By Alan T. Frankel, Charles J. Vallone, and James R. Lisa

Venture capitalists have served as an important catalyst for innovation and wealth creation in the U.S. economy for the past 30 years. Venture capitalists screen entrepreneurial projects, develop and retool business models, structure financing, and constantly monitor performance. They also provide a vast network of contacts to entrepreneurs and offer coaching and insight from professionals that specialize in developing businesses.

Venture Capital Funds

Venture capital ordinarily involves investments in illiquid private equity securities with higher degrees of risk (and higher possible rewards) than traditional investments in publicly traded securities. Capital is usually aggregated for purposes of making investments in private equity funds, structured as limited partnerships or limited liability companies.

The venture capitalist (VC) raises money from outside limited partners (LPs), frequently high-net-worth individuals and institutional investors such as investment banks, pension funds, insurance companies, and tax-exempt organizations. The VC will generally contribute up to 1% of the committed capital while the remaining limited partners contribute the remaining 99%. The venture capital partner will act as the general partner (GP) of the limited partnership or manager of the limited liability company. The GP will identify investments and then negotiate and structure the financing of the investment in an operating entity, generally referred to as a portfolio company. The VC will also monitor the portfolio company after the investment has been made. Oftentimes, the VC will serve as a board member or financial and strategic advisor to the portfolio company. The VC will also seek an exit strategy for the portfolio company investment. The VC does not seek to maintain long-term control over the portfolio company. Private equity investments made by the VC are intended to be held for a limited number of years with the expectation that there will be substantial growth in value, followed by a monetization event.

A VC’s exit strategy may include—

A VC generally purchases a relatively risky portion of the portfolio company’s capital structure in the form of common stock, straight preferred stock, convertible preferred stock, subordinated debt, convertible debt, or warrants. If the portfolio company does not prosper, the VC risks losing most or all of its investment. The VC thus requires a high rate of return on successful investments to cover its losses on the portfolio companies that fail.

Fund Management

The GP generally receives a management fee and a carried interest. The management fee represents the GP’s compensation to run the fund, while the carried interest represents the GP’s allocation of profits from the fund. The management fee is generally equal to 1.5% to 2.5% of capital commitments and is paid quarterly.

Typically, the GP is allocated 20% of the net profits of the fund as a carried interest. The remaining 80% of net profits is generally allocated to the GP and LPs according to their contributed capital. Generally, the GP is not allocated a portion of the carried interest until the LPs have recouped their contributed capital plus a preferred return in certain circumstances.

The fund bears expenses, including organizational and syndication expenditures, and the costs related to acquiring portfolio companies, including due diligence. The fund also bears responsibility for all costs related to accounting, legal, tax preparation, and advisory services rendered to the fund. The fund pays the GP’s management fee. Any losses incurred by the fund are generally allocated in the same proportion as profits and offset previously allocated profits. Losses in excess of previous profits are generally allocated based on contributed capital. The fund’s expenses should be treated as deductions related to portfolio income and reported on line 10 of Schedule K-1. Generally, line 10 deductions are treated as Schedule A itemized deductions and are subject to a 2% of adjusted gross income (AGI) limitation.

Fund expenses. For tax purposes, the fund is generally treated as engaged in an investment activity rather than a trade or business. Investment activity preserves capital gain treatment for the fund; fund expenses, however, are typically treated as a portfolio deduction as defined under IRC section 212. Such deductions include ordinary and necessary expenses paid or incurred during the taxable year for the production or collection of income and also for the management, conservation, or maintenance of property held for the production of income. Section 212 expenses are treated as a Schedule A itemized deduction subject to the 2% AGI floor.

Distributions

Distributions can be structured in various forms. The most advantageous to the LPs is a full payout of the capital prior to the GP recovering any cash distributions. In this setup, all of the cash available for distribution is made to the LPs and GP based on contributed capital. If a preferred return exists, the LPs and GP will also receive a preferred return on contributed capital. The GP receives no portion of the 20% carried interest until the LPs and GP have received all of the contributed capital plus any preferred return.

For example, assume a fund raises $100 million of committed capital and $40 million has been contributed to capital. The LPs have committed $99 million while the GP has committed $1 million. The fund has made investments in 10 portfolio companies for a total investment of $30 million. Suppose portfolio company A was purchased for $3 million and subsequently sold for $21 million. Under a full payment alternative, the GP would not receive any portion of the 20% carried interest on the $18 million gain. The GP would not be entitled to any carried interest until the LPs have received distributions equal to the $40 million of contributed capital. Of the $21 million available for distribution, $20.79 million would be distributed to the LPs and $210,000 to the GP.

The least advantageous structure for the LPs occurs where they receive a pro rata payout of the distributions equal to net profits. Distributions in excess of net profits would be distributed in proportion to capital contributions. Under this approach, the LPs would be entitled to a clawback from the GP that would be triggered if early profits are followed by losses that result in the GP receiving more than the 20% carried interest in profits net of losses and expenses. In the prior example, the $18 million would translate into the GP’s carried interest of $3,600,000 (20%). As a result the $21 million would be distributed as follows:

If the remaining nine investments become worthless, the GP would not be entitled to the $3,600,000 carried interest on the sale of portfolio company A. Under a clawback arrangement, the GP would contribute the $3,600,000 back into the partnership. When distributions are made equal to net profits, it is prudent for the partnership to hold a portion, if not all, of the carried interest in escrow to ensure that it is available for a clawback obligation.

A middle-road approach to structuring distributions would be to distribute sales proceeds on the disposition of an investment first to return contributed capital with respect to that investment. After a return of capital on the particular investment, a preferred return, if applicable, would then be distributed based on contributed capital. The next tier would return unreturned contributed capital with respect to any investment previously disposed of or written off. The next tier would allocate the 20% carried interest to the GP and the remaining 80% according to capital commitments. Under this approach, LPs would also seek a clawback from the GP that would be triggered if early profits were negated by subsequent losses.

Assume the fund raises $200 million of committed capital and $80 million has been contributed to capital. The LPs have committed $198 million while the GP has committed $2 million. Assume the fund started on July 1, 2000. The GP is entitled to a 2% management fee on committed capital and a 20% carried interest. From July 1, 2000, to December 31, 2002, the fund makes 10 investments in 10 separate portfolio companies for a total of $50 million. Assume portfolio company A was purchased on July 1, 2000, for $5 million and sold in 2002 for $35 million. As of December 31, 2002, portfolio companies B and C, which were acquired for $3 million and $7 million respectively, were written off as worthless for tax and book purposes. The remaining seven portfolio companies are valued at cost as of December 31, 2002. The fund also pays a 6% preferred return to the limited partners on a cumulative basis based on contributed capital. Assume the capital contributions were made on the following dates:

(Figures in thousands)

Based on the timing of the capital contributions, the LPs cumulative preferred return as of December 31, 2002, is $7,308,338, which is computed as follows (with annual compounding):

$19,800,000 x .06 2.5 yrs = $3,114,698
$19,800,000 x .06 1.5 yrs = $1,817,640
$39,600,000 x .06 1.0 yr = $2,376,000
                                            $7,308,338

The $35 million of sales proceeds received from portfolio company A would be distributed as shown in the Exhibit.

Another alternative distribution structure would be to return management fees and other expenses allocated to such realized investments prior to the allocation of a 20% carried interest to the GP, and the remaining 80% according to capital commitments.

If the GP is allocated profit that is not currently distributed, the GP is generally entitled to receive tax distributions to cover federal, state, and local income taxes.

Such tax distributions are generally credited against subsequent GP distributions.

IRS Tax Treatment

The limited liability company or partnership form places venture capital funds under IRC sections 1202 and 1045, which permit the fund and its investors to either:

These provisions provide a practical way for individual investors to pool their resources with institutional investors in order to benefit from both the tax and investment advantages offered by the funds, which are run by skilled professional managers.

QSBC stock is defined in IRC section 1202(c) as stock that meets the following conditions:

There are several exceptions to the requirement that QSBC stock be acquired at original issuance. Gifts, transfers at death, transfers from a partnership, corporate reorganizations, stock conversions, options, warrants, or convertible debt all provide exceptions to the requirement. QSBC stock acquired by the exercise of options or warrants, as well as the conversion of debt, is deemed acquired at original issue. The gross assets test is applied and the taxpayer’s holding period begins at the time of the exercise of the options or conversion of the debt to equity. In contrast, when QSBC stock is acquired by converting preferred stock, the gross assets test is applied at the time the convertible preferred stock is issued, and the holding period begins when the convertible stock is first acquired. This is significant because venture capital funds often receive preferred stock.

Treasury Regulations section 1.1202-2(a) provides anti-evasion rules that disqualify from QSBC treatment any stock acquired by a taxpayer on original issuance when, during the four-year period beginning on the date two years before the issuance of the stock, the issuing corporation purchases (directly or indirectly) more than a de minimis amount of its stock from the taxpayer or from a person related [under IRC section 267(b) or 707(b)] to the taxpayer. This de minimis amount is met if the aggregate amount paid for the stock exceeds $10,000 and more than 2% of the stock held by the taxpayer and related persons is acquired.

The regulations under Treasury Regulations section 1.1202-2 (b) provide that stock will also not qualify for the exclusion if the issuing corporation engages in a significant redemption [IRC section 1202(c)(3)(B)]. A redemption is significant if the corporation, within the two-year period beginning one year before the issuance of the stock, redeems stock with an aggregate value (measured at the time of redemption) exceeding 5% of the aggregate value of all the issuing corporation’s stock as of the beginning of the two-year period. The de minimis exception applies if either the aggregate amount paid for all stock redeemed during the two-year period does not exceed $10,000, or if no more than 2% of all outstanding stock of the issuing corporation is purchased during the two-year measuring period.

As discussed above, at least 80% (by value) of the corporation’s assets (including intangible assets) must be used in the active conduct of a qualified trade or business. Assets that are held to meet reasonable working capital needs of the corporation, or are held for investment and are reasonably expected to be used within the next two years to finance future research and experimentation, are treated as used in the active conduct of a trade or business. In addition, certain rights to computer software also qualify. If a corporation uses assets in certain start-up activities or in-house research activities, it is treated as using such assets in the active conduct of a trade or business.

Qualified Trade or Business

A qualified trade or business is any trade or business other than those listed in IRC section 1202(e)(3). A qualified trade or business includes, but is not limited to, services in the fields of health, law, engineering, architecture, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, or any business of operating a hotel, motel, restaurant, or similar business. A qualified trade or business does not include a trade or business whose principal asset is the reputation or skill of one or more of its employees. The business cannot be a regulated investment company, a real estate investment trust, a real estate mortgage investment conduit, or a cooperative. The corporation also generally cannot own real property the value of which exceeds 10% of its total assets or portfolio stock, nor can it own securities the value of which exceeds 10% of its total net assets.

Section 1202 provides for a 50% exclusion from income for capital gains generated by the sale of QSBC stock provided that—

If a fund has invested in a portfolio company that is a QSBC and it sells that QSBC stock, 50% of the gain recognized on that sale may be excluded from taxable income. While the exclusion amount is reported at the fund level, it is passed through to the partners; but each partner’s allocable share of the exclusion is limited to the amount that the partner could have excluded at the time the qualifying stock was first acquired by the fund. In effect, then, each partner can only exclude that percentage of gain equal to their respective ownership interest at the time the securities were first acquired by the fund, and only if they’ve been fund partners for the entire period in which the fund owned the securities.

In the event that the fund distributes the QSBC stock to the partners, the stock will retain its QSBC character only if the recipient was a member or a partner in the fund at the time the securities were first acquired by the fund and at all times thereafter. The qualifying recipient will assume the fund’s holding period. The purpose of the rule, which is set out in IRC section 1202(g), is to preclude funds and other passthrough entities from selling preferential gains.

Any gain excluded under the provision is also excluded for purposes of calculating the taxpayer’s long-term capital gain or loss, and is not investment income for purposes of the investment interest limitation [Conference Committee Report on P.L. 103-66 (1993)]. Forty-two percent of the excluded gain is a preference item for alternative minimum tax purposes. That portion of the gain that is not excluded is not taxed at the applicable long-term capital gain rate (15%). It is, however, generally taxed at a rate of 28%. Under the 2003 Tax Act, 7% of the excluded amount is an AMT tax preference item for stock purchase on or before May 5, 1998, and disposed of after May 5, 2003.

