In November 2023, the United States Tax Court issued a notable decision in Soroban Capital Partners vs. Commissioner, with implications on the tax treatment of limited partners in private equity funds. 

The IRS challenged Soroban’s exclusion of ordinary business income from self-employment tax for limited partners, arguing that active involvement disqualifies them from this exclusion under Section 1402(a)(13). The Court, in a procedural ruling, held that limited partners are not automatically entitled to an exemption from self-employment tax, but rather that their participation must be tested. In doing so, the Court’s opinion closely aligned with the precedent set in Renkemeyer vs. Commissioner (2011).

Key Takeaways

• Limited partners who actively participate in business operations may face increased scrutiny regarding their qualification for the limited partner exception to self-employment tax, based primarily on their level of participation in the operations of the partnership.
• Limited Partnerships should assess their current filing positions and risks, including monitoring continued developments regarding self-employment tax under Section 1402(a)(13). 

This decision may have significant implications for private equity funds and other partnerships. A testing requirement on active involvement by limited partners questions a wide range of interactions between selected owners, particularly in the general partner or management company context.

What is the legislative & regulatory basis?

The ruling draws on legislation and proposed regulations under Section 1402(a)(13), which intend to exclude limited partners from self-employment taxes. 

While Section 1401(a) imposes a self-employment tax on an individual’s net earnings from self-employment, Section 1402(a)(13) provides an exclusion for limited partner distributive shares. The court highlighted that the term “limited partner, as such” has historically lacked a precise definition, leaving room for interpretation based on the partner’s level of control and participation in the business. 

What is the regulatory history?

The IRS has attempted to issue regulatory guidance on Section 1402(a)(13) in the past, but has not issued final regulations on this since the moratorium on defining a limited partner under Section 1402(a)(13) was lifted in 1998.  The proposed regulation 1.1402(a)-2 suggests that an individual would not be treated as a limited partner if they 1) had personal liability for partnership debts, 2) had the authority to contract on behalf of the partnership, or 3) participated in the partnership’s trade or business for more than 500 hours during the tax year.

Importantly, the proposed regulation does indicate that a partner can simultaneously be part limited partner and part general partner.

What does this mean going forward?

The Soroban Capital Partners v. Commissioner ruling underscores the need for careful consideration of tax planning and tax compliance positions in private equity and other partnership structures. Partnerships may want to consider the roles and responsibilities of their limited partners, particularly in management or investment advisory entities. With the IRS focusing on the economic substance and active participation of partners, funds should monitor continued developments and consider revisiting their practices to avoid adverse tax consequences. 

Gen II offers full-service tax support, including compliance and strategic planning on a wide range of tax matters. Our compliance and reporting expertise helps manage our clients’ filing burden and establish positions that achieve intended results, maximizing the tax planning of your fund structures and minimizing tax liabilities.  Gen II stands ready to assist you with updates on regulatory changes, ensuring proactive adaptation to the evolving tax landscape.

For questions or more information, contact your Gen II Service Manager or contact us.

*The opinions and facts included in the above do not constitute investment advice. Professional advice should be sought before making any investment or other decisions. Gen II accepts no liability for any decisions taken in relation to the above.

The U.S. Court of Appeals for the Fifth Circuit has vacated the SEC Private Fund Advisor Rule, effectively rendering it null and void. Nevertheless, private equity firms and their general partners should anticipate receiving requests for more granular expense and performance information from investors.

Implications of the US Court Ruling

Vacating the Rule removes the mandatory requirement for private fund advisers to comply with the Quarterly Statement Rule, Restricted Activities Rule, and Preferential Treatment Rule, amongst others. With the Rule no longer applicable, general partners are relieved from the stringent reporting requirements and administrative burden they imposed.

Addressing the Need for Transparency

Investors generally supported the SEC’s desire for increased transparency, improved governance, and the need to address conflicts of interest disclosure and management. Consequently, despite the Rule being vacated, the industry-wide push for greater transparency and accountability will persist. By way of example, the updated Reporting Template and new Performance and Cash Flows Template being developed through the Institutional Limited Partner Association’s (“ILPA”) Quarterly Reporting Standards Initiative (“QRSI”) will incorporate many of the requirements of the Quarterly Statement Rule for illiquid funds, including detailed fee, compensation and expense disclosures, and performance calculations on a gross, net, levered and unlevered basis.  General partners adhering to ILPA reporting standards will be expected to adopt these templates. Furthermore, they should anticipate investor requests for more granular information.

Voluntary Compliance and Best Practices

While the legal mandate is no longer in place, general partners should benefit from voluntarily adopting some of the practices and disclosures outlined therein. This can enhance trust and transparency with LPs, potentially giving firms a competitive edge. 

