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| News & Scoreboards |
Private Equity's Tax Tangle
Marilen Cawad
09/01/2005
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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.
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