Staying private

Accidental classification as a publicly traded partnership carries a harsh consequence – taxation as a corporation rather than a partnership. Private equity limited partnerships obviously go to great lengths to avoid this outcome, steering clear of any transactions that would indicate that the fund’s interests are readily tradeable on a securities market or “its substantial equivalent”.

In the past, private equity firms have been fairly safe from being labeled a PTP, but now that secondary market volume is rising, GPs might need to revisit some of the technicalities of this area of the tax code.

“This is definitely an issue for firms, and in fact we’ve done quite a bit on this for certain firms,” said Steve Bortnick, a partner in the tax practice group of law firm Pepper Hamilton.

Funds typically rely on one of two safe harbours. The first is the private placement safe harbour, which exempts any fund with no more than 100 limited partners, whose partnership interests were issued in transactions that were not required to be registered under the Securities Act of 1933.

The second is a de minimus trading safe harbour: as long as no more than 2 percent of a fund’s interests have been traded during the last fiscal year, the fund remains private. Larger funds with more than 100 LPs typically rely on this safe harbour.

But as large numbers of limited partners are trying to offload chunks of their portfolio to meet liquidity demands or rebalance their portfolios, that 2 percent threshold could easily be breached for many funds.

GPs could simply refuse to recognize the transfer of an interest from an LP to a third party, Bortnick says, but this is not a common move, as it creates an undesirable legal situation for the LP and the secondary buyer alike.

“It basically means that the transferee will not have any of transferor’s voting rights and will not have the right to receive distributions from the partnership, and the original limited partner won’t be off the hook for its commitments,” he says. “But you don’t see that as often, because that’s not an arm’s length type of transfer. Who wants to be the transferee that has to hope the transferor really makes the payments to them?”

But a GP needn’t resort to this tactic if it carefully scrutinises the nature of the transfers which have occurred over the last fiscal year come tax season.  There are a variety of exceptions GPs can claim in order to avoid having to count a transfer towards the 2 percent threshold, and Bortnick says his clients are taking more time to familiarise themselves with these exceptions.

“What I’m seeing with certain clients is when someone comes in and requests a transfer, they’re really going to test it under those things and say ‘Do I really have to count it in my 2 percent?’,” he says.

For instance, a few fairly common exceptions are carryover basis transfers, transfers at the death of an LP, transfers between members of a family, transfers from retirement plans or individual retirement accounts, transfers resulting from a redemption or repurchase agreement that is exercisable upon death, disability, or mental incompetency, block transfers representing more than 2 percent of the total fund interests, change of control transfers of more than 50 percent of the total fund interests and transfers pursuant to a closed-end redemption plan.

Another option is to set up a “qualified matching service” which lists buyers’ bid and sellers’ ask prices and matches the two. Transfers conducted through such a service are exempt from the 2 percent threshold as well. But setting up a QMS is a complicated and technical process, and hence few private equity funds have opted to pursue this option, says Bortnick.

Of course, at the end of the day, though many funds regard the 2 percent threshold as a bright line test, Bortnick notes that having transfers exceeding 2 percent of the partnership interests does not necessarily mean the fund will be taxed as a PTP. The regulations provide that a fund should be considered a PTP “if, taking into account all of the facts and circumstances, the partners are readily able to buy, sell or exchange their partnership interests in a manner that is comparable, economically, to trading on an established securities market.” There is a certain amount of ambiguity in how this will be interpreted, of course, so it’s up to the GP whether it wants to take the risk by abiding by a “facts and circumstances” test rather than a bright line test.

And finally, even if a fund is determined to be a PTP, if the GP can prove that 90 percent or more of the gross income of the fund comes from passive income, it will not be taxed as a corporation. Passive income generally refers to interest, dividends, capital gains and some income from derivatives. Most private equity funds receive the vast majority of their income from these sources, and the income they receive from fees is generally routed away from the fund. So generally, it’s not difficult to prove that a private equity fund’s income is passive, Bortnick says. But under an administration that is looking to broaden its tax base, funds need to make sure that the right protections are in place.