There are many tax issues to consider when developing your own fund
Organizational expenses will most likely be the first costs incurred when raising the fund. These expenses typically include legal fees for negotiation and preparation of the partnership or operating agreement, accounting fees for setting up the fund bookkeeping, and business filing fees. Common expenditures that would not be considered organizational expenses are expenses connected with the acquisition of assets, addition or removal of limited partners (“LPs”) after the partnership has been organized, or syndication expenses.[i] However, we will discuss these in more detail later on.
To be considered an organizational expense, the expense must meet three requirements. First, the expense must be incident to the creation of the partnership. Simply because an expense is incurred before the creation of the partnership does not make it an organizational expense. For example, if a fund incurs expenses creating an investor deck or marketing materials before the fund has been legally formed, these expenses are not organizational expenses because the activity that generated the expense needs to relate directly to formation of the fund or entity.[ii]
Second, the expense needs to be chargeable to the partners’ capital account. In other words, the expense is not immediately deductible by the fund or partnership. Third, the expense could be amortized over the life of the fund meaning the expense does not offer a temporary benefit, but instead is beneficial for the duration of the life of the fund.[iii]
To be considered an organizational expense, the expense must meet three requirements. First, the expense must be incident to the creation of the partnership.Second, the expense needs to be chargeable to the partners’ capital account. Third, the expense could be amortized over the life of the fund meaning the expense does not offer a temporary benefit, but instead is beneficial for the duration of the life of the fund.
[iv] Organizational expenses are typically deducted ratably over a 180-month period. $5,000 in organizational expenditures can be immediately deducted, but this amount is reduced by the amount of total organizational expenses exceeding $50,000. For example, if you incurred $55,000 in organizational expenses during the tax year, your initial deduction would be reduced to zero. [v]
Syndication expenses are another common expense at the start of a new fund. Expenses in this category involve marketing interest of a fund. Some examples include brokerage fees, legal fees, offering materials and promotional materials.[vi] In certain cases, a fund will hire a placement agent to identify potential investors and LPs to join the fund. Fees paid to the placement agent would also be considered a syndication expense.
These expenses are not deductible for tax purposes when incurred, and they cannot be amortized. The General Partner (“GP”) typically pays these costs outside of the fund but cannot deduct them. One approach that can be advantageous to the GP is having syndication costs be directly allocable to the LP’s capital account. In turn, the GP agrees to reduce the management fee payable for the amount paid in syndication expenses.
This strategy is beneficial because the GP is effectively receiving a tax deduction in the form of reduced taxable income from management fee compensation. Although the GP is receiving a lower management fee, the GP is not bearing the burden of the syndication costs. From the LPs perspective they are paying the syndication costs that are not deductible and reducing their management fee expense, which is most likely not deductible as well. Therefore, there is a limited tax impact to the LPs. In the next section, we discuss how the deduction for management fees paid are severely limited by the tax code.[vii]
Most funds require payment of a management fee by the LPs. This fee is intended to cover day-to-day operational expenses of the fund’s management company and to provide a base level of compensation that is entirely based on fund performance. The management fee is generally based on a percentage of capital committed to the fund by the LPs or a percentage of the Net Asset Value of assets held by the fund.
As mentioned earlier, the management fee is subject to a number of limitations, especially for LPs that are individual taxpayers. The payment of a management fee is considered a “miscellaneous” itemized deduction. For an individual taxpayer, these deductions are limited to the extent they do not exceed 2% of the taxpayer’s adjusted gross income.[viii] Furthermore if the taxpayer’s adjusted gross income is over a specified threshold, there is a second limitation on the aggregate of all itemized deductions. When applicable, the reduction in total itemized deduction is the lesser of 3% of adjusted gross income over the applicable threshold or 80% of itemized deductions otherwise allowable.[ix] The threshold amounts for the 2017 tax year are $313,800, $287,650 and $261,500 for a joint, head of household or a single filer, respectively.
Similar to the treatment of syndication costs, most funds allocate the management fee to the LPs. In doing so they are shifting an expense that will provide little or no tax deduction to the LPs. In most waterfall structures, the LPs are entitled to a refund of those expenses through an allocation of income generated by the fund.
