(Part 2) Fund Tax Q&A with Andersen: Lessons Learned, Expenses & Reimbursements, Different States, and Deferred 2023 Filing Deadline for Storm Victims
In collaboration with some of the knowledgeable tax minds over at Andersen, we are bringing you the second installment of our 3-part series on venture fund tax planning and compliance strategies. In this piece, we will cover lessons learned in fund tax return preparation, best practices for substantiating and tracking fund expenses and reimbursements, filing obligations for general partners (GPs) in different states, and extended tax filing and payment deadline updates for those fund managers in California who qualify for disaster relief as a result of the recent storms.
Question #1 - What do you wish fund managers already knew?
Andersen - TL;DR
The timing of when income is recognized compared to when a partner receives reporting of that income on a Schedule K-1 can be significantly different.
The timing of when income is recognized for tax purposes is not determined by the cash flow coming out of the partnership.
Andersen - Detail
For investor relations purposes, it is important that fund managers understand the timing of when income is recognized for tax purposes, which can be different from the cash flow coming out of the partnership. For tax compliance purposes, fund managers need to be aware of the timeline for reporting of taxable income, as well as timing of tax payments on that income. It is common for a gain to be recognized for tax purposes in the year before each partner actually receives the cash related to their share of the gain or the Schedule K-1 necessary to report it.
The easiest way to track the timeline of income and reporting is with an example. Let’s say your Venture Fund, LP sells an investment in December 2022 that garners a $10 million capital gain. Proceeds from the sale are distributed to the partners in February 2023. That income will be recognized, reported, and subject to tax as follows:
Partnership Income Recognition – Venture Fund, LP recognizes $10 million of taxable income in 2022 and reports it on its 2022 tax return. Note the partnership does not pay any tax; it only reports income and flows information out to its partners on a Schedule K-1.
Schedule K-1 Reporting – Venture Fund, LP will report each partner’s share of the $10 million gain on its 2022 Schedule K-1. Those Schedule K-1s would likely be delivered to the partners by March 31, 2023. It is a common practice for a VC fund’s operating agreement to require this delivery date. However, it could be as late as September 15, 2023 when the Schedule K-1 is received. One could have up to a 21-month lag between when income is earned and when the partner receives the Schedule K-1 reporting it.
Partner Income Recognition – An individual partner will recognize their share of the $10 million gain on their 2022 personal income tax returns. It is important to understand that even though cash is not distributed until 2023, the income will be reported and subject to tax on the individual partners’ 2022 personal tax return.
Individual Partners’ Tax Return Filed – An individual’s personal income tax return for the 2022 tax year is due by April 18th, 2023. Accordingly, all tax payments for the 2022 tax year are due by April 18, 2023. However, the individual may extend their return, which gives them until October 16, 2023 to file the return. This is particularly useful for a partner that does not receive their 2022 Schedule K-1s until September 15, 2023.
Partners’ Estimated Tax Payments – Given the potential lag between when the income is earned in 2022 and when tax is due on April 18, 2023, the IRS requires individuals to make quarterly estimated tax payments on income earned each quarter. Note that income subject to withholding (i.e., W-2 wages) typically does not require an estimated payment (see Part #1).
Since the partnership earned the $10 million of income in the fourth quarter of 2022, the individual partners would potentially owe estimated tax on their share of the income by January 17, 2023.
It can be difficult to determine the tax due by the April due date given that the individual partners may not receive their 2022 Schedule K-1 until September 2023. For this reason, it is critical for fund managers to properly communicate with their investors regarding significant income events. This often takes planning as well as communication between GPs, the fund administrators, and tax advisors.
Oftentimes, GPs add into their agreements a provision for tax distributions. These tax distributions provide for a distribution of cash to cover the taxes due on income reported on the Schedule K-1. The distributions are made separately from the regular distribution of cash proceeds from a disposition event, and are a helpful tool for managing cash flow, especially with respect to GPs and their carry earned (see Part #1). In the example above, a tax distribution might be made at the beginning of January 2023 to provide the partners the cash on hand to pay the January 17th estimated tax payment. This preference or convenience can be added into the partnership agreement (optional). Such tax provisions are common for GPs, but also can extend to Limited Partners (LPs). This type of tax provision would typically be included in a section of the fund manager’s Limited Partnership Agreement (LPA).
Question #2 - What is the best way to handle fund expenses and reimbursements?
Andersen - TL;DR
From an accounting, recordkeeping, and tax compliance perspective, do not commingle personal and business accounts.
For a business expense to be deductible it needs to be an ordinary and necessary business expense.
Andersen - Detail
It is important for fund managers to understand what is deductible and what is not from an expenses and reimbursement standpoint. This is both an accounting or recordkeeping issue, as well as a tax issue.
