Structuring: What Are the Most Common Fund Structures and Entity Types?

In this release of Venture To Know we discuss the most common structures, entity types and fee arrangements from a tax perspective.

Emerging managers typically employ a three-vehicle structure, which includes a fund, a general partner entity, and a management company.

The fund serves as the vehicle for subscribing limited partners, receiving capital, and making investments.

The general partner entity, often with its own capital investment, is a partner in the fund. It also receives the carried interest—the share of profits that exceeds a predetermined threshold.

The management company, a separate entity typically owned by the same individuals who own the general partner entity, plays a pivotal role. It receives management fee income from the fund and handles the day-to-day operations of investment advisory to the fund. This entity houses employees and covers expenses related to the investment advisory business.

For tax purposes, all entities are generally classified as partnerships.

The three entities typically incorporate as either a Delaware Limited Partnership (LP) or Delaware Limited Liability Company (LLC). The fund will generally be formed as an LP and provide limited partners the protection of no personal liability beyond their investment; however, limited partners will not participate in the day-to-day decisions of the fund. The limited partnership agreement (LPA) details the terms and conditions of the partnership and is important to help avoid conflicts and misunderstandings among the partners and provide a clear framework for resolving issues that may arise.

General partner and management company entities are typically formed as LLCs. An LLC affords the members limited liability regardless of how much they participate in the operations of the business. The rights, responsibilities and ownership are detailed in the LLC operating agreement.

Usually, LLCs are taxed as partnerships. However, for emerging managers, they might initially begin as sole owners. In this case, the entities are treated as single-member LLCs and are disregarded for tax purposes. Consequently, no partnership tax return is necessary, and the activity is reported on the sole owner’s personal tax return using Schedule C as a separate business.

If a second member is introduced in the future, such as an advisor, an anchor investor, or when profits interest is issued to an employee, the entity transitions into a partnership. Consequently, it becomes mandatory to file a partnership tax return.

Special Purpose Vehicles(SPV) are formed to accommodate the structuring needs of the fund (or its investors) usually in connection with one particular investment. They are a separate legal entity, with its own filing requirement, created by a fund manager for a specific objective or activity and are generally formed as LLC’s.

Most venture capital investors push for incorporation in Delaware regardless of where operations take place due to its investment and investor friendly laws. Delaware has become the most common state for fund managers to register because of the state’s experience and ease of processing many entities. Delaware does not require physical presence to incorporate in the state and does not impose an income tax on entities. If it’s needed, there is a sophisticated court system established with expert judges. Investors privacy is protected, and filings are processed quickly. There is an annual filing and fee and if a court case were to arise, you would be required to travel to Delaware to attend in person.

If a fund is registered to do business in NYC, fund managers will want to ensure that their management company and general partner entities are organized as separate entities. NYC imposes a partnership level UBT tax of 4% on income from a trade and/or business, meaning management company net income (including an addback of any guaranteed payments made to members/partners). For this reason, a fund manager will want to keep carried interest (investment income) earned in the general partner entity separate from trade and/or business income generated in the management company to ensure not to taint the carried interest income as trade and/or business income and subject it to the 4% tax.

Authors: Colleen Fay, CPA, Partner | [email protected]; Amanda McKenna, CPA, Partner and Team Lead, Venture Capital Tax | [email protected]; and Joshua Pagano, CPA | [email protected]