As the fund enters the investment phase a number of costs will be incurred while pursuing investment opportunities and business acquisitions. In doing so, a number of costs are incurred to facilitate the transaction and execute the deal. These expenses would include securing an appraisal, obtaining tax or legal advice in structuring the transaction, preparation of the purchase agreement and preparation of regulatory filings. Costs paid to facilitate certain transaction are not immediately deductible and are required to be capitalized, meaning they are treated as an asset for tax purposes.[x]
This tax treatment would apply to a number of transactions including the acquisition of a trade or business, an acquisition of ownership interest in a business entity, tax-free contributions to a partnership or corporation, or recapitalizing a business entity. An amount is considered to facilitate a transaction if paid in the process of investigating or pursuing the transaction. One factor to consider is if the expense would have been incurred if the transaction was not taking place.[xi] Although the answer to this questions is a good indicator, this is not the sole determining factor and other facts and circumstances need to be considered.
These costs are normally added to the tax basis of the acquired assets in a taxable transaction.[xii] There is an exception in certain cases where expenses are incurred to determine if an existing business should be acquired. If there are costs specifically incurred to identify or investigate a target business, these expenses can be considered startup costs.[xiii] Startup costs undergo the same treatment as organizational costs, where $5,000 can be deducted in the current year subject to limitation, and the remaining amount is amortized over a 180-month period. Any expenses that are not amortized can be deducted in the tax year the trade or business is disposed.[xiv] In a tax-free transaction or acquisition, final regulations dictating the treatment of these costs have not been issued. There has been discussion of applying a safe-harbor allowing the costs to be amortized over 180 months, but no authoritative regulations have been issued to date.[xv]
There is also a bright-line test that can be applied in specific situations that would prevent certain transaction expenses from being capitalized. A cost is considered to facilitate a transaction if incurred after the earlier of the date on which a letter of intent or exclusivity agreement is executed, or the date on which the material terms of the transaction are authorized. If the cost is incurred before the aforementioned date the cost can be expensed in the current year and does not facilitate the transaction. However, the transaction needs to meet the definition of a “covered transaction” and the cost incurred cannot be an “inherently facilitative amount.”[xvi] The tax regulations provide specific guidelines for the application of this bright-line test and should be discussed with an experienced tax advisor before taking a position.
It is common for alternative asset management funds to identify opportunities with the help of an investment banker. In certain instances the fee structure will be arranged as a success-based fee, where the service provider will receive a substantial fee on the successful closing of a deal. When a success-based fee is paid, the taxpayer can elect a safe-harbor treatment that allows them to expense 70% of the cost as an amount that does not facilitate the transaction and capitalize the remaining 30%. The IRS will not challenge this allocation as long as a statement with certain required information is attached to the originally filed return in the year the expense is incurred.[xvii]
Broken Deal Costs
Before moving forward on closing a new deal, the fund and seller may agree on a termination fee if either party ceases to move forward with the transaction. This is sometimes referred to as a “dead deal” or “broken deal” cost. The recipient of the fee will recognize ordinary income. The party paying the cost to terminate a deal will generally have a tax deduction in the current year. However, this can change if the party terminating the deal is doing so to enable another separate transaction to occur. In this case, the broken deal cost is treated as an expense to facilitate a transaction as mentioned earlier. For example, if the seller cancels a transaction to pursue a transaction with a new buyer, it is likely the broken deal cost will need to be capitalized.
Understanding the tax treatment for expenses frequently borne by a newly formed investment fund can be advantageous when negotiating agreements with limited partners and sell side parties. At times, the treatment of some expenses can be ambiguous without a clear category. Depending on the nature of the expense or the transaction, working with a tax advisor to determine a tax position before or after an expense is incurred can help deliver a more efficient outcome for tax purposes.
[i] Treasury Regulation §1.709-2(a)(3)
[ii] Internal Revenue Code Sec. 709(b)(3)(A)
[iii] Internal Revenue Code Sec. 709(b)(3)(B)
[iv] Internal Revenue Code Sec. 709(b)(3)(C)
[v] Internal Revenue Code Sec. 709(b)(2)
[vi] Treasury Regulation §1.709-2(b)
[vii] Tax Deductions for Placement Agent Fees – Levin and Rocap
[viii] Internal Revenue Code Sec. 67(a)
[ix] Internal Revenue Code Sec. 68(a)
[x] Treasury Regulation § 1.263(a)-5(a)
[xi] Treasury Regulation § 1.263(a)-5(b)
[xii] Treasury Regulation § 1.263(a)-5(g)
[xiii] Revenue Ruling 99-23
[xiv] Internal Revenue Code Sec. 195(b)
[xv] IRS Notices 2004-18
[xvi] Treasury Regulation § 1.263(a)-5(e)
[xvii] Revenue Procedure 2011-29