Private Equity 20 Lectures（18）Taxation of private equity funds

Private Equity 20 Lectures, Legal Essentials for Silicon Valley Investors, I'm U.S. Attorney Xiaoxiao Liu.

In the last installment, we introduced the main source of income for the general partner (GP) of a private equity fund, which is Carried Interest. Once the money is earned, we have to think about how to pay taxes, so what are the common problems in the taxation of private equity funds? How does Phantom Income, which makes the general partner (GP) pay tax before making money, arise and how should it be avoided? In this issue, we will talk about the taxation of private equity funds.

First, the ghost income (Phantom Income)

The so-called "Phantom Income", that is, in the absence of any cash payment still need to pay taxes for it. People this listen to the nagging question? How can you pay taxes when you don't make any money?

Let's take a look at some of the areas where Phantom Income is commonly found:

1.Debt Forgiveness:

If a debt is forgiven or canceled, the Internal Revenue Service (IRS) may treat the forgiven amount as Taxable Income. For example, if you owe the bank $10,000 and the bank later gives you $5,000 in debt forgiveness, that $5,000 amount may be considered Phantom Income.

2.Real Estate Income:

In real estate investments, especially where depreciation is involved, it may be necessary to report income in excess of actual cash flow. For example, this year, a roof repair, spent 50,000, but according to the depreciation calculation can only be deducted 10,000, and this year's rent only collected a total of 50,000, if calculated according to the actual cash flow, there is no surplus this year do not have to pay taxes, and if calculated according to the depreciation of this year earned 40,000, or to pay taxes.

3.Stock Option:

We have talked about options before when we said options are divided into incentive stock options (ISO, Incentive Stock Option) and non-qualified stock options (NSO, Non-Qualified Stock Option), for the latter, if you exercise a stock option (Stock Option), the exercise price ( For the latter, if you exercise a stock option, the difference between the Exercise Price and the Fair Market Value (FMV) of the stock at the time of exercise is considered income and is taxable, even if the stock has not actually been sold to realize the cash gain.

4.Accrued Income:

Most corporate finance is on an accrual basis (Accrual Basis) rather than a cash basis (Cash Basis), which means that income is theoretically taxable at the time the bill is issued, not when it is actually received, which can also lead to Phantom Income.

Second, private equity funds in the Phantom Income

Having said that, let's take a look at Phantom Income in private equity funds.

So we know what the private equity fund is the income distribution system? The most common is the four-step Waterfall, right? Let's review it here:

1. Return of principal to Limited Partners.

2. Plus an 8% cummulative return on principal to Limited Partners.

3. Then a 20% full catch for GP equivalent to 20% of all distributions in steps 2 and 3.

4. Finally, an 80 / 20 split between GP / LP.

Then you will see that in steps 1 and 2, there is nothing for the GP to do, the money all goes to the Limited Partners (LP), but note that in step 1, even though there is a large amount of cash coming in, the Limited Partners (LP) do not need to pay a penny of tax, why? Because the limited partners (LP) at the beginning of the input, so in the first step of the process of repayment of capital, the limited partners (LP) is only in the recovery of the previous cost, have not had any capital gains (Capital Gain), but the general partner (GP) on the tragedy of the first step in front of the limited partners (LP) in the frantic back to the cash, the general partner (GP) A penny can not get, but every fund to the limited partners (LP) to play out any penny, in the tax on the general partner (GP) are equivalent to receive 20%, resulting in phantom income problem is, in fact, profit and loss (Profit and Loss) of the apportionment (Allocation) and the distribution (Distribution) of the out of sync The reason for the phantom revenue problem is that profit and loss (Profit and Loss) Allocation and Distribution are not synchronized.

• Allocation is how much of the company's earnings are nominally distributed to each shareholder, whether or not the earnings are credited directly to the shareholder's account.

• Distribution is how much of the company's earnings are actually credited to each shareholder.

Note that in the United States Limited Liability Company (Limited Liability Company) and Limited Partnership (Limited Partnership) S Corporations (S Corporations), these Tax-Pass Through Entity (Tax-Pass Through Entity) will have Profit and Loss (Profit and Loss) apportionment (A), (B), (C), (D), (E), (F), and (G). Allocation and Distribution of Profit and Loss are out of sync, and it is only this type of Tax-Pass Through Entity that has this problem, because for tax purposes, this layer of the Tax-Pass Through Entity is considered to be non-existent. The reason is that for tax purposes, the Tax-Pass Through Entity layer is considered to be non-existent, which results in the shareholders having to pay taxes at the tax level if the company makes money this year, regardless of whether the money goes to the shareholders or not.

