Private Equity Investments Through Partnerships & LLCs Presented to

London Business School May 26, 2011

By: Steven D. Bortnick | [email protected]

I. Introduction

2

Today We Will Consider • Why PE funds are formed as partnerships/LLCs • Advantages / disadvantages of funds investing into partnerships/LLCs • Limitations on investments into partnerships/LLCs • Treatment of carry • Legislative attacks on carry

3

Corporation vs. Partnership vs. LLC – Non-Tax Considerations

• • • •

4

Corporation No Member has unlimited liability for corporate debts SH’s appoint BOD. BOD appoint officers Perpetual existence File certificate of incorporation to form. By laws and SH agt. deal with governance

• • • •

Partnership GP has unlimited liability for partnership debts GP must manage Terminates if GP withdraws General partnership only needs verbal or written agreement. LP formed by filing certificate of formation. Governed by LP agreement

• • • •

LLC No member has unlimited liability for LLC debts Either member or manager managed Can be perpetual Form by filing certificate of formation. Governed by LLC operating Agreement

Some Basics on Investors

• US individuals taxed at rates up to 35% on ordinary income and short-term capital gain • US individuals taxed at 15% on long-term capital gain and qualified dividends until January 1, 2013 • Think about the carry partners! • US corporations taxed at 35% on all income • Tax-exempt organizations not taxed except on UBTI • Foreign investors generally not subject to tax in US except: • Withholding tax on US source income (e.g., dividends and interest, but usually not capital gains); and • Net basis tax on income effectively connected to US trade or business (including capital gain)

5

Partnerships vs. Corporations Partnerships/LLCs • Single level of tax (partners) taxed when partnership earns income • Capital gain on sale except for certain “hot assets” • Flow-through income character • Distributions first tax-free return of capital • Can transfer assets to partnership tax free (investments company exception) • UBTI & ECI flow through

6

Corporations • Double (or more) tax (corporation and shareholder) • Generally no shareholders tax until income distributed • Capital gain on sale • Character of distributions determined under distribution rules • Distributions-taxable dividends to extent of earnings and profits, then return of basis, then as capital gain • Can transfer assets to corporation tax free and transferors control (investment company exception) • Blocks UBTI and ECI

II. Fund Formation

7

Fund Formation LP or LLC • LP

8

• LLC

• GP - unlimited liability

• No GP

• LPs may be treated as GP if hold themselves out as GP (unlimited liability)

• May be member or manager managed - no unlimited liability issue

• Most developed countries treat as flow through for tax purposes

• No uniform treatment o/s US

PE Funds Formed as Partnership or LLC • Single Level of tax – partner level • Flow through of capital gain and qualified dividends • Flexible governing documents

9

PE Funds Formed as Partnership or LLCs • Flow through of UBTI • Flow through of ECI • Flow though of Commercial Income

10

UBTI – What’s the Big Deal?

• Tax on income from “Unrelated” trade or business (including debt-financed income) • Filing Requirements − Form 990T − Estimated Tax Payments

11

Primary UBTI Concerns in Private Equity Transactions

• Investments in flow-through vehicles • Leveraging investments • Guaranteeing portfolio company debt – Who is the true borrower? • Fee Income • Route to manager • Route to corporate vehicle

12

UBTI Through Partnerships

• Income of a partnership that would be UBTI to an exempt partner is UBTI in hands of exempt partners • Applied to unrelated debt financed income even though partners have no personal liability for debt • Gain on the sale of a partnership interest is UBTI if partnership has indebtedness

13

ECI – Who Cares?

• • • •

14

Nonresident alien individuals Foreign corporate investors Foreign governmental entities (special rules) Foreign pension funds and charities

ECI – What’s the Big Deal?

• Adverse tax consequences (let’s discuss) • U.S. filing obligation

15

Foreign Investors – Investment Income

• FDAP – Fixed or determinable annual or periodic income (e.g., interest & dividends) • Flat 30% tax on U.S. source FDAP • Rate subject to reduction or elimination by treaty • Tax collected by withholding • No tax return requirement if taxes withheld

16

Foreign Investors – Key Withholding Exceptions • Capital gains generally exempt • Portfolio interest generally exempt • Treaties may reduce or eliminate tax

17

Foreign Investors – Business Income

• ECI = Income effectively connected to a trade or business in the U.S.

