vote any stock held by the partnership. If Congress had intended attributive ownership of voting stock under the CFC rules to depend upon the power to direct the vote, it would not have imported the operative rules of §  318.

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Finally, any rule that would sever economic ownership of voting stock from ownership of voting power in this context will produce results that Congress could not possibly have intended. For example, if the mere power to direct the vote is sufficient to convey “ownership”of the voting stock, a foreign fund that owns 100% of the voting stock of a foreign corporation but has a domestic general partner must impute 100% of the voting stock to the general partner.  If the general partner “owns”the voting power, however, then the limited partners cannot.716  Accordingly, the domestic limited partners of the fund cannot qualify as U.S. Shareholders of the CFC,717  regardless of their relative economic investment in the fund.  As such, they would avoid any subpart F inclusion even if the partnership agreement entitled them to more than 50% of the CFC earnings. Meanwhile, the U.S. members of the general partner (if any) would include only their “pro rata” share of the subpart F income, and that share would never exceed 20%.718
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716 Otherwise, the attribution rules would impute the same voting power to two different groups of investors.

717 See §  951(b) (defining U.S. shareholder as owner of “10 percent or more of the total combined voting power ...”).

718 See §  951(b)(2) (defining “pro rata” share of subpart F income for a U.S. Shareholder of a CFC).

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5. Use of Offshore Parallel Vehicle 

If the fund is domestic, it may invest in a foreign portfolio company through a parallel vehicle to avoid CFC status.  Many fund agreements allow the general partner to call capital through an offshore parallel vehicle if the use of a parallel vehicle would otherwise mitigate adverse tax consequences to one or more classes of investors.719 As described above, if the investors invest through an offshore vehicle, the status of the portfolio company as a CFC will depend upon the domicile and attributive ownership of the fund investors and general partner.  It is possible, however, that the IRS would not respect the parallel entity as a foreign partnership for tax purposes.
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719 For discussion of the use of parallel entities generally, see II, A, 4, above, and VII, D, 6, above.

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The basis for this concern is that funds aggregate performance results, whether or not the fund effects any investments through a parallel vehicle.  Specifically, if investment gains of the parallel entity do not exceed investment losses of the primary fund, then the investors in the primary fund will not allow the general partner to receive carried interest distributions until they recover their losses in the primary fund.  In effect, therefore, the primary fund will participate on a contingent basis in the performance results of the parallel fund.  If the IRS were to recast this sharing arrangement as a “constructive partnership,” it would likely defeat the very purpose of the parallel structure.720
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720 For an excellent article on the potential recharacterization of various economic arrangements as constructive partnerships, see Brannan, “Recent Developments in the Law on Constructive Partnerships (and Constructive Non-Partnerships),”Tax Club (April 11, 2006).

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Although the investors can readily eliminate the constructive partnership risk by allowing a separate carry on the capital of the parallel entity, they would grant an economic windfall to the general partner in doing so.  Such a concession is unlikely, especially if the parallel vehicle disproportionately serves the tax objectives of the general partner. But even if the arrangement is a constructive partnership, it is not clear that the partnership is a “domestic partnership,”and therefore a “U.S. person.” Rather than confront this uncertainty, the parallel and primary fund may instead choose to form an actual foreign entity to make the investment, with the primary fund holding an interest that represents its contingent participation. If they do so, the IRS should respect the foreign entity as a non-U.S. person for CFC purposes.

6. Mitigating CFC Consequences 

In many cases, CFC status cannot be avoided.  For example, a domestic fund may acquire a controlling interest in the foreign portfolio company and the general partner may have no right to effect the investment through an offshore vehicle, either because the agreement does not provide for one or because the mitigation of CFC risk is not a permitted purpose of a parallel structure.  Alternatively, the portfolio company in question may already have substantial U.S. Shareholders.  Under these circumstances, the fund must resort to strategies that mitigate the consequences of CFC status to its U.S. investors.

a. Section 338(g) Election 

If the fund is able to structure a portfolio investment as a “qualified stock purchase” (“QSP”), it may elect under § 338(g) to treat the investment as a deemed purchase of assets for tax purposes.721 Since a direct investment in the portfolio company for newly issued shares is not a QSP,722 the  § 338(g) election is more commonly available to LBO funds.  So long as the foreign portfolio company is not a CFC before the investment, the § 338(g) election should have no adverse consequences to the sellers.723 To the fund, however, the election will purge the historic earnings and profits of the portfolio company and its foreign subsidiaries and “step-up”the inside tax basis of the assets.  The net effect of the election, therefore, is to reduce earnings and profits of the foreign portfolio company, and therefore future subpart F income and gain under  § 1248 to the U.S. investors in the fund.724 In addition, the election will often facilitate the tax-efficient restructuring of the portfolio company after closing.
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721 See 788 T.M., Stock Purchases Treated as Asset Acquisitions — Section 338 for a detailed discussion of § 338.

722 § 338(h)(3) (definition of “purchase”).

723 If the portfolio company is a CFC in the hands of the selling shareholders, then the deemed asset sale will increase the § 1248 amount to the U.S. shareholders. See Regs. § 1.338-9(b).

724 Subpart F income for any taxable year cannot exceed total earnings and profits for the taxable year.   § 952(c)(1)(A); Regs.  § 1.952-1(c)(1), -(e)(1).  Current losses attributable to “active” income therefore reduce subpart F income inclusions, subject to a special recapture rule.  See  § 952(c)(2).

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b. Use of Hybrid Entities 

The judicious use of hybrid entities is yet another strategy to temper the severity of the CFC rules to U.S. investors.  In many offshore investments, the portfolio company operates in multiple jurisdictions, some of which impose high rates of local taxation.  A common strategy in European acquisitions, for example, is to interpose one or more Dutch or Luxembourg holding companies (“Holdco”) between the fund and the various operating subsidiaries.  The Holdco jurisdiction typically imposes a low or zero rate of tax on interest, dividends and capital gains and no withholding tax on distributions from Holdco to its foreign shareholders.  As part of this strategy, the fund often downstreams the equity capital as intercompany debt between Holdco and the operating subsidiaries.  The net effect of the intercompany leverage is to move earnings from the high tax jurisdictions of the operating subsidiaries to the low tax jurisdiction of Holdco, reducing the global effective tax rate of the consolidated enterprise.  Interest payments and other capital flows between the subsidiaries and Holdco generally avoid significant withholding taxes in the local jurisdictions under applicable treaties and/or “participation exemptions.”Structures such as these may also facilitate the tax-efficient flow of capital between the operating subsidiaries to meet the cash demands of the business within each jurisdiction.

If Holdco is a CFC, however, the interest and dividend payments from the operating subsidiaries will often give rise to subpart F income. To the extent that these payments bear immediate U.S. tax, they will undermine the global tax efficiency of the structure.  To avoid future subpart F inclusions, the fund may therefore attempt to convert the subsidiaries to “branches” for U.S. tax purposes by making one or more CTB elections.725 If a foreign subsidiary is a disregarded entity, then the nominal payments of interest, dividends or capital gains from the subsidiary to its parent constitute “divisional” payments within a single tax entity rather than subpart F income to the U.S. Shareholders of the parent.726 A CTB election will also convert gain from a sale of the stock of any of the foreign subsidiaries to gain from a deemed sale of assets for U.S. tax purposes.  Providing that the assets so disposed of were used in the conduct of a trade or business, the gain should not constitute subpart F income.727
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725 With the exception of certain per se entities, the fund may elect to treat most wholly-owned foreign subsidiaries as disregarded entities for U.S. tax purposes. See IV, B, 2, c and d, above.

726 On July 13, 1999, Treasury issued proposed regulations that would recharacterize certain payments by disregarded “hybrid branch” entities that reduce foreign income taxes of the payor as subpart F income.  See Prop. Regs. § 1.954-9(a). These regulations will be effective no earlier than five years after the date that they become final.  Prop. Regs. § 1.954-9(c)(1).

727 See Regs. § 1.954-2(e)(3)(ii). If a foreign parent makes a CTB election for a wholly owned foreign subsidiary, resulting in a deemed liquidation under § 332, but with the pre-existing intention of selling the stock in a “deemed” asset sale, the IRS may contend under various theories that the gain does not qualify as gain from the sale of assets used in a trade or business of the electing parent; see Notice 2003-46, 2003-28 I.R.B. 53 (withdrawing “extraordinary transactions” regulations); see also FSA 200046008. For a general discussion of whether “check-and-sell”transactions give rise to subpart F income, see Sheppard, “News Analysis: Behind the Eight Ball on Check-the-Box Abuses,” 2003 TNT 208-7.

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U.S. Income Portfolios: Other Pass-through Entities 
  Portfolio 735-2nd: Private Equity Funds 
  Detailed Analysis 
  XI. Anti-Deferral Rules for Foreign Investments by Private Equity Funds

C. Portfolio Investments in PFICs 

1. Classification as a PFIC 

Generally, a foreign corporation is a PFIC if (i) 75% or more of its gross income for a taxable year is passive within the meaning of § 954(c) (the “income test”), or (ii) 50% or more of the average value of its assets produce, or are held for the production of, passive income (the “asset test”).728 Unlike the rules that apply to CFCs and FPHCs, the PFIC rules do not require any minimum level of U.S. ownership.
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728 § 1297(a).

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a. The Income Test 

A foreign corporation satisfies the income test of  § 1297(a)(1) if 75% or more of its gross income for the taxable year is “passive.”Income is “passive” for this purpose if it is of a kind that would qualify as foreign personal holding company income (FPHCI)under § 954(c). Passive income therefore includes most categories of interest, dividends, and capital gain.729
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729 § § 1297(b)(1); 954(c). Note that the 2004 American Jobs Creation Act, P.L. 108-357, § 413(a), repealed the rules applicable to foreign personal holding companies (§ § 551-558), effective for taxable years of foreign corporations beginning after Dec. 31, 2004, and taxable years of U.S. shareholders with or within which such taxable years of foreign corporations end. See XI, D, below.

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b. The Asset Test 

A foreign corporation satisfies the asset test if 50% or more of its assets during the taxable year produce passive income or are held for the production of passive income.730 According to Notice 88-22, the asset test “applies on a gross basis,” and therefore includes assets funded with debt, “whether secured by particular assets or otherwise traceable to particular assets.”731 In applying the “asset test,” a foreign corporation must determine the average fair market value of its assets as of the end of each quarter.  If an asset generates both passive and nonpassive income, it is bifurcated into an “active” and a “passive” asset based upon the relative percentages of each category of income it produces.732 Notice 88-22 provides special rules for certain types of assets, including intangible assets and working capital.
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730 § 1297(a)(2).

731 Notice 88-22, 1988-1 C.B. 489.

732 Id.

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c. The “Look-Through”Rules 

For purposes of determining whether a foreign corporation is a PFIC, § 1297(c) provides for a special “look-through”rule.  Under the look-through rule, if a foreign corporation owns, directly or indirectly, at least 25% by value of the stock of another corporation, it is treated as owning its proportionate share of assets and earning its proportionate share of the income of the corporation.733 As such, the PFIC rules disregard actual dividends from such subsidiaries, crediting the parent instead with its pro rata share of the subsidiary's passive and active income.  Moreover, since this look-through rule treats a foreign corporation as owning its proportionate share of the subsidiary's gross assets and earning its proportionate share of the subsidiary's gross income, a relatively small equity investment in an active subsidiary may “swamp” the directly held passive assets and gross income of the foreign corporation if the subsidiary is highly leveraged.
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733 § 1297(c)(1), (2).

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d. Exceptions from the PFIC Provisions 

The PFIC provisions of the Code include three exceptions of special relevance to fund investors.  First, a foreign corporation will not be treated as a PFIC during its “start-up” year, defined as the first taxable year in which the corporation has gross income. To qualify under the “start-up” exception, the corporation must satisfy the IRS that it will not be classified as a PFIC for the two year period following the start-up year and must not in fact be classified as a PFIC during that period.734 This exception allows a foreign corporation that intends to engage in active business operations to avoid PFIC status even if it generates no income other than passive income during its start-up year.
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734 § 1298(b)(2).

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Note: Certain “start-up” corporations do not generate sufficient “active” income during periods after the start-up year.  These corporations will fail the requirements of § 1298(b)(2) and will therefore be classified as PFICs even though they have little or no gross revenues and substantial operating losses.

Second, a foreign corporation will not be treated as a PFIC merely because it meets the statutory definition during a period of transition from one active business to another.  To qualify under the “change in business” exception, neither the foreign corporation nor any predecessor may have been a PFIC for any prior taxable year, substantially all the passive income of the foreign corporation for such taxable year must be attributable to proceeds from the disposition of one or more active trades or businesses, and the foreign corporation must not be a PFIC for either of the two following taxable years.735
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735 § 1298(b)(3).

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Third, a foreign corporation that is a CFC is not a PFIC with respect to its U.S. Shareholders.736 Under the CFC exception, U.S. Shareholders already subject to the CFC regime therefore avoid the broader inclusion rules that apply to PFICs.  Even if a foreign corporation is a CFC, however, the PFIC rules will continue to apply to any U.S. investor who is not a U.S. Shareholder.
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736 § 1297(d), as redesignated by the 2007 Tax Technical Corrections Act, P.L. 110-172, § 11(a)(24).

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2. Application to Fund Investments 

If a fund invests in a PFIC, its U.S. investors may bear tax under the “excess distribution” regime of § 1291.  Section 1291 imposes a special tax and interest charge on “excess distributions,” which include gain realized from the disposition of stock in a PFIC.737 Section 1291 applies not only to sales, but to many tax-free dispositions as well,738 imposing a rate of tax equal to the “[h]ighest rate ..... in effect for such taxable year.”739 To compute the special interest charge, the PFIC rules “prorate” the excess distribution over the investor's entire holding period.740 U.S. investors subject to this regime may not apply any otherwise available net operating losses or other deductions to shelter the gain on the portion of an excess distribution allocated to earlier periods.741
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737 § 1291(a)(2).