Gain Deferral

The second of these two provisions, IRC section 1045, allows for a deferral of recognition of all or a portion of capital gain generated by the sale of QSBC stock. Individual or noncorporate shareholders that purchase and hold QSBC stock for more than six months can elect to defer any gain recognition, if all or a portion of the sales proceeds are rolled over or reinvested in other QSBC stock within 60 days. Gain is recognized only to the extent that the amount realized on the sale exceeds the cost of the replacement QSBC stock.

As originally enacted in 1997, certain partnerships and subchapter S corporations could purchase QSBC stock, but the rollover provision referred only to individuals. A retroactive technical correction made it clear that the rollover provisions apply to passthrough entities. Rules similar to those set out in IRC sections 1202(f) through 1202(k) apply to the rollover provisions, enabling only those noncorporate partners in the funds at the time of the acquisition of the QSBC stock to benefit from this deferral, and only to the extent of their ownership interest in the fund on the date the stock was first acquired.

To the extent that gain goes unrecognized because of this provision, it reduces the taxpayer’s basis in the QSBC stock purchased. The unrecognized gain from the sale of QSBC stock reduces the bases of QSBC stock purchased during the 60-day period beginning on the date of sale, in the order the purchases were made.
For purposes of the rollover provision, the replacement stock must meet the active business requirement for the six-month period following its purchase. Except for purposes of determining whether the active business test is met, the holding period of the replacement stock includes the holding period of the stock sold.

There are three scenarios under which partners in VC funds may benefit from IRC section 1045. The first would occur if the VC fund sold the QSBC stock and rolled it over into other QSBC stock within 60 days. In that case, the election to defer gain, which must be made no later than the filing date (including extensions) for the tax year in which the QSBC stock was sold (Revenue Procedure 98-48), must be reflected on the VC fund tax return.

The second scenario would occur if the VC fund sold QSBC stock and distributed the proceeds to the partners. In this case, regardless of when the proceeds are distributed, the partner has only 60 days from the date on which the fund disposed of the QSBC stock to reinvest in other QSBC stock. A transaction such as this would require the noncorporate partner to make the IRC section 1045 deferral election.

The third scenario would occur if the VC fund distributed the securities to the partners, in which case the QSBC stock would retain its character in the hands of qualifying recipients. They then could elect to defer any gain on the sale of those securities in the year of its disposition. Regardless of when the proceeds are distributed to the members of the fund, the 60-day rollover period cannot be extended.

VC funds commonly seek an “IRC section 1202 certificate” from the issuing corporation at the time the fund makes its investment. This certificate amounts to a representation by the issuer that the securities issued qualify as QSBC stock. This certificate or representation can be included in the stock purchase agreement or issued separately by the portfolio company.

Tax Reporting

For funds with gains eligible for the IRC section 1202 exclusion, the amount eligible for the exclusion should be reported on line 7 of Schedule K. The exclusion will flow through to each partner and they will determine if they are eligible for the exclusion. An attachment to line 7 (other income) of Schedule K-1 should report the name of the corporation that issued the stock, the partners’ share of the fund’s adjusted basis and sales price of the stock, and the dates the stock was bought and sold.

Gains eligible for IRC section 1045 rollover should also be reported on Line 7 (other income) of Schedule K-1. A distinction should be made for gains where replacement stock is purchased by the partnership within 60 days and for gains eligible for section 1045 rollover treatment where the partnership did not acquire replacement stock within 60 days. The gains eligible for rollover must be reported on line 7 as other income rather than a long-term capital gain because some partners may not be eligible for rollover treatment or may have other investments. VC funds also need to identify shares eligible for section 1202 or 1045 treatment if the shares are distributed to the partners. Similar to the disclosure required for the section 1202 exclusion, the partnership must report on an attachment to line 7 the name of the corporation that issued the stock, the partners’ share of the fund’s adjusted basis, the sales price of the stock, and the dates that the stock was bought and sold.

Worthless Investments

Funds often invest in portfolio companies through either straight cash purchases or through loans that are subsequently converted into equity positions. IRC section 165(g)(1) provides that “if any security which is a capital asset becomes worthless during the taxable year, the loss resulting therefrom shall … be treated as a loss from the sale or exchange, on the last day of the taxable year, of a capital asset.” In those circumstances where a portfolio investment company becomes worthless, the fund will recognize a capital loss to the extent of its tax basis in the underlying security. This loss can offset any corresponding capital gain at the fund level, and the excess loss will be passed on to the members on their Schedule K-1. The holding period for the securities begins on the acquisition date and ends on the last day of the taxable year in which the security becomes worthless.