In the case of a Tax Blocker such as C Corporations, if the corporation does not actually put money on the shareholders' books, then no tax liability arises.

Having said that, do you somewhat understand the harm caused by the lack of synchronization of apportionment and distribution in a Tax-Pass Through Entity (TPE).

And combined with the content of our last issue, you will find that, compared to the liquidation of the private equity fund by deal (Deal by Deal), now the market mainstream Back-End-Loaded (Back-End-Loaded) private equity funds will be more obviously affected by the impact of this kind of, because the former will be a distribution at the time of exit of each project, then the general partner (GP) is still likely to be more or less get some money. But Back-End-Loaded (Back-End-Loaded) private equity funds to ensure that the limited partners (LP) for the entire fund all the first step of the principal repayment of the principal and the second step of the guaranteed eight are completed before the general partner (GP) share of the money, then it can be imagined that the general partner (GP) in the many years ahead of the time will be faced with a high Phantom Income.

Third, tax distribution (Tax Distribution)

As a result, most private equity funds include a provision that allows the private equity fund to make a special tax treatment called Tax Distribution.

Below we can see an example of a private equity fund's Tax Distribution:

Tax Distributions. Within ninety (90) days after the end of each calendar year during the Partnership term, the Partnership may distribute to each Partner in cash an amount up to the excess, if any of (a) the Applicable Tax Rate multiplied by the net taxable income allocated to such Partner as a result of (a) the Applicable Tax Rate multiplied by the net taxable income allocated to such Partner as a result of such Partner's ownership of an interest in the Partnership for such calendar year, over (b) all prior cash distributions made pursuant to Notwithstanding the foregoing, the General Partner shall have the authority, in its sole discretion, to make good faith estimates of the amount of such Partner's net taxable income. Notwithstanding the foregoing, the General Partner shall have the authority, in its sole discretion, to make good faith estimates of amounts expected to be distributable pursuant to the first sentence of this paragraph 7.4 with respect to a given calendar year and to distribute such estimated amounts. The General Partner shall have the authority, in its sole discretion, to make good faith estimates of amounts expected to be distributable pursuant to the first sentence of this paragraph 7.4 with respect to a given calendar year and to distribute such estimated amounts to the Partners as advances from time to time during such calendar year. Applicable Tax Rate" shall mean the combination of the highest local, state, Federal, self-employment and Medicare tax rates payable by individuals who are members of the General Partner, applied by taking into account the character of the taxable income in question (e.g., long-term capital gains, ordinary income, etc.). Distributions made pursuant to paragraph 7.4 shall be deemed advances under, and shall reduce the distributions to the extent that they are not in conformity with the provisions of this Agreement. Distributions made pursuant to paragraph 7.4 shall be deemed advances under, and shall reduce the distributions to be made under, the relevant provisions of paragraph 7.5.

A typical Limited Partnership Agreement (LPA) will usually define "Tax Distribution" as the amount of Carried Interest to be distributed to the General Partner (GP) during the period in which the distribution is made. The LPA usually defines "Tax Distribution" as the amount of tax equal to the amount of Taxable Income to be distributed to the General Partner (GP) during the period in which the Carried Interest is distributed to the General Partner (GP). It is also common to state that the highest U.S. federal, state and local income tax marginal tax rates must be assumed to apply to each member of the general partner (GP) when calculating the expected tax. It is also important to note that a Tax Distribution is generally considered to be an early distribution of the amount available for distribution by the General Partner (GP), which reduces the Capital Account of the General Partner (GP).

It is important to realize that without the system of Tax Distribution, the excess taxes paid by a General Partner (GP) on Phantom Income are usually not refundable. A general partner (GP) has no principal, so every penny earned is based on book earnings at the time, and even if those earnings don't ultimately materialize, they are still subject to tax. In this case, the general partner (GP) incurs an actual cash flow loss. Private equity funds that do not have a Tax Distribution regime may need to find other ways to address this issue, such as compensating the general partner (GP) through financial arrangements within the fund or adjusting the investment strategy to minimize the impact of Phantom Income. However, none of these alternatives are as direct and effective as the Tax Distribution system.

So, as you can see, distribution of private equity funds is a real headache. Deal by Deal leads to a lot of clawback calculations, and Back-End-Loaded leads to Phantom Income tax returns.

This is Private Equity 20 Lectures, a must-attend course on the law for Silicon Valley investors, I'm U.S. attorney Liu Xiaoxiao, and I'll see you in the next installment.