Express delivery

One of the biggest challenges GPs face during tax season is delivery of the Schedule K-1, which provides US-based LPs with their allocation of a fund’s partnership income, deductions, gains and losses – information they need to meet their own tax filing obligations.

As any GP would be able to tell you, it’s a time-consuming exercise in light of the complexity of fund structures used today, the varying information needs of investors with different tax profiles and a greater number of information requests from LPs on the K-1 that are often pages of questions long.

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 February, the data is vetted, and the forms are completed, sealed in envelopes and shipped out by February 31. Tax returns are then filed by all parties before an April 15 deadline.

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.

But often times reporting deadlines are simply not met. For instance, non-US GPs less familiar with US tax rules sometimes struggle with providing US investors their K-1s on time. But more frequently the problem starts at the portfolio company-level. To prepare the fund’s K-1 report, fund advisors need certain portfolio companies to send their own K-1s in a timely fashion – a mark often missed, causing GPs delay in their own reporting.

One way to reduce this risk is by having the CFO serve as a conduit among the various parties involved in the K-1 reporting process. CFOs can ensure 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 necessary figures, the CFO can pick up the phone and communicate the urgency in doing so.

But if that doesn’t work, some firms are opting to rely on tax estimates to replace final portfolio company information (in fact, recent EY research conducted with PEI found that half of GPs have adopted this approach).

Unfortunately, however, tax estimates are not a perfect solution. For instance, some audit and accounting firms won’t sign off on a tax return if a large portion of it is based off of estimates, says Cécile Beurrier, international tax counsel for Debevoise & Plimpton. When this is the case, GPs have no choice but to wait until they have more definitive tax data. Moreover there is a cost and time element here: the K-1 will need to be updated once the finalized data comes in, adds Jeff Hecht, an EY tax partner.

PROMPT PLANNING

Another strategy GPs use to provide K-1 information on time is making available a draft K-1 report that provides LPs a majority of the fund tax information they need before 15 April. But even a draft K-1 can come late. The tendency among some GPs and their accounting firms might be to wait until the year-end audit report is signed off before commencing the K-1 preparation process.

That can be a mistake. The audit is often held up by factors that have no bearing on the K-1s – for example wording in the footnotes or a representation letter – but the numbers needed for tax-related work are often locked-in far before then, according to sources.

Hecht suggests that the solution here is for the auditors, tax preparers, and GPs to identify when the tax information needed for K-1s is finalized so that the reporting process is not unnecessarily delayed. “I tell my clients to talk to the portfolio company as early as November and set out a timeline for the delivery of the [K-1] information.”

Others say discussions should start before the portfolio company is even acquired. “There are certain firms where [timely K-1 reporting] is part of the deal package,” says one industry tax expert, who adds portfolio companies that cannot commit to this are viewed as less attractive targets.

Doing so may not be a deal partner’s top priority, sources say, but the practice can benefit the fund in the long-run. “It’s a lot easier to negotiate before writing the check,” says the tax expert.

It’s also a tactic used by LPs prior to signing a fund commitment. “We advise our [LP] clients that require US tax information to make sure covenants are included in the legal documentation to ensure the GP will give them K-1 or K-1 equivalent information within a specified timeframe,” says Beurrier.

But GPs who are likely to miss their agreed deadline – and so risk breach of contract – don’t necessarily face legal action. “It’s certainly rare that someone would be sued over not providing timely tax information – I’ve not seen it happen,” says Matt Saronson, tax partner at Debevoise & Plimpton. “Covenants essentially give the LPs something concrete to point to in case of noncompliance.”

Nonetheless, 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.

In the end, a well-executed K-1 delivery is a good mark on your firm’s operations in the eyes of LPs. And the good news is that investors largely understand that filing a tax extension request is the norm, as not every GP is capable of meeting April deadlines. But communicating in advance when the K-1 should be expected helps eliminate requests that can be a GP’s very own Mission Impossible.