General Partners Share of taxes on Unrealized gains

[aceskc]

Hi Everyone,

 

To give some background I've been shadow managing accounts for a few family/friends of nearly 5 years now, which have done reasonably well and outperformed over the period (albeit largely in a bull market),and the money has grown enough that its now difficult to do trade execution/hedges and replicate portfolio's in different accounts. So I'm thinking of potentially launching a partnership either in 2020/2021 but I am still on an H1-b so need to figure out an immigration work around.

 

My question to those who are already running partnerships is about the tax treatment in a regular GP/LP structure. More specifically i understand carried interest and how performance fees work, but my question specifically is how does the GP pay taxes on his share of the profits on unrealized gains? In a hypothetical example if a 100k account has grown to 126k  by year end and all gains are unrealized, assuming the partnership is based on the Buffett type model (25% PF after 6% hurdle)...the partner would be owed 5k in perf. fees. Does he pay taxes upfront on this 5k? Please let me know how taxes work for GP on unrealized gains.  Appreciate anyone's help on this.

[aws]

I believe under that type of structure you would be taxed on the income when the capital is allocated to you, regardless of whether or not the gains it came from are realized.  It should also all be ordinary income instead of taxed at long-term capital gains rates like carried interest.  I don't think you can get deferred taxation or long-term rates on anything except private equity type investments held for many years, but those are beyond the scope of anything I work on.

 

[Guest oakwood42]

Hi Everyone,

 

To give some background I've been shadow managing accounts for a few family/friends of nearly 5 years now, which have done reasonably well and outperformed over the period (albeit largely in a bull market),and the money has grown enough that its now difficult to do trade execution/hedges and replicate portfolio's in different accounts. So I'm thinking of potentially launching a partnership either in 2020/2021 but I am still on an H1-b so need to figure out an immigration work around.

 

My question to those who are already running partnerships is about the tax treatment in a regular GP/LP structure. More specifically i understand carried interest and how performance fees work, but my question specifically is how does the GP pay taxes on his share of the profits on unrealized gains? In a hypothetical example if a 100k account has grown to 126k  by year end and all gains are unrealized, assuming the partnership is based on the Buffett type model (25% PF after 6% hurdle)...the partner would be owed 5k in perf. fees. Does he pay taxes upfront on this 5k? Please let me know how taxes work for GP on unrealized gains.  Appreciate anyone's help on this.

 

I am curious how this work  - Do you plan to keep track of the unrealized gain (in this example $5k) or do you sell some of the portfolio each year to realize the performance fee?

[aws]

No cash would need to change hands to make a special allocation to a partner so you wouldn't need to sell stock unless you were cashing out your share instead of keeping it invested.  The balance sheet of the partnership before and after the allocation is the same, it's just how it's divided up that will change.  This can be kind of wonky when you are doing the partnership tax return in situations where the gains are all unrealized, because if there is no taxable income to allocate to the manager you have to create phantom income to allocate to them.

 

I think this type of structure works well in theory, but is probably too burdensome to work well in practice for small partnerships.  Partnership law is very complex, as is making sure you are following are rules about who can invest in these entities (accredited investors).  If you go down this route you would definitely want to start by talking to a competent attorney that works in this field.

[Guest oakwood42]

No cash would need to change hands to make a special allocation to a partner so you wouldn't need to sell stock unless you were cashing out your share instead of keeping it invested.  The balance sheet of the partnership before and after the allocation is the same, it's just how it's divided up that will change.  This can be kind of wonky when you are doing the partnership tax return in situations where the gains are all unrealized, because if there is no taxable income to allocate to the manager you have to create phantom income to allocate to them.

 

I think this type of structure works well in theory, but is probably too burdensome to work well in practice for small partnerships.  Partnership law is very complex, as is making sure you are following are rules about who can invest in these entities (accredited investors).  If you go down this route you would definitely want to start by talking to a competent attorney that works in this field.

 

 

Thanks for the explanation AWS - I know this is not expert advice however what would you recommend in the topic author's case?