Heading Off Carry Tax Issues

Buyout shops have begun requesting clauses in their partnership agreements that let them try to maintain their anticipated level of after-tax profits in the event that proposed tax legislation passes. Some investors are OK with the language, provided it doesn’t affect their own profit stream. But others oppose it.

Legislation was introduced in Congress this spring to treat carried interest as ordinary income, typically taxed at 35 percent for buyout pros. Today they pay the far lower 15 percent capital gains rate on their share of profits. Congress has also proposed taxing certain publicly traded limited partnerships as corporations, a proposal that could raise the tax bill for buyout shops that have gone public. Both bills remain alive and well, and, regardless of their success, similar proposals may continue cropping up.

Mark Foster, who represents limited partners in fund negotiations as a partner at Nixon Peabody, said he’s starting to see clauses inserted in a handful of buyout fund agreements to address the issue. The proposed terms would let the general partner amend the agreement, without LP approval, to respond to a change in U.S. tax law affecting carried interest. However, the GP would generally have to get the consent of investors—or at least a high percentage of investors—to amend the agreement if it would affect their economic interest in the partnership.
As long as investors get the deal they bargained for, Foster said, “we wouldn’t be averse to that kind of language.”

However, Nixon Peabody would negotiate “pretty hard,” he added, were a firm to propose a more GP-friendly version giving it the ability to amend an agreement without LP approval and regardless of how the amendment affected their economics.

Two large buyout firms in the market have proposed having the ability to do just that, according to David Watson, a fund attorney at Goodwin Procter, which represents both GPs and LPs. At least one of the two, Watson said, has since backed off the idea and replaced the clause with a more LP-friendly one.

On behalf of his own buyout clients, Watson said that within the last two months he’s started to propose the more LP-friendly carry clause—the one that protects LPs from economic harm unless they agree otherwise. It’s too early to say whether investors will sign on to it, said Watson, who works on some 30 to 35 mid-market buyout funds per year. Early reaction? Some investors are fine with the clause, Watson said, but others have said they would prefer not to address the issue until legislation passes.

Jose Fernandez, managing director and general counsel at StepStone Group, an advisor to several institutional investors, said he hasn’t seen a partnership agreement include the carried-interest tax clause yet. But he would advise his clients to require a vote of at least a majority of LPs before any amendments get made to the agreement, even if the GP promises not to impact their economics. “Usually any changes affect the LPs in some way, and I can see legitimate differences of opinions [arising] between GPs and LPs whether it’s adversely impacting” investors, he said.

But say the carried interest legislation does pass, and a buyout firm has the LP-friendly carry clause in its partnership agreement. What could it do to recover tax dollars without harming its backers? Nixon Peabody’s Foster points to at least three ways—though the first two are far from foolproof. One is to have the LPs make additional payments to the GP to make up any shortfall; those LPs that can deduct those payments on their taxes wouldn’t be hurt. The glaring problem with that solution: Many investors are tax-exempt and wouldn’t enjoy the benefit. Another way to make up the shortfall is by having portfolio companies pay the GP a carried interest. In theory, the portfolio companies could take the expense as a tax deduction, leaving them no worse off financially. But again, questions arise as to whether portfolio companies would in fact have the ability to take those deductions.

Perhaps the most viable idea to be floated is for LPs to loan money to the GP at the beginning of a fund. That loan, which would take the place of some or all of the GP contribution, would eventually turn into profits taxed at the capital gains rate.

For more, reach Mark Foster of Nixon Peabody at mfoster@nixonpeabody.com; reach David Watson of Goodwin Procter at dwatson@goodwinprocter.com.