738 § 1291(f).

739 § 1291(c)(2).

740 § 1291(a)(1)(A).

741 § 1291(c)(2).

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A U.S. shareholder acquires stock of a PFIC at the beginning of Year 1 for $100. At the end of Year 10, it sells the stock for $600. Assume that the PFIC made no distributions during the intervening period, that the highest marginal rate of the U.S. shareholder was 40% during the entire holding period, and that the underpayment rate was 8%. Under § 1291, the U.S. shareholder must allocate the $500 of gain throughout its holding period in the PFIC stock. Thus, $450 is treated as an excess distribution in Years 1 through 9 and is subject to a “aggregate increase in tax” of $180 ($450 x 40%) and to an interest charge of $90. The $50 allocated to Year 10 is treated as “other income"and is subject to tax of $20 ($50 x 40%); the amount allocated to Year 10 is not subject to an interest charge. In this instance, therefore, § 1291 imposes an effective tax rate on the gain of 58% (($180 + $90 + $20)/$500).

Private equity funds do not, as a rule, invest in offshore investment companies, the principal target of the PFIC legislation. The reason that funds nevertheless run afoul of the PFIC provisions is that the statute also applies to “inadvertent PFICs.” In the typical case, an inadvertent PFIC is a foreign portfolio company that has yet to generate active revenues but earns passive income from the temporary investment of working capital.  While  § 1298(b)(2) provides a general exception from PFIC status for the initial year in which a “start-up”company has any gross income, many start-up businesses do not generate operating revenues for periods extending beyond one year.  If such a business earns interest income on “idle”capital during this period, they will become PFICs under the income test.  The U.S. investors will therefore bear tax on any future gains under the “excess distribution” regime, even if the portfolio company generates substantial losses during the start-up period.

In most cases, U.S. investors in a fund that invests in this particular species of PFIC can avoid these consequences by making a timely “qualified electing fund” election (a “QEF Election”).742 If a U.S. investor makes a QEF Election, it must include in gross income its pro rata share of the ordinary earnings and net capital gain of the PFIC for each taxable year.743 Since § 1293 measures the inclusion by reference to earnings and profits, a U.S. shareholder in a typical “inadvertent PFIC” with a QEF Election in effect will incur no tax liability during the start-up period.  When the PFIC begins to generate active income in later years, it will lose the PFIC “taint” with respect to any electing investor.  In the vast majority of cases, therefore, a U.S. investor who makes a timely QEF Election for an “inadvertent PFIC” will avoid any inclusion under the PFIC regime during his holding period.
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742 § 1291(d).

743 § 1293(a)(1).

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This assumes, of course, that the QEF Election is timely.  If it is not, the electing U.S. shareholder will bear tax not only under the current inclusion rules of § 1293, but under the § 1291 excess distribution regime in a later sale, even if the sale occurs after the business has matured into an active trade or business.  In general, a QEF Election is timely if the U.S. shareholder makes the election on or before the due date of its tax return for the first taxable year to which the QEF Election applies.744 Any “U.S. person” that is a PFIC shareholder during a taxable year may make the QEF Election.745 If the shareholder is a domestic fund, therefore, the fund itself must make the QEF Election rather than its U.S. investors.746 If the shareholder is a foreign fund, it is not eligible to make the QEF Election.  Instead, its U.S. investors must make the QEF Election directly.  In this situation, the QEF election will apply only to the electing U.S. investors rather than to each U.S. investor in the fund.747
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744 Regs. § 1.1295-1(e).

745 Regs.  § 1.1295-1(d)(1).

746 § 7701(a)(30); Regs. § 1.1295-1(d)(2)(A).

747 Regs. § 1.1295-1(d)(2)(B).

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In practice, achieving compliance with the QEF Election regime can be cumbersome.  If the fund is foreign, for example, its U.S. investors may not have sufficient notice of the potential PFIC status of a fund investment to make a timely QEF Election.  The U.S. investors may therefore insist on some form of covenant in the fund agreement to require the general partner to notify its U.S. investors of the PFIC status of an investment.  Given the punitive consequences of failing to make a timely election, however, the general partner may resist such an undertaking.  Moreover, a QEF Election is valid only if the PFIC itself agrees to provide an annual information statement that sets forth each U.S. investor's pro rata share of its ordinary earnings and net capital gain.748 If a PFIC refuses to comply, the QEF Election is invalid.
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748 Regs. § 1.1295-1(g).

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Comment: In certain cases, a foreign fund with significant U.S. investors may interpose a PFIC “gatekeeper” between the fund and its U.S. investors to facilitate the QEF Election.  As described above, only the first “U.S. person” in a chain of ownership may make a QEF Election.749 To satisfy this requirement, the general partner may therefore allow electing U.S. investors to hold their interest in the fund through a domestic pass-through entity, typically an LLC.  It should be noted that the contribution to the LLC will not terminate any previous QEF Election by the contributing investor.750 Instead, § 1293 and the annual QEF reporting requirements will continue to apply to the investor unless the LLC itself makes a timely QEF Election.751 If it does, the U.S. investors will include their pro rata share of the LLC's § 1293 inclusion under the normal rules that apply to income earned through a pass-through entity.752 The QEF Election at the LLC level will also terminate any further QEF reporting requirements at the investor level.  Finally, any U.S. investor that did not make a valid QEF Election with respect to a particular PFIC investment in the fund before the contribution to the LLC will not benefit from these regulations.753
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749 Regs.  § 1.1295-1(d)(1).

750 Regs.  § 1.1295-1(c)(2)(iv).

751 See Regs. § § 1.1295-1(c)(2)(v) Ex. 3, 1.1293-1(c)(2).

752 Regs. § § 1.1293-1(c)(1), 1.1295-1(d)(2)(i)(A).

753 The PFIC stock transferred indirectly to the LLC would not qualify as stock of a “pedigreed QEF.” See Regs. § 1.1295-1(b)(3)(iv)(B).

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U.S. Income Portfolios: Other Pass-through Entities 
  Portfolio 735-2nd: Private Equity Funds 
  Detailed Analysis 
  XII. Taking the “Private” Out of Private Equity — the IPO

A. Introduction 

In the years following the decline of the stock market in 2001, many private equity fund managers experienced rapid growth. In 2006, funds raised $401 billion in new capital commitments, exceeding the record set in just the previous year by more than $90 billion.754 With these additional commitments, fund managers in the private equity sector soon controlled enormous portfolios of assets.
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754 See Private Equity Intelligence's 2007 Global Fundraising Review, available at http://www.preqin.com/itemProduct.aspx?s=101& itemid=888.

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As the size of the average private equity fund increased, so did the size of the average deal.  In some acquisitions, the enterprise value of the portfolio company was so high that no single fund could finance the entire equity commitment. With both limited capital to invest and an obligation to diversify their portfolios, many sponsors formed consortiums or “club deals” with other sponsors to finance the bigger deals. By coinvesting in a single LBO with another fund, a sponsor is often able to participate in a deal that would otherwise violate the terms of its fund agreement.

Both of these developments augmented the value of the carried interest. The equivalent of a call option, a carried interest on a large fund is considerably more valuable than a carried interest on a small fund. In spite of the rising value of the carried interest, however, the general partner still had no way to monetize it. As it had for decades, the sponsor called capital from investors, invested it over time, and retained 20% of the  gains on a realized basis.

Meanwhile, the economy began to rebound, precipitating a surge in acquisitions. The increasing appetite for new deals in the market allowed many fund managers to call capital on the “buy”side of these transactions and return capital on the “sell”side of these transactions over much shorter time horizons. As most funds are self-liquidating, the compressed holding period of the average portfolio investment shortened the lifespan of the fund itself. This in turn required fund managers to raise and syndicate new funds to replenish the depleted capital from their old funds with increasing frequency.

Finally, these phenomena aggravated an already chronic problem for investment professionals in the fund sector: lack of diversification. An investor with the capacity to do so will usually allocate his investments across a range of different asset classes to reduce his exposure to loss within any single class. In the fund sector, however, many managers were forced to commit a substantial percentage of their private wealth to the funds of their own employers. For some, the inherent illiquidity of these commitments made it difficult for them to finance the general partner's capital commitment to each of its sponsor funds.

In 2006 and 2007, a handful of funds responded to this perfect storm of events by doing something almost unprecedented — they went public.

U.S. Income Portfolios: Other Pass-through Entities 
  Portfolio 735-2nd: Private Equity Funds 
  Detailed Analysis 
  XII. Taking the “Private” Out of Private Equity — the IPO

B. The KKR, Apollo, Fortress & Blackstone IPOs 

In April 2006, a public vehicle called KKR Private Equity Investors(“KKR”), a limited partnership in Guernsey, listed its stock on the Euronext Amsterdam exchange in a $5 billion IPO. By investing in the public vehicle, a retail investor could now participate in the performance results of several of the KKR sponsor funds.

In July 2006, Apollo listed AP Alternative Assets, L.P. (“AAA”), also a limited partnership in Guernsey, on Euronext Amsterdam in an IPO.755 Like KKR, AAA announced its intention to invest the proceeds from the IPO in its various sponsor funds, together with other coinvestment opportunities.
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755 See Prospectus of AP Alternative Assets, L.P. dated July 31, 2006, available at http://www.apolloalternativeassets.com/pdf/60700acl.pdf.

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On November 8, 2006, Fortress Investment Group Holdings LLC (“Fortress”)filed a prospectus with the SEC for an initial public offering of shares.756 Unlike KKR and AAA, however, Fortress did not invest the IPO proceeds in its underlying sponsor funds, but rather in the sponsor entities themselves. Fortress listed the shares on the New York Stock Exchange.
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756 See Form S-1 of Fortress Investment Group Holdings LLC, as filed with the SEC on November 8, 2006 and amended on February 8. 2007, available at http://www.sec.gov/Archives/edgar/data/1380393/000095013607000793/file1.htm#page216  (the “Fortress Prospectus”).

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On June 21, 2007, The Blackstone Group LP (“Blackstone”)filed a prospectus with the SEC for an initial public offering of shares.757 Like Fortress, Blackstone is also the sponsor of multiple funds, including private equity, hedge funds, and various other hybrid vehicles. Blackstone also listed the shares on the New York Stock Exchange.
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757 See Form S-1 of The Blackstone Group LP, available at http://ir.blackstone.com/secfiling.cfm?filingID=1047469-07-5100  (the “Blackstone Prospectus”).

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Each of the foregoing IPOs allowed retail investors to participate in the performance results of a sector in the market previously available only to institutional and other wealthy investors. As described more fully below, however, the form of these IPOs fell into one of two categories, each with a distinct structure and set of tax considerations.

U.S. Income Portfolios: Other Pass-through Entities 
  Portfolio 735-2nd: Private Equity Funds 
  Detailed Analysis 
  XII. Taking the “Private” Out of Private Equity — the IPO

C. Basic Structure 

1. Public Funds: The “Permanent Capital” Vehicle 

To retail investors, the listings by Apollo and KKR provided access to a market that otherwise required a far larger financial commitment.758 A public buyer in the KKR IPO, for example, could now participate for the first time as an indirect limited partner of several KKR funds at the modest price of $25 per share.759 To the sponsors, the listings provided access to a truly scarce commodity: “permanent capital.” An investor in this sector of the market usually achieves liquidity only as and when the underlying fund sells its investments and distributes the proceeds.760 An investor in the IPO vehicle, to the contrary, has immediate liquidity: if he needs cash, he simply sells his shares on the market at the prevailing market price. From the sponsor's point of view, therefore, any capital it calls from the IPO vehicle is permanently available to the underlying funds because the underlying funds have no obligation to distribute future sales proceeds back to the IPO vehicle to afford liquidity to the public owners. Like the manager of a hedge fund, the sponsor could instead reinvest the proceeds in the underlying fund and charge a further carry on the additional investment.761
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758 In many funds, the minimum capital commitment exceeds $25 million.

759 See “KKR:Barbarians At Your Gate,” Business Week (May 15, 2006), available at http://www.businessweek.com/magazine/content/06_20/b3984059.htm.

760 See III, B, above.

761 The KKR prospectus dated April 18, 2006, for example, includes the following disclosure:

Generally, the terms of KKR's private equity funds require that current income and other net cash proceeds from the funds' investments and from dispositions of investments be distributed to the limited partners within specified periods. We are not required to distribute to our unit holders any cash received from our investments in these funds or from any of our other investments ... Accordingly, the only way our unitholders may be able to realize a return on their investment in us is to the sell the common units or RDUs that they own.

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The listings by Apollo and KKR also created a “captive”coinvestor for the sponsor. By establishing a large reservoir of cash in an IPO, the sponsor no longer had to syndicate every large acquisition in a “club deal” with a competitor. By reducing its commitment to these types of investments, the sponsor also avoided the often overwhelming governance complexity associated with a club deal.

In the permanent capital IPOs, the sponsor formed both the IPO vehicle and its subsidiary as partnerships for tax purposes. The sponsor received an indirect carried interest in the public vehicle through the subsidiary partnership,762 which invested capital on behalf of the public vehicle in all future acquisitions. The IPO vehicle was therefore a pure holding company, its sole assets consisting of the cash proceeds of the IPO and the shares of the subsidiary partnership. The public vehicle retained the IPO proceeds pending the future capital calls, which it effected by staggered contributions to the subsidiary partnership for ultimate deployment in each portfolio investment. These investments included direct investments in underlying sponsor funds, convestments with the sponsor funds, and other temporary or opportunistic acquisitions.
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762 The sponsor also holds a direct equity interest in the IPO vehicle itself.  Although these shares have nominal economic rights, they convey effective voting control over the IPO vehicle, allowing it to avoid registration as an “investment company”under the 40 Act.

