Tax planning and compliance for secondary market fund investments
Tax considerations for secondaries funds involve layers of complexity arising from the portfolio-of-funds structure and secondary market transaction mechanics. The fund holds interests in numerous underlying partnerships, each generating its own tax attributes that flow through to the secondaries fund and ultimately to its LPs. Managing tax planning and compliance across this structure requires coordination with underlying GPs, tax advisors, and fund administrators.
Secondaries funds typically structure as partnerships, with tax attributes flowing through to investors rather than being taxed at the fund level. This pass-through treatment applies to income, gains, losses, deductions, and credits from both the fund's direct activities and its underlying fund positions. LPs receive K-1s reporting their share of these items.
The layered partnership structure creates additional complexity. When the secondaries fund holds interests in underlying partnerships, it receives K-1s from each underlying fund. These are aggregated and allocated to the secondaries fund's LPs through their own K-1s. This aggregation process can delay K-1 delivery since the secondaries fund cannot finalize its reporting until underlying K-1s are received.
When acquiring fund interests in secondary transactions, establishing appropriate tax basis is fundamental. The purchase price paid for acquired interests becomes the initial outside basis in those positions. This basis affects the tax characterization of subsequent distributions and gains or losses on disposition.
Section 743(b) adjustments may apply when partnership interests change hands. These adjustments allow the acquiring partnership to adjust its share of inside basis in partnership assets to reflect the purchase price paid, potentially affecting depreciation, amortization, and gain recognition. Whether elections are made and how adjustments are calculated requires careful analysis for each acquisition.
Holding periods for acquired fund interests typically begin on the acquisition date for the secondary buyer, regardless of how long the selling LP held the position. This matters for distinguishing short-term versus long-term capital gain treatment on subsequent dispositions.
However, the underlying funds' holding periods in their portfolio investments are unaffected by the secondary transaction. Long-term capital gain treatment at the underlying level flows through regardless of when the secondaries fund acquired its position.
The K-1 process for secondaries funds involves substantial operational complexity. Key considerations include:
Tax administrators and fund accountants play important roles in managing this process efficiently.
Tax-exempt investors and foreign investors have particular concerns about unrelated business taxable income (UBTI) and effectively connected income (ECI). Secondaries funds must track these items across all underlying positions.
UBTI typically arises from debt-financed income and operating business income. When underlying funds use leverage or hold operating businesses, UBTI may be generated. Secondaries funds often structure to minimize UBTI exposure for tax-exempt LPs, though this depends on underlying fund structures.
ECI is relevant for foreign investors and can arise from underlying fund activities conducted in the United States. Foreign LPs may have US tax filing obligations and withholding exposure depending on ECI generation.
Secondaries funds may have withholding obligations on distributions to certain investors. Common withholding situations include:
Withholding on ECI allocations to foreign partners under Section 1446, based on the fund's effectively connected taxable income.
FIRPTA withholding when underlying funds dispose of US real property interests, potentially triggering withholding on distributions attributable to those dispositions.
State withholding requirements varying by jurisdiction and LP type.
Tracking withholding across multiple underlying fund positions requires robust systems and procedures.
Secondaries funds may use various structures to address investor tax preferences:
Blocker corporations can be used to block UBTI or ECI for certain investors, though at the cost of corporate-level taxation and potentially reduced returns.
Parallel fund structures may separate taxable and tax-exempt investors, or US and foreign investors, allowing tailored treatment for different investor categories.
Alternative investment vehicles may be offered for certain investor types with specific tax requirements.
Given the complexity of secondaries tax matters, most funds engage specialized tax advisors. Advisor responsibilities may include: