(Part 3) Fund Tax Q&A with Andersen: PTET, QSBS & the 1045
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This is the third installment of our 3-part series on venture fund tax planning and strategies in collaboration with some of the knowledgeable tax minds over at Andersen. In this final piece in the series, we will cover planning and preventable mistakes with Pass-Through Entity Tax (PTET) elections and Qualified Small Business Stock (QSBS) exclusions and rollovers.
Question #1 - What is PTET?
Andersen - TL;DR
California has implemented a “Pass-Through Entity Tax,” or PTET for short, where a partnership can annually elect to pay California income tax at the entity level and receive a federal deduction for the payment of the tax.
Dollar for dollar, the benefit for that deduction can be different for each individual partner based on their personal tax rate, but payment of a $25,000 California state income tax liability can result in a $25,000 federal deduction, thus enabling an individual partner to receive a federal SALT deduction in excess of the $10,000 cap.
Andersen - Detail
A partnership typically does not pay income tax. By its nature as a pass-through entity, it aggregates the income and expenses from its investments and flows through the information to its individual partners. The individual partners use this information to calculate their taxes (see Part #1).
So why would you elect to have your partnership pay tax?
One result of the 2017 Tax Cuts and Jobs Act (TCJA) is that it limited an individual’s federal deduction for state and local taxes (SALT) paid to $10,000. In response, New York, California, and several other states enacted so-called SALT “workaround” laws that allow pass-through entities (e.g., partnerships) to pay the state income tax for its partners. These PTET regimes function to enable partners to receive a federal SALT deduction in excess of the $10,000 cap.
Here is how PTET regimes generally work. When the partnership pays the state income tax for its partners, the partnership can take a full federal deduction for state taxes paid. It is not limited to the $10,000 cap. By virtue of their ownership in the pass-through entity, the partners receive the benefit of that deduction —even when their share of the amount is more than the $10,000 cap. For example, if Partnership AB paid $50,000 in state income tax, it would deduct $50,000 for its SALT payment. Its 50/50 partners A and B would each receive a $25,000 deduction on their Schedule K-1.
Each state’s PTET regime has its own nuances. Some PTE regimes are elective (such as California, Illinois and New York), while others are mandatory (such as Connecticut). California implemented its PTET regime for taxable years 2021-2025. Many California pass-through entities have elected to make PTET payments to take advantage of the deduction. However, making the election is not always clear cut. There are complexities of federal and California law beyond the scope of this discussion. Further, there are the cash flow considerations of the partnership making the election. We recommend discussing an election with your tax advisor. If you have questions, Andersen has a State and Local tax team that works in concert with its Alternative Investment Fund team to consult on these issues.
Question #2 - Does warehousing deals impact QSBS?
Andersen - TL;DR
A fund must directly invest in QSB stock for the partners to be eligible for QSBS gain exclusion.
If a GP makes a QSBS investment and subsequently contributes the QSBS to the fund, no one is eligible for gain exclusion. QSBS status is negated for that investment.
Andersen - Detail
Investing in Qualified Small Business Stock (QSBS) can have significant tax advantages. Gains from selling QSBS may be excluded from federal income tax to the extent of $10 million or 10 times your tax basis. For example, if you invest $1 million into QSBS in 2013, and sell the stock five or more years later for $11 million, the $10 million of gain would not be subject to federal income tax. Note that only QSBS acquired after September 18, 2010, is eligible for 100% gain exclusion.
There are some basic requirements to be eligible for the exclusion, which include, among others:
Investing in a company that is a domestic C corporation;
Basis of the assets of the corporation immediately after issuance of the stock is $50 million or less;
Stock must be held for at least five years; and
Stock must be acquired directly from the company.
This last requirement creates a potential pitfall for VC funds.
Oftentimes, fund managers are faced with the choice of investing in a deal before their fund is fully set up and all capital is closed or missing out on the deal entirely. Given this choice, GPs may choose to make the investment with their own cash and then later transfer the investment to the fund. This practice is sometimes referred to as “warehousing.” Fund managers may be surprised and frustrated to learn that this practice negates QSBS status. The fund must be the one that directly acquires the stock for it to be eligible for QSBS. Furthermore, when an individual contributes the investment to the partnership, the individual who was the original investor loses QSBS treatment too. Thus, neither the original investor nor the fund can take advantage of the QSBS gain exclusion. Also, note that contributing securities to a fund causes other tax complexities, including potentially having to specially allocate gains when the security is later sold.
Another common scenario for funds with potentially disappointing QSBS consequences can happen when the fund has a first and second capital close. One must be a partner in the fund at the time when the QSBS investment is made to be eligible for the gain exclusion on that stock. If a fund has a first close and then makes an investment in QSBS before the second close, all the LPs who joined at the second close are not eligible for the gain exclusion when the fund sells that stock. However, everyone who was a partner as of the first close, will be eligible for the QSBS gain exclusion. As a fund manager, it is important to consult with a tax advisor and manage expectations for incoming LPs to avoid future disappointment.
Also, it is worth noting that there are other actions that the company may take that can jeopardize QSBS eligibility, such as redemptions. If a QSBS eligible company makes certain redemptions, those redemptions can retroactively disqualify QSBS treatment for the investors. This is a significant matter for fund managers to raise with the companies they invest in.
Another recent issue relates to whether a corporation is a Qualified Small Business at the time the fund makes its investment. Beginning January 1, 2022, the TCJA requires taxpayers to capitalize previously deductible Research & Experimentation (R&E) expenses. Capitalizing this expense means these costs are added to the company’s tax basis in its assets. The potential impact of this increase to basis is that it will accelerate when a company exceeds the $50 million threshold for determining whether it is a Qualified Small Business. Note that once a corporation's assets exceed the $50 million threshold, it can never issue QSBS again, even if the assets fall below the threshold at a later date.
It is easy to run afoul of the complex rules for QSBS. Andersen has deep experience advising both fund managers and portfolio companies on how to handle the nuances of QSBS.
Question #3 - What is a QSBS rollover, and how does it work?
Andersen - TL;DR
Sec. 1045 of the tax code allows an individual or partnership to defer gain on the sale of QSBS if the proceeds are used to purchase new QSBS within 60 days.
Andersen - Detail
Another powerful tool with QSBS is the Sec. 1045 rollover. The rollover provision allows for a deferral of gain when QSBS, which has been held for at least six-months, is sold and the proceeds are used to purchase replacement QSBS within 60-days of the sale. The deferred gain is not recognized until the replacement QSBS is sold.
A Sec. 1045 rollover can be helpful when a fund wants to dispose of its first QSBS investment and has not met the five-year holding requirement for gain exclusion. The fund’s holding period in the original QSBS investment gets tacked onto the holding period of the replacement QSBS. For example, say QSBS #1 was held three-years before being sold, those three-years get tacked onto the holding period of replacement stock QSBS #2. QSBS #2 only needs to be held two-years to meet the five-year requirement for gain exclusion.
Assuming the relevant requirements are met, the partnership can make an election to apply Sec. 1045. Subsequently, each eligible partner may (but is not required) to defer their share of the gain. Note, corporations cannot make the election or defer gain.
There are often several hurdles for the fund itself to make a Sec. 1045 rollover election. The fund may not have another QSBS investment that it wants to make. Also, not all partners may benefit from QSBS. In addition, the rollover adds complexity to tax distributions. Moreover, fund managers should consult their advisors regarding any potential limitations in their operating agreements for reinvesting capital.
Another unique aspect of the Sec. 1045 rollover is that when a partnership sells QSBS, an eligible partner can purchase their own replacement QSBS outside the partnership and defer their share of gain. Further, if the eligible partner is a partner in a second partnership and that second partnership purchases QSBS within the 60-day window, that could also enable the partner to take advantage of a Sec. 1045 rollover.
Given some of the complexities discussed above, this latter route of notifying partners of the opportunity for a 1045 rollover is often the approach taken by funds. Since the partners only have a 60-day window in which to act, it is a meaningful point of communication between the fund managers and their LPs to provide notice when a QSBS investment is sold. We highly recommend fund managers consult with their tax advisors when planning for an exit from a QSBS.
We hope this deep dive into tax planning has been useful to you as a fund manager as you consider communication and planning for 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 us here.
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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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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.