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Worksheet 19 presents a simplified diagram of the fund IPO structure in a “permanent capital” vehicle.

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

A fund manager IPO is an entirely different species. The public vehicle in these IPOs did not invest directly in any of the underlying funds of the sponsor. Nor did they involve any public offering of the portfolio companies of the sponsor funds. The retail buyers in these IPOs instead acquired an indirect equity interest in each of the discrete categories of sponsor income, including the carried interest and the periodic management fees. A fund manager IPO is an IPO of the sponsor itself.

Worksheet 20 presents a simplified diagram of the fund structure in a fund manager IPO.

The sponsor will invariably cite a laundry list of reasons for going public, among them the creation of a publicly-traded security as potential “currency” to fund one or more future acquisitions.763   From the perspective of the founders, however, the true economic benefit of the IPO is that it “monetizes” the future value of the carried interest. In particular, it allows the sponsor to realize a gain from the carried interest before the underlying funds even sell a portfolio investment. This particular benefit is rarely cited in the financial commentary on these IPOs: in the private realm, the carry participates only in realized gains.764  Until a fund calls capital, invests it, and then sells the underlying investment at a gain, the general partner will not realize any return. In the fund manager IPOs, the sponsor realizes a return immediately from the cash proceeds of the offering, which reflect the present value of what the market expects the general partner to generate in the future (whether it does so or not). So the sponsor realizes a cash return before the underlying funds realize any actual gains. Indeed, because the sponsor had yet to even call the full capital commitment of the various investors in these funds, many of the underlying investments do not exist at the time of the IPO. In the fund manager IPOs, therefore, the sponsor in fact realizes a current return on the “future” value of the carried interest.
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763 In the Fortress Prospectus, for example, the issuer cites the following reasons for the IPO:  (i)to increase Fortress' ability to provide financial incentives to existing and future employees, (ii) to solidify Fortress' institutional presence as an “investor”, (iii) to more efficiently access capital to develop the business and create new investment products, and (iv) to create a publicly-traded security to finance strategic acquisitions. See Fortress Prospectus, available at http://www.sec.gov/Archives/edgar/data/1380393/000095013607000793/file1.htm#page216.

764 See III, B, above.

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U.S. Income Portfolios: Other Pass-through Entities 
  Portfolio 735-2nd: Private Equity Funds 
  Detailed Analysis 
  XII. Taking the “Private” Out of Private Equity — the IPO

D. The PTP Limitations 

As described more fully in IV, B, 3, above, a private equity fund that otherwise qualifies as a partnership under the CTB regulations will be taxable as a PTP if the partnership interests in the fund are either traded on an “established securities market” or are “readily tradable” on a secondary market or its equivalent.765 Because the shares of the public vehicles in both the fund manager and permanent capital IPOs are publicly-traded, the public vehicles must satisfy the “qualifying income”exception under §  7704 to remain taxable as partnerships. The term “qualifying income”generally includes —
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765 §  7704(b); Regs. 1.7704-1(a)(1).

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• interest (other than certain interest contingent on profits766 and interest derived in the conduct of a financial or insurance business767);
 
• dividends;

• real property rents;

• gain from the sale of real property (including gains earned as a dealer);

• gain from the sale of a capital asset held for the production of qualifying income;768

•  income from securities lending activities;

• gain from the sale or other disposition of stock or securities or foreign currencies;

• other income (including but not limited to gains from options, futures, or forward contracts)derived with respect to its business of investing in such stock, securities or currencies”;769

• income from swaps (but only if the property, income or cash flow that determines the amounts to which the partnership is entitled under the swap would itself give rise to qualifying income if held or received directly by the partnership);770

• income from certain commodities transactions;771 and
 
• “other substantially similar income from ordinary and routine investments to the extent determined by the Commissioner.”772

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766 §  7704(d)(2)(B); §  856(f).

767 §  7704(d)(2)(A).

768 §  7704(d)(1).

769 §  7704(d)(4); §  851(b)(2)(A).

770 Regs.  §  1.7704-3(a)(1).

771 §  7704(d)(1)(G).

772 Regs.  §  1.7704-3(a)(1).

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The IPO vehicle in the permanent capital IPOs is just a glorified “public”limited partner of (and coinvestor with) the underlying sponsor funds. As a pure holding company, it derives virtually all of its gross income in the form of distributive share from other partnerships. As described more fully in VII, above, these partnerships usually structure their portfolio investments to avoid ECI to their foreign investors. Although separate provisions of the Code establish the types of income that are eligible under the §  864(b) “trading”safe harbor and the types of income that are eligible under the §  7704(d) “qualifying income”safe harbor, both safe harbors include most categories of interest, dividends, capital gains and income attributable to swaps and other derivatives. If the underlying fund earns no ECI, therefore, the income it allocates to the public vehicle is likely to qualify as “qualifying income” as well.773
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773 For a fuller discussion of how private equity funds endeavor to avoid investments that generate ECI or UBTI, see VII, above.

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In the fund manager IPOs (e.g., Blackstone, Fortress), to the contrary, relief under the qualifying income exception is both more difficult to achieve and more critical to attain. First, unlike their permanent capital counterparts, the public vehicle of a U.S.-based sponsor in a fund manager IPO is usually a domestic rather than a foreign entity. The primary tax reason for the domestic domicile of the public vehicle is that the use of a foreign domicile is likely to trigger the “anti-inversion”rules of §  7874, which in the extreme case would subject the IPO vehicle to full corporate-level tax as a domestic corporation. In addition to losing its status as a pass-through entity, therefore, the public vehicle would bear entity-level tax not only on its U.S. source income, but on capital gain from the sale of stock or securities and all other categories of foreign source income.774 Second, as described above, a fund manager derives four discrete streams of income: (i) periodic management fees for managing the underlying funds, (ii) allocations of income with respect to carried interest in underlying funds, (iii) incentive fees for providing similar services to hedge funds, and (iv) income with respect to invested capital. Because the definition of “qualifying income”under §  7704(d) excludes service compensation,775 the public vehicle must earn the fee income through one or more “blocker” subsidiaries. The public vehicle will therefore bear the economic burden of corporate level tax on the fee income in spite of its status as a partnership.776 Third, the Carry Bill, which (if enacted) will be effective for taxable years beginning after December 31, 2010, will treat the underlying carried interest in most sponsor funds as an “ISPI,”777 disqualifying even the carry allocations as “qualifying income” under §  7704(d).778
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774 A foreign corporation will avoid many of these taxes under the §  864(b) trading safe harbor. Its U.S. shareholders, however, will likely bear tax on the income (on a current or other unfavorable basis) under the PFIC rules. Based upon the nature of its assets and income, the public vehicle in the fund manager IPOs is likely to qualify as a PFIC under these conditions. See  §  1297.

775 §  7704(d); Regs. §  1.7704-3.

776 In some of these deals (e.g., Fortress), however, the public vehicle capitalized the blocker entities with intercompany debt in an effort to convert a portion of the fee income into “qualifying” interest that the blocker could claim as an offsetting deduction. See Fortress Prospectus, available at http://www.sec.gov/Archives/edgar/data/1380393/000095013607000793/file1.htm#page216.

777 For a fuller discussion of the Carry Bill, see VI, B, 2, above.

778 See H.R. 4213, 111th Cong., 1st Sess., § 602(b) (adding new  §  7704(d)(6) to the Code). The Carry Bill would also grandfather any existing PTP as of the date of enactment for 10 years. Id.

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U.S. Income Portfolios: Other Pass-through Entities 
  Portfolio 735-2nd: Private Equity Funds 
  Detailed Analysis 
  XII. Taking the “Private” Out of Private Equity — the IPO

E. The “Fungibility”Problem 

A PTP is subject to one operational constraint unique to partnerships: “fungibility.”For any business organized as a separate legal entity, “fungibility”means that each outstanding share within the same class is identical. In the private domain, shares of a partnership usually lack fungibility. Here, however, the buyers and sellers transfer their shares in privately-negotiated transactions, often with the consent and participation of the issuing partnership. The absence of fungibility is therefore of little consequence in the private domain. In the public domain, however, lack of fungibility is fatal because a public company cannot trace the purchase and sale of every share.779
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779 See Marich, “The Remedial Allocation Method: A Viable Cure for the Ceiling Rule,” 65 Tax Notes 1267, 1280 (December 5, 1994) (“in the case of a publicly traded partnership, fungibility is a necessity given that partnership interests trade on the market and there may be no practical means of determining which interest a purchaser has acquired”).

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To be fungible, the attributes of a particular share (including the tax attributes) cannot depend upon the identity of its previous owners.780 With corporate stock, the provenance of a share is irrelevant to fungibility because a corporation is a separate taxpayer from its shareholders. For a corporation, therefore, each share of common stock is fungible with each other share of common stock. For a partnership, however, even the simplest of capital structures may lack this essential attribute in the public domain.
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780 The fact that different units of a PTP are acquired on different dates or at different prices will not deprive the units of fungibility, any more than it would a sale of corporate stock.

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A partnership is an aggregate of its partners. Accordingly, the shares of a partnership cannot be fungible if the partnership makes tax distributions to some partners but not others, or withholds taxes with respect to some partners but not others. Even if it does neither, the partnership must still apportion income and loss between the buying and selling partners under §  706, which presupposes that the partnership is able to identify the parties to each transfer.781 Finally, if a partner contributes property to a partnership under §  721, the partnership must allocate future taxable income to take into account any unrealized gain on the property under §  704(c).782 Indeed, even if no partner contributes property, a later offering of interests for cash (or other “book up” event) will require “reverse” §  704(c) allocations by the partnership to reflect the untaxed gain inherent in the partnership assets on the date of the revaluation. This in turn will require the partnership to make disproportionate allocations of taxable income to the historic partners during future periods even though the historic partners hold partnership interests that are identical on a pre-tax basis to the partnership interests issued by the partnership to the new investors.783
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781 The Blackstone Prospectus dated June 21, 2007, for example, includes the following disclosure:

Because we cannot match transferors and transferees of common units, we will adopt depreciation, amortization and other tax accounting positions that may not conform with all aspects of existing Treasury regulations. A successful IRS challenge to those positions could adversely affect the amount of tax benefits available to our common unitholders.

Form S-1, available at http://ir.blackstone.com/secfiling.cfm?filingID=1047469-07-5100 (emphasis added). The Fortress Prospectus includes similar disclosure:

Section 706 of the Code generally provides that items of partnership income and deductions must be allocated between transferors and transferees of Class A shares. We will apply certain assumptions and conventions in an attempt to comply with applicable rules and to report income, gain, loss, deduction and credit to holders in a manner that reflects such holders' beneficial shares of our items. These conventions are designed to more closely align the receipt of cash and the allocation of income between holders of Class A shares, but these assumptions and conventions may not be in compliance with all aspects of applicable tax requirements.

See Fortress Prospectus, available at http://www.sec.gov/Archives/edgar/data/1380393/000095013607000793/file1.htm#page216  (emphasis added).

782 Regs.  §  1.704-3(a)(1).

783 Regs.  §  1.704-3(a)(6).

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In each and every one of these cases, a transferee partner's right to either future distributions or future allocations of income or loss may depend upon the identity of the transferor. Given these constraints, how do PTPs achieve fungibility and still comply with their reporting obligations under the Code?

1. All Distributions Pro Rata 

As described above, even a partnership with an “all common”capital structure may make non-pro rata distributions from time to time. When it does, it must debit the distributee partner's capital account, which will reduce future distributions to which the distributee would otherwise be entitled relative to the other partners. The most common example of a non-pro rata distribution is a tax distribution. If the distributee partner were to sell his partnership interest after receiving a tax distribution, therefore, the transferee partner would be entitled to fewer distributions from the partnership than a transferee of a partner who did not receive the same tax distribution. Indeed, the transferee would presumably pay a reduced purchase price for the acquired interest to reflect the reduced capital account balance of the particular transferor.

A PTP cannot make non-pro rata distributions. First, transferees on the public market are in no position to negotiate the terms of purchase;they have no choice but to pay the market price for the publicly-traded shares. Second, even if they could, the issuing partnership could not identify which transferee within its vast shareholder base happens to hold the share with the debited capital account. In a PTP, therefore, the public entity will not discriminate among its public holders with respect to distributions.784 If the PTP decides to make a tax distribution to provide cash to its holders to fund tax liabilities, it will make the same distribution to every holder, including those who may be entirely exempt from tax.
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784 The KKR prospectus dated April 18, 2006, for example, includes the following disclosure:

Our Managing General Partner has adopted a distribution policy for our partnership pursuant to which we intend to make cash distributions(which we intend to pay to all of our Unitholders on a quarterly basis)in an amount in U.S. dollars that is generally expected to be sufficient to permit our U.S. unit holders to fund their estimated U.S. tax obligations ...We cannot assure you that, for any particular unitholder, such distributions will be sufficient to pay the unitholder's actual U.S. or non-U.S. tax liability.

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2. Deliberate Overwithholding of Taxes 

In any investment partnership, the partnership is also likely to collect W-8s and W-9s from each of its partners and, on the basis of these forms, withhold tax only on its foreign partners and only on their allocable share of FDAP income at a 30% or reduced treaty rate. When it does, the partnership will treat the amount withheld as if it had actually distributed the withheld tax to the foreign partner rather than paid it to the appropriate tax authority.785 As such, the partnership will debit the capital account balance of the foreign partner by the amount of the withheld tax.
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785 See Worksheet 17 for an example of such a provision.