A security becomes totally worthless when it has no value or potential value. The determinations of whether and when a stock has become worthless are questions of fact. The securities must be shown to have some value at the beginning of a given tax year and become worthless due to some identifiable event. The burden of proving the worthlessness is on the taxpayer.

The book value of the corporation’s assets may be used to prove that stock had some value. The taxpayer’s purchase of stock in a previous year does not establish that the stock had value in that year. Stock may be worthless even though the taxpayer operated the issuing corporation for part of the tax year before ultimately abandoning it. The deduction for worthless securities must be taken for the tax year in which the securities became completely worthless [IRC section 165(g)].

The identifying event that generally establishes worthlessness might be the corporation’s bankruptcy, cessation of business, liquidation of corporate assets, or appointment of a receiver for the corporation [Treasury Regulations section 1.165-1(b)]. The event must clearly indicate to a person of average understanding that there is no probability of realizing anything of value for the securities from a sale, liquidation, or otherwise. An event does not conclusively establish worthlessness if other facts indicate that the stock still has value. The fact that securities have been written off for book purposes does not establish worthlessness for income tax purposes. No deduction is allowed if the write-off is based on market fluctuations in the price of the stock, or if there has been no reasonable attempt to determine that the securities are worthless.

Management Compensation

In order to entice talented individuals to participate in the management of VC funds, they may be offered an interest in the fund in exchange for their services. It is common for the GP’s carried interest to be subject to a vesting schedule over a period of time, such as a straight-line vesting schedule over 48 months.

A capital interest is defined in Revenue Procedure 93-27 as an “interest … that would give the holder a share of the proceeds of the partnership’s assets if they were sold at fair market value and then the proceeds were distributed in a complete liquidation of the partnership.” A grant of an unfettered capital interest to an employee in exchange for services provided is taxable as compensation [Treasury Regulation Section 1.721-1(b)(1)]. Such a grant to an employee or member would require the recipient to pay tax on the fair market value of the capital interest without having received any cash.

An alternative solution without current tax consequences is a profits interest grant. It gives the grantee the right to a designated percentage of the profits of the fund, or, if applicable, to a designated percentage of the appreciation in certain investments made by the fund. This appreciation will be calculated from the date of grant, and can be granted immediately or vest over time. In either event, the Eighth Circuit United States Court of Appeals, in Campbell v. Comm’r [943 F2d 815 (1991)], has indicated that a profits interest is not taxable income to the recipient when received because it is speculative in nature.

It is prudent for recipients to file IRC section 83(b) elections to lock in the value of a profits interest grant. The election must be made within 30 days of receipt, and equal the difference between the fair market value of the interest at the time of transfer and the amount paid for such interest being subject to tax as compensation for services in the year the election is made. The benefit of such an election is realized when the profits interest is disposed of, because the difference between the amount realized at sale over the fair market value of the interest at the time of the election is a capital gain rather than ordinary income in the year of disposition.

The IRS indicated in Revenue Procedure 93-27 that a person receiving a profits interest in exchange for the provision of services to or for the benefit of a partnership in a partner capacity or in anticipation of being a partner will not trigger a taxable event. This rule would not apply, however, under the following circumstances:

It is often impossible to determine conclusively that the profits interest would not be disposed of within two years, or that the IRS would not deem the income generated by the fund to be “substantially certain and predictable.” Therefore, recipients of profits interests continued to make “protective” IRC section 83(b) elections to lock in the fair market value at the date of receipt and ensure capital gains treatment.

The IRS indicated in Revenue Procedure 2001-43 that, for purposes of Revenue Procedure 93-27, where a partnership grants an interest in the partnership that is substantially nonvested to a service provider, the service provider will be treated as receiving the interest on the date of its grant, provided that the following conditions are met:

Because the safe harbor outlined in Revenue Procedure 2001-43 requires that all conditions of Revenue Procedure 93-27 must be satisfied, it is still prudent on the part of recipients of a profit’s interest to make a “protective” Section 83(b) election. The purpose of making a protective Section 83(b) election is the possibility that a partner may dispose of his interest within two years of receipt, which is in clear contravention of the safe harbor as set out in Revenue Procedure 93-27.