Beware of the PTP Rules: Who Ends up Liable if a Secondary Transfer Triggers Section 7704?
April 30, 2012Legislative Actions
Private equity funds often have lock up periods that prevent limited partners from transferring their interest. However, these periods eventually expire and limited partners who want to exit the fund early have the option of disposing their interest on the secondary market. This option is often conditioned on providing a legal opinion of counsel or an LP certification that the transfer would not cause the fund to be treated as a “publicly traded partnership” under Section 7704 of the Code. If the fund is treated as a “publicly traded partnership” there could be negative tax consequences that would spill over to the remaining partners. These consequences arise from the fact that the fund will be treated as a corporation for Federal income tax purposes. Thus, it is important to make sure that secondary transfers do not trigger Section 7704. Usually, a private equity fund would not be taxed as a corporation even if it is a PTP if it meets the 90/10 passive income test. However, for some funds this test might be difficult to meet, or plainly, there might be a legal issue or an ambiguity as to whether the fund’s income qualifies under the test. In the abundance of caution, GPs of certain funds (particularly those having more than 100 owners and high volume of secondary transfers) may request, or only approve, transfers that are carried out through a “qualified matching service.” These are broker services that meet the Reg. 1.7704-1(g) safe harbor which contains certain restrictions on the type of quotes that can be listed, the timeframe for entering into a binding commitment and so on. Regarding these services, a recent ruling illustrates a sufficiently technical question of whether listing an interest on a nonqualified service through a QMS would violate the Reg. 1.7704-1(g) safe harbor, and thus, cause PTP issues. PLR 201217005, which basically reaffirms two prior rulings - PLR 201016026 and PLR 200507001- provides that QMS will not be disqualified as qualified matching service solely by listing interests on a nonqualifying service.
The year 2012 ruling is not new law but I wanted to blog about it for the following reason. According to industry reporters such as Pitchbook and Prequin, secondaries are becoming more and more popular. Some fund sponsors have even created their own matching services to facilitate secondary transfers. As evident from the ruling discussed in this blog entry, the question of whether a service qualifies for the QMS safe harbor could involve some intricate issues that may not be so obvious. It is a matter of time, in light of the increased level of secondaries, before some fund, somewhere loses its partnership status due to some QMS mishap. The IRS may decide that a particular service does not qualify as a QMS or that a specific transfer was not executed through a QMS. This may create some practical implications as to the ultimate liability and damages in case the fund is treated as a PTP and taxed as a corporation. First, let’s consider what’s fair. Depending on the specific circumstances, the fund, the QMS provider, the lawyer, or the LP may be considered at fault that the PTP rules kicked in. The fund could be considered at fault because it has the most accurate knowledge of how much fund interest is being transferred during the year and the type of income earned during the year. The LP could be seen to be at fault because it should have transferred its interest without implicating Section 7704 but it did not do so. The lawyer could be viewed as being responsible because it gave an inaccurate opinion. The QMS provider could be at fault because its platform did not qualify as a QMS. Lastly, nobody may be at fault, for example, if the service provider had done everything to qualify its service as a QMS but for some unforeseen reason the service did not qualify. A reasonable person would argue that the party that was ultimately at fault should bear the damages, or if several parties are at fault, they should be contributory liable. On the other hand, even if nobody is at fault, unfortunately, someone still has to bear the ultimate liability because the IRS will want to collect the increase in tax due arising from the PTP rules.
Where liability ends up may very well depend on what actions the parties to the transaction take, what documents are being executed and the specific representations in the documents. For example, while many fund agreements require a legal opinion that a transaction does not violate the PTP rules, in practice, with the fund’s manager approval, many limited partners provide only a certificate to the effect that the LP transfer will not cause the fund to be treated as a PTP or disqualify it for the Section 7704 safe harbors. The LP may, or may not, have some informal discussion with its tax advisers regarding the issues. Thus, if things go wrong, the LP might have nobody to blame and could be on the hook for PTP related damages suffered by the fund and other investors, assuming the IRS does not agree that the transfer is void ab initio. This could be particularly unpleasant because blowing the PTP rules might not be the LP’s sole fault, since as it is often the case, other LPs are selling their interest in the same tax year. Moreover, the LP might be particularly aghast if it has read in the fund’s private placement memorandum that the GP expects that the fund will be treated as a partnership for tax purposes. A cautious LP could be well served in taking all precaution in making sure that the liability stays where it belongs. For example, if the LP is making a representation that the transfer would not trigger Section 7704, the LP could be extra scrupulous and make sure that the limited partnership interest is being transferred through a qualifying service. Considering that compliance with the requirements for a qualified matching service is the sole responsibility of the matching service, the LP could do either of two things: it can request an assurance or representation letter from the service that the requirements of Reg. 1.7704-1(g) are met (some services such as InvestorFlow even have representations on their websites that the IRS requirements are satisfied), or even better, it can make sure that the service has obtained a ruling from the IRS that it qualifies as a QMS (some providers may have such a ruling, other may not – nothing requires a provider to seek a ruling). Thus, if later there is an issue with the qualification of the QMS, the LP will be in a better position to seek recourse against the party at fault. While these issues may seem sufficiently technical and esoteric, being aware of the issues and being proactive could help both the LP and the fund in minimizing the risk of a PTP classification and could also help sort out damages issues in case things go wrong. Tags: