(Part 1) Fund Tax Q&A with Andersen : Structure, Partnerships, and K-1 vs W-2
One of our favorite parts about writing The Venture Fund Blueprint is hearing from all of you with questions, feedback, and insights about building a best-in-class firm with a foundation of operational excellence, as well as photos of you reading our book on the beach, in the air, and at home. Many of the questions we receive involve tax compliance and planning. Both are critical components of building and maintaining a successful fund.
In this 3-part series on venture fund tax planning and strategies, we will share some commonly asked tax questions from emerging fund managers with answers from the knowledgeable minds at Andersen.
Question #1 - What is the best way to structure my fund from a tax perspective?
Andersen - TL;DR
Common wisdom for the structure of a venture fund includes the following trifecta:
Management Company, LLC - the management company is usually formed as an LLC and is the entity that manages the operations of running the fund. The Management Company LLC typically receives a fee for its services.
Fund, LP - the fund itself is typically formed as a Limited Partnership. Investors commit capital to the fund and hold equity interests as limited partners.
General Partner, LLC – the general partner of the Fund is usually an entity formed as an LLC. It is the entity that acts as the decision maker for the fund. This LLC also typically receives the carry allocation. “Carry” is an incentive allocation based on the fund’s performance.
Andersen - Detail
Venture funds usually follow a standard three entity structure. Each of these entities is a pass-through entity in which gains and losses flow through to the owners and are taxed once at the individual taxpayer level. This contrasts with C corporations for which gains are taxed at the entity level and then again when distributed to shareholders (double taxation).
The type of entity chosen for each piece of the venture fund’s structure serves a specific purpose.
The fund itself is typically formed as a Limited Partnership. As the name suggests, a limited partnership limits the extent of the investors’ liability to the amount of money invested in the partnership. Limited partners are passive investors and do not participate in the management or decision-making.
A limited partnership is required to have a general partner. That general partner has unlimited liability and is responsible for managing the fund. Typically, there are multiple individuals who are acting as decision makers for the fund, commonly referred to as the ‘GPs.’ The GPs form a partnership, General Partner LLC, to serve as the general partner to Fund, LP. Choosing the LLC entity type limits the liability for these individuals, so that their outside assets are protected. In other words, these LLC members can only lose what is in the LLC, not their personal assets.
The third entity is the Management Company. This entity also is set up as an LLC to limit the liability of its members. The Management Co is the operating entity that manages the daily tasks needed to run the fund, such as paying expenses. The members of the Management Company LLC are typically the same individuals who are the members of the General Partner, LLC (i.e., the GPs).
The GPs are commonly paid in two parts: 1) a management fee and, 2) an incentive allocation called “carry.” The management fee is usually 2% of assets under management or capital contributed. This is a flat fee paid to the Management Co. The carry is an allocation of the fund’s income to the General Partner LLC and depends on the fund’s performance. The carry is in addition to the allocation the General Partner LLC receives based on the capital it contributed to the fund.
As an example, consider a fund where the General Partner LLC contributed 1% and the investors contributed 99% of the total capital into the fund. Absent any carry, the General Partner LLC would be allocated 1% of the income and loss items of the fund. This pro-rata allocation reflects the basic concept of the partnership where all the partners have pooled their money to make an investment and they each get their pro-rata share of income earned and expenses paid.
Now consider a fund that has realized a profit on its investments. The General Partner LLC would likely be allocated a carry, which is often 20% of the fund’s income, in addition to the 1% they are receiving based on their capital contributed. This allocation is 20% of each line item of income and expense incurred by the fund and reported on the Schedule K-1, including long-term capital gains and qualified dividend income. These items of income have the potential to be taxed at preferential capital gains rates on the GPs’ individual tax returns. Keep in mind that if the fund does not earn a profit, then the General Partner LLC may not earn any carry from the fund and simply be allocated their 1% share.
There are many factors that affect how the carry is calculated. One is how the fund’s performance is measured, such as deal-by-deal or cumulative since the fund’s inception. Also, fund agreements typically include a “waterfall,“ which prioritizes how cash will be distributed from the fund. Within the waterfall, there are often a number of items that will impact the carry allocation, including returning capital to the investors, possibly paying them a preferred return, and whether the General Partner will be paid a “GP Catch-Up”-- an allocation aimed at distributing to the General Partner 20% (or whatever their carry percentage is) of total cumulative income/distributions. GPs typically benefit from engaging a tax firm to analyze the computation and tax treatment of this income.
Question #2 - What are the effects on my General Partner LLC entity if I bring on another partner later?
Andersen - TL;DR
There are different options for admitting a new partner. Depending on the approach, a special allocation of taxable income (or loss) may be required later.
Andersen - Detail
When forming a partnership, the ideal scenario is to have your GPs identified from the outset. However, if the partnership wishes to admit another partner after formation, there are various ways in which a new partner may join the General Partner LLC. These include (1) having entering partner purchase an existing partner’s interest in the General Partner LLC, or (2) having entering partner invest cash or other assets directly in the General Partner LLC.
Let’s review option 2 with an example, as it is a very common approach. Consider Partnership ABC with original members A, B and C each holding an equal 1/3rd interest in the partnership. The original partners decide they want to bring on New Partner D. A, B and C likely would have contributed capital at formation. In turn, New Partner D typically will contribute cash (or other assets) to Partnership ABC to become the fourth partner in the partnership.
One significant tax consideration is the treatment of the appreciation (or depreciation) that has occurred in the partnership’s asset(s) before the entering partner joined the partnership, known as “built-in gain or loss.” The built-in gain or loss will need be allocated to the original partners, A, B and C, when the asset is sold.
For example, Partnership ABC holds an asset with $150 of built-in gain at the time New Partner D is admitted. If ABC later sells the asset for a gain of $150, the $150 built-in gain is allocated only to the original partners A, B and C ($50 each), with zero gain allocated to D. Only future gains or losses incurred after D becomes a partner would be allocated pro-rata to A, B, C and D. While this may appear reasonably straightforward at first, it can create significant complications with tracking and allocations later down the road.
Further, adding a new partner also has important legal implications. The LLC’s operating agreement will need to be amended to reflect each partner’s percentage of ownership, rights and responsibilities.
Question #3: Is it optimal to set up each partner as a member and have them paid as a pass- through entity (K-1) or to set up salaries (W-2) for everyone?
Andersen - TL;DR
You cannot be a partner and an employee of the same partnership.
In the Management Company LLC, the partners receive a K-1 only.
Do not pay a W-2 to your partners.
Andersen - Detail
You cannot be a partner and an employee of the same partnership. Accordingly, in the Management Company LLC, the partners receive a K-1 only. However, most GPs want an annual income that is not linked to the fund’s performance. This is dispensed in the form of a “guaranteed payment,” which is a line item on their K-1. The guaranteed payment is defined as an income item not related to income earned by that partnership entity and, as such, essentially constitutes the partner’s “salary.” The Management Company can deduct the guaranteed payments and thus reduce the taxable income of the Management Company similar to the treatment of a W-2 wage expense. Partners receiving guaranteed payments are subject to both ordinary income tax and self-employment tax on that income. Because the Management Company does not withhold any taxes on the guaranteed payment, the members of the Management Company LLC will need to make estimated payments for the guaranteed payment income (in contrast to if they had received a W-2 salary that had been subject to withholding.)
In addition, it is worth noting that the GPs may want to award a junior employee with a profits interest (i.e., a share of future profits). The General Partner LLC entity may give a profits interest to an employee of the Management Company, which entitles the employee to a share of future carry allocated to the General Partner LLC. This is a common practice and will not cause a problem if the employee is employed by the Management Company LLC, not the General Partner LLC.
We hope this deep dive into tax planning has been useful to you as a fund manager with fiduciary duty to your LPs. The next installment of our series will cover a number of topics, including: timing of income compared to cashflow, handling of expenses, and Qualified Small Business Stock (QSBS). If you are interested in speaking with Andersen directly, please reach out to Kathryn.Leung@andersen.com. If you have more suggested topics about which you would like to learn about, we would love to hear from you! You can reach us here.
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Glossary of Terms
GP - General Partner – The general partner is responsible for managing the fund. Their responsibilities generally include making investment decisions, overseeing portfolio companies, and raising capital from limited partners (LPs). The GP serves as the face of the firm to both existing and potential investors.
K-1 - Schedule K-1, Partner’s Share of Income, Deductions, Credits, etc. is a tax form that is used to report the income, deductions, and credits of a partnership or limited liability company (LLC) to its partners or members. Partnerships are not subject to income tax. Instead, the partnership passes-through profits and losses to its partners who utilize that information in determining their own tax liability. The partnership includes a copy of Schedule K-1 with its federal partnership return (Form 1065) for the IRS.
LLC - Limited Liability Company – A limited liability company is a business structure that protects its owners from becoming personally liable for the company’s debts or liabilities and allows profits and losses to pass-through to its members. The entity can choose to be treated as a corporation or a partnership. In venture capital structures, it is typically treated as partnership.
LP - Limited Partner – A limited partner is an investor in a limited partnership. As a limited partner’s liability is limited to the amount of money that they have invested in the partnership. The limited partner is a passive investor of capital and does not participate in the management or decision-making of the partnership.
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Sincere appreciation to our co-author Kathryn Dery Leung, Managing Director at Andersen. Along with Shea Tate-Di Donna and Kaego Ogbechie Rust, authors of The Venture Fund Blueprint.
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More Articles in this Tax Series:
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Disclaimer: The providers, companies, examples, products, and services shared represent only a subset of available options and are based solely on internal fund manager conversations. These options are intended to be a general framework, not an exhaustive catalog, and should not be viewed as legal or tax advice, endorsements, recommendations, approvals, or rankings. We encourage you to do additional research into each category to find the resources that best fit your specific needs.
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Disclaimer: The opinions and analyses expressed herein subject to change at any time and are solely of the individual expressing them. Any suggestions contained herein are general, and do not take into account an individual’s or entity’s specific circumstances or applicable governing law, which may vary from jurisdiction to jurisdiction and be subject to change. No warranty or representation, express or implied, is made by the author, nor does the author accept any liability with respect to the information and data set forth herein. Distribution hereof does not constitute legal, tax, accounting, investment or other professional advice. Recipients should consult their professional advisors prior to acting on the information set forth herein. © 2023 Andersen Tax LLC. All rights reserved.
