Venture capital and private equity fund sponsors frequently ask “how much money do I actually have to contribute to a partnership as the general partner (or “GP”)?”
Unfortunately, the answer is that old tax lawyer chestnut: “It’s not entirely clear, and largely depends on your personal risk tolerance.”
First, my corporate colleagues would want me to point out that how much a GP needs to contribute to a fund isn’t purely a tax question. Investors want the people running their investment fund to have skin in the game, so a GP’s commitment amount is frequently set by investor pressure, as opposed to tax concerns.
We’ll kick off the fun by reviewing a pair of IRS Revenue Procedures (each a “Rev. Proc.”) – IRS-issued guidelines a partnership had to meet before the IRS would issue a ruling whether an entity was properly classified as a partnership for US federal income tax purposes, prior to the existence of check-the-box-elections that allowed entities to elect their tax classification.
Rev. Proc. 74-17 states:
“the interests of all the general partners, taken together in each material item of partnership income, gain, loss, deduction or credit is equal to at least one percent…”[1]
Hold on, that’s a clear bright-line rule right there – one percent! Can’t we leave it at that?
The IRS decided to throw a wrench in the works and issued Rev. Proc. 89-12, which specifically superseded Rev. Proc. 74-17[2], and had its own guidelines. Rev. Proc. 89-12 repeated the same 1% rule from Rev. Proc. 74-17[3], but it went a step further:
“if the limited partnership has total contributions exceeding $50 million, the general partners need not meet the 1-percent standard. However… the general partners’ aggregate interest at all times in each material item must be at least 1 percent divided by the ratio of total contributions to $50 million.”[4]
As an example – if total contributions to the fund are $125 million, then the GP’s interest must be at least .4% (1% divided by 125/50). Most importantly, Rev. Proc. 89-12 adds:
“In no event… may the general partners’ aggregate interest at any time in any material item be less than .2 percent.”[5]
Okay… so now we have two brightline rules – 1%, unless you’ve got at least a $50 million fund and then it can be as low as .2% after we do some math… are we done yet?
The IRS wasn’t done yet. They issued Revenue Ruling 2003-99, which ruled Rev. Proc. 74-17 and Rev. Proc. 89-12 obsolete thanks to new check-the-box election regulations.
So why make us read through obsolete IRS guidance– is this what tax lawyers do for fun? Even though technically obsolete (taxpayers no longer need IRS rulings on their tax classification), these Rev. Procs. still give us the clearest picture of IRS thinking on what percentage a GP needs to contribute to a partnership to be respected as a partner in that partnership. And private equity and venture capital tax practitioners still rely on the 1% rule and, if applicable, the .2% rule.
This is not the only guidance, by any means. The Tax Court continues to hand down decisions where partners with widely varying percentage interests are still treated as partners in a partnership.[6] Typically, in these cases the IRS benefits from these tiny partnership interests being respected. That said, a taxpayer could point to these cases to justify a <.2% capital commitment, depending on their level of risk tolerance.
For GPs, the tables are turned – there is a big tax benefit to the GP if they are respected as a partner in the partnership. A GP receives a special interest in the profits of the partnership (after capital contributions have been returned) called “carried interest” (discussed further in our previous blog post[7]). Currently, carried interest is eligible for long-term capital gains tax rates (typically 20%), provided the underlying investment that generated the profits was held for at least three years.[8] If a GP in receipt of a carried interest distribution was not respected as a partner, that carried interest distribution could be viewed as a fee paid to the GP for managing the fund. Fees are not eligible for long-term capital gains tax rates, but are instead subject to federal ordinary income tax rates of up to 37%.
It is crucial to note that the GP capital contribution we’ve been discussing must come directly from the GP itself, as opposed to affiliates of the GP. While investors may be fine with “friends and family” capital commitments counting toward the GP’s overall capital commitment, the IRS will only look to amounts contributed by the actual GP entity or entities.
So, what does a first-time fund sponsor do when they are short on cash but they, and their investors, want a 1% GP capital contribution? A sponsor could borrow to fund their contribution, but this can lead to complicated tax consequences, depending on the lender.[9] Another alternative is to use “deemed contributions” which involve using LP contributions made with respect to an automatically waived management fee to fund the GP’s commitment. This option adds complexity to a fund agreement, and is beyond the scope of this blog post.
Tax practitioners in the private equity and venture capital world still look to the 1% standard in Rev. Proc. 74-17 and Rev. Proc. 89-12 as a reasonable GP capital commitment, despite this IRS guidance being technically obsolete. A lower amount may be respected, based on the additional guidance provided by Rev. Proc. 89-12 and more recent Tax Court cases, but fund sponsors should generally aim to contribute at least 1% of capital to any fund they manage.
Emily Cummins frequently advises with respect to investment fund matters. For additional information, please contact emily@mbakertaxlaw.com.
[1] Rev. Proc. 89-12, 1989-1 CB 798, section 3.01
[2] Rev. Proc. 89-12, 1989-1 CB 798, section 1.01
[3] Rev. Proc. 89-12, 1989-1 CB 798, section 4.01
[4] Rev. Proc. 89-12, 1989-1 CB 798, section 4.02
[5] Ibid.
[6] See: Historic Boardwalk Hall, LLC, 136 TC 1 (2011), 2011 WL 9078, rev’d and rem’d on other grounds, 694 F.3d 425 , 110 AFTR 2d 2012-5710 (CA-3, 2012) (cert. denied) – IRS did not specifically assert that a general partner holding only a .1% interest in a partnership was not actually a partner in the partnership; Brumbaugh v. Commissioner, 109 T.C.M. (CCH) 1360, T.C. Memo. 2015-65 – the IRS treated a limited partner with a .02% in an LLC as a partner for tax purposes.
[7] Partnership Equity | Baker Tax Law (mbakertaxlaw.com)
[8] Code Section 1061. It’s worth noting that carried interest is a favorite target for legislators, who want to make carried interest ineligible for long-term capital gains treatment entirely.
[9] Treasury Regulations Section 1.1061-3(c)(3)(b) – Capital contributions made with certain non-recourse loans made or guaranteed by the general partner entity are not treated as a capital interest and gain with respect to these loan-funded capital contributions could be recharacterized as short-term gain.