18

Foreign Investors – Taxed Like U.S. Residents

• • • •

19

Graduated rates up to 35%, plus state and local taxes Effectively connected interest and capital gains taxes 30% Branch profits tax Tax return filing requirement

ECI Through Partnerships

• If a partnership is engaged in a trade or business in the U.S., so are each of its partners • U.S. partnership required to withhold at highest rate on ECI allowable to foreign partners • Each partner has to file U.S. tax returns

20

ECI on Exit

• If partnership is engaged in a trade or business, sale of partnership is treated as a sale of underlying assets which generates ECI (and withholding obligation on fund). Rev. Rul. 91-32

21

Special Rules for Foreign Governments -§892

• Exempt from tax on income from: • Stocks, bonds or other domestic securities • Financial instruments held in execution of governmental financial or monetary policy • Interest on deposits in U.S. banks

22

Special Rules for Foreign Governments §892 • No exemption for income: • from conduct of commercial activities (even outside of U.S.) • by 50% controlled commercial entity • from (directly or indirectly) 50% controlled commercial entity • from disposition of 50% controlled commercial entity Note – all or nothing in last 3 bullets

23

Covenants Regarding ECI and UBTI

• Level of commitment varies depending on investors − Best efforts to avoid − Reasonable efforts to avoid − Reasonable efforts to avoid/minimize UBTI/ECI consistent with obligation to maximize return to investors

• Not typical for fund of funds • Greater acceptance of UBTI

24

III. Investments in Partnerships/LLCs

25

Investments in LP/LLC

• Single level of tax • Basis step up on sale • UBTI/ECI Concerns − UBTI and ECI flow through to partners − Sale at exit may be ECI

26

Fund vs. Founders

• Founders - Individuals – prefer to continue partnership • Funds may have ECI/UBTI restrictions • Fund may have to form “blockers”

27

Partnership Acquisitions – Basis Step Up • • • •

Buyer takes cost basis in partnership interest 754 – basis step up in assets of partnership for Buyer No tax to B A gets capital gain (except for “hot” assets) $ Buyer

A

Partnership Interest

B

Partnership

Assets

28

The Big Deal About Step Up In Basis

• Reduced gain on sale of assets • Increased depreciation/amortization on acquired assets − Goodwill, going concern value and similar intangibles amortizable over 15 years

• Buyer likely to pay more for company with higher asset basis

29

Use of Partnership to Acquire Corporate Target

PE Fund

Acq. L.P.

ts ofi Pr

I

ts res e t n

LP Interests

sh get Tar

Mgt

SHs s are

Buyer Buyer

30

• Management of profits interests tax free • Possible 338 election

$

s re ha s et rg a T

• SHs can rollover shares tax free and sell other shares – full use of basis

Target

IV. Carry

31

Carry in PE Funds

• Typically a “profits interest” in fund partnership/LLC • Often a special purpose partnership/LLC holds all carry and managers share through flow through partnership

32

Carry vs. Incentive Fee

• • • •

Fee Taxed @ 35% FICA/SECA (15.3%) Subject to anti-deferral rules Subject to 4% NY UBT

•

• • •

33

Carry Flow through of income – LTCG & qualified dividends taxed at 15% No FICA /SECA Only taxed as fund earns income No New York UBT

Attack on Carry

• Multiple attempts by House to pass legislation • Would treat all income flowing through partnership to investment manager as ordinary services income (taxed at rates up to 35% plus SECA) • Tax sales of partnership interest by investor service provider as ordinary services income • Exception for interests acquired with manager’s capital don’t apply if fund makes or guarantees loan to acquire interest • Treat income from options, derivatives & convertible interest in entity for which investment manager services provided as ordinary service income • Trigger gain on distribution of property to investment services provider • Substantial penalties (40%) for avoidance of rules

34

Our Locations Pepper has expanded from its Philadelphia origins to 11 locations. BERWYN

BOSTON

DETROIT

HARRISBURG

400 Berwyn Park 899 Cassatt Road Berwyn, PA 19312-1183 610.640.7800 FAX 610.640.7835

15th Floor Oliver Street Tower 125 High Street Boston, MA 02110-2736 617.204.5100 FAX 617.204.5150

Suite 3600 100 Renaissance Center Detroit, MI 48243-1157 313.259.7110 FAX 313.259.7926

Suite 200 100 Market Street P.O. Box 1181 Harrisburg, PA 17108-1181 717.255.1155 FAX 717.238.0575

NEW YORK

ORANGE COUNTY

PHILADELPHIA

PITTSBURGH

The New York Times Building 37th Floor, 620 Eighth Ave New York, NY 10018-1405 212.808.2700 FAX 212.286.9806

Suite 1200 4 Park Plaza Irvine, CA 92614-5955 949.567.3500 FAX 949.863.0151

3000 Two Logan Square Eighteenth and Arch Streets Philadelphia, PA 19103-2799 215.981.4000 FAX 215.981.4750

50th Floor 500 Grant Street Pittsburgh, PA 15219-2502 412.454.5000 FAX 412.281.0717

PRINCETON

WASHINGTON

WILMINGTON

Suite 400 301 Carnegie Center Princeton, NJ 08543-5276 609.452.0808 FAX 609.452.1147

Hamilton Square 600 Fourteenth Street, N.W. Washington, DC 20005-2004 202.220.1200 FAX 202.220.1665

Hercules Plaza, Suite 5100 1313 Market Street P.O. Box 1709 Wilmington, DE 19899-1709 302.777.6500 FAX 302.421.8390

www.pepperlaw.com 35

For more information, visit www.pepperlaw.com.

36