United States: New Tax Legislation Will Affect Transfers of Interests in Private Equity Funds

Attached is a memorandum sent by the National Venture Capital Association to its members that describes a provision in recently-enacted tax legislation – commonly referred to as the "mandatory Section 754" provision – that could affect private equity funds with respect to transfers of fund interests after October 22, 2004 (the effective date of the provision). Testa, Hurwitz & Thibeault, LLP assisted the National Venture Capital Association in their lobbying efforts with respect to this legislation. This memorandum discusses in more detail how the mandatory Section 754 provision is likely to affect private equity funds, funds-of-funds (including secondary funds), general partner entities and secondary purchasers of private equity fund interests.

Background. As the NVCA notes in its memorandum, this new provision is aimed at precluding manipulation of partnership tax rules to create or accelerate tax losses. Prior to this legislation, partnership tax basis adjustments — commonly referred to as "Section 754 adjustments" — were elective because of the administrative burdens that partnerships must incur in making, and subsequently accounting for, these adjustments. An earlier version of the bill that passed the Senate would have created serious problems for private equity funds and the secondary market for fund interests. It would have required all partnerships, including private equity funds, to adjust the tax basis of their assets — on a partner-by-partner and asset-by-asset basis — upon certain transfers of partnership interests, and would have required all partnerships to adjust the tax basis of their assets upon certain distributions.

Under the final bill the mandatory basis adjustment rules will apply upon a transfer of an interest in a fund by sale or exchange or upon the death of a partner, but only if (A) immediately after the transfer, the fund’s adjusted basis in its assets exceeds their fair market value by more than $250,000, and (B) the fund is not an "electing investment partnership."

The exception for "electing investment partnerships" generally is intended to exempt private equity funds and funds-of-funds from the new mandatory basis adjustments requirements. In order to qualify for this exception, however, a fund must meet each of nine requirements, summarized here: (1) the fund makes an irrevocable election to have the exception apply; (2) the fund would be an SEC-registered investment company, but for the Section 3(c)(1) or the Section 3(c)(7) exception in the Investment Company Act; (3) the fund has "never been engaged in a trade or business;" (4) "substantially all" of the fund assets are held for investment; (5) at least 95% of the assets contributed to the fund consist of money; (6) no contributed assets had an adjusted basis in excess of their fair market value at the time of their contribution; (7) all fund interests are issued under a private offering and issued within 24 months of the first capital contribution to the fund; (8) the partnership agreement has "substantive restrictions" on each partner’s ability to cause a redemption of the partner’s interest (this requirement is not applicable to funds in existence on June 4, 2004); and (9) the partnership agreement "provides for a term that is not in excess of 15 years" (20 years in the case of funds in existence on June 4, 2004).

Private Equity Funds. Under the new mandatory Section 754 provision, most typical private equity funds should qualify to make an election to be an "electing investment partnership." If a fund makes this election, it will not be required to make basis adjustments upon transfers of interests in the fund, but persons who acquire interests in the fund from existing partners ("transferee partners") will be subject to the loss disallowance rule discussed in more detail below. If a fund does not make an election to be an electing investment partnership, it will be required to adjust the tax basis of its assets, with respect to the transferee partner’s share only, upon any transfer by sale or exchange or upon the death of a partner that occurs when the fund’s adjusted tax basis in its assets exceeds their fair market value by more than $250,000 (this is referred to as a "substantial built-in loss").

Example: At a time when the adjusted tax basis of the assets of Fund ABC exceeds their fair market value by more than $250,000, partner C sells its interest in the Fund to D at a loss of $100,000. Fund ABC must decrease the adjusted tax basis of its property by $100,000. The decrease is an adjustment with respect to D only. There is no adverse consequence to partners other than D, but the Fund must incur expense to track the basis adjustments.

