Effective immediately, there is a new requirement that each particular portfolio company interest which is the subject of a disposition event needs to have been held by the fund for more than 3 years in order for the allocable carried interest income at the general partner level to be taxed as long term capital gain. If the holding period is not adhered to, the allocated income is taxed as short term capital gain at a higher rate (in general 37% instead of 20%).
For venture capital fund managers, given average holding periods a supermajority of investments should be very likely to qualify for capital gains tax treatment. However, there are certainly situations from time to time where the holding period is not three years in length and thus the resulting carried interest may be taxed as short term capital gain. This may be particularly true in the current environment, due to a few factors: first, the investment pace in terms of timing between rounds is fairly fast compared to historical norms; second, many VCs are participating in late rounds that may occur shortly before an exit (think of the early or growth stage manager that has raised a “top up” fund for home run deals, or has SPVs for this purpose, which make investments at late stages); and third, while news abounds of unicorns staying private for lengthy periods, there is no question that M&A and even IPO transactions – i.e., exits – are occurring frequently in many cases. So it is certainly plausible to expect that at least some VC deals will not meet the holding period requirement, and will thus have the potential to result in short term capital gains.
A chance for short term capital gains may also arise due to certain transaction structures, and those transactions may need re-thinking going forward (which will have to be done carefully, keeping in mind fiduciary obligations to obtain the best outcomes for investors). For example, a CFO I work with called out that there may be cases where a fund has held an investment for several years, and upon an M&A transaction the fund receives new stock of a public company. In this case, the fund recognizes one taxable transaction upon the receipt of new shares in exchange for its old shares, and then a second taxable transaction upon the public market sale of the new shares, with the holding period applicable to the new shares measured from the time the fund receives such shares in the M&A transaction (rather than the time of the underlying investment in the original company). If either stage is sub- “3 year” (and often at least the second stage would be, since venture capital funds are not usually in the business of holding public shares long term, and many LPAs might force their disposition on near term timing), this will result in short term capital gains for the fund manager.
So, what to do? Some managers are considering amending fund agreements to provide that the GP’s carried interest will be allocated solely from gains arising from investments held for longer than 3 years. This is not dissimilar to the methodology used in the case of cashless contribution or fee waivers stipulating that the income allocated to fill up the GP’s capital account would need to be from investments held for more than 1 year (it also being the intention in this case to assure long term versus short term capital gains or other income forms). It is early days to know how many managers may propose this, or how successful they may be in making the case to their LPs for the proposed change.
U.S. tax-exempt and most non-U.S. taxable LPs are not very likely to mind. In fact, they may see benefit in what is the downside of the proposal for GPs, namely, that there may be insufficient “3 year” gains to in fact fill up the GP’s capital account, particularly in a situation where some of the last deals in a fund’s lifecycle happen to be sub- “3 year” deals. GPs for their part may propose to add late lifecycle protections (such as that the rule governs only for some initial period of time after which any gains can be used), but this may not pass muster with tax authorities if not LPs themselves. On the other hand, U.S. taxable LPs may see this proposal as against their interest, since it may lead to situations where they are allocated an outsize amount of less desirable gains (like short term capital gains).
While it is too soon to say how this develops, at this early stage I can say that many GPs I have talked to have anxiety about this issue and are thinking through options. Personally, I would guess that many GPs in the VC space will refrain from taking affirmative action and instead will count their blessings that the tax law changes provided for the “3 year” rule which will protect the supermajority of their carried interest income from higher taxation. But there will certainly be some GPs, I would imagine, who would like to deploy the most tax advantaged structure, and may press for this change with their LPs. I will revisit this topic later to provide more details about GP reactions.