From an accounting, recordkeeping and tax compliance standpoint, it is important to maintain separate business and personal accounts and avoid commingling funds. Sometimes as a GP is starting their first fund, there is a tendency to use their personal account for personal and business purposes. This can make it difficult later to identify the proper tax-deductible business expenses. The best practice is to have separate accounts. In later years, when the GPs may have multiple funds, it is also important to track expenses separately for each fund. For example, if Fund I pays an expense on behalf of Fund II and Fund III, Fund II and Fund III should reimburse Fund I for the expense.
Your Management LLC is your operating entity that is in the business of managing your venture funds. In this regard, you need to understand which expenses are deductible and which are not. For a business expense to be deductible, the expense must be both ordinary and necessary for the trade or business. Also, there are a host of additional limitations on specific expenses that are not always intuitive.
For example, with regard to charitable deductions, the IRS rule for business gifts is a $25.00 limit per recipient. Another consideration is the use of your car. If you use your car for business and personal activity, then expenses need to be divided between personal and business based on mileage. It can be difficult to determine the business percentage of all your different car expenses (i.e., gas, repairs, insurance, etc.), so often the more convenient option is to deduct the standard mileage rate. The standard mileage rate for 2023 expenses is 65.5 cents per mile for all miles of business use (business standard mileage rate). It is also worth noting that commuting expenses between your home and your business are generally not deductible.
Another common business expense deduction is for meal and entertainment expenses. Generally, the deduction for meal expenses is limited to 50% of the expense incurred, while entertainment expenses are generally non-deductible. For example, the expenses for golf outings and sporting events are non-deductible, even if business discussions occurred with the activity.
Substantiating business expenses by maintaining accurate and sufficiently detailed books and records is essential to claiming deductions for business expenses and defending them on audit. Management companies tend to be audited with reasonable frequency, and the auditors scrutinize the expenses because there are often easily identifiable errors. Thus, it serves fund managers to do the work necessary to avoid having a substantiation issue raised on audit.
Question #3 - What additional considerations are necessary if GPs are in different states?
Andersen - TL;DR
Having partners in different states may trigger a Non-Resident Return, which requires a tax filing in the state where the partner resides even if no activity happens there.
If GPs are in two different states, the Management Company will need to look at each state’s income sourcing rules to determine if there is state sourced income and potential tax liability in that state.
Andersen - Detail
There are two important considerations when partners reside in different states:
(1) Non-Resident State Returns – No State Sourced Income – When a partnership has partners residing in different states, it may trigger an obligation to file one or more state partnership returns solely due to a partner residing in the state. Nine states, including New York and New Jersey, have rules that require a filing when certain partners of the partnership reside in their state even if the partnership is not otherwise doing business in the state. This applies whether the partner is a GP or an LP. In this situation, the partnership return is merely an informational return. Importantly, the filing responsibility as a result of partner residency does not mean the other partners will owe state income taxes due to this filing.
For example, if your fund has an individual partner that resides in New York but no other connection to New York, your fund will need to file a partnership return in New York. This is required even though your fund is not based in New York, has no activity in New York, and no income sourced to New York. The key to understand is that the filing does not create an additional tax burden for any of the partners who do not live in New York (i.e., the non-residents). Nor does it create additional tax for the resident partner because the resident of New York must already pay state income tax to New York on income earned from the partnership.
(2) Non-Resident State Returns – State Sourced Income – In contrast to the above, your partnership could have state sourced income that requires the filing of a state partnership tax return. If this is the case, then the partners would be allocated or apportioned a share of state-sourced income, which could create a state income tax liability for those partners who are not residents of that state.
State-sourced income typically comes into play with the Management Company when the GPs reside in different states. Note the GPs also are usually the same people who are the members of the Management company (see Part #1). Having these individuals operating in different states generally causes the income earned by the management company to be subject to apportionment, which means that part of the income may be sourced to State A and part may be sourced to State B. This can result in the partner who is a resident of State A owing tax to State B (and vice versa), in addition to the taxes they already owe to their home state.
Each state has different rules for sourcing of income, and it is critical to review the rules of the relevant states. Factors for state determinations often include where services are performed, where the benefit of the services is received, or where services are delivered. Ideally, the partner of State A will be able to get a state tax credit for taxes paid to State B to avoid double taxation on the income. However, state tax credits are tricky and do not always work out to provide an exact solution to double taxation. Andersen has a state and local tax service if you are looking for help with a specific situation.
We hope this deep dive into tax planning has been useful to you as a fund manager and with fiduciary duty to your LPs. 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 here.
2022 Tax Deadline Extended for Many California Funds
On February 24, 2023, IRS announced (IR-2023-33) that it was extending the filing and tax payment deadline to October 16, 2023 (from a previous May 15, 2023 extension) for California storm victims. The specific counties that qualify for the relief and additional details on the scope of the relief are provided in CA-2023-01, CA-2023-02, CA-2023-03. California announced conformity with the federal postponement for purposes of the state's income tax.
Note the October 16, 2023, deadline also applies to extension payments due April 18, 2023, as well as quarterly estimated tax payments due January 17, 2023, April 18, 2023, June 15, 2023, and September 15, 2023. For more information, please review the IRS announcement.
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Sincere appreciation to our contributing 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.