Although the electing investment partnership exception was intended to exempt private equity funds and funds-of-funds, these funds must satisfy the nine-part definition in order to qualify. Before consenting to any transfer after October 22, 2004, funds should determine whether they qualify as an electing investment partnership. Some examples of circumstances in which a fund might not qualify under the definition include: the fund held its final closing more than two years after the first capital contributions were made to the fund, the partnership agreement for a fund that was in existence on June 4, 2004 provides for a term that exceeds 20 years (for a fund formed after June 4, 2004, its stated term must not exceed 15 years), or one or more partners made contributions other than in money (for example, in securities) and those contributions exceeded 5% of the fund’s contributed assets.

Until further guidance is issued by the IRS, some parts of the nine-part definition will be subject to uncertainty. For example, the 20-year and 15-year term requirements do not address the effect of extensions of a fund’s term that may be set forth in its partnership agreement, or the effect of amendments to the agreement extending its term. If the initial term plus permissible extensions provided in a partnership agreement exceed the 15-year or 20-year threshold (whichever is applicable), it is possible that the fund would not qualify for the electing investment partnership exception. If the term as set forth in a fund’s partnership agreement originally does not exceed the applicable threshold, but the agreement is later amended to extend the term beyond the threshold, the fund likely would not qualify as an electing investment partnership as of the time of such amendment. The legislative history to the mandatory Section 754 provision makes clear, however, that basis adjustments would be required only for transfers that occur after a fund ceases to qualify as an electing investment partnership.

Another area of uncertainty in the electing investment partnership definition is the requirement that a fund "has never been engaged in a trade or business." The phrase "trade or business" is used in numerous provisions of the Internal Revenue Code, but it is not defined in the Code and is often subject to a facts-and-circumstances analysis or differing interpretations under different Code sections. A few provisions of the Code expressly provide that, for specific purposes, the trade or business activities of a partnership (or LLC) will be imputed to any person or entity (including another partnership) that holds an interest in the operating partnership. If this authority were applied to the "trade or business" test of the electing investment partnership definition, funds that have made portfolio investments in entities structured as partnerships or LLCs could be disqualified from the exception. There is no indication in the statutory language of the electing investment partnership definition or in the relevant legislative history, however, whether this authority will be applied to the electing investment partnership definition. Congress was aware of the fact that it was not uncommon for private equity funds to invest in operating LLCs, and it nevertheless stated in the legislative history to the mandatory Section 754 provision that the electing investment partnership definition was intended to include such funds.

Funds-of-funds. The electing investment partnership definition was also intended to include funds-of-funds, including secondary funds, and, like direct-investing private equity funds, most funds-of-funds should qualify for the exception.

If a fund-of-funds is not an electing investment partnership, however, the mandatory basis adjustments could be triggered at multiple partnership levels. Under existing IRS authority, when a partnership (upper-tier partnership) holds an interest in another partnership (lower-tier partnership), and both are required to make basis adjustments (because both have Section 754 elections in effect), a transfer of an interest in the upper-tier partnership will require basis adjustments also at the lower-tier partnership level. Applying this authority in the context of the new mandatory basis adjustment rules, if there is a transfer of an interest in a fund-of-funds at a time when it has a substantial built-in loss, any lower-tier funds that (i) are not electing investment partnerships and (ii) that also have a substantial built-in loss would be required to adjust the basis of their assets with respect to the indirect share of such assets attributable to the transferee partner of the fund-of-funds. It is not clear, however, whether this IRS authority – which was issued when basis adjustments were only elective – will continue to be applied by the IRS under the new mandatory basis adjustment rules. Congress has directed the Treasury Department to issue regulations on the application of the new mandatory Section 754 provision to tiered partnership arrangements, but it could be years before such guidance is issued. Until such guidance is issued, we expect that most funds will follow existing IRS authority on basis adjustments in tiered partnership agreements. See, for example, Revenue Ruling 87-115, 1987-2 CB 163.

General Partner Entities. A general partner entity (whether structured as a limited partnership or LLC) of a private equity fund or fund-of-funds might not qualify as an electing investment partnership for a variety of reasons, including:

• A general partner entity that receives management fees from the fund would be treated as "engaged in a trade or business";
• New members might have been admitted to the general partner entity (and therefore new interests issued) more than two years after the first capital contribution was made to the entity; or
• The partnership agreement of the general partner entity might not provide "substantive restrictions" on a member’s ability to cause a redemption of its interest.