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For the same reason that a PTP cannot make non-pro rata distributions, a PTP cannot withhold only on its foreign partners even though the withholding tax only applies to the foreign partners. In the KKR and Blackstone IPOs, therefore, the fund manager undertook to withhold at a constant 30% rate on all U.S. source FDAP income without regard to whether its partners were foreign or domestic or, if foreign, were entitled to treaty relief.786 They simply advised their domestic partners to apply the withheld amount as a credit to their federal income liability for the taxable year and their treaty-eligible foreign partners to file a refund claim.787 Again, the price of fungibility.
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786 The KKR prospectus dated April 18, 2006 includes the following disclosure:

The U.S. limited partners of KKR's private equity funds generally receive dividends from U.S. portfolio companies free and clear of any U.S. withholding tax. Also, the non-U.S. limited partners of KKR's private equity funds resident in countries with a tax treaty ... generally are, without filing of a U.S. income tax return, subject to U.S. withholding tax on such dividends only at the reduced rate provided by such treaty ..., since we may not be able to provide complete information about the tax status of our investors ... and to preserve the fungibility of our common units, any dividends ... will be subject to U.S. withholding tax at a rate of 30%.

The Blackstone Prospectus includes the following disclosure:

Although each non-U.S. Holder is required to provide an IRS Form W-8, we may not be able to provide complete information related to the tax status of our investors to Blackstone Holdings for purposes of obtaining reduced rates of withholding on behalf of our investors. Accordingly, to the extent we receive dividends from a U.S. corporation ..., your allocable share of distributions of such dividend income will be subject to U.S. withholding tax at a rate of 30% ...If such information is not provided and you would not be subject to U.S. tax based on your tax status or are eligible for a reduced rate of U.S. withholding, you may need to take additional steps to receive a credit or refund of any excess withholding tax paid on your account, which may include the filing of a non-resident U.S. income tax return with the IRS.

See Blackstone Prospectus, available at http://ir.blackstone.com/secfiling.cfm?filingID=1047469-07-5100 (emphasis added).

787 Id.

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3. § 704(c) Compliance 

Under §  704(c), a partnership must allocate the deferred gain on property contributed to a partnership in a §  721 exchange back to the contributing partner during future periods. Similar principles apply to “reverse” §  704(c) allocations resulting from a “book-up”event. The obligation to allocate §  704(c) gain to the contributing partner is a fundamental principle of subchapter K. In the public arena, however, harmonizing this principle with the market requirement of fungibility is difficult:

Example: X is a PTP with two categories of holders: public buyers who purchased newly issued shares from the PTP for cash in a primary offering and public buyers who purchased previously-issued shares from the founder for cash in a secondary offering. Assume that the founders originally acquired their shares in tax-free exchanges for appreciated property under §  721. Although the founders will recognize gain in the secondary offering, the public buyers will nevertheless “step into the shoes” of the founders with respect to any remaining §  704(c) gain inherent in the PTP portfolio.788 When the PTP later realizes the gain, it must allocate the gain to the public buyers in the secondary offering.

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788 See Regs.  §  1.704-3(a)(7) (“If a contributing partner transfers a partnership interest, built-in gain or loss must be allocated to the transferee partner as it would have been allocated to the transferor partner”).

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In a nutshell, that is the problem. On any given date, a PTP should know how many shares it has outstanding. On any given date, it should also know how many shares changed hands on the market. Indeed, it may even be able to establish how many shares a particular holder purchased on that date and how many shares a particular holder sold on that date. What it cannot know, however, is the identity of the specific counterparties to each trade. How then can the PTP comply with its obligations to allocate §  704(c) gain to the appropriate partners?

Indeed, the problem is not even limited to PTPs that hold contributed property subject to §  704(c). Consider the following example:

Example: same facts as in previous example, except that the founders acquired their shares for cash before the IPO at a lower price.

Here, the founders did not contribute any appreciated property to the partnership in a §  721 exchange. When the PTP issues new shares at a higher price, however, the PTP will revalue its assets immediately before the IPO, creating a new “reverse” §  704(c) layer of unrealized gain in the PTP assets. The PTP must allocate these tax gains to either the founders or their transferees during future periods.789 As in the first example, however, the PTP cannot identify the relevant transferees in the secondary offering.
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789 Regs. §  1.704-3(a)(6)(i).

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a. The § 754 Solution 

Is a §  754 election the path to fungibility? After all, the purpose of the §  754 election is to protect the buyer from bearing tax on the future allocations of gain (including §  704(c) gain) associated with the seller's share of the underlying partnership assets, which the seller will have recognized in the preceding sale. Possibly, but only if the timing and amount of the buyer's depreciation of the resulting basis “step-up” under §  743(b) exactly coincides with the timing and amount of the §  704(c) items allocable to the buyer during each and every future period.

Unless the PTP elects to report §  704(c) gain under the “remedial method,”790 however, the limitations of the “ceiling rule” will usually prohibit the buying partner from depreciating the § 743(b) basis step-up  in annual increments that precisely match the offsetting allocations of §  704(c) gain.791 In fact, before 1998, even the remedial method of reporting §  704(c) gain did not ensure fungibility because the recovery period for amortizing the §  743(b) basis step-up did not match the remaining recovery period under § 704(c):792
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790 Regs.  §  1.704-3(d).

791 See Marich, “The Remedial Allocation Method: A Viable Cure for the Ceiling Rule,” 65 Tax Notes 1267, 1280 (December 5, 1994) (“The optional basis adjustment provided by section 743(b) can provide an avenue to fungibility, although section 704(c) allocations may, in certain situations, prevent section 743(b) adjustments from rendering partnership interests fungible.”).

792 See Marich, “The Remedial Allocation Method: A Viable Cure for the Ceiling Rule,”65 Tax Notes 1267, 1280 (December 5, 1994) (“The section 743(b) adjustment available to a transferee of M's partnership interest can make the ...partnership interests fungible only if it can equalize the transferee's book and tax depreciation on an annual basis ...Unfortunately, under the proposed cost recovery regulations, this will almost never occur.”) (emphasis added); See also Marich and McKee, “Sections 704(c) and 743(b): The Shortcomings of Existing Regulations and the Problems of Publicly Traded Partnerships,”41 Tax L. Rev. 627 at 662-668 (1986).

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Example: A and B form AB as a partnership, with A contributing$100 of cash and B contributing property with a basis of $0 and a value of $100. Assume that the contributed property has a 5 year remaining useful life, depreciable on a straight line basis. Assume further that AB acquires similar depreciable property for $100. Had B instead contributed depreciable property with a $100 tax basis on the date of contribution, each of A and B would have been allocated $10 of book and tax depreciation with respect to such property. Assume further that AB has a valid § 754 election in effect, elects to report the $100 of § 704(c) gain during future periods under the remedial method, and operates on a break even basis for the first year. Under the remedial method, AB will therefore reallocate to B $10 of annual tax depreciation otherwise allocable to A. At the end of the first year, assume that AB goes public at the same valuation and that B sells his shares in the IPO, realizing a gain of $90.

Before 1998, the acquiring partner would recover its $90 positive basis adjustment under §  743(b) over five years even though AB would report the remaining $90 of § 704(c) gain over four years. The incremental §  704(c) gain allocable to the acquiring partner in future periods ($10) would therefore exceed the offsetting depreciation of the §  743(b) basis step-up ($9) for the next four years, resulting in a higher tax liability to the acquiring partner than to any partner who acquires otherwise identical shares of AB for cash in the IPO.793 As a result, the shares of AB are no longer fungible.
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793 See also Marich, “The Remedial Allocation Method: A Viable Cure for the Ceiling Rule,”65 Tax Notes 1267, 1280 (December 5, 1994) (“When contributed property is burdened by section 704(c) allocations of built-in gain, a purchaser will generally prefer a cash unit since a property unit would carry a relatively greater tax burden ...”).

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In 1998, however, the IRS amended the §  743 regulations to allow a partnership with a valid §  754 election in effect that elects to report §  704(c) items under the remedial method to report the amortization of the §  743(b) basis step-up over the remaining recovery period of the §  704(c) property.794 Accordingly, if the PTP adopts the remedial method to report §  704(c) items, it is possible for the PTP to preserve the fungibility of its shares.
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794 See Regs. §  1.743-1(j)(4)(i)(B)(2) (“If a partnership elects to use the remedial allocation method described in Section 1.704-3(d) with respect to an item of the partnership's recovery property, then the portion of any increase in the basis of the item of the partnership's recovery property under section 743(b) that is attributable to section 704(c) built-in gain is recovered over the remaining recovery period for the partnership's excess book basis in the property as determined in the final sentence of Section 1.704-3(d)(2).”). See also Preamble to the proposed regulations, NPRM REG-209682-94, I.R.B. 1998-17, 20 (3/27/98) (“one result of the proposal is that interests in a partnership will generally be fungible if(i) each partnership interest has an identical right in capital and profits, and (ii) each item of the partnership's section 704(c) property is subject to the remedial method”) (emphasis added).

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Worksheet 21 presents a simplified diagram of a tiered partnership IPO structure that achieves fungibility with a §  754 election.

So here is the paradox: The express purpose of the 1998 amendments was to allow PTPs to comply with their obligations under §  704(c) without sacrificing the fungibility of their shares.795 Nevertheless, the sponsor in many of the fund manager and “permanent capital”IPOs did not covenant to make the §  754 election on behalf of the public vehicle.796 One reason is that §  754 compliance is administratively burdensome, in particular for a tiered partnership.797 Another reason is that if a partnership elects to report §  704(c) gain under the remedial method, the election will only accelerate the future recognition of §  704(c) gain to the founding partners in these offerings. Although this will certainly benefit the public shareholders, it will deprive its founding partners of much of the deferral benefit of the prior §  721 exchange.
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795 See Preamble to the proposed regulations, NPRM REG-209682-94, I.R.B. 1998-17, 20 (3/27/98) (“one result of the proposal is that interests in a partnership will generally be fungible if (i)each partnership interest has an identical right in capital and profits, and (ii) each item of the partnership's  section 704(c) property is subject to the remedial method”).

796 The Blackstone Prospectus, for example, provides that “we currently do not intend to make, or cause to be made, an election to adjust asset basis under Section 754 ... Consequently, upon a sale of an asset by us ..., gain allocable to a holder of common units could include built-in gain in the asset existing at the time we acquired those interests ... which built-in gain would otherwise generally be eliminated ...” See Blackstone Prospectus, available at http://ir.blackstone.com/secfiling.cfm?filingID=1047469-07-5100 (emphasis added).

797 As described in XII, E, 3, b, below, the public vehicle is likely to be a component member of a tiered partnership structure.  Accordingly, each partner in the various tiers would also have to make the §  754 election and elect to eliminate §  704(c) gain under the remedial method.

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So if these vehicles do not make the §  754 election and do not use the remedial method, how do they maintain fungibility?

b. The “Tiered Partnership” Solution 

Each public vehicle in each of the foregoing IPOs, including KKR, Apollo, Fortress and Blackstone, is a component member of a tiered partnership. A threshold issue in any tiered partnership structure is whether, given the specific tax issue in question, subchapter K should respect the various partnership entities as distinct partnerships or “collapse” them as necessary to produce a result approximating the result that would obtain in a single partnership in which the partners of the upper-tier partnership (“UTPs”) were direct partners of the lower-tier partnership (“LTP”).798 Nowhere is this concern more acute than under §  704(c) of the Code.799
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798 For an excellent discussion of the “aggregate vs. entity” issues in the context of a tiered partnership, see Huffman &  Hortenstein, “Tiers in Your Eyes: Peeling Back the Layers on Tiered Partnerships,” 86 Taxes 179(March 2008).

799 In August 2009, Treasury requested comments on the application of §  704(c) to tiered partnerships. See Notice 2009-70, I.R.B. 2009-34 (“... the IRS and the Treasury Department have become aware that practitioners are taking  positions based upon different interpretations of the current tiered partnership rules[Regs. §  1.704-3(a)(9) ... One view is that an aggregate approach should apply or be permitted such that a tiered partnership arrangement can by “looked through”and section 704(c) applied as if the partners of the upper-tier partnership directly own a portion of the assets of the lower-tier partnership ... Another view is the entity approach under which the upper-tier partnership is treated as owning an interest in the lower-tier partnership but is not treated as owning any interest in the section 704(c) property of the lower-tier partnership.”).

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Consider the case in which a partner contributes appreciated property to a UTP, which in turn transfers the contributed property to a LTP, both in a §  721 rollover transaction. Under the current regulations, the UTP must allocate its distributive share of any income allocable to it by the LTP to take into account any §  704(c) gain originally allocable to the partners of the UTP.800
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800 See Regs. §  1.704-3(a)(9).

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Example: A and B form UTP as equal partners. A contributes an appreciated asset worth $100 and B contributes $100 of cash. UTP then contributes the appreciated asset to LTP for a 30% interest in LTP. Following these contributions, LTP sells the contributed asset for $100 and recognizes $100 of gain. Under §  704(c), LTP must allocate the gain to UTP, which in turn must allocate all of the gain to A even though B is an equal partner of UTP.

In this example, the regulations adopt a quasi “aggregate”approach to §  704(c) even though they otherwise respect the separate status of the two partnerships. They therefore apply §  704(c) sequentially, first at the LTP level and then at the UTP level.801
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801 See Huffman &  Hortenstein, “Tiers in Your Eyes: Peeling Back the Layers on Tiered Partnerships,”86 Taxes 179, 213 (March 2008).

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But what if A, like one of the founders in the Fortress or Blackstone IPOs, never contributed appreciated property to the UTP in the first place? Consider the following example:

Example: A, B and C form GP as equal partners. GP then raises a new fund (“Fund”) from the capital commitments of multiple LP investors. The LPs contribute capital to Fund over time in exchange for the right to 80% of the profits and GP contributes services to Fund in exchange for the right to the remaining 20% of the profits. Assume that Fund calls and invests $1,000 of capital from the LPs in multiple portfolio investments and that the investments appreciate to $2,000. A, B and C then decide to take GP public in an IPO by contributing their shares in GP to a newly formed PTP. In exchange for their contribution, A, B and C receive shares of the PTP with an aggregate unrealized gain of $200 (i.e., $1,000 gain x 20%). PTP then issues shares to the public in an IPO.

In this example, the GP interests contributed to PTP on the date of the IPO had an original “liquidation value” of zero. Moreover, the GP issued these interests to A, B and C for services, not property. At the time of their later contribution to PTP by A, B and C, however, the GP interests became §  704(c) property by virtue of the interim appreciation of the fund investments. The investments themselves, however, are not  §  704(c) property — the Fund acquired these investments for cash and did not contribute them at any time thereafter to another partnership in a §  721 exchange. As such, neither Regs. §  1.704-3(a)(9) nor any other provision of the §  704(c) regulations specifically require PTP to allocate its distributive share of future Fund income to A, B and C to reflect the unrealized gain inherent in these investments at the time of the IPO. Instead, the PTP holds the contributed GP interests as the sole §  704(c) asset of either partnership, which it will neither sell nor depreciate.

This example is the basis on which Blackstone (and perhaps Fortress)achieve fungibility in spite of §  704(c). If it works, then neither the fund manager nor the underlying sponsor funds in either offering needs to make a §  754 election or to reconcile book/tax differences under §  704(c) under the remedial method.

Read literally, the regulations support this approach.802 Although Regs. §  1.704-3(a)(9) describes how a partnership should apply §  704(c) in the tiered partnership context, it does not by its terms apply to the preceding example. By not applying the basic principle of the regulation, however, the PTP in this example imposes tax on the public shareholders on taxable gains that represent the economic realization of §  704(c) gain to the founders. On the other hand, the regulations also permit the application of §  704(c) under “a reasonable method that is consistent with the purposes of §  704(c).”803 Although it would certainly be reasonable to allocate the gain to A, B and C in the foregoing example, it may also be reasonable not to do so in light of the limited scope of a regulation that directly addresses the application of §  704(c) to a tiered partnership.804
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802 But see Notice 2009-70, I.R.B. 2009-34 (soliciting comments on a number of questions, among them “When should Treas. Regs. §  1.704-3(a)(9) permit taxpayers to use an Aggregate Approach or Entity Approach?”).

803 See Regs. §  1.704-3(a)(1).

804 See Rubin and Macintosh, “Exploring the Outer Limits of the 704(c) Partnership Built-in Gain Rule (Part 3),” 89 J. Tax'n 271, 277 (Nov. 1998) (“given that Regs. 1.704-3(a)(9) expressly refers to tiered partnerships but does not by its terms require application of Section 704(c) in situations like Example 13, it is also “reasonable” not to apply Section 704(c) in such cases”).

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Nevertheless, a purely pro rata allocation of the gains conflicts with the purpose of §  704(c) because it spreads the burden of taxation on built-in gains inherent in the fund portfolio at the time of the IPO from A, B and C to all of the partners. Assume, for example, that PTP were to sell the contributed GP interests.  Section 704(c) would require the PTP to specifically allocate a disproportionate amount of the gain to A, B and C. Here, however, the PTP does not sell the GP interest. Should that make a difference? Perhaps not. As a rule, §  704(c) does not suspend the elimination of unrealized gain to the contributing partner until the partnership sells the contributed property. Rather, so long as the contributed property is either depreciable or amortizable, §  704(c) will accelerate the recognition of §  704(c) items under each of the “traditional,” “curative”or “remedial” methods by requiring a partnership to reallocate items of tax depreciation otherwise allocable to the contributing partner to the non-contributing partners. Here, the GP interests are not amortizable for tax purposes. In any fund that is self-liquidating, however, the carried interest is nevertheless a “wasting asset.”The only logical way to apply §  704(c) principles in this context, therefore, is to allocate the underlying gains to the founding partners.

Worksheet 22 presents a simplified diagram a tiered partnership IPO structure that purports to achieve fungibility without a §  754 election.

U.S. Income Portfolios: Other Pass-through Entities 
  Portfolio 735-2nd: Private Equity Funds 
  Working Papers

	
B-101
	
Worksheet 1
	
Direct Investment Fund Structure.

B-201
	
Worksheet 2
	
Parallel Fund Structure.

B-301
	
Worksheet 3
	
Sample Clawback Provision.

B-401
	
Worksheet 4
	
Sample Provisions for Escrow of Carry Distributions.

B-501
	
Worksheet 5
	
Sample Tax Distribution Provision.

B-601
	
Worksheet 6
	
Sample “Agency”Characterization of Distribution-in-Kind.

B-701
	
Worksheet 7
	
Sample “Targeted Capital Account” Provisions.

B-801
	
Worksheet 8
	
Sample “Variable Sharing”of Carry Distributions.

B-901
	
Worksheet 9
	
Sample Fee Offset Provisions for Fund Agreement.

B-1001
	
Worksheet 10
	
Sample “Blocker”Provision.

B-1101
	
Worksheet 11
	
Below-the-Fund Blocker Structure.

B-1201
	
Worksheet 12
	
Sample “Parallel Vehicle”Provision.

B-1301
	
Worksheet 13
	
Sample Provision to “Gross Up” General Partner for Cost of Blocker.

B-1401
	
Worksheet 14
	
Sample “Series”LLC Structure.

B-1501
	
Worksheet 15
	
Option Structure for Fund Manager Investment.

B-1601
	
Worksheet 16
	
Sample “Best Efforts”Covenant.

B-1701
	
Worksheet 17
	
Sample Withholding Tax Provision of Fund Agreement.

B-1801
	
Worksheet 18
	
“Qualified Small Business”Representation.

B-1901
	
Worksheet 19
	
Typical “Permanent Capital” IPO Structure.

B-2001
	
Worksheet 20
	
Typical “Fund Manager” IPO Structure (Simplified).

B-2101
	
Worksheet 21
	
Tiered Partnership IPO: ‘Fungibility' with a § 754 Election

B-2201
	
Worksheet 22
	
Tiered Partnership IPO: ‘Fungibility' without a § 754 Election

U.S. Income Portfolios: Other Pass-through Entities 
  Portfolio 735-2nd: Private Equity Funds 
  Working Papers

Worksheet 1 Direct Investment Fund Structure 

Direct Investment Fund Structure

U.S. Income Portfolios: Other Pass-through Entities 
  Portfolio 735-2nd: Private Equity Funds 
  Working Papers

Worksheet 2 Parallel Fund Structure 

Parallel Fund Structure

U.S. Income Portfolios: Other Pass-through Entities 
  Portfolio 735-2nd: Private Equity Funds 
  Working Papers

Worksheet 3 Sample Clawback Provision 

Section__  Clawback.

If, after giving effect to all distributions made pursuant to Sections [Distribution Provisions of Fund Agreement], but before giving effect to this Section __, the General Partner has received distributions pursuant to Section [Distribution Provisions of Fund Agreement] attributable to any Limited Partner that exceed the Carried Interest Percentage of the excess of (i) the amount of Distributable Cash and the Value of Securities attributable to Portfolio Investments apportioned to such Limited Partners pursuant to the second sentence of Section [Distribution Provisions of Fund Agreement] over (ii) the Capital Contributions of such Limited Partner used to fund the acquisition cost of Portfolio Investments and Fund Expenses (such excess, “Cumulative Profits”), then the General Partner shall contribute to the Fund the lesser of:

(x) the excess described above, and

(y) the amount of distributions received by the General Partner pursuant to Section [Distribution Provisions of Fund Agreement] attributable to such Limited Partner, less the amount of taxes paid or payable by the General Partner(and/or its members) with respect to such distributions, as reasonably determined by the General Partner (and/or its members), based on the maximum combined United States federal, State of New York and City of New York tax rate applicable to individuals on ordinary income, net short-term capital gains and/or net long-term capital gains, as applicable, and taking into account the deductibility of state and local income taxes for United States federal income tax purposes, the deductibility of local income taxes for state tax purposes and the amount of tax losses relating to the Fund allocated to the General Partner (and/or such members) to the extent such tax losses offset tax gains of the Fund, plus, without duplication, the amount of tax benefits realized by the General Partner (and/or its members) as a result of any payment pursuant to this Section __ that are actually utilized by them in the same taxable year as the year in which such payment is made;

and the Fund shall distribute such amount to such Limited Partner. The obligations of the General Partner hereunder are guaranteed severally pursuant to a separate guarantee provided by the members of the General Partner to the Fund.

U.S. Income Portfolios: Other Pass-through Entities 
  Portfolio 735-2nd: Private Equity Funds 
  Working Papers

Worksheet 4 Sample Provisions for Escrow of Carry Distributions 

Section__ Escrow Account.

(a)  Establishment of Escrow Account. The Fund shall establish an escrow account (the “Escrow Account”) with a sub-account for each Limited Partner. Subject to Section __(d) below, the General Partner shall be required upon its receipt of any Carried Interest(exclusive of tax distributions received under Section __) with respect to such Limited Partner to deposit into such Limited Partner's sub-account in the Escrow Account an amount equal to 25% of the product of (i) one minus the Assumed Income Tax Rate and (ii) the amount of such Carried Interest.  The Escrow Account shall be maintained at and in the name of and under the control of __________ (the “Escrow Agent”).

(b) Permitted Withdrawals Out of the Escrow Account. All interest or other amounts earned by the funds deposited in the Escrow Account shall remain therein and may not be withdrawn by the General Partner; provided that the Escrow Agent shall permit the General Partner to withdraw from the Escrow Account the amount of cash necessary to pay when due any income taxes imposed on it and its direct and indirect owners attributable to the interest or other amounts earned by the funds in the Escrow Account.

(c) Payment of Clawback Amount Out Of Escrow Account. (i)if, following the dissolution, winding up and termination of the Fund and the distribution of all or substantially all of the Fund's assets (the “Clawback Determination Date”), distributions of Carried Interest to the General Partner have been made with respect to any Limited Partner and either:

(A) 8% Preferred Return Clawback: The excess of (a) the cumulative distributions to such Limited Partner of Investment Proceeds minus (b)the aggregate amount of Capital Contributions, Direct Payments and returns of distributions pursuant to Section __ made by such Limited Partner (the “Cumulative Net Distributions” with respect to such Limited Partner), does not equal or exceed an 8% per annum return) on the aggregate amount of Capital Contributions made by such Limited Partner, or

(B) 80/20 Clawback: The aggregate distributions of Carried Interest to the General Partner with respect to any Limited Partner exceeds 20% of the sum of (I) the cumulative Net Distributions with respect to such Limited Partner, and (II) the aggregate distributions of Carried Interest to the General Partner with respect to such Limited Partner,

in each case determined after giving effect to all transactions through the Clawback Determination Date, then the Escrow Agent shall return promptly to the Fund for distribution to such Limited Partner, to the extent of the amount in such Limited Partner's sub-account in the Escrow Account and without prejudice to the General Partner's further obligations under Section __, an amount determined after giving effect to all transactions through the Clawback Determination Date equal to the “Clawback Amount”with respect to such Limited Partner. The “Clawback Amount”with respect to such Limited Partner shall equal the greater of:

(X) 8% Preferred Return Clawback: An amount such that if such amount were distributed to such Limited Partner, the Cumulative Net Distributions with respect to such Limited Partner equals an 8% per annum return on the aggregate amount of Capital Contributions made by such Limited Partner, and

(Y) 80/20 Clawback: An amount such that if such amount were distributed to such Limited Partner, the aggregate distributions of Carried Interest to the General Partner with respect to such Limited Partner would equal 20% of the sum of (I) such Limited Partner's Cumulative Net Distributions (after increase for such amount) and (II) the aggregate distributions of Carried Interest to the General Partner with respect to such Limited Partner;

(ii) Any amount remaining in such Limited Partner's sub-account in the Escrow Account after the payment to such Limited Partner of all amounts required under this Section __ shall be immediately released by the Escrow Agent to the General Partner.

(d) Release of Escrow Account. If on any date after the earlier of the expiration or termination of the Commitment Period or the date on which the Fund's aggregate Capital Commitments have been fully drawn as Capital Contributions, a Limited Partner has received aggregate distributions of Investment Proceeds equal to the sum of(i) the aggregate amount of Capital Contributions made by such Limited Partner and (ii) a 15% per annum return on the aggregate amount in clause (i), then 50% of any amount in such Limited Partner's sub-account in the Escrow Account shall be immediately released by the Escrow Agent to the General Partner, and the General Partner shall no longer be required to place any amounts in the Escrow Account in respect of such Limited Partner.

(e)For purposes of calculating distributions and maintaining Capital Accounts, amounts distributed by the Fund and placed in escrow by the General Partner will be considered distributed to the General Partner and amounts required to be returned to the Fund shall be considered a contribution to capital by the General Partner.

U.S. Income Portfolios: Other Pass-through Entities 
  Portfolio 735-2nd: Private Equity Funds 
  Working Papers

Worksheet 5 Sample Tax Distribution Provision 

“Tax Rate” means the highest marginal tax rates for an individual resident in New York City applicable to ordinary income or capital gains, as appropriate, taking into account the holding period of the investments disposed of and the year in which the taxable net income is recognized by the Fund, and taking into account the deductibility of state and local income taxes as applicable at the time for U.S. federal income tax purposes and any limitations thereon including pursuant to Section 68 of the Code.

Section__ Tax Advance.

(i)Notwithstanding the foregoing distribution provisions of this Section__, if, with respect to the General Partner as of any distribution date, (A) the lesser of (x) the product of (1) the cumulative historic taxable income allocated to the General Partner pursuant to this Agreement(after taking into account any taxable loss so allocated to the General Partner) for all fiscal years, or portions thereof, ending on or before such distribution date multiplied by (2) the Tax Rate or (y) the product of (1) the taxable net income allocated to the General Partner pursuant to this Agreement for the fiscal year (or portion thereof) that includes such distribution date multiplied by (2) the Tax Rate, exceeds (B) the aggregate amount distributed or to be distributed to the General Partner with respect to such Fiscal Year (or portion thereof) ending on such distribution date pursuant to this Section__ the General Partner may, in its sole discretion, elect to have the Fund make a tax advance (“Tax Advance”)to the General Partner in an amount up to the aggregate excess tax liability of the General Partner for all Fiscal Years over the aggregate amounts distributed pursuant to this Section __ in each prior or future Fiscal Year, or portion thereof.

(ii)All Tax Advances made on behalf of the General Partner shall be repaid to the Fund by reducing the amount of the next succeeding distribution or distributions which would otherwise have been made to the General Partner, or, if such distributions are not sufficient for that purpose, by so reducing the proceeds of liquidation otherwise payable to the General Partner.  To the extent that an amount otherwise distributable to the General Partner is so applied, it shall be treated for all purposes hereof as if such amount had actually been distributed.

U.S. Income Portfolios: Other Pass-through Entities 
  Portfolio 735-2nd: Private Equity Funds 
  Working Papers

Worksheet 6 Sample “Agency” Characterization of Distribution-in-Kind 

In the event that such Member does not provide the Manager with such notice in a timely manner (such Member to be referred to as the “Electing Member”), any assets that are distributed to some, but not all, Members will, for purposes of determining the amount of the distributions made to each Member, be deemed to have been distributed to all Members on the effective date of such distribution for those Members receiving such in-kind distribution and, in addition, the following provisions shall apply:

(i) The Manager will act as sales agent and temporary manager of the securities or other assets (the “Managed Assets”) for the exclusive benefit of the Electing Member without collecting a fee for such sales or management services.

(ii) The Company or a Subsidiary shall hold the Managed Assets as nominee for the benefit of, and on behalf of, the Electing Member. The Manager shall have sole and absolute discretion with respect to the sale, exchange or disposition of the Managed Assets and shall have no fiduciary or other duty to the Company or the other Members in the exercise of such discretion. The Electing Member shall be liable for all taxes and other charges levied upon the Managed Assets and on any income or distributions thereon, and shall be liable for any and all costs incurred by the Company for the benefit of the Electing Member pursuant to this Section.  The Electing Member shall have the benefit, and bear the risk, of all distributions of income, dividends, cash or other property on or relating to the Managed Assets or any change in the character of the Managed Assets. The provisions of Sections__ shall be available with respect to the Managed Assets; provided, that any indemnification obligation arising under Sections __ with respect to the Managed Assets shall be borne solely by the Electing Member to the extent of the fair market value of all Managed Assets held by the Company or its subsidiary on behalf of the Electing Member and determined at the time that securities corresponding to such Managed Assets were originally distributed in-kind to the other Members.

(iii) Upon any disposition of the Managed Assets for cash, the Company shall transfer to the Electing Member the proceeds of such disposition, less the amount of any expenses related to such disposition.

(iv) For all purposes under this Agreement, including for purposes of determining the Electing Member's Capital Account and Preferred Return, the Electing Member shall be treated as if it received the Managed Assets at the time that assets corresponding to such Managed Assets were originally distributed in-kind to the other Members.

U.S. Income Portfolios: Other Pass-through Entities 
  Portfolio 735-2nd: Private Equity Funds 
  Working Papers

Worksheet 7 Sample “Targeted Capital Account” Provisions 

“Partially Adjusted Capital Account” shall mean, with respect to any Member and any period, the Capital Account of such Member as of the beginning of such period, adjusted for all Capital Contributions and distributions during such period but before giving effect to any allocations of Net Profit or Net Loss for such period pursuant to Section __ hereof.

“Target Capital Account” shall mean, with respect to any Member and any period, the amount (which may be either a positive or a deficit balance) that such Member would receive as a distribution or would be required to contribute to the Fund if (i) all assets of the Fund as of the end of such period were sold for cash equal to the amount for which such assets are carried on the books of the Fund,(ii) all Fund liabilities were satisfied to the extent required by their terms (other than liabilities the discharge of which would give rise to a deduction for U.S. federal income tax purposes) and (iii)the net proceeds were distributed pursuant to Section __, all of the foregoing computed after all actual distributions or Capital Contributions have been made for such period.

Section__ Allocations of Net Profit and Net Loss.

(a)Subject to Section __(b), Net Profit and Net Loss shall be allocated among the Members so as to reduce, proportionately, the difference between their respective Target Capital Accounts and Partially Adjusted Capital Accounts as of the end of such period, provided that no portion of Net Profit or Net Loss for any period shall be allocated to a Member, in the case of a Net Profit, whose Partially Adjusted Capital Account is greater than or equal to its Target Capital Account or, in the case of a Net Loss, whose Target Capital Account is greater than or equal to its Partially Adjusted Capital Account for such period.

(b)If (i) the Fund has a Net Profit for any period and, notwithstanding the application of Section __(a), the balance of any Member's Partially Adjusted Capital Account is greater than the balance of its Target Capital Account, then the Member with such excess balance shall be specially allocated items of Fund expense or loss for such period (to the extent available) equal to the difference between its Partially Adjusted Capital Account and its Target Capital Account;(ii) the Fund has a Net Loss for any Period and, notwithstanding the application of Section __(a), the balance of any Member's Partially Adjusted Capital Account is less than the balance of its Target Capital Account, then the Member with such deficient balance shall be specially allocated items of Fund income or gain for such period (to the extent available) equal to the difference between its Partially Adjusted Capital Account and its Target Capital Account; and (iii) the Fund has neither a Net Profit nor a Net Loss for any period and, notwithstanding the application of Section __(a), the balance of any Member's Partially Adjusted Capital Account differs from the balance of its Target Capital Account, then the Member with an excess or deficient balance, as the case may be, shall be specially allocated items of Fund expense or loss or income or gain, as the case may be, for such period (to the extent available) equal to the difference between its Partially Adjusted Capital Account and its Target Capital Account. Solely for purposes of this Section __(b), Net Profit and Net Loss shall be determined by giving effect to any items of gain, income, deduction or loss specially allocated pursuant to this Section __(b).

(c)Except as otherwise provided herein, the income, gains, losses, credits and deductions recognized by the Fund shall be allocated among the Members, for United States federal, state and local income tax purposes, to the extent permitted under the Code and the Treasury Regulations, in the same manner that each such item is allocated to the Members’Capital Accounts.

U.S. Income Portfolios: Other Pass-through Entities 
  Portfolio 735-2nd: Private Equity Funds 
  Working Papers

Worksheet 8 Sample “Variable Sharing” of Carry Distributions 

“Profit Sharing Percentage” of a Member applicable to a particular Portfolio Investment means the percentage interest of such Member in Carried Interest Proceeds to be distributed to the Members from such Portfolio Investment.  The Profit Sharing Percentage of a Member applicable to Portfolio Investments initially shall be as set forth in the Interest Letter between the Company and such Member.

Section__ Amounts and Priority of Distributions.

(a) Treatment of Investment Proceeds. Each distribution of Investment Proceeds from a Portfolio Investment shall be made to the Members in proportion to their respective capital contributions with respect to such Portfolio Investment.  A Member shall be entitled to its share of such distributions notwithstanding the termination of such Member's employment with the Investment Advisor and its affiliates for any reason.

(b) Treatment of Carried Interest Proceeds. Any distribution of Carried Interest Proceeds shall be paid to the Members in proportion to their respective Profit Sharing Percentages applicable to the relevant Portfolio Investment as of the date of such Member's distribution, provided that, distributions with respect to Reserved Percentages applicable to a particular Portfolio Investment shall be allocated equally among the then Managing Members in Good Standing.

Section__ Reserved Percentages; Adjustments in Profit Sharing Percentages.

(a) Establishment of Reserved Percentages. The Management Committee may determine in its sole and absolute discretion to allocate less than all of the Profit Sharing Percentages applicable to a particular Portfolio Investment among the Members.  Profit Sharing Percentage amounts in respect of a particular Portfolio Investment which are not so allocated and the amount by which any Member's Profit Sharing Percentage is reduced due to termination of employment, default or an event of Cause shall be deemed to be a “Reserved Percentage”app1icable to such Portfolio Investment and shall be allocated equally among the Managing Members then in Good Standing.

(b) Increases in Profit Sharing Percentages Out of Reserved Percentages. The Management Committee in its sole and absolute discretion may increase the Profit Sharing Percentage of any existing Member applicable to a particular Portfolio Investment or Unfunded Portfolio Investment or to Funded Portfolio Investments or Unfunded Portfolio Investments generally by an amount equal to all or any portion of the then Reserved Percentage in respect of such Portfolio Investment.  Upon the earlier of (A) the date on which the Company has funded or otherwise expended at least 90% of the Capital Commitments and (B) the end of the Commitment Period, the Profit Sharing Percentages of all Managing Members then in Good Standing applicable to Funded Portfolio Investments or Unfunded Portfolio Investments generally shall be increased by an equal share of all of the then existing Reserved Percentages, and any Reserved Percentages subsequently created shall automatically be allocated among the Profit Sharing Percentages of all Managing Members then in Good Standing.

(c) Reduction in Profit Sharing Percentages. The Management Committee in its sole and absolute discretion may reduce the Profit Sharing Percentage of any Non-Managing Member applicable to Unfunded Portfolio Investments.  On the date of such reduction, the amount of any such reduction in Profit Sharing Percentage shall be deemed to be a “Reserved Percentage” applicable to such Unfunded Portfolio Investments.  Except as provided in Sections __ herein,(i) the Profit Sharing Percentage of any Member applicable to any Funded Portfolio Investment shall not be reduced without its consent and (ii) the Profit Sharing Percentage of any Managing Member applicable to Unfunded Portfolio Investments shall not be reduced without his consent.

(d) Adjustments in Respect of Additional Members.  In the event of the admission of any person as an additional Member pursuant to Section __, the Profit Sharing Percentages allocated to such additional Member applicable to Funded Portfolio Investments and to Unfunded Portfolio Investments shall first be taken out of the then available Reserved Percentage applicable to such Portfolio Investments, if any.

U.S. Income Portfolios: Other Pass-through Entities 
  Portfolio 735-2nd: Private Equity Funds 
  Working Papers

Worksheet 9 Sample Fee Offset Provisions for Fund Agreement 

“Fee Income” means all transaction fees, break-up fees, set-up fees, acquisition fees, commitment fees, termination fees, portfolio company management fees, advisory fees, monitoring fees, investment banking fees and similar fees, payments or compensation(whether in the form of cash, options, warrants, stock or otherwise)received by the General Partner, the Fund Manager or any affiliate of the foregoing specifically in connection with a proposed investment or the consummation, disposition, holding or termination of an investment paid by the Fund, the General Partner, the Fund Manager, or any affiliate of the foregoing related to the transactions or services with respect to which such fee is received).

Alternative 1:

Section__ Fee Income.  All Fee Income shall be payable to and be income of the Fund Manager or its affiliates.  An amount equal to the sum of (i) 50% of all Fee Income, shall reduce the management fees calculated on the date of, or in the periods following, payment of such fees.

Alternative 2 (carryforward limitation):

Section__ Fee Income.  To reflect the reduced time and effort the Fund Manager and its affiliates will devote to the Fund by reason of the performance of such services to companies in which the Fund has made an Investment, the amount of any Fee Income received by the Fund Manager and its affiliates from any company or entity in which the Fund has an interest (other than direct reimbursement of the out-of-pocket expenses of the Fund Manager and its affiliates) shall be offset against and reduce [X%] of the amount of the management fee next due the Fund Manager pursuant to Section __ hereof, and to the extent the amounts of any such offsets exceed [X%] of the management fee next due the Fund Manager, then the remaining offset amounts shall be carried forward to offset succeeding management fees due the Fund Manager; provided, however, that notwithstanding the foregoing, in no event shall any offset amounts be carried forward as an offset to the management fee payments hereunder for more than[twenty-four (24)] consecutive months.

U.S. Income Portfolios: Other Pass-through Entities 
  Portfolio 735-2nd: Private Equity Funds 
  Working Papers

Worksheet 10 Sample “Blocker” Provision 

Section___ Alternative Investment Vehicles.

(a)If in the determination of the General Partner an investment is likely to give rise to (i) ECI with respect to a Non-U.S. Partner, (ii) Section 892 Income to a Section 892 Partner, (iii) income tax under the “controlled foreign corporation” or “foreign personal holding company”provisions of the Code to any partner, (iv) unrelated business taxable income, as defined by Sections 512 and 514 of the Code (“UBTI”), to a tax-exempt partner, or (v) any other adverse tax consequences to the Fund or any partner, the General Partner shall have the right to direct that Capital Contributions of certain or all partners with respect to such potential investment be effected through an alternative investment vehicle (an “AIV”)if the use of such a vehicle would reasonably be expected to cause such partners not to recognize the tax consequences described above.

(b)Each AIV shall provide for the limited liability of the Limited Partners. Any Limited Partners of the AIV may invest in the AIV through an entity that is treated as a corporation for U.S. federal income tax purposes.  The General Partner of the Fund shall serve as the General Partner of each AIV.  Each AIV shall be managed by the Fund Manager or an affiliate thereof and shall be governed by one or more agreements with terms and conditions substantially similar to the terms and conditions of this Agreement.

