Alert: Transfers Of Private Equity Fund Interests Should Be Reviewed For Publicly Traded Partnership Issues

February 2009

In the current economic environment, private equity fund investors increasingly desire to transfer their partnership interests in a fund.  Interest transfers may cause some investment funds to face a risk of being classified as a publicly traded partnership (“PTP”).  The consequences of PTP status are severe, since a PTP can be separately taxable as a corporation, not a partnership. 

This client alert is intended to provide fund managers with a brief summary of the rules regarding PTP classification, including available safe harbors that protect a fund from being classified as a PTP.  To avoid PTP status, fund managers should make every effort to stay within the safe harbors when reviewing requests to transfer interests. 

Classification as a PTP

A partnership generally will be classified as a PTP if its interests are either traded on an established securities market or are readily tradable on a secondary market or its substantial equivalent.  Since fund partnership interests typically are not traded on an established market, the crucial issue is determining whether a secondary market for interests or its equivalent exists.

The determination of whether a secondary market or its substantial equivalent exists is based on the total facts and circumstances.  As a result, the outcome is often difficult to predict.  The PTP rules, however, provide safe harbors that permit certain transfers without risk of PTP classification.  Due to the uncertainty of the facts and circumstances test, fund managers should try to only approve transfers that fall within one of the established safe harbors.

Safe Harbors

A fund can avoid PTP classification by qualifying either under the “private placement” or “de minimis trading” safe harbor.  Qualifying under either safe harbor makes it unnecessary to determine whether fund interests are traded on a secondary market or its substantial equivalent.  In addition, even if a fund is classified as a PTP, it may nonetheless avoid taxation as a corporation if its income meets an income-based safe harbor.  However, it risky for a fund to rely solely on the income-based safe harbor.

·        Private Placement Safe Harbor.  There are two elements to the private placement safe harbor: (i) the fund must have no more than 100 partners during its taxable year, and (ii) all interests must be issued in a transaction that is exempt from the registration requirements under the Securities Act of 1933.  Generally, the second element is not problematic, but the first element is more complex than it initially appears.  Complex look-through rules apply for certain pass-through entities, and the determination must be made annually. 

·        De Minimis Trading Safe Harbor.  A fund meets the de minimis trading safe harbor if the sum of all percentage interests in its capital and profits transferred during the tax year at issue does not exceed 2% of all interests in its capital and profits.  In determining the 2% threshold, some types of transfers are not considered.  These include, but are not limited to, transfers by a partner or a related party of more than 2% of the outstanding interests within a 30 day period (so-called “block transfers”), intrafamily transfers, certain types of redemptions, transfers through a computerized or printed service that matches buyers and sellers and meets specified qualifications, and certain others.

·        Income-Based Safe Harbor.  A fund classified as a PTP may nevertheless avoid taxation as a corporation if 90% or more of its gross income for the year is investment-type income.  This type of income generally includes dividends, real property rents, certain types of interest, and gains from the sale of real property.  However, because the income test must be met annually and many funds generate substantial non-qualifying income through allocations from a portfolio investment, it is in most cases risky to rely solely on the income-based safe harbor.

Conclusion

Requests to transfer fund interests should be considered with an eye toward the PTP rules.  If a requested transfer, in combination with other transfers, will push the fund against the limits of the de minimis trading safe harbor, and if it has more than 100 partners, the fund manager is in the difficult position of choosing either not to approve the transfer or making the facts and circumstances determination that no secondary market or substantial equivalent exists. 

This alert is only a summary of the rules and should not be relied upon without independent tax advice with respect to your particular circumstances. Please feel free to call Larry Arem (215-569-4142) or Keith Kaplan (215-569-4143) if you would like to discuss these rules and their impact on you.

CIRCULAR 230 NOTICE.  Any advice expressed above as to tax matters was neither written nor intended by the sender or Klehr, Harrison, Harvey, Branzburg LLP to be used and cannot be used by any taxpayer for the purpose of avoiding tax penalties that may be imposed on the taxpayer.  The recipient may not and should not rely upon any advice expressed above for any purpose and should seek advice based on the recipient’s particular circumstances from an independent tax advisor.