In addition, at present it is unclear whether contributions made in the form of promissory notes will be treated as contributions of assets other than money. If so, then contributions by members of a general partner entity in the form of promissory notes, in an amount greater than 5% of the general partner entity’s assets, would disqualify the general partner entity from being an electing investment partnership.

The consequences of a general partner entity not qualifying as an electing investment partnership may not be significant if the private equity fund or fund-of-funds that it manages is an electing investment partnership. Under the existing IRS authority applicable to tiered partnerships discussed above, in these circumstances the general partner entity would have to adjust the basis in its interest in the fund – a single asset – upon a transfer of an interest in the general partner entity, but no basis adjustments would be triggered at the fund level. Moreover, no basis adjustments are required under the new rules unless the general partner entity has a substantial built-in loss at the time of the transfer, and a general partner entity might be less likely to exceed the $250,000 threshold.

Secondary Purchasers of Private Equity Fund Interests – Loss Disallowance for Transferee Partners. Transferee partners in an electing investment partnership will be subject to a special loss disallowance rule, whether or not the fund has a substantial built-in loss at the time of the transfer. Under this rule, a transferee partner’s share of gross losses (i.e., losses are not netted against partnership gains) from the sale or exchange of partnership property will be disallowed, until it is established that the amount of such disallowed losses exceeds the amount of loss that the transferor partner recognized as a result of the transfer. The transferee partner’s basis in its partnership interest is not reduced by losses disallowed under this rule.

By disallowing losses on a gross basis, this rule could result in transferee partners recognizing taxable gain on an accelerated basis. For example, if a transferor partner recognizes a $60 loss upon a sale of an interest to a transferee, and in that year the transferee partner’s share of partnership income would otherwise have been $100 of capital gain offset by $100 of capital loss, the transferee partner would instead recognize $60 of capital gain, because $60 of the loss would be disallowed. As a result of the loss disallowance rule, transferee partners might have an incentive to argue that a fund does not qualify as an electing investment partnership. Funds that intend to be electing investment partnerships therefore should consider adding provisions to their transfer documentation to the effect that, as a condition to the general partner’s consent to a transfer, the transferee partner agrees that it will not take a position on its tax return that is inconsistent with the fund’s status as an electing investment partnership.

The mandatory Section 754 provision provides that a partnership must provide any transferee partner with the information necessary "to compute the amount of losses disallowed." The scope of this provision is unclear. It might result in a change to the form of Schedule K-1 so that losses and gains will be reported on a gross basis, or additional detail might be required.

With respect to the amount of loss that the transferor partner recognized on the transfer, the transferee partner might obtain this information in one of several ways:

• The transferee partner could obtain the information from the transferor partner, which is contemplated by the legislative history and would not involve the partnership.
• If the information is not received from the transferor partner, the transferee partner might be able to "reconstruct" the transferor partner’s basis in its partnership interest with information provided by the partnership (i.e., the transferor partner’s total contributions, distributions, and allocations of taxable gain or loss). The transferor partner’s loss generally will be equal to the extent by which this number exceeds the transfer price. Accordingly, partnerships that historically have not tracked their partners’ outside basis in their partnership interests might want to consider doing so.
• In cases where the required information is not available (for example, when an interest has been transferred multiple times, the price of prior transfers might not be known by the transferor partner or the partnership), in order to "establish" the amount of each transferor partner’s loss, the transferee partner may have to assume prior transfer prices of zero. Thus, the amount of any prior transferor partner’s loss would be assumed to be its tax basis in the partnership interest at the time of the transfer (which would need to be "reconstructed" by the transferee partner). Alternatively, in order to avoid situations in which neither the transferee partner nor the partnership has the information necessary to compute the loss disallowance amount, partnerships might want to consider collecting information as to the price at which each transfer occurs.

Basis Adjustments Upon Distributions by Partnerships. The new legislation also includes a provision requiring adjustments to the basis of partnership property upon certain distributions by the partnership. As a practical matter, it is unlikely that basis adjustments will be required by a private equity fund except upon a total liquidation of a partner’s interest.