Private Equity Investments Through Partnerships & LLCs

Transcription

1 Private Equity Investments Through Partnerships & LLCs Presented to London Business School May 26, 2011 By: Steven D. Bortnick

2 2 I. Introduction

3 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 3

4 Corporation vs. Partnership vs. LLC Non-Tax Considerations 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 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 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 4

5 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) 5

6 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 6

7 7 II. Fund Formation

8 Fund Formation LP or LLC LP GP - unlimited liability No GP LLC LPs may be treated as GP if hold themselves out as GP (unlimited liability) Most developed countries treat as flow through for tax purposes May be member or manager managed - no unlimited liability issue No uniform treatment o/s US 8

9 PE Funds Formed as Partnership or LLC Single Level of tax partner level Flow through of capital gain and qualified dividends Flexible governing documents 9

10 PE Funds Formed as Partnership or LLCs Flow through of UBTI Flow through of ECI Flow though of Commercial Income 10

11 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 11

12 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 12

13 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 13

14 ECI Who Cares? Nonresident alien individuals Foreign corporate investors Foreign governmental entities (special rules) Foreign pension funds and charities 14

15 ECI What s the Big Deal? Adverse tax consequences (let s discuss) U.S. filing obligation 15

16 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 16

17 Foreign Investors Key Withholding Exceptions Capital gains generally exempt Portfolio interest generally exempt Treaties may reduce or eliminate tax 17

18 Foreign Investors Business Income ECI = Income effectively connected to a trade or business in the U.S. 18

19 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 19

20 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 20

21 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

22 Special Rules for Foreign Governments 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 22

23 Special Rules for Foreign Governments 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 entity Note all or nothing in last 3 bullets 23

24 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 24

25 25 III. Investments in Partnerships/LLCs

26 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 26

27 Fund vs. Founders Founders - Individuals prefer to continue partnership Funds may have ECI/UBTI restrictions Fund may have to form blockers 27

28 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) $ Buyer A B Partnership Interest Partnership Assets 28

29 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 29

30 Use of Partnership to Acquire Corporate Target PE Fund Profits Interests Mgt SHs can rollover shares tax free and sell other shares full use of basis Acq. L.P. LP Interests Target shares SHs Management of profits interests tax free Buyer $ Target shares Target Possible 338 election 30

31 31 IV. Carry

32 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 32

33 Carry vs. Incentive Fee Fee 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 33

34 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 in entity 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 34

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