Somewhere, right now, an LP would like their K-1 to arrive. They’d have preferred it yesterday, but today will be fine. They understand that it’s an imposition, and not terribly realistic.
They may be a fund of funds whose own proper filing hinges on the arrival of dozens of Forms 1065, the US Partnership Return of Income, the Schedule K-1, reporting partnership income, deductions, gains and losses. From the months of February and March, this document will be LPs’ principal focus, and if general partners know what’s good for them, they’ll have devoted time and attention to the K-1 for much longer than that.
The ideal scenario for filing a Schedule K-1 would involve a year-long process, with accountants and other administrators gathering intelligence from general partners, lawyers and portfolio company management, who all deliver beautifully prepared reports on the firm’s activities for the year that are at once accurate, comprehensive and on time. As of January, the data is vetted, and the forms are completed, sealed in envelopes and shipped out by January 31.
Returning to planet Earth, it’s easy to see the possibility for error with so many parties wrestling with so much nitty-gritty detail. Taking into consideration that mere mortals are part of the process, filing a K-1 requires diligent planning and constant communication to deliver the filings that meet LP expectations in terms of timing and quality.
Each LP is special
Proper planning starts with knowing the needs of each limited partner. In order to capitalize on tax benefits for varied limited partners and varied transactions, fund structures have become even more complex. Tax exempt and foreign investors need certain structures to make sure that income doesn’t flow to them to taint their tax status. So multiple tiers are established that have taxable corporate entities, non-US entities, Cayman partnerships, among others for the most tax efficient mix.
This diversity requires expertise on a host of tax issues including many that don’t seem immediately relevant to private equity, but may change the filing requirements for high net worth individuals invested in the fund. One attorney noted that there’s little tax legislation that that doesn’t trickle down to influence private equity in some way. With limited partners hailing from such a vast array of countries, any private equity firm should demand their tax professionals have a grasp on any and all the regulatory regimes with implications for the investors within a fund.
“The complexity of the K-1 process and the need for accurate and timely tax reporting to LPs is an important part of the reason we maintain a full service tax group that works alongside, our accounting team,” says Richard Jahn, Senior Vice President in charge of the tax department at BISYS, a fund administrator. “We’re evaluating transactions as they happen. Even changes in the fund’s demographics impact the K-1 process because it may lead to additional disclosures or additional state filings. Many states require a return to be filed if you have a resident partner domiciled in that state.”
Most tax professionals already comb through Congressional records of tax committees and the like, but that regulatory expertise has to be applied to the firm’s latest activities. A quarterly review of tax relevant events with a service provider can put their perspective to work, and troubleshoot for filing concerns throughout the year. Steve Alecia, a Senior Vice President at BISYS explains, “Our accounting teams get Richard involved with every transaction throughout the year to effectively plan and to make certain adequate documentation from the portfolio companies is coming in. We’ve built into our processes that with every distribution, our tax team has to sign off before that distribution is sent to identify the tax implications and if withholding is required.”
The pace of private equity these days, with quick flips and recapitalizations, only further complicates the matter, as a few years ago the tax issues surrounding an acquisition and an exit would rarely need to be addressed in the same year. And the individual transactions are becoming more sophisticated so that elements such as the deal structure need to be examined for tax implications, not just in the event of an exit, but with regards to filing tactics this year. This complexity demands that no matter how much or how little the filing responsibilities are outsourced, the responsible parties need an ongoing and detailed dialogue not only with GPs, but with portfolio management.
What all this communication allows for is realistic expectations. Planning is modified as situations arise so that tax preparation professionals can troubleshoot and predict late or missing pieces of information that will delay delivery of a K-1 to a limited partner. Neither the secondary fund with 160 underlying funds, nor a portfolio company with an unorthodox reporting schedule, are likely to deliver information in time for a fund’s filing needs, but neither situation should be a surprise come January.
Jahn says, “All funds must plan ahead, especially fund of funds. We’ll send out information requests to underlying funds at year-end specifically asking for information that may cause delays or complexities while preparing the K-1s such as foreign reporting and info that relates to tax exempt investors. All LPs expect the K-1 at least by March, but we educate the LPs to explain why that’s not possible if that’s the case. The K-1s for funds of funds are almost never in the March timeframe. We communicate estimated info to file extensions in April for August or September filing.”
A separate service provider recommended that in some cases, if a particular acquisition or exit poses a substantial tax question or filing issue for a limited partner, a firm should contact them as soon as possible, as opposed to waiting until the end of the year.
Frequent and detailed communication with limited partners to manage their expectations and allow them to plan accordingly is greatly appreciated.
One fund of funds manager explains that for the most part, LPs understand how many issues fall out of the fund’s control, but deadlines missed without warning leave them scrambling, and frustrated that the GP didn’t have a better grasp of the process.
Private equity CFOs can facilitate these best practices by serving as the conduit among the various parties involved. CFOs can insure that fellow GPs, lawyers and portfolio management produce the information that the accountants and tax professionals request. If a portfolio company is slow to deliver figures surrounding a strategic acquisition, the CFO can pick up the phone and communicate the urgency in doing so. Sitting down for quarterly reviews with the responsible tax staff speaks volumes of the firm’s commitment to address filing issues before the end of the year. And those quarterly reviews can also keep the CFO abreast of any delays that should be addressed to certain limited partners on a more personal basis.
Applying such a rigorous approach isn’t without its costs. CFOs budgeting for tax preparation need to examine the number of limited partners, the number of different geographies relevant to them, and the likely activity for the firm, not simply at the fund level for exits and acquisitions, but all the way down to the portfolio companies.
No doubt the quarterly reviews, increased correspondence to LPs and the coordination effort make a strong case for bringing aboard a service provider or in-house tax specialist.
The end goal of all this chatter is to avoid the mad dash to prepare these filings, either by the GP or the LP. Haste produces the real folly in the process, as Jahn warns of the dangers in failing to sweat the small stuff. “Make certain you have the name of the LP spelled correctly and address on the K-1 right. The details count.” Today’s K-1 is far too taxing to falter at the finishing line, which seems farther off each year.
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