General Partners Of Private Funds Can Qualify for A Trade Or Business Classification
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Owners of Private Investment Funds typically structure their funds as limited partnerships coupled with an entity as a general partner responsible for the overall management. The entity is rewarded for its effort by a performance fee or allocation (carried interest). In terms of Sec. 162 of the internal revenue code, these entities are not typically engaged in a trade or business.
The TCJA, 2017, in P.L. 115-97 made it less desirable to classify advisory fees and investment expenses as Sec. 212 portfolio expenses. Under Sec. 212, these fees are no longer deductible to individual fund members or tax entities, including trusts. The TCJA eliminated miscellaneous itemized deductions for the tax years from 2018 to 2025.
The question is whether fund-related expenses can be deducted under Sec. 162. Investment funds often employ a management company that qualifies as being engaged in a trade or business. What is more, the management company usually has the delegated authority of the general partner entity to run the day-to-day operations of the investment partnership in exchange for a fee, and it is typically formally separate from the general partner. Usually, the general partner and the management company share at least partial common ownership with one another. Some private investment funds receive trader fund status – if their trading activity is sufficiently voluminous, for them to be treated as engaged in a ‘trade or business.’ Those who manage that can classify their expenses as business expenses under Sec. 162, which allows individual investors to deduct their management fees and other investment expenses in full in arriving at AGI.
The more important question is whether the general partner entity can be engaged in a Sec. 162 trade or business. This becomes even more important when the funds needed to operate and manage the investment funds are held by the general partner entity and not the management company. In this event, it might be undesirable to distribute the cash from the general partner entity to its partners for contributing to the management company – or to loan the funds directly to the management company. In this situation, the general partner entity needs to pay these expenses directly. To maintain the tax treatment for these expenses under Sec. 162, as they would have received if paid for with cash from the management company, becomes a concern at this point. It all depends on the answer to the question, “is this general partner of an investment fund engaged in a Sec. 162 trade or business?”
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Discussion
The management company is typically structured as a partnership with the authority to manage the day-to-day operations. The management company is compensated through management fees, usually based on the value of the assets managed by the fund. The management fees are as a rule intended to cover the basic overheads, to keep the lights on, and the dependability of the payments make it easier to manage the funds with a sense of regularity.
The general partner of an investment fund is often structured as a partnership and receives compensation through incentive compensation via incentive allocation form the underlying investment fund based on the performance of the fund.
Sometimes there are cases in which the general partner pays the expenses of running the fund. If no consideration is given to whether the entity is running a trade or business, the fund managers may lose out on the deductibility of these expenses if they are classified under Sec. 212. It seems unfair that the costs, when paid by the management company directly, receive Sec. 162 treatment but not if the general partner pays the same. This apparent inconsistency can only be overcome if the appropriate authority offers the necessary guidance.
Continuity & Regularity
The partners of the general partner are typically involved in the day-to-day operations of the investment fund through the life of the business. The general partner is granted the authority explicitly in the partnership agreement. It has the right to delegate specific duties to the management company. Still, it continues to be responsible for the management and decision making concerning the investment fund in addition to sharing common ownership.
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Income Or Profits Is The Primary Purpose For Engaging In The Business Activity
Whether this is the case or not is a factual question. General partners often invest some of their capital in the find to show that they have skin in the game. These gains are separate from any returns on the interest in profits received in exchange for the performance of services. This is a complication.
In King, 89 T.C. 445 (1987), it is stated that ‘no matter how extensive his activities an investor is never considered to be engaged in a trade or business concerning his investment activities. Does this investment element, therefore, preclude the general partner from participating in a trade or business?
In Dagres, 136 T.C. 263 (2011), a venture capitalist was disallowed a business bad debt deduction under Sec. 166(a). The tax court held that the income remained compensation, its capital gain notwithstanding.
So, even though a typical general partner of an investment fund does receive an incentive allocation as compensation for its services, neither the investment function of the general partner’s capital nor the capital gain character of the income earned, disqualified the entity from being treated as engaged in a trade or business.
In Lender Management LLC, T.C. Memo 2017-246 a taxpayer received compensation from a contingent profit interest dependent on the success of the investments it was managing.
The tax court held that the taxpayer was engaged in a trade or business of providing investment management services and could deduct its expenses under Sec. 162.
The court specifically addressed how the services provided by Lender Management were comparable to those offered by a traditional hedge fund manager and stated that the contingent nature of profits interest does not negate their being compensated for services.
When the general partner entity meets the tests outlined in the Groetzinger and other cases, a typical general partner entity of an investment fund partnership can be considered engaged in a Section 162 trade or business.
Readers should note that this article is only intended to convey general information on these issues and that FAS CPA & Consultants (FAS) in no way intends for the contents of this article to be construed as accounting, business, financial, investment, legal, tax, or other professional advice or services. This article cannot serve as a substitute for such professional services or advice. Any decision or action that may affect the reader’s business should not rely solely on the contents of this article, but should rather be consulted on with a qualified professional adviser. FAS shall not be responsible for any loss sustained by any person who relies on this presentation. This article is subject to change at any time and for any reason.
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