Private Equity Investments Through Partnerships & LLCs · Partnerships vs. Corporations Partnerships/LLCs • Single level of tax (partners) taxed when partnership earns income •

Private Equity Investments Through Partnerships & LLCs

Presented to London Business School

May 26, 2011

By: Steven D. Bortnick | [email protected]

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I. Introduction

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Today We Will Consider

• Why PE funds are formed as partnerships/LLCs• Advantages / disadvantages of funds investing into

partnerships/LLCs• Limitations on investments into partnerships/LLCs• Treatment of carry • Legislative attacks on carry

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Corporation vs. Partnership vs. LLC – Non-Tax Considerations

Partnership• GP has unlimited

liability for partnership debts

• GP must manage• Terminates if GP

withdraws• General partnership

only needs verbal or written agreement. LP formed by filing certificate of formation. Governed by LP agreement

Corporation• No Member has

unlimited liability for corporate debts

• SH’s appoint BOD. BOD appoint officers

• Perpetual existence

• File certificate of incorporation to form. By laws and SH agt. deal with governance

LLC• No member has

unlimited liability for LLC debts

• Either member or manager managed

• Can be perpetual • Form by filing

certificate of formation. Governed by LLC operating Agreement

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Some Basics on Investors

• US individuals taxed at rates up to 35% on ordinary income and short-term capital gain

• US individuals taxed at 15% on long-term capital gain and qualified dividends until January 1, 2013

• Think about the carry partners!• US corporations taxed at 35% on all income• Tax-exempt organizations not taxed except on UBTI• Foreign investors generally not subject to tax in US except:

• Withholding tax on US source income (e.g., dividends and interest, but usually not capital gains); and

• Net basis tax on income effectively connected to US trade or business (including capital gain)

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Partnerships vs. Corporations

Partnerships/LLCs• Single level of tax (partners) taxed

when partnership earns income• Capital gain on sale except for

certain “hot assets”• Flow-through income character• Distributions first tax-free return of

capital• Can transfer assets to partnership tax

free (investments company exception)

• UBTI & ECI flow through

Corporations• Double (or more) tax (corporation

and shareholder)• Generally no shareholders tax until

income distributed• Capital gain on sale• Character of distributions determined

under distribution rules• Distributions-taxable dividends to

extent of earnings and profits, then return of basis, then as capital gain

• Can transfer assets to corporation tax free and transferors control (investment company exception)

• Blocks UBTI and ECI

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II. Fund Formation

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Fund Formation LP or LLC

• LP• GP - unlimited liability

• LPs may be treated as GP if hold themselves out as GP (unlimited liability)

• Most developed countries treat as flow through for tax purposes

• LLC• No GP

• May be member or manager managed - no unlimited liability issue

• No uniform treatment o/s US

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PE Funds Formed as Partnership or LLC

• Single Level of tax – partner level

• Flow through of capital gain and qualified dividends

• Flexible governing documents

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PE Funds Formed as Partnership or LLCs

• Flow through of UBTI

• Flow through of ECI

• Flow though of Commercial Income

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UBTI – What’s the Big Deal?

• Tax on income from “Unrelated” trade or business (including debt-financed income)

• Filing Requirements− Form 990T− Estimated Tax Payments

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Primary UBTI Concerns in Private Equity Transactions

• Investments in flow-through vehicles• Leveraging investments• Guaranteeing portfolio company debt – Who is the

true borrower?• Fee Income

• Route to manager• Route to corporate vehicle

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UBTI Through Partnerships

• Income of a partnership that would be UBTI to an exempt partner is UBTI in hands of exempt partners

• Applied to unrelated debt financed income even though partners have no personal liability for debt

• Gain on the sale of a partnership interest is UBTI if partnership has indebtedness

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ECI – Who Cares?

• Nonresident alien individuals• Foreign corporate investors• Foreign governmental entities (special rules)• Foreign pension funds and charities

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ECI – What’s the Big Deal?

• Adverse tax consequences (let’s discuss)

• U.S. filing obligation

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Foreign Investors – Investment Income

• FDAP – Fixed or determinable annual or periodic income (e.g., interest & dividends)

• Flat 30% tax on U.S. source FDAP• Rate subject to reduction or elimination by treaty• Tax collected by withholding• No tax return requirement if taxes withheld

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Foreign Investors – Key Withholding Exceptions

• Capital gains generally exempt

• Portfolio interest generally exempt

• Treaties may reduce or eliminate tax

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Foreign Investors – Business Income

• ECI = Income effectively connected to a trade or business in the U.S.

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Foreign Investors – Taxed Like U.S. Residents

• Graduated rates up to 35%, plus state and local taxes• Effectively connected interest and capital gains taxes• 30% Branch profits tax• Tax return filing requirement

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ECI Through Partnerships

• If a partnership is engaged in a trade or business in the U.S., so are each of its partners

• U.S. partnership required to withhold at highest rate on ECI allowable to foreign partners

• Each partner has to file U.S. tax returns

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ECI on Exit

• If partnership is engaged in a trade or business, sale of partnership is treated as a sale of underlying assets which generates ECI (and withholding obligation on fund).

Rev. Rul. 91-32

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Special Rules for Foreign Governments -§892

• Exempt from tax on income from:• Stocks, bonds or other domestic securities• Financial instruments held in execution of

governmental financial or monetary policy• Interest on deposits in U.S. banks

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Special Rules for Foreign Governments -§892

• No exemption for income:• from conduct of commercial activities (even outside of

U.S.)• by 50% controlled commercial entity• from (directly or indirectly) 50% controlled commercial

entity• from disposition of 50% controlled commercial entityNote – all or nothing in last 3 bullets

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Covenants Regarding ECI and UBTI

• Level of commitment varies depending on investors− Best efforts to avoid− Reasonable efforts to avoid− Reasonable efforts to avoid/minimize UBTI/ECI

consistent with obligation to maximize return to investors

• Not typical for fund of funds • Greater acceptance of UBTI

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III. Investments in Partnerships/LLCs

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Investments in LP/LLC

• Single level of tax• Basis step up on sale• UBTI/ECI Concerns

− UBTI and ECI flow through to partners− Sale at exit may be ECI

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Fund vs. Founders

• Founders - Individuals – prefer to continue partnership• Funds may have ECI/UBTI restrictions• Fund may have to form “blockers”

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Partnership Acquisitions – Basis Step Up

• Buyer takes cost basis in partnership interest• 754 – basis step up in assets of partnership for Buyer• No tax to B• A gets capital gain (except for “hot” assets)

Assets

Partnership Interest

A B

Partnership

Buyer

$

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The Big Deal About Step Up In Basis

• Reduced gain on sale of assets• Increased depreciation/amortization on acquired

assets− Goodwill, going concern value and similar intangibles

amortizable over 15 years• Buyer likely to pay more for company with higher

asset basis

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Use of Partnership to Acquire Corporate Target

• SHs can rollover shares tax free and sell other shares – full use of basis

• Management of profits interests tax free

• Possible 338 election

MgtPEFund

Profits Interests

SHs

Target shares

$

BuyerTarg

et sh

ares

TargetBuyer

Acq.L.P.

LP Interests

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IV. Carry

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Carry in PE Funds

• Typically a “profits interest” in fund partnership/LLC• Often a special purpose partnership/LLC holds all

carry and managers share through flow through partnership

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Carry vs. Incentive Fee

Fee• Taxed @ 35%• FICA/SECA (15.3%)• Subject to anti-deferral rules• Subject to 4% NY UBT

Carry• Flow through of income –

LTCG & qualified dividends taxed at 15%

• No FICA /SECA• Only taxed as fund earns

income• No New York UBT

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Attack on Carry

• Multiple attempts by House to pass legislation• Would treat all income flowing through partnership to investment

manager as ordinary services income (taxed at rates up to 35% plus SECA)

• Tax sales of partnership interest by investor service provider as ordinary services income

• Exception for interests acquired with manager’s capital don’t apply if fund makes or guarantees loan to acquire interest

• Treat income from options, derivatives & convertible interest inentity for which investment manager services provided as ordinary service income

• Trigger gain on distribution of property to investment services provider

• Substantial penalties (40%) for avoidance of rules

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