Marilen Cawad
09/01/2005
If rules proposed in May by the Treasury Department and IRS go into effect next year, limited partners in private equity funds will be swamped with requests to amend investment agreements. The proposals are primarily of concern to general partners; they would change how the tax code treats partnership interests that are received in exchange for providing services to the partnership. But private investors may have to make additional cash distributions so the partnership can pay the general partners’ taxes. General partners now pay taxes on the profits from the fund, but usually do not have to pay taxes on the receipt of their partnership interest in the fund.
“It is important for investors to look into their partnership agreement to ensure that they are properly structured, so that the economic deal between the investors and the asset managers is preserved,” explains Andrew Solomon, a tax attorney and partner at Sullivan & Cromwell in New York.
The proposals would force firms to value their partnership interests. “This is difficult to do since, in many cases, the value of the partnership interests given to the asset managers depends on unpredictable future events and assets and liabilities that have no readily established market value,” Solomon notes. The Treasury Department understands this difficulty and will allow a fund to file a “safe harbor election,” so that it can appraise interests at liquidation value.
“What’s odd about this proposed regulation is that private equity funds will have to make sure that the amendments are enforceable against each and every one of their limited partners,” says David Schnabel, a partner at the New York law firm of Debevoise & Plimpton. Each limited partner will need to sign off on the agreement with the new tax treatment that allows general partners to adopt the liquidation value approach. If the limited partners do not agree to value their interests the same way, a general partner could, upon vesting, immediately be taxed on the value of his partnership interest.