Private equity fund managers are sometimes surprised to find that their distributions from a fund don’t correspond with their taxable income from it. For example, you might have received $1 million in cash distributions, but your taxable income is reported as $1.5 million — resulting in a tax bill that rings in significantly higher than expected. Read on to learn why this happens and what can be done to mitigate the tax repercussions.

The Root of the Difference

Most fund managers receive a partnership interest in the fund’s general partner. As partners, they’re allocated shares of the partnership’s income, gain, loss, deductions and credits. For tax purposes, partners typically are taxed on the partnership’s income or loss according to their economic interests in the partnership, regardless of whether distributions are actually made to the partners.

Much of a fund manager’s compensation will come from its allocation of the partnership’s carried interest. Of course, carried interest typically isn’t paid out until other conditions are met, such as the return of limited partners’ capital and the payment of the preferred returns (or the hurdle rate). 

However, carried-interest holders may be allocated taxable income from the partnership even if they haven’t yet received the related cash distributions.  That’s because, once the conditions for carried interest are met — such as the return of capital and preferred return to limited partners — taxable income is allocated to all investors, including the general partner and, in turn, its fund manager partners. These allocations are typically determined based on the partnership agreement’s target capital and hypothetical liquidation provisions and are taxable when made, even if no cash is distributed at the time.

The excess of taxable income over distributions is sometimes called “phantom income” or “dry income.” The waterfall structure dictated by the limited partnership agreement plays a large role in whether a fund manager is susceptible to it. For example, if the partnership is entitled to a 20% carried interest in the profits, the partners could be taxed on their share even if they haven’t received distributions because the fund operates under a return-all-capital (or European-style) waterfall. However, with a deal-by-deal (or American-style) waterfall, the partnership may be paid before investors; therefore, the partners will be less likely to come up short at tax time.

Tax Distributions: Yay or Nay?

Some private equity funds make so-called tax distributions to their fund managers to help them bridge the gap between their tax obligations on phantom income and their carried interest distributions. The tax distributions are customarily treated as advances against future carried interest distributions. However, the provisions that allow for tax distributions must be carefully crafted, taking the following questions into account:

• Should the distributions be based on actual or assumed tax rates? If the latter, should the private equity firm apply the same assumed rate for all managers, or should it factor in where each manager resides for tax purposes?
• Should the assumed rate include state taxes and the federal net investment income tax?
• Can tax distributions be “clawed back” if circumstances change — for example, if a manager leaves the firm or the underlying investment falls short of expectations?
• Should the distributions be calculated on a cumulative basis so that prior-year losses are accounted for when computing the distribution amount?
• How should the distributions be timed?

Beware: The fund’s limited partners might oppose the inclusion of tax distribution provisions. Such distributions also might not be advisable due to the impact on the fund’s cash flow.

FAQs- Carried Interest Taxation

1. What is phantom income, and why does it matter to fund managers?
Phantom income refers to taxable income allocated to a partner that hasn’t been received in cash. For fund managers, this often arises from carried interest allocations that are made before they actually receive distributions.

2. How does the fund’s waterfall structure impact tax timing?
The waterfall structure determines when carried interest is distributed. In a European-style waterfall, fund managers may be allocated income before receiving cash, leading to phantom income. In contrast, an American-style (deal-by-deal) waterfall typically results in distributions being made earlier, reducing the risk of a tax mismatch.

3. What are tax distributions, and are they common?
Tax distributions are payments made to fund managers to help cover taxes on phantom income. These are treated as advances against future carried interest but must be carefully structured. While helpful for managers, they can be controversial among limited partners and may impact fund cash flow.

4. Can tax distributions be customized to individual fund managers?
Yes. Tax distributions can be based on actual or assumed tax rates and may consider factors like a manager’s residence, state taxes, and the federal net investment income tax. However, such provisions require careful planning to address fairness, clawbacks, and timing.

Carried interest is generally an appealing form of compensation for private equity fund managers. If certain conditions are satisfied, carried interest will generally be taxed as long-term capital gains rather than ordinary income.