- Fundamentals
- Posts
- 💰️ Investment Fund Tax Planning, Part 1: The Foundation
💰️ Investment Fund Tax Planning, Part 1: The Foundation
Reasons to care about tax, types of tax applicable to funds, and factors affecting tax structure

Happy Friday, Funds Family!
Today, we’re going to kick off a series of articles on everyone’s favorite topic…TAX! 🏦
Whether this topic triggers a dash to the medicine cabinet for Tylenol or goosebumps from excitement, there is no denying that tax is critical.
But first, let’s sit down with Search Fund Ventures in our client café ☕️


Asset Class:
Search Fund
Executive Summary:
Search Fund Ventures is working with a sponsor to acquire a niche Canadian industrial equipment repair business. The company provides repair, refurbishment, and maintenance services for decanter centrifuges and is expected to do $17.3mm in revenue and $3.2mm in EBITDA in 2024. The purchase price for the company is CAD 13.75 million, implying a 4.4x EBITDA multiple. Soft commitments are requested by December 16th. Please feel free to let us know if you are interested in this opportunity and find below a bit more detail on the sponsor, the terms, and the opportunity more broadly.
The Sponsor:
Significant U.S. private equity and investment banking experience in Chicago and Minneapolis. Executed 17 deals with a cumulative worth of approximately $2.5 billion. Now leading a Toronto-based independent sponsor.
Note: Client Cafe is a free service we provide to our clients. We do not earn any fees from introductions, investments, or anything else (other than being lawyers). We are not investment advisers and make no recommendation as to any highlighted investments.
Alright, let’s dive into the article now! 😃
The upside of prudent tax planning is simple: GPs and LPs alike get to keep more money without getting into trouble with the taxing authorities. 💵
The impact can be quite dramatic considering that the combined effective tax rate on your fund’s returns can range from 0% to over 50%! Complicating matters, these tax rates might vary between different LPs (and the GP). Note: “Combined” effective rate” refers to the sum of local, state, federal, and possibly ex-U.S. taxes divided by the gross return before taxes.
However, while Benjamin Franklin’s famous tax quote rings true - “The only certain things in life are death and taxes” – a well-structured fund can pay fewer taxes thanks to a strong industry lobby and clever tax practitioners! We may know some tax lawyers if you need help.😉
Let’s dive in!
Why do investment funds invest in tax structuring?
Four main goals of GPs and LPs include the following:
Minimize taxable income: Not all “income” is taxable (e.g. gain on the sale of “qualified small business stock” discussed below). Plus, not all costs are immediately tax-deductible.
Minimize tax rates: Different types of income are taxed at different rates (e.g. carried interest income may be taxed at preferential long-term capital gain rates).
Defer taxes as long as possible: Per the time value of money, you are generally better off deferring tax to pay in later years. Plus, if you defer long enough, you may avoid tax altogether and your heirs might receive a stepped-up basis down the line.
Tax Risk & Administration: You’ll need to determine the balance that’s right for you between minimizing taxes, minimizing audit risk, and maintaining a reasonable budget for your CPA and tax lawyer.
Which taxes apply to investment funds and syndications?
Three main categories of taxes may impact your fund’s tax structure. The elephant in the room is usually U.S. federal income tax. Unless we indicate otherwise, any discussion of tax in this series of articles is U.S.-focused.
🏦 U.S. Federal Income Tax
The current top marginal rate for U.S. individuals on ordinary income is a whopping 37% (currently scheduled to increase to 39.6% in 2026…we’ll see what Trump does). The top marginal rate for U.S. corporations is 21%. Finally, the top marginal rate for long-term capital gains and qualified dividends is effectively 23.8%.
🛠️ Ordinary income includes most people’s compensation, such as salaries and wages, and most operating income from a business. For GPs, management fees are typically taxed at ordinary income rates. For LPs, this includes certain types of income a fund may generate, such as interest from debt securities or hedge fund income from sales of securities held less than a year (technically, this is “short-term capital gain” which is generally taxed at the same rate as ordinary income).
📈 Long-term capital gain includes sales of assets held for investment that satisfy certain holding periods and other requirements. For funds, this includes the sale of portfolio company equity or real estate assets held longer than a year (however, for the GP’s carried interest, the holding period requirement for long-term capital gains treatment is three years 🕑️ ).
As a super-bonus for venture capital (and some private equity) funds, portfolio company equity held for more than five years may be eligible for the “qualified small business stock” exemption, under which up to $10M of gain (sometimes even more!) per investor (and possibly per principal) from the sale of the equity may be 100% exempt from U.S. federal income tax. 🥳 🥳 🥳
💰️ U.S. State and Local Tax
These tax rules often mostly mimic the federal tax rules and planning for these taxes typically takes a backseat to U.S. federal income tax. However, they can be substantial in certain jurisdictions and impact structure.
For example, special NYC tax rules drive many NYC-based principals to form one entity to receive the management fee and another entity to receive the carried interest. The application of state and local taxes usually depends on where the fund management team operates, investors reside, and/or portfolio assets are located.
🌍️ Ex-U.S. Taxes
Funds with GPs or LPs who reside and/or operate abroad or portfolio assets located offshore should be extra careful about ex-U.S. taxes. Additionally, some funds with special structuring may have one or more entities formed in an offshore jurisdiction, such as the Cayman Islands, in which case tax planning is needed to minimize tax in these offshore jurisdictions.
What determines investment fund tax structure?
Every fund and syndication is unique and deserves the loving attention of a doting tax lawyer. 💓
However, four factors play a big role in determining the tax classifications and jurisdictions of the various entities in your fund’s structure.
Fund Type & Strategy: Tax treatment and structure differ substantially across different types of funds, such as venture capital, real estate, private equity, private equity, and hedge funds. Key considerations include the anticipated asset mix, asset holding periods, income stream sources, and nature and geographic situs of fund management team activity.
LP Base: Different “tax types” of investors are taxed differently and therefore have different tax structuring needs. Common investor types include: (a) high net worth U.S. taxable individuals and family offices; (b) institutional U.S. taxable investors, such as corporate venture arms; (c) U.S. tax-exempt investors, such as IRAs, private pension funds, and endowments; (d) “super” tax-exempts, such as state and local government agencies and instrumentalities, including public pension funds; and (e) non-U.S. investors such as non-U.S. individuals and sovereign wealth funds.
Assets Under Management (AUM): Tax structures vary significantly in complexity, cost, and administrative burden. The right structure for a $10 million loan origination fund may differ dramatically from a $1 billion fund in the same asset class.
Risk Tolerance: Tax can be viewed as another type of business risk to manage. A good tax practitioner will help tailor tax structure to the risk tolerance of the GP and LPs.
/ WRAPPING THE CASE
![]() |
|
Thanks for reading, everyone.
Have a great weekend! 🙌
/ ABOUT THE CO-AUTHOR
Adam Krotman

Adam is a tax and transactional investment funds attorney with extensive experience advising funds, investors, and family offices in both an in-house and outside counsel capacity. In addition to his tax counsel role advising on fund formations at The Investments Lawyers, Adam is a partner at Transition Point Law, where he co-launched a Fractional GC+ Service focused on outside general counsel support for investment fund and family office clients throughout their life cycles. His prior career experience includes stints as a “big law” attorney, in-house counsel at Amazon, and general counsel at an emerging venture fund manager and international family office. Outside of tax and investment funds, Adam enjoys family time, adventures in the mountains, and travel.
You can reach Adam directly with any questions or inquiries at [email protected].
/ JURY TRIAL
How did you like today's post? |
Have you enjoyed this newsletter? Don’t forget to share it with your GP, Co-GP, LPs, or anyone else you think might find it valuable!
You can also propose a topic that you would like us to cover! Just reply to this email or submit your suggestions 🔗 here.
⚠️ Note: This newsletter is for informational purposes only and nothing should be considered legal advice. For that, hire a lawyer! I am a lawyer, but not your lawyer (unless I actually am your lawyer because you’ve signed an engagement letter and we’re working together). This newsletter may be considered attorney advertising.
Reply