2017 Essential Tax and Wealth Planning Guide
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Tax implications of fund investing
Types of investment funds
and income tax characteristics
Introduction
What is an investment fund?
Types of investment
funds and income tax
characteristics
• Marketable securities
Hedge funds
• Private equity/venture capital
.
Publicly traded partnerships
Real estate funds
.
Fund of funds
Investment fund attributes
• Trader versus investor
entities
Passive versus
non-passive income
Separately stated activity
(including PTPs)
Qualified small business
stock (QSBS)
Unrelated business
taxable income
• State tax reporting
Conclusion
.
Resources
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The investment period of the PEF is typically
closed to new investors 6-12 months
after the initial closing. To the extent that
investors acquire an interest in the fund
after the first fund closing, they are often
required to pay interest to the fund and the
fund allocates this interest income to the
investors who invested in the first closing.
The general partner (GP) will require capital
contributions to be made to the fund over a
3-5 year commitment period. The PEF calls
capital commitments in stages as it identifies
investment opportunities or as needed to
fund management fees and other expenses.
Capital contributions are made pro rata by
all partners in proportion to their capital
commitments, with the limited partners
committing most of the capital and the GP
contributing a small portion of the capital.
Investments in PEFS are typically illiquid, as
capital is locked-up for many years, with
infrequent distributions until there is a
liquidity event. Investors typically do not have
an ability to withdraw their capital. The PEF's
profits and losses are allocated to the capital
accounts of the partners as agreed upon in
the partnership agreement. The PEF's profits
are typically distributed to all partners based
on their respective capital contributions, with
a preferred return allocable to the limited
partners over the life of the fund primarily
for the use of their capital. In most instances,
the GP or a separate management company
is paid an annual management fee. To the
Lifecycle of a Private Equity Fund
Marketing
period
Investment
period
Holding
period
Exit
period
Call
capital
Manage
Find and make
investments
Raise
capital
Set up fund
entity structure
Offering and
closings
Allocate
carry
Collect
management fees
extent the PEF earns an aggregate return on
its investment that exceeds the preferred
return, management fees, and partnership
expenses, the GP will be allocated a portion
of the excess profit, referred to as the
carried interest.
Some PEFS have started to use debt or
lines of credit to help fund investments in
portfolio companies for a period of time
between when an opportunity is identified
and when the capital can be called from
investors. If implementing such a strategy,
the PEF is generally able to increase the
internal rate of returns to its investors, but
this approach can create tax ramifications,
specifically for tax-exempt investors,
creating unrelated business taxable
income (UBTI). See page 60 for additional
information on UBTI.
portfolio
Collect
management fees
Dispose of
investments
Return capital and
wrap up fund
Collect
management fees
Collect carry,
if profitable
Venture Capital Funds
A venture capital (VCF) is a type of PEF that
typically focuses on providing equity and
financing to start-up emerging businesses
with a focus on providing its investors above-
average returns. VCFS can be attractive to
investors versus traditional PEFS because
they typically invest in businesses that are
less developed. If these less-developed
businesses become successful, they may
provide for higher growth opportunities.
On the other hand, there is more risk on
the downside because many of the less-
developed businesses may ultimately not
be successful. Another difference between
VCFs and PEFS is that investments in VCFs
are typically equity whereas investments in
PEFS can be both equity and debt.
2017 Essential Tax and Wealth Planning Guide | Tax implications of fund investing
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