(c)The General Partner shall have the discretion to use one or more AIVs to invest: (i) indirectly through the Fund as a Limited Partner of the Fund or as a partner, member or owner of another AIV (a “Partner Vehicle”); (ii) directly in lieu of the Fund; or (iii) as a corporate subsidiary of the Fund or of an AIV to which the Capital Contributions of Non -U.S. Partners, Section 892 Partners or Tax-Exempt Partners will be contributed by the Fund or the AIV, as the case may be, and which will invest in such investment as and when the Fund or the AIV so invests (in which event costs and expenses (including entity-level taxes) relating to the corporation, and all other items of income, gain or loss received by the Fund or the AIV shall be specifically allocated to the partners whose Capital Contributions toward such investment were contributed, and all other items of income, gain or loss received by the Fund or the AIV, as the case may be, from such investment shall be specifically allocated to the other partners.  For example, if the Fund determines to invest in a pass-through entity in a manner that could cause a Non-U.S. Partner to recognize ECI, the General Partner may create a Partner Vehicle that qualifies as a corporation for U.S. federal income tax purposes and direct that each Non-U.S. Partner effect its investment through the Parallel Vehicle.  Costs and expenses relating to such Partner Vehicle (including entity-level taxes) shall be borne solely by such Section 892 Partners, Non-U.S. Partners and Tax-Exempt Partners who invest therein.

(d)For purposes of this Agreement, all amounts distributed to an AIV shall be treated as having been distributed directly to Limited Partners participating in such investment through such AIV.

U.S. Income Portfolios: Other Pass-through Entities 
  Portfolio 735-2nd: Private Equity Funds 
  Working Papers

Worksheet 11 Below-the-Fund Blocker Structure 

Below-the-Fund Blocker Structure

U.S. Income Portfolios: Other Pass-through Entities 
  Portfolio 735-2nd: Private Equity Funds 
  Working Papers

Worksheet 12 Sample “Parallel Vehicle” Provision 

Section__ Parallel Investment Entities.

Notwithstanding any other provision of this Agreement, the General Partner reserves the right to establish one or more separate entities for legal, regulatory, tax or other reasons (each, a “Parallel Vehicle”and collectively, the “Parallel Investment Entities”)which will coinvest pro rata with the Fund in each of the Fund's investments on the basis of capital committed to the Parallel Investment Entities.  Any investment made by a Parallel Vehicle shall be made on the same terms and conditions as those that apply to the investment made by the Fund in each investment; provided, however, that (A) the Parallel Vehicle shall be prohibited from disposing of its investment unless the Fund concurrently disposes of or distributes a pro rata portion of its investment and (B) the Parallel Vehicle may make an investment with different terms and conditions than those applicable to the Fund's investment if such discrepancy relates to legal, tax, regulatory or other matters specific to the Parallel Vehicle and such discrepancy has been approved by the Advisory Board.

U.S. Income Portfolios: Other Pass-through Entities 
  Portfolio 735-2nd: Private Equity Funds 
  Working Papers

Worksheet 13 Sample Provision to “Gross Up” General Partner for Cost of Blocker 

Section X.  Blocker Corporations. If the Adviser determines, in its sole discretion (that a Portfolio Investment is likely to give rise to the realization of UBTI by a Tax-Exempt Member or ECI by a Non-U.S. Member, the Adviser may structure the acquisition of such Portfolio Investment so that the interests of any Tax-Exempt Members (in the case of a Portfolio Investment that is likely to give rise to UBTI) and/or Non-U.S. Members (in the case of a Portfolio Investment that is likely to give rise to ECI) that elect, within five Business Days after receiving the applicable Drawdown Notice, to be “Designated Members” with respect to such Portfolio Investment are held through a blocker entity (or entities) that is taxable as a corporation for United States federal income tax purposes(a “Blocker Corporation”). The interests of the Company and of the Blocker Corporation in the Portfolio Investment shall be held through an intermediate entity that is taxable as a partnership for United States federal income tax purposes, which shall make distributions in accordance with Section Y below.

Section Y. Portfolio Investments Held Through Blocker Corporation.  If any Portfolio Investment is held, in part, through a Blocker Corporation in accordance with Section __, any amount distributable by the intermediate entity through which such Portfolio Investment is held shall be distributed as follows:

(i) an amount equal to the aggregate amount that would have been distributed to the Designated Members with respect to such Portfolio Investment under [the distribution waterfall] in respect of such Portfolio Investment if such Portfolio Investment had been wholly owned by the Company(and had not been owned in part through such Blocker Corporation)shall be distributed to such Blocker Corporation, and the proceeds of such distribution (net of all costs and expenses, including taxes, attributable to the Blocker Corporation) shall be distributed thereafter to the Company, and thereafter to such Designated Members, in proportion to their interests therein,

(ii) an amount equal to the aggregate amount that would have been distributed to the Carry Participants from Distributable Cash apportioned to such Designated Members in respect of such Portfolio Investment if such Portfolio Investment had been wholly owned by the Company (and had not been owned in part through such Blocker Corporation) shall be distributed to the Company and shall be distributed thereafter to the Carry Participants, and

(iii) the remaining amount distributable by such intermediate entity shall be distributed to the Company and the resulting Distributable Cash shall be apportioned thereafter solely among the Members other than such Designated Members and distributed thereafter to such Members in accordance with  [the distribution waterfall].

The portion of any distributions made by such intermediate entity to such Blocker Corporation that are attributable to such a Designated Member shall for all purposes of this Agreement be treated as having actually been made to such Designated Member pursuant to the appropriate clause of  [the distribution waterfall] (and any distributions made by such Blocker Corporation to the Company in respect of such Designated Member shall be disregarded), for purposes of making the computations required by  [the distribution waterfall]. With the consent of the Management Board, the Adviser shall make such adjustments to the provisions of this Agreement as the Adviser shall in its sole discretion deem appropriate to effectuate the intent of this provision.

U.S. Income Portfolios: Other Pass-through Entities 
  Portfolio 735-2nd: Private Equity Funds 
  Working Papers

Worksheet 14 Sample “Series” LLC Structure 

Sample “Series” LLC Structure

U.S. Income Portfolios: Other Pass-through Entities 
  Portfolio 735-2nd: Private Equity Funds 
  Working Papers

Worksheet 15 Option Structure for Fund Manager Investment 

Option Structure for Fund Manager Investment

U.S. Income Portfolios: Other Pass-through Entities 
  Portfolio 735-2nd: Private Equity Funds 
  Working Papers

Worksheet 16 Sample “Best Efforts” Covenant 

Section____ The General Partner agrees that it shall use its reasonable best efforts to conduct the affairs of the Fund in such a manner cause the Fund not to engage, directly or indirectly, in any activity that would cause (i) a Limited Partner that is not a United States person within the meaning of Section 7701(a)(30) of the Code and is not otherwise subject to U.S. federal income taxation under Section 871(b) or Section 882(a)(1) of the Code with respect to its distributive share of Fund income to recognize, solely as a result of its status as a Limited Partner in the Fund, income that is effectively connected with the conduct of a trade or business in the United States, within the meaning of Section 871(b) or Section 882(a)(1) of the Code (in each case excluding income described in Section 897 of the Code); (ii) a Limited Partner that is a foreign government and is not otherwise subject to U.S. federal income taxation under Section 892 of the Code with respect to its distributive share of Fund income to recognize, solely as a result of its status as a Limited Partner in the Fund, income from the conduct of commercial activities, within the meaning of Section 892 of the Code (excluding income that arises as a result of, or with respect to, an interest described in Section 897(c)(1)(A)(ii) of the Code); or (iii) a Limited Partner that is a tax-exempt entity to realize any “unrelated business taxable income” within the meaning of Section 512 and 514 of the Code.

U.S. Income Portfolios: Other Pass-through Entities 
  Portfolio 735-2nd: Private Equity Funds 
  Working Papers

Worksheet 17 Sample Withholding Tax Provision of Fund Agreement 

(a) Withholding.  The General Partner shall be entitled to withhold from any distribution to a Limited Partner such amounts, if any, as are required by applicable law.  The Limited Partner shall provide any information required to be provided under applicable law(including any certificates or other documentation prescribed under the Code or the regulations thereunder) to permit the General Partner to determine its withholding obligations with respect to any Limited Partner.  Notwithstanding the foregoing, the General Partner shall have no liability to the Partnership or the Limited Partner for failure to withhold in respect of any Partner who has not furnished such information to the General Partner.

(b) Indemnity.  If the Partnership or the General Partner incurs any liability with respect to (i) any withholding obligation imposed by applicable law or (ii) any amount (including any tax, penalty, or interest) in respect of any failure to withhold as required by, the Limited Partner shall reimburse the Partnership or the General Partner on demand for the amount of such liability plus interest thereon at a rate per annum of __.  Each Person paying an amount (including any taxes, penalties, and interest) in respect of a Limited Partner's tax shall have a security interest in the Partnership interest of any Limited Partner who is required to reimburse any Person pursuant to this Section __(b).  In addition to all other rights and remedies of such paying Person with respect to such security interest or otherwise available at law or in equity, the General Partner shall have the right to offset against the Limited Partner's distributions under this Agreement all amounts owed by the Limited Partner to such Person pursuant to this Section __ (b).  The rights and obligations set forth in this Section __(b) shall survive the dissolution, liquidation, and termination of the Partnership.

(c) Amounts Withheld Treated as Distributions.  Any amounts withheld or offset by the General Partner in accordance with Section__(a) or (b) shall nevertheless, for purposes of this Agreement, be deemed to have been distributed to the Limited Partner.

U.S. Income Portfolios: Other Pass-through Entities 
  Portfolio 735-2nd: Private Equity Funds 
  Working Papers

Worksheet 18 “Qualified Small Business” Representation 

Qualified Small Business. 

The Company represents and warrants to the Investors that:

(a)The Company is a “qualified small business” within the meaning of Section 1202(d) of the Internal Revenue Code of 1986, as amended (the “Code”) as of the date hereof;

(b)The Series __ Preferred Stock qualifies as “qualified small business stock” as defined in Section 1202(c) of the Code as of the date hereof;

(c)As of the date hereof, the Company meets the “active business requirement” of Section 1202(e) of the Code;

(d)The Company has made no “significant redemptions” within the meaning of Section 1202(c)(3)(B) of the Code; and

(e)The Company has executed and delivered a Qualified Small Business Stock Checklist in the form attached hereto as Exhibit __.

U.S. Income Portfolios: Other Pass-through Entities 
  Portfolio 735-2nd: Private Equity Funds 
  Working Papers

Worksheet 19 Typical “Permanent Capital” IPO Structure 

“Permanent Capital” IPO Structure

U.S. Income Portfolios: Other Pass-through Entities 
  Portfolio 735-2nd: Private Equity Funds 
  Working Papers

Worksheet 20 Typical “Fund Manager” IPO Structure (Simplified) 

“Fund Manager” IPO Structure

U.S. Income Portfolios: Other Pass-through Entities 
  Portfolio 735-2nd: Private Equity Funds 
  Working Papers

Worksheet 21 Tiered Partnership IPO: ‘Fungibility' with a § 754 Election 

Tiered Partnership IPO: ‘Fungibility' with a § 754 Election

U.S. Income Portfolios: Other Pass-through Entities 
  Portfolio 735-2nd: Private Equity Funds 
  Working Papers

Worksheet 22 Tiered Partnership IPO: ‘Fungibility' without a § 754 Election 

Tiered Partnership IPO: ‘Fungibility' without a § 754 Election

U.S. Income Portfolios: Other Pass-through Entities 
  Portfolio 735-2nd: Private Equity Funds 
  Bibliography

OFFICIAL 

Statutes: 

Internal Revenue Code: § § 1, 11, 56, 61, 67, 163, 166, 212, 246, 269, 301, 302, 305, 311, 316, 318, 351, 357, 368, 381, 482, 511, 512, 513, 514, 551, 552, 553, 554, 555, 556, 557, 558, 702, 704, 731, 732, 741, 743, 751, 752, 754, 864, 871, 872, 875, 881, 882, 884, 951, 952, 953, 954, 955, 956, 957, 958, 959, 960, 961, 962, 963, 964, 1045, 1162, 1202, 1234, 1271, 1272, 1273, 1275, 1291, 1292, 1293, 1294, 1295, 1296, 1297, 1298, 1402, 1441, 1442, 1446, 6011, 6012, 6111, 6112, 7701, 7704, 7874.

See the Treasury Regulations promulgated pursuant to the above cited Internal Revenue Code sections.

New York City Administrative Code: Sections 11-502, 11-503, 11-505, 11-506, 11-507, 11-508.

Public Laws: 

P. L. 103-66.

P. L. 105-34.

P. L. 108-27.

Committee Reports: 

H.R. Rep. No. 1337, 83d Cong., 2d Sess.(1954).

S. Rep. No. 1622, 83d Cong., 2d Sess.(1954).

H.R. Conf. Rep. No. 861, 98th Con., 1st Sess. (1984).

Joint Committee on Taxation, General Explanation of the Revenue Provisions of the Deficit Reduction Act of 1984, at 684 (1984).

H.R. Rep. No. 881, 101st Cong. 2d Sess. 348 (1990).

H.R. Rep. No. 213, 103d Cong., 1st Sess. 523 (1993).

N.Y.S. Bill No. 3424, 218th Gen. Ass., 1st Reg. Sess. (June 11, 1996).

H.R. Conf. Rep. No. 126, 108th Cong., 1st Sess. (2003).

Treasury Rulings: 

Rev. Proc. 93-27, 1993-2 C.B. 343.

Rev. Proc. 2001-43, 2001-34 I.R.B. 191.

Rev. Proc. 2003-24, 2003-11 I.R.B. 599.

Rev. Proc. 2003-25, 2003-11 I.R.B. 601.

Rev. Proc. 2003-64, 2003-32 I.R.B. 306.

Rev. Rul. 54-43, 1954-1 C.B. 119.

