Part 2: Navigating Fund and Management Company Expenses in Venture Capital
We are bringing you the second installment of our 2-part series exploring the nuances of venture fund and management company expenses in collaboration with some of the knowledgeable tax minds over at Andersen and Morris Accounting & Advisory. Your active participation and thought-provoking inquiries are the driving force behind our discussions and insights. Here, we continue our deep dive into the intricacies of building a top-tier venture firm grounded in operational excellence with this piece unraveling the complexities of fund versus management company expenses and their implications for venture capital operations.
Fund Expenses Vs. Management Company Expenses
In the context of venture capital partnership tax, it is crucial to understand the distinction between fund expenses and management company expenses. These terms refer to different categories of costs incurred by a venture capital partnership and its management entity.
Fund Expenses
● Fund expenses are costs directly associated with the operation and management of the investment fund itself. These expenses are related to the partnership's investment activities and the maintenance of the fund's investment portfolio such as tax, legal, audit fees, custodian fees, administrative costs, due diligence expenses, deal sourcing, and monitoring of portfolio companies.
Pro Tip: Annual fund meeting expenses are also commonly fund expenses.
● For tax purposes, fund expenses are typically passed through to the Limited Partners (LPs) of the fund, including the General Partner (GP). It is important to note that these types of fund expenses are considered "portfolio expenses" and are generally nondeductible to the partners at the individual tax level as a result of the Tax Cuts and Jobs Act of 2017 (TCJA). Management fees are also paid by the fund to the management company and are likewise considered portfolio expenses for tax purposes, generally nondeductible at the individual partner level.
Pro Tip: Prior to the formation and operations commencing for a given fund entity, expenses related to the formation and fundraising of the fund are subject to special tax rules.
● Organizational costs refer to the expenses incurred in the process of forming a partnership before the funds’ investment operations commence. These costs are associated with the creation of the partnership structure and the preparation of the partnership agreement, E.g., generally legal fees, accounting fees, filing fees, and other expenses directly related to the formation of the partnership.
● For tax purposes, organizational costs are required to be capitalized and are by default amortized over a period of 180-months. The Internal Revenue Code (IRC), however, provides that the fund can elect out of amortizing the organizational costs. As a result of the TCJA that made portfolio type expenses (including amortizable organizational costs incurred at the fund level) generally nondeductible at the individual taxpayer level, it is generally advisable for the fund to elect out of amortization and capitalize all organizational costs. The tax basis associated with such capitalized expenses therefore, is recovered upon liquidation of the fund.
● Unlike organizational costs, syndication costs are associated with the process of raising capital for the fund and are typically required to be treated as capital expenditures and are not subject to the same amortization rules as organizational costs. These costs are incurred when seeking investors and raising funds to be invested in the partnership's activities and can include legal fees, accounting fees, marketing expenses, and other costs directly related to the solicitation of investors and the capital-raising process. Instead, a partner’s share of syndication costs is capitalized to the partners tax capital accounts and recovered upon liquidation of the fund.
Management Company Expenses
● Management company expenses are costs incurred by the entity that manages the day-to-day operations of the venture capital fund. This entity is typically structured as a separate partnership entity (LP or LLC taxable as a partnership) that provides investment management, advisory, and administrative services to the fund. Typical expenses include salaries, office rent, technology expenses, and other general operational costs associated with running the management company, fund management and advisory services. These expenses are distinct from those directly tied to the fund's investment activities.
Pro Tip: Branding and intellectual property related costs are typically management company expenses.
● For tax purposes, management company expenses are typically borne by the management company itself. Subject to some special rules under the IRC, the management company may deduct these expenses as ordinary business expenses against its taxable income, E.g., fee revenue paid to the management company by the funds under management. The net taxable income of the management company is passed through to the partners in the management company and does not impact the LPs in the funds.
● Some managers are inclined to use a single partnership entity to serve both the management company function and also to serve as the general partner / carried interest holder. It is important to consult your tax advisor when structuring your management company and related fund and general partner entities as there are many instances where it is inadvisable to have the management company and general partner entities commingled into a single partnership entity. For example, for management companies operating out of New York City, having the general partner and management company combined into a single partnership entity causes the carried interest allocated to the general partner to be subject to the 4% New York City UBT tax, whereas were the entities structured separately, only trade or business income earned by the management company would be subject to the 4% tax.
It is important to pay close attention to the fund’s operating agreement when evaluating fund vs. management company expenses. There may be limitations on expenditures at the fund level such as a cap on organizational or syndication costs that can be expensed at the fund. Any fees that exceed that cap would be expenses of the management company.
Management Company Expenses: Business Expense Deductibility
Where they exist, new manager expense policies are extremely variable. There is a wide spectrum in the magnitude of expenses for both new and established managers. Ultimately, these policies are motivated primarily by business decisions, based in part on the magnitude of fee revenue, but it is important to understand the tax rules and regulations for the most common type of expenses incurred by VC firms that may have additional nuance with respect to tax deductibility. As a threshold matter, to be deductible, expenses must be ordinary and necessary to the income producing activity of the management company. Some types of expenses are subject to special rules with respect to deductibility. Due to the complexity of rules governing deductibility of expenses commonly incurred by fund management companies, fund managers should consult their tax advisor and fund administrators up front to assist in setting policies and understanding the tax rules governing such expenses. Some common types of expenses and general guidelines are included below:
● Business Travel Expenses - Business travel expenses require proper documentation, including receipts and records, and it is crucial to substantiate business travel expenses to ensure deductibility by the management company with the following guidelines:
○ Documentation Requirements - Records should detail the business purpose, dates, locations, and amounts of expenses.