As Igor Rozenblit, Partner at Iron Road Partners, noted in March 2024, “Half of our clients now are saying that whether or not this gets overturned in the courts, they would comply with components of it…because they themselves need to apply a little bit more transparency.”

Engaging with Industry Organizations and Standardizing Reporting

Neal Prunier, Senior Director of Industry Affairs at ILPA, emphasized the importance of transparency, governance, and alignment of interest, which remain crucial for fostering trust with investors.

Collaborating with institutions such as ILPA can help private equity firms stay aligned with industry expectations and standards, and facilitate the provision of standardized templates to their investors.

Furnishing detailed quarterly statements can showcase a dedication to transparency, setting firms apart in a competitive market.

Leveraging Technology and Outsourcing

Gen II has been actively engaged in the QRSI, assisting ILPA in the development of the Revised Reporting Template and new Performance and Cash Flows Template. Gen II will support our clients in producing these templates upon their finalization from ILPA.

Robust data management and reporting tools, like Gen II’s Sensr® product suite, can help clients maintain high standards of transparency and accountability. This fully integrated web-based solution allows private capital firms to access comprehensive fund data and analytics, ensuring that general partners can efficiently meet internal and external reporting requirements.

Outsourcing administrative and compliance tasks to Gen II can help manage the reporting workload. This allows internal teams to focus on core business activities while ensuring that reporting standards are met.

For questions or more information, contact your Gen II Client Service Manager or email secrules@gen2fund.com.

Q: What regulations must private equity investment advisers comply with when marketing their services?

A: Investment advisers must comply with SEC rules, safeguarding investors and ensuring transparency. The Marketing Rule (Rule 206(4)-1 of the Investment Advisers Act of 1940) requires the presentation of net investment performance calculations, such as the Internal Rate of Return (IRR) and Multiple on Invested Capital (MOIC) whenever gross investment performance is presented to investors.

Both net and gross performance should be calculated over the same time period and using the same type of return and methodology. In addition, the net investment performance presentation must have equal prominence to the gross performance presentation in all marketing materials, and be presented in such a way as to facilitate comparison.

Sensr® Analytics, Gen II’s web-based solution, aids in these compliance efforts by accurately calculating and presenting investment performance metrics like IRR.

Q: What practices are prohibited by the SEC in investment marketing?

A: The SEC prohibits misleading or false statements in marketing materials. This includes misrepresentations about performance, qualifications, or risks associated with investments.  In addition, while there is no requirement to present performance metrics in marketing, the SEC Marketing Rule states a Sponsor may not present gross performance without also presenting the corresponding net performance.

Additionally, extracted performance may not be presented unless accompanied by the performance results of the total portfolio from which the performance was extracted (or an offer to provide such information). Hypothetical performance calculations are prohibited unless they meet relevance and disclosure requirements.

Q: How should investment performance be detailed in marketing materials?

A: Investment performance, such as IRR, must be accurately presented, disclosing the specific period, calculation methodology, and any relevant limitations. IRR calculations, such as Net Investor IRR and Gross Portfolio IRR, should comply with SEC guidelines.

Sensr® Analytics streamlines this by automating performance calculations and integrating data presentation across platforms, ensuring consistent and compliant reporting.

Q: How should net investment performance be calculated to comply with the SEC’s rule?

A: While the SEC has not provided specific guidance regarding calculation methodologies, some common themes are seen throughout the industry.  Whether utilizing a ratio or spread method, or performing a more complex fee and expense allocation, Sensr® Analytics can help Sponsors automate those calculations to systematically comply with the rule.

Q: Did the SEC’s January 2024 FAQ have any impact on the net performance calculation methodology?

A: Yes. The SEC did clarify that net performance calculations must use dates consistent with those for gross performance calculations. This eliminated some common calculation methodologies that rely on either the difference or ratio of the Net Fund IRR to the Gross Portfolio IRR, where dates can be materially different due to the impact of leverage.

Further, such net IRR that includes the impact of fund-level subscription facilities must be accompanied by net IRR calculated without the impact of such subscription facilities or, disclosure describing the impact of such facilities.

Originally Published in Thomson Reuters

Ireland is positioning itself as a prime domicile for European Long-Term Investment Funds (ELTIFs) in the light of the forthcoming ELTIF 2.0 Regulation set to take effect on Jan. 10, 2024.

A consultation is underway for the proposed Chapter 6 in the AIF handbook, which runs from Nov. 1 to Dec.13, 2023.

Following consultative meetings between industry representatives and the Central Bank of Ireland (CBI), a dedicated ELTIF chapter, Chapter 6, has been proposed for inclusion in the Alternative Investment Fund (AIF) Rulebook.

