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💰️ Investment Fund Tax Planning, Part 3: Simple US Fund Structure

A typical setup for US funds with US investors and investments

Happy Friday, Funds Family!

Today is Part 3 in our investment fund and syndication tax series. Let’s get after it!

Last week, we discussed the differences between pass-throughs and C-corps for tax purposes. Today, we’ll review a sample tax structure of a simple US-based investment fund.

“Tax” in this article refers to U.S. federal income tax unless otherwise specified.

But first, let’s sit down with one of our special clients in our client café ☕️

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.

Thanks for reading, now we are ready to dive into the article 😃 

🏗️ A typical tax structure for an investment fund

A simple fund with US-based GPs, LPs, and investments might look like the below.

For reference, the chart might be for a real estate fund or syndication 🏘️ (which is why there’s a prop-co to hold real estate).

In this structure, the Fund, GP, and Management Company are all “pass-through” entities for U.S. federal income tax purposes, which avoids double-taxation and passes through the character of any underlying income taxed at preferential rates, such as long-term capital gain or QSBS (more on this magical tax exemption for venture funds in a future article 🪄 ), to the ultimate owners.

Let’s examine each entity in our structure in detail.

💼 Fund, LP (pass-through)

Investors invest in the Fund, which in turn invests in portfolio assets directly or through subsidiaries. In this example, the fund invests in real estate through a wholly-owned LLC (taxed as a pass-through entity).

The Fund’s principals also hold an equity interest in the Fund indirectly through the GP. 💵 

The Fund is the entity that directly earns taxable income from portfolio assets and incurs tax expenses such as the management fee. The Fund entity pays no Fund-level tax itself and instead allocates tax items of income or loss to the LPs and GP each year in rough parity to the respective distribution rights. Gains and losses will show up on the K-1s issued after the end of each year. 📃 

The “type” and amount of income or loss varies significantly among different fund types. For example, high-frequency hedge funds often generate large amounts of short-term capital gain and loss. On the other hand, venture capital funds often generate losses for several years and then (hopefully!) long-term capital gains or QSBS when they exit portfolio companies. 📈 

Some funds, such as venture capital funds, are highly limited in the ability of GPs or LPs to use tax losses which are often permanently disallowed under current law. Others such as hedge funds and real estate development funds provide more flexibility to utilize tax losses. This feature relates to special rules that limit taxpayers’ ability to use investment-related expenses and may change in 2026 when certain provisions of the 2017 tax act (TCJA) are set to expire. Different funds are treated differently under these rules depending on whether they are deemed engaged in mere passive investment or a “trade or business” for tax purposes.

👔 General Partner, LLC (pass-through)

The General Partner (GP) is the entity through which the principals hold an equity interest in the Fund. GPs have both a capital interest (received for the principals’ investment in the Fund) and a carried interest (the GP’s extra share of the profits for managing the Fund). 💰️ 

Like the Fund, the GP’s pass-through nature means that the GP itself pays no tax. Instead, it passes through the income or loss (and related character) to the principals.

Structuring the carried interest as an equity interest in the fund is the “magic” mechanism by which principals convert ♻️ the carried interest from what would be ordinary income if received via a contractual fee for services into potential capital gains or other tax-preferred income.

To accomplish this objective, the carried interest must be carefully structured so that, among other things, (1) it is an interest only in the future profits of the fund (after a return of capital) and (2) certain 3-year holding period requirements are met for the underlying asset generating the income. ✅ 

A failure to satisfy the above conditions can have catastrophic results for the principals, including potential “phantom income” 👻 at ordinary income rates at the time the carried interest is granted (or vests). This can happen if the carried interest is determined not to be a so-called “profits interest” for U.S. federal income tax purposes. Make sure to work with a good tax lawyer so this doesn’t happen!

📋️ Management Company, LLC (pass-through)

The Management Company (ManCo) is often owned by the same people that own the GP. Rather than an equity interest in the Fund, the ManCo typically has a management agreement with the Fund requiring the Fund to pay the ManCo a periodic fee for its investment management services.

The Management Company typically employs the investment team and incurs expenses that are not allocated to the Fund. Examples include salaries, office rent, and other overhead.

Just like the Fund and GP, the ManCo pays no tax at the entity level and passes through income and loss to its owners. However, the ManCo owners don’t get preferential long-term capital gains treatment 😢 – the fee income earned by the ManCo (management fee, other fund fees, and possibly portfolio company fees) is generally taxed at ordinary income rates.

On the other hand, unlike Fund expenses (which have significant restrictions on deductibility), ManCo expenses like salaries, professional service fees, and overhead, are typically deductible against fee income. As a result, many fund managers can limit (or even eliminate) net tax from the Management Company.

↔️ The tax reasons to separate the GP from the ManCo

It’s often preferable from a tax perspective to split up the Manco and GP for at least three (and sometimes four) reasons:

  1. Deductibility of expenses. Separating the entities mitigates the risk that ManCo-related expenses get commingled with GP expenses and/or allocated to the GP’s equity interest in the fund. Such a misallocation of expenses to the GP equity interest could delay or entirely disallow the utilization of certain expenses which would normally offset ManCo fee income as it is earned. In short, misallocation could create excess tax liability and possibly “phantom” income where owners have a tax liability without the net cash to pay the taxes. 👎️ 

  2. Employee matters. Separating the entities facilitates grants of carry equity from the GP to ManCo employees without causing the employees to lose their ManCo W-2 status and related access to certain fringe benefits.

  3. Future planning. Separating the entities can facilitate future tax planning in connection with potential third-party investments, insider sales, and other changes in entity ownership.

  4. State or Local Tax. Certain state and local jurisdictions have special tax regimes that drive GPs and ManCos apart. For example, funds with NYC-based principals often divide Manco and the GP into separate entities to mitigate the impact of the dreaded NYC “unincorporated business tax” which can impose an extra 4% on income or gain.

/ WRAPPING THE CASE

  1. Pass-Through Benefits
    The Fund, GP, and ManCo are typically taxed as pass-through entities in US-only structures.

  2. Taxation of GP Income

    The GP’s carried interest is typically taxed at capital gains rates (if conditions are met).

  3. Taxation of ManCo income
    ManCo fee income is taxed as ordinary income, but its expenses are fully deductible.

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

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