Below is a brief, general overview of certain basic venture fund organizational issues, and related tax planning issues applicable to foreign investors:
Organization
A typical venture fund (“Fund”) is organized as a limited partnership (“LP”). Most LPs are established under the laws of the State of Delaware due to (1) the comprehensive nature of Delaware corporate law, and (2) the history and predictability of such jurisdiction. A Fund is ordinarily sponsored through the efforts of one or more key individuals (the “Principals”). The Principals ordinarily organize and own an entity, often a limited liability company, to serve as the general partner of the Fund (the “General Partner”). The General Partner can also function as the manager or investment adviser of the Fund (the “Manager”). Alternatively, the Principals can organize another “sister” limited liability company for this purpose. Investors subscribe for interests in and become limited partners of the Fund (“Limited Partners”).
Funding
Under the terms of the Fund’s partnership agreement (the “Partnership Agreement”), the General Partner and the Investors would each have commitments (“Commitments”) to make capital contributions (“Capital Contributions”) in specified maximum amounts to the Fund. Typically, the General Partner is expected to make a Commitment of at least 1% of the total Capital Contributions, and the Limited Partners agree to provide the remaining 99%. This traditional allocation is derived from prior legal requirements, but today it usually varies between 1% and 5%. Capital Contributions are used by the Fund, under the exclusive control of the General Partner, to pay Fund expenses (“Fund Expenses”) and make investments (“Portfolio Investments”) in a manner consistent with the investment strategy or guidelines established for the fund (the “Investment Guidelines”).
The common practice is to schedule an initial closing of the sale of interests in the Fund once a specified minimum level of Capital Commitments has been achieved. The Fund then retains the ability to add investors in one or more subsequent closings. In most cases, the period ranges from three to twelve months. Later investors are then required to retroactively contribute pro rata to the expenses of the Funds.
Management
The Manager is responsible under the terms of the Partnership Agreement (or, under the terms of an investment advisory or management agreement, as applicable) for identifying and evaluating prospective Portfolio Investments, monitoring Portfolio Investments on behalf of the Fund, and recommending sales or other exit strategies (“Exits”).
In return for these services, the Manager is paid an annual management fee (“Management Fee”). The Management Fee is expected to cover salaries of the Principals and other operating costs (collectively, “Management Expenses”). A typical annual Management Fee ranges between 1.5% and 3.0% of the size of the Fund. A smaller Fund tends to charge a higher Management Fee and vice-versa a larger Fund. Most venture funds begin operating with a Management Fee based on the total value of the Commitments, and then transition to a formula combining Commitments and Contributions.
Profits by the Fund are generally divided according to a formula that provides the General Partner with a share (typically 20%) of the profits (the “Carried Interest”) attributable to the investors’ Capital Contributions. The timing of the distribution of the Carried Interest, as well as the order in which it is paid first, can vary. For example, the Carried Interest may apply to incremental profits in excess of a base rate of return (i.e. 8%) (“Hurdle Rate”). Or in case where early investments generate profits and later investments do not, payment of the Carried Interest to the General Partner can be subject to an obligation to restore some of those profits to investors (“Clawback”).
Tax issues for offshore investors
Normally, a foreign Limited Partner is not subject to U.S. federal income tax, so long as the Fund operates in such a way that it is not deemed to be “engaged in a trade or business in the United States” and its income is “not effectively connected with the United States.”[1]
A Fund is typically not deemed to be “engaged in a trade or business in the United States” solely as a result of acquiring or disposing of investment and the ancillary activities associated with that. However, as a precaution with foreign Limited Partners, it is very important for the Partnership Agreement to either (1) prohibit the Fund to invest in activities that would make the Fund be deemed to be “engaged in a trade or business in the United States” (i.e. investments in operating companies classified as partnerships), or (2) permit the foreign Limited Partners to organize an alternative investment vehicle.
Likewise, so long as the Fund invests in stock and does not invest in activities associated with real estate or real property holding corporations, the income would normally be “not effectively connected with the United States”[2]. An important point in this respect is that income from advisory activities (i.e. advisory services to Portfolio Companies) would, however, be deemed to be “effectively connected”. As such, to reduce the risk of U.S. tax exposure to the foreign Limited Partners, the Fund ought to be structured in such a way that either (1) prohibits the provision and remuneration of advisory services, or (2) has the Manager, and not the Fund, earn those advisory fees, possibly crediting them back against Management Fees, as permitted by law.
One exception to the general exclusion from U.S. federal income tax for foreign Limited Partners is for dividend and interest income received by the Fund. Tax on this type of income would be withheld in the U.S. on account of the foreign Limited Partners.
Finally, it is important to note that regulatory concerns and tax planning for investors outside the United States, in their jurisdictions, could also affect the basic structure outlined above and, if necessary for the investors, lead to the creation of multiple entity fund structure, grouping investors into “feeder” entities, each created in accordance with the tax preferences of the investors. These entities can be other limited partnerships, tax-haven corporations, offshore business trusts or other entities.
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Specific tax and organizational planning, including an analysis of the applicable securities law offering exemptions, will be possible once the target fund size, number and jurisdiction of the investors have been defined.
Matteo G. Daste, Esq. is the author of this post and may be contacted at mdaste@lpslaw.com Mr.Daste counsels a variety of technology startups and entrepreneurs in capital raising and operational matters.
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