○ Travel Vs. Commuting - Expenses related to commuting from home to a regular place of business are typically considered personal commuting expenses and are not deductible. Travel between different work locations, temporary work assignments away from the tax home, or travel for business purposes such as investor relations, deal sourcing, etc. are generally deductible.
○ Deductibility of Airfare - The cost of airfare for business travel is generally 100% deductible for persons with a bona fide business purpose. If the trip involves both business and personal activities, only the portion directly related to business is deductible. It is extremely important to maintain flight logs and other relevant support when mixed business and personal travel expenses are incurred, as this is one of the more closely scrutinized expense categories in an audit. List each attendee and note if they were attending on business or if their attendance was personal in nature. Substantiate the business components of the itinerary, E.g., business purpose of the trip, on which days were business meetings conducted, etc. Attach digital copies of receipts to the memo.
Pro Tip: If the trip is primarily personal in nature, none of the traveling expenses are deductible. This is true even if you engage in some nominal business activities while traveling. Business must be the primary purpose of the trip for some portion of expenses to be deductible.
○ International Travel - A trip is presumed 100% for business if the following requirements are met: a) You were outside the U.S. for a week or less combining business and personal activities (a week is seven consecutive days - not counting the day you leave the U.S., but counting the day you return to the U.S.), and b) The agenda consisted of less than 25 percent of time on personal activities (for example, you were outside the U.S. for more than a week, but you spent less than 25 percent of the total time you were in a foreign country on personal activities, counting both the day your trip began and the day it ended).
○ Local Transportation - Local transportation expenses incurred at the business destination, such as taxis, rental cars, or other local transportation, are usually deductible if they are directly related to business activities.
○ Special Considerations - The IRS provides standard per diem rates for meals and incidental expenses. Taxpayers may use these rates instead of substantiating the actual costs.
Pro Tip: The rules governing deductibility of airfare are extremely complex; please consult your tax advisor.
● Meals & Entertainment - For a business to take an income tax deduction for M&E expenses, it must first show that the cost is an ordinary and necessary business expense. A business must also substantiate the expense with adequate records or sufficient evidence. Generally, the deduction for meal expenses is limited to 50% of the expense incurred, while entertainment expenses are generally non-deductible for expenses paid or incurred after December 31, 2017 as a result of the TCJA. Many companies mistakenly rely on the 50% limitation as the standard for all business expenses related to meals or do not adequately segregate expenses related to otherwise fully deductible business meetings, travel, public relations activities with meal related expenses.
○ There are several exceptions to the 50% limitation, which allow the business to deduct 100% of the expense incurred, for example. meals provided to employees for the convenience of the employer on the employer's premises are generally 100% deductible. Such expenses should be separately identifiable with adequate substantiation.
○ Although the deduction for entertainment is 100% disallowed after December 31, 2017, except in situations involving certain recreational events for the benefit of employees, any separately stated food and beverage expense incurred in connection with entertainment is 50% deductible.
Business Expense Vs. Personal Expenses/Guaranteed Payments
As established, ordinary and necessary business expenses are generally deductible subject to certain special tax rules, whereas nonbusiness related expenses are non-deductible to the business. Some special rules and guidelines apply to expenses paid by the management to or on behalf of the principals / owners of the management company:
● Partner salaries are deductible business expenses that are netted against management company fee revenue. In the case of such salary and any potential bonus payments made to the management company principals, these expenses are considered "guaranteed payments" for tax purposes and can be thought of as the corollary to income reported via form W-2 to employees. Such guaranteed payments are subject to self-employment tax, which can be thought of as the corollary to the Federal Insurance Contributions Act (FICA) (ie., “payroll”) taxes withheld from salary payments made via W-2 to employees. Partners in the management company are technically required to be paid by guaranteed payment and should not receive a W-2. These guaranteed payments are reported on the partners schedule k-1 on a separate line from the partners share of the net trade or business income earned by the management company and are included on the partner’s own individual tax return, similar to how an employee receiving salary payments via form W-2 includes such salary on their individual tax return.
● Occasionally, for various reasons, principals may want to pay certain non business related expenses through the management company, for example, personal related travel expenses. When this occurs, those expenses are either treated as non-deductible to the management company (because they are not related to the business), or treated as deductible expenses but includable as guaranteed payments made to the respective partner, i.e., essentially treating such payments as additional salary paid to the partner.
In conclusion, the delineation between fund expenses and management company expenses is not just a matter of bookkeeping but a cornerstone of strategic financial management in venture capital. Understanding these nuances and implementing structured policies and reporting mechanisms are essential steps toward ensuring a fund’s operational excellence and long-term success. Remember, the way these expenses are managed and reported can significantly impact both the fund's performance and compliance with regulatory standards.
More Articles in this Fund Expense Series
● Part 1: Mastering Venture Fund Expenses: From Policies to Reporting
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Sincere appreciation to our co-authors John Griffin, Managing Director at Andersen and Jennifer Morris, CPA at Morris Accounting & Advisory, along with Shea Tate-Di Donna and Kaego Ogbechie Rust, authors of The Venture Fund Blueprint.
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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 are 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.
