Another Thing for Neurotic VCs to Worry About

A couple of weeks ago, Erin wrote about a little tax rule designed to dissuade more than 2% of a fund’s LP interests from changing hands in a single year. The danger, as she reported, is that any fund that sees more than 2 percent of its LP interests sell on the secondary market is in danger of losing its “private” status, and the related tax benefits.

Erin was writing about buyout funds, but I gathered the rule was applicable to venture funds as well, so earlier today, I called up Ben Berk, an attorney in the tax strategies and planning group of Howard Rice in San Francisco. Ben told me much more about the rule, and whether, given the uptick in venture shares trading around on the secondary market these days, VCs should be concerned about it.

Can you put this 2 percent rule into some context for us?

Sure, it’s one of at least three safe harbors that people try to structure into. The first safe harbor is that if 90 percent of the income of a fund is qualifying income — basically capital gains dividends and interest income — then you’re not going to be considered [by the IRS] to be publicly traded. If in any year, that qualifying income is less than 90 percent, then you have to move on to a second test.

Before we resort to test two, is this first test a problem for the many firms whose only income right now derives from management fees — the same firms whose LPs are probably looking to liquidate their shares?

No, because a fund is typically a limited partnership, and the GP entity is an LLC. The fund pays the management fee to the firm, so that’s income to the firm, not income to the fund. It’s an expense of the fund.

Even if all your income from the year was interest income, like maybe from some dividends or from working capital for a bank — if not from the sale of a company’s stock when it goes public or gets acquired — that qualifies.

What could put pressure on the 90 percent test are funds that are expanding their activities. Some are doing lending activities and getting income or fees that wouldn’t qualify for the 90 percent test. Also, historically, funds have only invested in corporations, but now they’re investing in LLCs, too. That can mean more and more business income, and that’s not good for the 90 percent test.

Why does it matter if a startup is structured as an LLC versus as a corporation?

You see more and more startups organized as LLCs because it’s more tax efficient for the individual owners; the owners of an LLC pay a single tax, whereas corporations pay a double tax. The result is that the fund gets the same income as the LLC — business income — which puts tension on the 90 percent test.

Okay, let’s move on to the second safe harbor strategy before my head explodes.

That’s a test that says if you have less than 100 partners at all times, and you satisfy two other requirements, then you qualify for “private placement” safe harbor. Typically, venture funds meet this particular test, although some of the bigger ones might not. It’s more an issue for the mega buyout funds.

And the third safe harbor test? The 2 percent rule? How does that work?

It basically says you pass if during the taxable year, the percentage interest transferred in a fund isn’t greater than 2 percent of the total percentage interest of the fund.

Wait, the NAV or the nominal value of the fund?

It’s the total percentage interest in the fund, the relative interest as a partner. It’s based on capital commitments typically, not on the value of the fund. If I’m a 1 percent partner, I can transfer my interest, but if three of us do it we’ve violated the 3 percent rule.

Wow! That’s really limiting. Are there exceptions?

There are; certain transfers don’t count — gifts, because of death. A bigger exception is that if you own more than 2 percent of the fund, you transfer a block of your shares, then that doesn’t count. If you’re a 5 percent owner and you transfer your interests, it wouldn’t count for the purposes of the 2 percent rule

I’m totally confused now. Why would the IRS punish those who own less of the fund and give a pass to bigger owners to trade their shares at will?

Well, basically the concern is that if you have a series of transfers that in the aggregate exceed 2 percent, there’s kind of a liquid market being created by all the activity going on. Meanwhile, if one partner transfers 5 percent of a fund to someone else, it’s harder to say that’s a “market.” It’s volume versus large transfers essentially.

That sounds unfair, but I guess the bigger question is: should VCs be concerned? Should their smaller LPs be concerned? Is this a real problem?

It was a non-issue until recently; we’re obviously seeing more secondaries and the like.

In aggregate, you’ve either got to rely on these other safe harbors, or ultimately take the position that even though you’re not a safe harbor, you’re not a publicly traded partnership because you’re a closed end fund.

And the IRS will be satisfied with that position?

If you don’t qualify for the safe harbors, then your might have to rely on [that presumably factual position].

Are you aware of the IRS going after any venture firms or trying to strip them of their private status because of too many LP interests changing hands?

No, it’s much more of an issue in hedge funds than private equity or venture capital funds because until recently, they were very liquid with lots of redemptions and people coming in and out. Closed-end private equity funds are just not structured to be anything close to liquid. So this has never historically been an issue.

Still, it could be a limiting factor on secondary transactions. The GP has to look at everything globally and think about what’s gone on in the calendar year. Certainly, it’d be nice to try to meet these tests.