Rev. Rul. 56-136, 1956-1 C.B. 92, revoked by Rev. Rul. 81-160, 1981-1 C.B. 312.

Rev. Rul. 58-63, 1958-1 C.B. 624.

Rev. Rul. 58-234, 1958-1 C.B. 279.

Rev. Rul. 60-249, 1960-2 C.B. 264.

Rev. Rul. 67-321, 1967-2 C.B. 470.

Rev. Rul. 68-601, 1968-2 C.B. 124.

Rev. Rul. 69-130, 1969-1 CB 93.

Rev. Rul. 69-131, 1969-1 CB 94.

Rev. Rul. 70-108, 1970-1 C.B. 78.

Rev. Rul. 70-140, 1970-1 C.B. 73.

Rev. Rul. 70-540, 1970-2 C.B. 101.

Rev. Rul. 70-543, 1970-2 C.B. 172.

Rev. Rul. 72-265, 1972-1 C.B. 222.

Rev. Rul. 75-320, 1975-2 C.B. 105.

Rev. Rul. 76-95, 1976-1 C.B. 172.

Rev. Rul. 77-85, 1977-1 C.B. 12.

Rev. Rul. 80-274, 1980-2 C.B. 27.

Rev. Rul. 81-16, 1981-1 C.B. 312.

Rev. Rul. 81-225, 1981-2 C.B. 13.

Rev. Rul. 82-54, 1982-1 C.B. 11.

Rev. Rul. 82-150, 1982-2 C.B. 110.

Rev. Rul. 82-158, 1982-2 C.B. 77.

Rev. Rul. 83-22, 1983-1 C.B. 17.

Rev. Rul. 84-111, 1984-2 C.B. 88.

Rev. Rul. 84-152, 1984-2 C.B. 381.

Rev. Rul. 84-153, 1984-2 C.B. 381.

Rev. Rul. 85-4, 1985-1 C.B. 294.

Rev. Rul. 90-80, 1990-2 C.B. 170.

Rev. Rul. 91-32, 1991-1 C.B. 107.

Rev. Rul. 99-6, 1999-6 I.R.B. 6.

Rev. Rul. 2002-31, 2002-22 I.R.B. 102.

Rev. Rul. 2003-51, 2003-51 I.R.B. 938.

Rev. Rul. 2003-91, 2003-33 I.R.B. 347.

Rev. Rul. 2003-92, 2003-33 I.R.B. 350.

Cases: 

Aiken Industries, Inc. v. Comr., 56 T.C. 925 (1971), acq., 1972-1 C.B. 1.

American Savings Bank v. Comr., 56 T.C. 828 (1971).

Arrowsmith v. Comr., 344 U.S. 6 (1952).

Baker v. Comr., T.C. Memo 1995-385.

Banac Est. v. Comr., 17 T.C. 748 (1951).

Bank of America v. U.S., 680 F.2d 142 (Ct. Cl. 1982).

Bass v. Comr., 50 T.C. 595 (1968).

Campbell v. Comr., T.C. Memo 1990-162, rev'd, 943 F.2d 815 (8th Cir. 1991).

Christoffersen v. U.S., 749 F.2d 513 (8th Cir. 1984).

Court Holding, Comr. v., 324 U.S. 331 (1945).

Crown v. Comr., 58 T.C. 825 (1972), aff'd, 487 F.2d 1404 (7th Cir. 1973).

Deputy v. DuPont, 308 U.S. 488 (1939).

De Vegvar v. Comr., 28 T.C. 1055 (1957).

Diamond v. Comr., 56 T.C. 530 (1971), aff'd, 492 F.2d 286 (7th Cir. 1974).

Dobson v. Comr., 320 U.S. 489 (1943).

Donroy, Ltd. v. U.S., 301 F.2d 200 (9th Cir. 1962).

Eberhart v. Comr., T.C. Memo 1977-155.

Fong v. Comr., T.C. Memo 1984-402.

Gilmore, U.S. v., 372 U.S. 39 (1963).

Goldsmith v. Comr., 22 T.C. 1137 (1954).

Griffith v. Comr., 308 U.S. 355 (1939).

Hale v. Comr., T.C. Memo 1965-274.

Hazeltine Corp. v. Comr., 89 F.2d 513 (3d Cir. 1937).

Higgins v. Comr., 312 U.S. 212 (1941).

Hilton Hotels Corp., U.S. v., 397 U.S. 580 (1970).

Horst, Helvering v., 311 U.S. 112 (1940).

Imel v. Comr., 61 T.C. 318 (1973).

Intermountain Lumber Co. v. Comr., 65 T.C. 1025 (1976).

InverWorld Inc. v. Comr., T.C. Memo 1996-301.

Johnston v. Comr., 24 T.C. 920 (1955).

Kelly v. Patterson, 331 F.2d 753 (5th Cir. 1964).

Kenroy, Inc. v. Comr., T.C. Memo 1984-232.

Liang v. Comr., 23 T.C. 1040 (1955).

Lucas v. Earl, 281 U.S. 111 (1930).

Luna v. Comr., 42 T.C. 1067 (1964).

McDonald's Restaurants of Ill. v. Comr., 688 F.2d 520 (7th Cir. 1982).

Megargel v. Comr., 3 T.C. 238 (1944).

Milsap v. Comr., 46 T.C. 751 (1966).

Moline Properties v. Comr., 319 U.S. 436 (1943).

Moran, Comr. v., 236 F.2d 595 (8th Cir. 1956).

Murphy Logging Co. v. U.S., 378 F.2d 222 (9th Cir. 1967).

Nat Harrison Associates, Inc. v. Comr., 42 T.C. 601 (1964).

National Carbide Corp. v. Comr., 336 U.S. 422 (1949).

Olton Feed Yard, Inc. v. U.S., 592 F.2d 272 (5th Cir. 1979).

Pacheco, U.S. v., 912 F.2d 297 (9th Cir. 1990).

Pinchot v. Comr., 113 F.2d 718 (2d Cir. 1940).

Plantation Patterns v. Comr., 462 F.2d 712 (5th Cir. 1972).

Raytheon Productions Corp. v. Comr., 144 F.2d 110 (1st Cir. 1944).

Ross Glove Company v. Comr., 60 T.C. 569 (1973).

Santa Anita Consolidated Inc. v. Comr., 50 T.C. 536 (1968).

Seminole Thriftway, Inc. v. U.S., 99-1 USTC ¶ 50,155.

Seyburn v. Comr., 51 T.C. 578 (1969).

Siegel v. Comr., 45 T.C. 566 (1966).

Spangler v. Comr., 323 F.2d 913 (9th Cir. 1963).

St. John v. U.S., 53 AFTR2d 84-718 (C.D. Ill. 1983).

Swid-Pearlman Management v. Tully, 413 N.Y.S.2d 239 (3d Dep't 1979).

Tulia Feedlot, Inc. v. U.S., 513 F.2d 800 (5th Cir. 1975).

Tulia Feedlot, Inc. v. U.S., 3 Cl. Ct. 364 (1983).

Unger v. Comr., 936 F.2d 1316 (D.C. Cir. 1991).

United Parcel Service of America, Inc. v. Comr., T.C. Memo 1999-268, rev'd, 254 F.3d 1014 (11th Cir. 2001).

Weikel v. Comr., T.C. Memo 1986-58.

Whipple v. Comr., 373 U.S. 193 (1963).

Wilson v. Comr., 49 T.C. 406 (1968), rev'd, 412 F.2d 314 (9th Cir. 1969).

Woodward v. Comr., 397 U.S. 572 (1970).

U.S. Income Portfolios: Other Pass-through Entities 
  Portfolio 735-2nd: Private Equity Funds 
  Bibliography

UNOFFICIAL 

Treatises: 

Arthur B. Willis et al., Partnership Taxation (1971).

Bittker &  Eustice, Federal Income Taxation of Corporations and Shareholders (6th ed. 1994).

Ginsburg &  Levin, Mergers, Acquisitions and Buyouts, A Transactional Analysis of the Governing Tax, Legal and Accounting Considerations (June 2002).

Kahn &  Lehman, Corporate Income Taxation (4th ed. 1994).

McKee, Nelson &  Whitmire, Federal Taxation of Partnerships and Partners (3d ed. 1997).

Schell, Private Equity Funds: Business Structure and Operations.

Periodicals: 

1986 

Marich and McKee, “Sections 704(c) and 743(b): The Shortcomings of Existing Regulations and the Problems of Publicly Traded Partnerships,” 41 Tax L. Rev. 627.

1991 

ABA Section of Taxation, Committee on Insurance Companies, “A Roadmap to the Federal Income Taxation of Non-Qualified Annuity Contracts,” 45 Tax Law. 123.

1992 

Shapiro, “Private Securities Partnership —The Trade or Business Issue Examined,” 56 Tax Notes 85(July 6).

1994 

Marich, “The Remedial Allocation Method:  A Viable Cure for the Ceiling Rule,” 65 Tax Notes 1267(Dec. 5).

1996 

Kingson, “The David Tillinghast Lecture: Taxing the Future,” 51 Tax L. Rev.

1997 

Blanchard, “Rev. Rul. 91-32: Extrastatutory Attribution of Partnership Activities to Partners,” 1776 Tax Notes 1331 (Sept. 8).

1998 

Mullin, “The Impact of the ’97 Tax Act on Private Investment Funds,” 15 J. Tax'n Investments 91.

Rubin and Macintosh, “Exploring the Outer Limits of the 704(c) Partnership Built-in Gain Rule (Part 3),” 89 J. Tax'n 271 (Nov.).

2000 

Alster, “Shifts of Partnership Capital in the New Service Economy,” Tax Club (Nov. 27).

Schneider and O'Connor, “LLC Capital Shifts: Avoiding Problems When Applying Corporate Principles,”92  J. Tax'n 13 (Jan.).

Weigel, “Private Investment Fund Interests Held by Employees — Campbell, Section 83(b) and Other Considerations,” Tax Forum No. 543 (June 5).

2001 

Baneman, “Selected Tax Issues in Equity-Based Compensation for Partnerships and LLCs,” Tax Club (Jan.).

Kalinka, “Rev. Proc. 2001-43 and the Transfer of a Nonvested Partnership Profits Interest,” 79 TAXES 11 (Dec.).

Leder and Richard, “Tax-Driven Partnership Allocations with Economic Effect: The Overall After-Tax Present Value Test for Substantiality and other Considerations,”54 Tax Law. 753 (Summer).

Mincey et al., “Rev. Proc. 2001-43, Section 83(b), and Unvested Profits Interests — The Final Facet of Diamond?,” 95 J. Tax'n 205 (Oct.).

2002 

Gallagher, “Private Equity Funds —Selected Tax Issues,” Tax Club 1 (Jan. 16).

Humphries, “The Way (Securitization)Things Ought To Be,” Tax Forum No. 561 (Nov. 4).

Karig, “Taxation of Tax-Exempt and Foreign Investors in U.S. Private Investment Funds,” 533 P.L.I. 89.

NYSBA Tax Section, “Report on Taxation of Partnership Options and Convertible Securities,” (Jan. 29).

2003 

Banoff, “First IRS Ruling on Unvested Partnership Profits Interest: No Income Recognized but Questions Remain,”99 J. Tax'n 133 (Sept.).

Ellis and Needhan, “New Regs on Investor Control Rules: Concerns with the Roadmap,” 100 Tax Notes 1605 (Sept. 22).

Entin, “Partnerships and the Portfolio Interest Exemption,” 100 Tax Notes 1171 (Sept. 1).

Neufeld, “New Guidance on Investor Control Rule:  Road Map or Roadblock?,” 100 Tax Notes 1191 (Sept. 1).

Rosenthal and Falstrom, “Me, A Material Advisor? What Now?” 98 Tax Notes 1749(Mar. 17).

Sheppard, “News Analysis: Behind the Eight Ball on Check-the-Box Abuses,” 2003 TNT 208-7.

Sicular, “Selected Current Effectively Connected Income Issues for Investment Funds,” 56 Tax Law. 719 (Summer).

2005 

Luke, “Beating the ‘Wrap': The Agency Effort to Control Wraparound Insurance Tax Shelters,”25 Va. Tax Rev. 129.

NYSBA Tax Section, “Report on the Proposed Regulations and Revenue Procedures relating to Partnership Equity Transferred in Connection with the Performance of Services,”109 Tax Notes 1311 (Oct. 26).

2006 

Brannan, “Recent Developments in the Law on Constructive Partnerships (and Constructive Non-Partnerships),” Tax Club (April 11).

Mollerus, “Disguised Sales of Partnership Interests and the Proposed Section 707(a)(2)(B) Regulations,” PLI/Partnerships Vol. 7 (2006).

2007 

Abrams, “A Close Look at the Carried Interest Legislation,” 117 Tax Notes 961(Dec. 3).

NYSBA Tax Section, “Report on Proposed Carried Interest and Fee Deferral Legislation” (Sept. 24).

Sheppard, “Carried Away: Management Fee Conversion,” 116 Tax Notes 532(August 13).

2008 

Huffman &  Hortenstein, “Tiers in Your Eyes:  Peeling Back the Layers on Tiered Partnerships,”86 Taxes 179, 213 (March).

NYSBA Tax Section, “Notice 2008-19 and Protected Cell Companies Outside of the Insurance Arena,”(May).

NYSBA Tax Section, “Report on Proposed Carried Interest and Fee Deferral Legislation” (Sept. 24).

Schler, “Taxing Partnership Profits Interests as Compensation,” 119 Tax Notes 829(May 26).

2009 

NYSBA Tax Section, “Report on Tax Provisions of the 2009-2010 New York State Executive Budget Legislation (S.60/A.160),” (March 10).

Polsky, “Private Equity Management Fee Conversions,” 122 Tax Notes 743(Feb. 9).