Smart Strategies for Tax Implications of Carried Interest

LP Tax Implications of Carry Structures: A Comprehensive Guide for Investors

Introduction

Limited Partners (LPs) have the potential to reap significant rewards from their investments in venture capital (VC), but these opportunities can come with complexities given the tax implications, most notably when it comes to carried interest (carry) structures. Evolve Venture Capital is a VC firm dedicated to supporting our investors in understanding how to navigate these complexities, with the goal of maximizing LP returns, and minimizing taxes. In this blog, we will outline the tax implications of carry structures, get into the details, and discuss how Evolve Venture Capital can partner with you to better understand your tax strategy. 

The Attractive Hook

Imagine this: You decided to invest in a startup through a VC fund, and after years of hard work as LPs and VC Partners, the investment yielded more than you expected. You feel exceptional; then a moment goes by, you realize that the tax implications could take portions of percentages away as taxes that you could actually retain. As such, you realize that understanding carry structures as an LP through a tax lens is vital, so you can retain as much of the returns as possible.

Pain Points for LPs

1. Complex Tax Treatments: The tax treatment of carried interest is complicated and differs by jurisdiction. In the U.S. for instance, carried interest is generally treated as capital gains when the investment is held for more than one year, however, legislation such as the Tax Cuts and Jobs Act of 2017 requires a three-year investment.
2. Hurdle Rates and Catch-Up Provisions: Most funds have hurdle rates that need to be achieved prior to GPs earning any carry. Hurdle rates essentially restrict GPs from earning any carry until LPs receive a minimum return on their investment. Hurdle rates may affect the timing of distributions and the carry distribution and its associated tax liability given LPs own the carry.
3. International Tax Considerations: If you are an international investor or if the fund is investing into foreign markets, the treatment of carried interest can change dramatically. In the UK, for example, carried interest is taxed at a capital gains rate of 28%. Whereas, in Australia,  friendly tax treatment for venture capital funds exists, and one can be taxed at a concessional rate up to 23.5%. Knowing the nuances of international tax law can be challenging.

In-Depth Analysis

To make the best decisions regarding your tax strategy, it’s important to understand the components of the carry structure and the taxation around each piece.

1. Carry Calculation and Distribution:
   • 1. Calculate the total profits of the Fund: This amount includes all of the profit that accrues to the fund such as capital gains, dividends and interest income.
   •  Subtract the hurdle rate: Most funds have a hurdle rate between 8% to 10%, which will be the return LPs need to receive before a GP can earn some of the carry.
   • Subtract the carry percentage: The GP will earn a predetermined percentage, usually between 20% to 30%, of the remaining profits only after that amount exceeds the hurdle. 
2. Tax Treatment of Carried Interest:
   • Long-term versus short-term capital gains: Long-term capital gains have a lower tax rate. Long-term capital gains are applicable for investments held for more than 12 months, while short-term capital gains are applicable for investments held for less than 12 months. So it is important to take the long view when planning how the profits will be recognized for tax purposes.
   • Qualified Small Business Stock (QSBS): Certain types of investment will qualify for QSBS treatment. If certain criteria are met, investors can exclude a large percentage of taxable gains from being taxed. QSBS is a very powerful way to optimize tax strategy.
3. Structuring for Tax Efficiency:
   • Deal-by-deal vs. whole fund models – A deal-by-deal structure can be favorable to the GP in situations where one big deal can create the opportunity to receive a carry payment, even if there are other poorer-performing investments. In contrast, a whole fund model ensures that GPs earn carry only when the entire fund makes money.
   • Clawback provisions – Clawback provisions require GPs to return a portion of carried interest already distributed, when future losses impact the total money distributed from a fund exceeding the agreed upon percentage of carried interest. These provisions are meant to protect LPs from being overpaid in carry. 

How Evolve Venture Capital Can Help

At Evolve Venture Capital, we recognize that venture capital carries tax implications and we are here to support our investors. Here’s how we can help:

1. Tax Advisory Excellence: Our tax professionals are knowledgeable about all aspects of current tax legislation, and have significant experience in providing practical tailored advice to optimize tax strategies.
2. Transparent Reporting: We provide all necessary reporting on carry calculations and distributions for you to make informed decisions.
3. Tailored Investment Structuring: We work alongside you to develop ways to structure your investments to minimize tax without diminishing the potential returns. Legislation allows for unique tax opportunities with QSBS treatment and other implementable ways to take advantage of tax efficient structures.
4. Global Approach: We provide a global approach with our assistance in looking at the tax implications of cross border investment. We help navigate international tax compliance, and advise so you don’t land yourself in hot water.

Conclusion

It is important for LPs to also consider the tax implications of carried interest structures for their venture capital investment. With the learnings from this blog and if they choose to partner with Evolve Venture Capital, they can better structure tax strategies in relation to agencies, and optimize investment outcomes. Please reach out today to learn more about your venture capital investing journey!