Private markets and taxes: the basics

Private Assets

October 7, 2024

Table of Contents

Key takeaways

The unique structure and operations of private markets funds often lead to more complicated tax filing requirements than traditional investments. Consulting a certified public accountant with expertise in private markets is essential.
Investors in private funds receive annual Schedule K-1s, which may necessitate filing extensions and could require tax returns to be filed in multiple states depending on the fund's operations.
The way income from private investments is categorized - whether as capital gains, dividends, or ordinary income - significantly affects tax rates. Some strategies may also result in “phantom income”, which can complicate tax calculations.

Investment ideas

Forms and filings

Investors in private funds receive an annual Schedule K-1 instead of a Form 1099. The Schedule K-1 (or just “K-1”) is a US Internal Revenue Service form that reports each investor’s share of a private fund’s earnings, losses, deductions, and credits. K-1s may be delivered several months into the next year, which means you will probably need to file an extension for your federal and state (if applicable) taxes.

Investors may also need to file tax returns in multiple states if the private fund in which they invested operates in several states.

Private funds and income

Private markets funds are often structured as partnerships (Limited Partnerships), or a Limited Liability Company (LLC). These are pass-through entities, which means that income, deductions, and credits are passed through directly to investors. This can create a more complex tax situation and may require making estimated tax payments.

Acronym watch: LPs and GPs

You may have seen the terms LP and GP used. These are private fund-specific terms that reflect the structure of the funds, which are set up as single-use “limited partnerships”. This terminology simply denotes that the liability of investors in the fund is limited to the amount they commit to the fund. The individual or institutional investors are therefore referred to as limited partners (or LPs), while the fund manager is called the general partner (or GP), and has unlimited liability - so, not just for their capital, but also the debt of the fund and any other liabilities that it may accrue.

How the passed-through income is characterized is important. Some private investments are tax-deferred, which means that you do not owe taxes until the investment is liquidated or sold, but whether that income is classified as capital gains, dividends, or ordinary income will significantly affect the tax rate.

For example, carried interest from a private equity investment might be taxed as a long-term capital gain, which is lower than ordinary income. Other private investments have the potential to trigger the alternative minimum tax (AMT), which could increase your tax bill.

Some strategies can generate phantom income, which refers to income that an investor is taxed on, even though they do not actually receive any cash or a tangible distribution.

For example, capital recycling may generate phantom income. In this instance, the manager reinvests the proceeds from the sale or exit of an investment into new investments to continuously deploy capital and generate additional returns. While the strategy is meant to optimize the portfolio and maximize growth and profit potential, it may result in cash-flow issues for investors. This is because the income may be taxed, but without any cash being distributed.

From what they invest in to how they are taxed, private markets investments are different. It is crucial to work closely with your advisor and knowledgeable tax professionals before and after investing.

Key Terms

Capital recycling: Capital recycling is an investment strategy where proceeds from the sale or exit of an investment are reinvested into new opportunities. This continuous deployment of capital aims to optimize the portfolio, maximize growth, and enhance returns.

Carried interest: Carried interest is a share of the profits from an investment that a fund manager earns as compensation. It is typically a percentage of the fund's gains and is only paid if the investment achieves a certain level of performance.

Phantom income: Phantom income is taxable income that an investor must report and pay taxes on, even though they have not received any actual cash or tangible distribution from the investment.

Schedule K-1: Schedule K-1 is a tax document issued by partnerships, LLCs, and S corporations to report each investor's share of earnings, losses, deductions, and credits. Investors use this form to complete their individual tax returns.

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