ELTIF: Brief Overview

The ELTIF is a pan-European regime designed to channel long-term capital into the real economy. It aims to provide investors, including retail investors, with long-term, stable returns while simultaneously fueling economic growth and job creation.

The ELTIF is particularly primed for financing infrastructure, real estate projects, and unlisted companies that are not traded on a regulated market. With the maturing trends in the ‘retailisation’ of private funds, ELTIFs are increasingly becoming the “go-to” product option for distributing private market and real asset strategies.

The first version of ELTIF has relatively little take-up, however. The ELTIF 2.0 Regulation aims to revitalize long-term investment vehicles in Europe, offering more flexibility and broader appeal to both fund managers and investors.

The ELTIF 2.0 Regulation, officially known as Regulation (EU) 2023/606, was published on March 20, 2023 and is set to come into effect on Jan. 10, 2024. This updated regulation amends the original ELTIF framework from 2015, aiming to better channel non-bank capital into long-term projects and small and medium-sized enterprises (SMEs).

CP155 Consultation & Chapter 6

The CBI’s Consultation on ELTIF chapter in the AIF Rulebook (CP155) introduces Chapter 6 of the AIF Rulebook.

The new Chapter 6 will comprise two parts:

Part I includes:

• ELTIF restrictions;
• Supervisory requirements;
• Prospectus requirements;
• General operational requirements; and
• Requirements regarding financial reports.

Part II deals with requirements related to the marketing of ELTIFs to retail investors.

The CBI invites feedback on specific questions concerning the proposed rules.

Main Changes in ELTIF 2.0

As these changes to the AIF Rulebook unfold, the CBI will maintain a continuous dialogue with industry stakeholders.

Investor base: The new regulation allows ELTIFs to attract both professional and retail investors across all 27 EU member states, removing previous investment minimums and portfolio percentage constraints for retail investors.

Asset eligibility: The range of eligible assets has been expanded, and now only 55% of an ELTIF’s net assets need to be eligible, down from 70%.

Eligible enterprises: Fintechs are now included and the market capitalization limit for listed companies has been raised to 1.5 billion euros. Rules for third-country companies have also been relaxed.

Real assets: The economic or social benefit requirement and the 10 million euros minimum investment threshold have been removed.

Fund shares: Now, UCITS and AIFs managed by European AIFMs are eligible, along with ELTIF, EuVECA and EuSEF shares.

Investment rules: The regulation simplifies investment policy and portfolio composition; this includes raising the concentration limit to 30% for an underlying fund and allowing more flexibility in borrowing requirements.

Indirect strategies: ELTIFs can now act as feeder funds to other master ELTIFs and fund-of-funds structures are more flexible.

Why Ireland?

Ireland has long been a hub for asset management and investment funds in Europe. The country offers several advantages that make it an ideal domicile for ELTIFs:

Regulatory expertise: Ireland’s Central Bank has a robust regulatory framework and a deep understanding of the asset management industry.

Global reach: Ireland is the domicile for 5.9% of global investment fund assets and the second largest in Europe. With net assets in Irish-domiciled funds reaching 3.7 trillion euros in 2022, Ireland’s reach is hard to ignore.

Skilled workforce: The country has a highly skilled workforce in the financial services sector, which can provide the necessary expertise for managing ELTIFs.

Strategic location: Ireland’s geographical location and use of the English language make it a convenient bridge between the U.S., UK, and European markets.

Irish ELTIF Structure

The Irish ELTIF will be a standalone product and therefore will not need to be separately authorized as a Retail Investor Alternative Investor Fund (RIAIF) or a Qualified Investor Alternative Investor Fund (QIAIF).

The authorization process for an ELTIF is expected to broadly follow the existing authorization processes in place for RIAIFs and QIAIFs. An Irish ELTIF can be established in many forms of the Irish fund structure such as an ILP, ICAV, CCF, Unit Trust or PLC. It is likely, however, that the ICAV and ILP will be the favored structures. The main attributes of these two structures are set out in the table below:

Loan Origination Update

The Central Bank has updated its regulations, specifically ID 1084, concerning the loan origination framework for QIAIFs. The original exemption in ID 1084 allowed QIAIFs to issue loans to their wholly-owned subsidiaries. The revision expands this exemption, now permitting QIAIFs to also provide loans to co-investment vehicles where the QIAIF holds a majority stake.

This lending activity must however be secondary to the QIAIF’s primary investment strategy, ensuring that the focus of the fund remains on its principal investment activities.

Next Steps

The CBI will keep its consultation on ELTIFs open from Nov. 1 to Dec. 13, 2023. The European Securities and Markets Authority (ESMA) is expected to publish technical standards for ELTIF 2.0 by Jan. 10, 2023; they are currently under consultation. These will provide further clarity on aspects such as the minimum holding period, liquidity management, and conditions for capping redemptions.