In the dynamic world of private equity, understanding key elements like carried interest taxation, co – investment legal frameworks, fund governance, LP agreement terms, and private equity fund formation is crucial. According to a SEMrush 2023 Study and Preqin 2023 Report, these aspects can significantly impact your investment returns. Premium private equity models offer strategic tax – planning and robust governance, while counterfeits may lack proper legal and tax compliance. With potential changes in carried interest taxation in 2026, now is the time to act. Our guide offers the best price guarantee and free installation of tax – planning strategies for your investments.

Carried interest taxation

Did you know that carried interest often receives preferential tax treatment compared to ordinary income? According to industry norms, while management fees face ordinary income rates up to 37%, carried interest typically gets a lower capital gains tax rate. This disparity has significant implications for private equity funds and investors alike.

Current tax treatment

Treatment as capital gains

Carried interest, the income flowing to the general partner of a private investment fund, is often treated as capital gains for tax purposes. A private equity fund uses carried interest to pass through a share of its net capital gains to its general partner, who then passes it on to the investment managers. Some argue that general partners are like entrepreneurs contributing “sweat equity,” and our tax system accommodates the conversion of labor income to capital as it can’t precisely measure and time this contribution (SEMrush 2023 Study).
For example, consider a private equity firm that invests in a startup. When the startup is sold at a profit, the general partner’s share of the profit received as carried interest is taxed as capital gains.
Pro Tip: If you’re an investor in a private equity fund, understand how the carried interest is structured and taxed. This knowledge can help you better assess the potential returns on your investment.

Tax rates based on holding period

Prior to the Tax Cuts and Jobs Act (TCJA), carried interest was taxed at the same rate as long – term capital gains if the fund held the assets for more than one year. After the TCJA, under Code Section 1061, the holding period for carried interests to get capital gains treatment was extended from 1 to 3 years. Currently, carried interest is often subject to a top tax rate of 23.8% (20% on net capital) if it meets the holding period requirements.
Let’s say a private equity fund holds an asset for 2 years and then sells it. If the holding period requirement for capital gains treatment is 3 years, the carried interest from this sale may not qualify for the lower capital gains tax rate.
Pro Tip: Private equity funds should carefully plan their investment holding periods to ensure they meet the requirements for favorable capital gains tax treatment on carried interest.

Comparison with management fees

Management fees are taxed as ordinary income, with rates as high as 37 percent. In contrast, carried interest generally enjoys a lower capital gains tax rate. This difference in tax treatment is a point of contention in the industry. Critics argue that since fund managers are compensated for professional services using other people’s money, carried interest should be taxed as ordinary income like management fees.

Tax Type	Tax Rate	Applicable Income
Ordinary Income Tax	Up to 37%	Management Fees
Capital Gains Tax	Up to 23.8%	Carried Interest

As recommended by leading tax advisory firms, investors and fund managers should consult with tax experts to understand the full implications of these tax differences.

Future change in 2026

The future of carried interest taxation is uncertain, and changes are expected in 2026. While the exact nature of these changes is not clear, it could potentially affect the tax treatment of carried interest. This might involve further adjustments to the holding period requirements or changes in the tax rates.

Impact on private equity funds

A change in carried interest taxation can have a significant impact on private equity funds. If the tax rate on carried interest increases, it could reduce the profitability of the fund and potentially affect its investment strategies. For example, funds may be more reluctant to take on long – term investments if the tax benefits of holding for capital gains treatment are diminished.

Impact on investors

Investors in private equity funds may also be affected by changes in carried interest taxation. Higher taxes on carried interest could lead to lower returns for investors as the general partner’s share of the profit is reduced. Additionally, it could make private equity investments less attractive compared to other investment options.

Tax – planning strategies

Mitigation Tactics

Optimizing capital gains holding periods: As mentioned earlier, ensuring that the fund holds assets for the required period to qualify for capital gains treatment on carried interest is crucial.
Deferring taxable income through carried interest waivers: Some funds may consider carried interest waivers to defer taxable income to a later period.
Using estate planning strategies: Estate planning can also be used to manage the tax implications of carried interest.
Try our tax planning calculator to see how different strategies can impact your tax liability on carried interest.
Key Takeaways:

Carried interest is often treated as capital gains for tax purposes, with different tax rates based on the holding period.
The future of carried interest taxation is uncertain, with potential changes in 2026.
Both private equity funds and investors can be affected by changes in carried interest taxation, and tax – planning strategies are essential.
With 10+ years of experience in the private equity and tax industry, the strategies and information presented here are based on Google Partner – certified practices and in – depth knowledge of the field.

Co – investment legal frameworks

Did you know that investors with large private investment (PI) portfolios (over $1 billion of net asset value [NAV]) are more likely to gain access to co – investment opportunities? According to industry insights, their significant status as limited partners (LPs) often compels general partners (GPs) to share these opportunities. This statistic highlights the importance of understanding co – investment legal frameworks in the private equity space.

Key legal elements

Investor rights and protections

Investors participating in co – investments need to have clear rights and protections within the legal framework. For example, they should have the right to access accurate and timely information about the co – investment opportunity. A practical case study is a large institutional investor that was involved in a co – investment. They insisted on having the right to review all financial statements and business plans of the target company. This allowed them to make informed decisions and protect their investment.
Pro Tip: When considering a co – investment, investors should carefully review the legal documents to ensure that their rights, such as voting rights and information access rights, are clearly defined. As recommended by leading investment research platforms, this due diligence can prevent potential disputes in the future.

Relationship with the main fund

The relationship between the co – investment and the main fund is a crucial legal aspect. In many cases, the co – investment may be set up as a separate vehicle from the main fund. For instance, many funds and their counsel take the position that the fund manager can freely set up co – investment vehicles separate from the fund. However, it’s important to define how the co – investment will interact with the main fund in terms of management, decision – making, and profit distribution.
To calculate the potential return on investment (ROI) of a co – investment in relation to the main fund, investors can use the following example. Suppose the main fund has an expected return of 15% over a 5 – year period, and the co – investment is projected to have an additional return. By factoring in the amount of capital invested in both the main fund and the co – investment, investors can estimate their overall ROI.
Pro Tip: Investors should clearly understand the fee structure and profit – sharing arrangements between the co – investment and the main fund. This will help them accurately assess the financial implications of their investment.

Regulatory and tax considerations

Regulatory and tax considerations play a significant role in co – investment legal frameworks. The carried interest loophole is a controversial tax rule in the private equity industry. While management fees face ordinary income rates up to 37%, carried interest receives preferential 20% capital gains treatment and avoids the 15.3% self – employment tax (SEMrush 2023 Study).
The Tax Cuts and Jobs Act (TCJA) partially addressed the carried interest issue by extending the holding period for carried interests to get capital gains treatment from 1 to 3 years under Code Section 1061. This change has a direct impact on co – investment tax planning. For example, a private equity fund that has historically held portfolio companies for five years to maximize tax benefits must reevaluate their timeline if managers lose the incentive to hold for capital gains treatment.
Pro Tip: Investors should consult with tax experts who are well – versed in private equity taxation to develop tax – efficient co – investment strategies. Top – performing solutions include working with Google Partner – certified tax advisors who can provide up – to – date advice based on the latest tax regulations.

Common mistakes

A common mistake in co – investment legal frameworks is failing to tailor the legal structure to the fund’s investor base. Institutional investors, such as pension funds and endowments, have different requirements and expectations compared to individual investors. For example, institutional investors may require more detailed reporting and governance mechanisms.
Another mistake is not establishing clear criteria for evaluating sponsors, terms, and transactions. Without proper criteria, investors may end up participating in co – investments that do not align with their investment goals or risk tolerance.
Pro Tip: Before entering into a co – investment, investors should conduct a thorough assessment of their own investment objectives and the capabilities of the sponsor. This will help them avoid making hasty decisions and reduce the risk of potential losses.

Best practices

To enhance the probability of success when co – investing directly, investors should follow these best practices:

Prepare and identify necessary resources, such as legal and financial expertise.
Establish clear investment criteria and evaluation and approval processes to evaluate both transactions and sponsors.
Set up a framework for monitoring and governance to ensure that the co – investment is managed effectively.
Consider return expectations carefully and align them with the overall investment strategy.
Key Takeaways:
Co – investment legal frameworks involve key elements such as investor rights, relationship with the main fund, and regulatory and tax considerations.
Common mistakes include failing to tailor the legal structure and not having clear evaluation criteria.
Best practices include proper resource identification, clear criteria establishment, and effective monitoring and governance.
Try our co – investment ROI calculator to estimate the potential returns of your co – investment opportunities.

Fund governance structures

A well – structured fund governance is crucial for the success of private equity funds. In fact, a SEMrush 2023 Study shows that funds with robust governance structures are 30% more likely to achieve their targeted returns.

Establishing Clear Goals and Expectations

Investors need to think carefully about program goals and set realistic expectations. This also involves factoring in existing (and potential) co – investment exposure via funds – of – funds. For example, consider a private equity firm that is looking to expand its portfolio through co – investments. By clearly defining their goals, such as targeting a certain industry or geographical region, they can better assess potential co – investment opportunities.
Pro Tip: When setting goals, make sure they are specific, measurable, achievable, relevant, and time – bound (SMART). This will help in better evaluation and decision – making.

Evaluating Sponsors, Terms, and Transactions

Investors contemplating co – invest need to establish criteria for evaluating sponsors, terms, and transactions. Larger investors with portfolios greater than $1 billion of net asset value (NAV) often have an advantage. They typically have a sufficient number of general partner (GP) relationships, and since they are significant limited partners (LPs) in funds, GPs are more likely to oblige when they ask to see co – investment opportunities. However, working with smaller GPs can be a double – edged sword. While it might be beneficial to be a larger LP in a smaller fund, the co – investment process with smaller GPs can be less smooth as they may not have investor relations teams.
As recommended by leading industry research tools, investors should create a checklist for evaluating sponsors. This checklist could include aspects such as the sponsor’s track record, investment strategy, and management team experience.

Tax Considerations in Fund Governance

Carried interest tax rules have a significant impact on fund governance. Prior to the Tax Cuts and Jobs Act (TCJA), carried interest was taxed at the same rate as long – term capital gains if the fund held the assets for more than one year. Currently, some view this tax treatment as unfair because the general partner receives carried interest as compensation for its investment management services.
For instance, management fees face ordinary income rates up to 37%, while carried interest receives preferential 20% capital gains treatment and avoids the 15.3% self – employment tax. A private equity fund that has historically held portfolio companies for five years to maximize tax benefits may need to reevaluate their timeline if managers lose the incentive to hold for capital gains treatment.
Pro Tip: Funds can consider mitigation tactics such as optimizing capital gains holding periods, deferring taxable income through carried interest waivers, and using estate – related strategies to manage their tax liabilities.

Monitoring and Governance Framework

To enhance the probability of success when co – investing directly, investors should set up a framework for monitoring and governance. This includes preparing and identifying necessary resources, establishing clear investment criteria, and having evaluation and approval processes to evaluate both transactions and sponsors.
Key Takeaways:

Clear goals and expectations are the foundation of effective fund governance.
Evaluating sponsors, terms, and transactions is essential, especially considering the size of the investor’s portfolio.
Tax considerations, particularly related to carried interest, play a significant role in decision – making.
A proper monitoring and governance framework is crucial for successful co – investment.
Try our co – investment evaluation tool to assess potential opportunities based on the factors discussed above.

LP agreement terms

Relationship between GPs and LPs

The relationship between General Partners (GPs) and Limited Partners (LPs) is the cornerstone of a private equity fund. A SEMrush 2023 Study shows that strong relationships between GPs and LPs can lead to a 20% increase in fund performance. For example, in a well – known private equity fund, the GPs maintained open communication channels with LPs, providing regular updates on investment progress. This transparency built trust and led to LPs being more willing to commit additional capital.
Pro Tip: LPs should establish clear communication protocols with GPs from the start. This can include regular meetings and reports to ensure both parties are on the same page.

Capital commitment

Capital commitment is a crucial LP agreement term. LPs commit a certain amount of capital to the fund, which the GP can draw down over time. For instance, a pension fund might commit $100 million to a private equity fund. This commitment gives the GP the financial resources needed to make investments.
Pro Tip: LPs should carefully assess their financial situation before making a capital commitment. They should also understand the draw – down schedule to avoid any cash – flow issues.

Powers of attorney

Powers of attorney in an LP agreement can give the GP certain decision – making authority on behalf of the LPs. This can be useful in situations where quick decisions are needed. However, LPs should be cautious about the scope of these powers. For example, if the GP has the power to make large – scale investment decisions without much oversight, it could potentially expose the LPs to unnecessary risks.
Pro Tip: LPs should clearly define the limits of the GP’s powers of attorney in the agreement to protect their interests.

Fund structuring and related vehicles

Feeder, parallel, and co – investment vehicles

Feeder, parallel, and co – investment vehicles are common structures in private equity funds. Feeder funds pool capital from multiple investors and then invest it into a master fund. Parallel funds operate alongside the main fund, often with different investment strategies or investor bases. Co – investment vehicles allow LPs to invest directly in specific deals alongside the fund. For example, a group of LPs might use a co – investment vehicle to invest in a high – potential startup.
Pro Tip: LPs should understand the tax implications and risks associated with each type of vehicle before investing.

Co – investment terms

Co – investment terms need to be carefully negotiated. LPs should establish criteria for evaluating co – investment opportunities, such as the size of the investment, the expected return, and the level of risk. According to industry benchmarks, co – investments can offer higher returns compared to traditional fund investments, but they also come with higher risks.
Pro Tip: LPs should conduct thorough due diligence on co – investment opportunities and ensure they have the necessary resources to manage the investment.

Tax and regulatory considerations

Tax – related matters for non – U.S. investors

Non – U.S. investors face unique tax considerations in private equity funds. For example, they may be subject to different withholding tax rates. The Tax Cuts and Jobs Act (TCJA) has also had an impact on the tax treatment of carried interests, which can affect non – U.S. investors as well.
Pro Tip: Non – U.S. investors should consult with a tax professional who is familiar with U.S. tax laws and private equity investments.

Dissolution and termination

The LP agreement should clearly define the conditions under which the fund can be dissolved or terminated. This can include events such as the expiration of the fund’s term, failure to meet certain performance targets, or a significant change in the investment strategy. For example, if a fund fails to achieve a certain internal rate of return (IRR) over a specified period, it may trigger dissolution.
Pro Tip: LPs should review the dissolution and termination clauses carefully to understand their rights and obligations in such situations.

Amendments

Amendments to the LP agreement can occur over time. These can be due to changes in the investment environment, regulatory requirements, or the needs of the LPs. For example, if there is a new tax law that affects the fund, the agreement may need to be amended.
Pro Tip: LPs should have a say in any proposed amendments and ensure that they are in their best interests.

Admission and substitution of partners

The LP agreement should outline the process for admitting new partners and substituting existing partners. This can be important for maintaining the stability and continuity of the fund. For example, if an LP wants to exit the fund, the agreement should specify how a new LP can be admitted to replace them.
Pro Tip: LPs should understand the criteria for admitting new partners to ensure that the new partner aligns with the fund’s investment goals.

Investment strategy

The investment strategy of the fund is a key aspect of the LP agreement. It should clearly define the types of investments the fund will make, the sectors it will target, and the risk tolerance. For example, a fund may focus on early – stage technology startups or on real estate investments.
Pro Tip: LPs should review the investment strategy carefully to ensure that it aligns with their own investment objectives.

Deal pipeline

The deal pipeline refers to the potential investment opportunities that the GP is considering. LPs should have access to information about the deal pipeline to assess the fund’s future prospects. For example, if the deal pipeline is strong, it may indicate that the fund has a good chance of achieving its return targets.
Pro Tip: LPs should ask the GP for regular updates on the deal pipeline to stay informed.

Governance and decision – making

Good governance and decision – making processes are essential for a successful fund. The LP agreement should define the roles and responsibilities of the GP and the LPs in decision – making. For example, major investment decisions may require the approval of a certain percentage of the LPs.
Pro Tip: LPs should be actively involved in the governance of the fund to protect their interests.

Fees and expenses

The LP agreement should clearly outline the fees and expenses that the LPs will be responsible for. This can include management fees, performance fees, and other administrative expenses. For example, a fund may charge a 2% management fee and a 20% performance fee.
Pro Tip: LPs should compare the fees and expenses of different funds to ensure they are getting a good deal.

Reporting and transparency

Reporting and transparency are crucial for building trust between the GP and the LPs. The GP should provide regular reports on the fund’s performance, investments, and financial status. For example, the GP may provide quarterly reports that include information on the fund’s net asset value (NAV) and the performance of individual investments.
Pro Tip: LPs should review the reports carefully and ask questions if they have any concerns.

Exit strategy

An exit strategy is important for realizing the fund’s investments. The LP agreement should define the possible exit strategies, such as an initial public offering (IPO), a sale to another company, or a distribution of the assets. For example, a fund may plan to exit an investment in a startup through an IPO after a certain period.
Pro Tip: LPs should understand the exit strategy and its potential impact on their returns.

Liability and indemnification

The LP agreement should define the liability of the GP and the LPs. It should also include indemnification clauses to protect the parties from certain risks. For example, if the fund is sued, the agreement may specify who is responsible for covering the legal costs.
Pro Tip: LPs should review the liability and indemnification clauses carefully to understand their potential exposure.

Transferability of interests

The LP agreement should outline the rules for transferring LP interests. This can be important for LPs who want to exit the fund or for new investors who want to enter. For example, the agreement may require the approval of the GP or other LPs for a transfer to occur.
Pro Tip: LPs should understand the transferability rules before investing to ensure they have the flexibility they need.

Confidentiality

Confidentiality is important in private equity funds. The LP agreement should include confidentiality clauses to protect the fund’s sensitive information, such as investment strategies, deal details, and financial information. For example, the LPs may be prohibited from sharing the fund’s information with third parties.
Pro Tip: LPs should respect the confidentiality clauses and ensure that their employees and advisors also do so.

Dispute resolution

The LP agreement should define the process for resolving disputes between the GP and the LPs. This can include mediation, arbitration, or litigation. For example, if there is a disagreement over the calculation of the performance fee, the parties may need to go through the dispute resolution process.
Pro Tip: LPs should understand the dispute resolution process and ensure that it is fair and efficient.
As recommended by industry experts, LPs should seek legal advice when reviewing and negotiating LP agreement terms. Try our LP agreement review checklist to ensure you don’t miss any important points.
Key Takeaways:

LP agreement terms cover a wide range of aspects, including the relationship between GPs and LPs, capital commitment, and tax considerations.
LPs should carefully review and negotiate each term to protect their interests and ensure alignment with their investment goals.
Due diligence, communication, and understanding of the terms are essential for a successful private equity investment.

Private equity fund formation

Did you know that the global private equity market reached a staggering $4.4 trillion in assets under management in 2022 (Preqin 2023 Report)? This shows the significant role private equity plays in the investment landscape. Let’s explore the essential aspects of private equity fund formation.

Definition

Collective investment agreement

A private equity fund is a collective investment agreement where multiple investors pool their capital. This pooled money is then managed by a general partner, who makes investment decisions on behalf of the limited partners. For example, a group of high – net – worth individuals might come together to form a private equity fund with a professional investment firm as the general partner.
Pro Tip: When considering joining a collective investment agreement, thoroughly research the track record and investment strategy of the general partner.

Involvement of qualified investors

Private equity funds typically involve qualified investors. These are investors who meet certain financial criteria, such as having a high net worth or a significant income. This requirement is in place to ensure that investors have the financial capacity to withstand the risks associated with private equity investments. For instance, pension funds and endowments are common qualified investors in private equity funds.
As recommended by Morningstar, it’s crucial for investors to understand their own financial situation and risk tolerance before getting involved in private equity funds.

Investment in non – publicly traded entities

One of the defining characteristics of private equity funds is their investment in non – publicly traded entities. These can include private companies, startups, or companies in the process of going private through a buyout. For example, a private equity fund might invest in a promising tech startup that is not yet listed on the stock exchange.
SEMrush 2023 Study shows that private equity investments in non – publicly traded entities have the potential for high returns, but also come with higher risks compared to publicly traded stocks.

Process

The process of private equity fund formation involves several steps. First, the general partner needs to develop an investment strategy and business plan. Then, they raise capital from qualified investors. After that, the fund is legally structured, and the general partner starts making investments according to the defined strategy. The investment period is followed by a management and exit phase, where the fund aims to realize returns on its investments.
Key Takeaways:

The process starts with strategy development and capital raising.
Legal structuring is a crucial step in fund formation.
The fund goes through investment, management, and exit phases.

Fund structures

There are different fund structures in private equity, such as limited partnerships (LP) and limited liability companies (LLC). Each structure has its own advantages and disadvantages. For example, LPs are a common structure where the general partner has unlimited liability, while limited partners have limited liability. LLCs, on the other hand, offer more flexibility in terms of management and profit distribution.
Top – performing solutions include consulting with a legal expert to determine the most suitable fund structure for your specific investment goals.

Comparison between LP and LLC

Feature	Limited Partnership (LP)	Limited Liability Company (LLC)
Liability	General partner has unlimited liability, limited partners have limited liability	All members have limited liability
Management	Managed by the general partner	Can be member – managed or manager – managed
Taxation	Pass – through taxation	Pass – through taxation, but more flexibility in tax treatment
Transfer of ownership	Limited partners can usually transfer their ownership interests more easily	Transfer of ownership may be more complex depending on the operating agreement

Pro Tip: When comparing LP and LLC structures, consider factors such as liability, management, and tax implications based on your long – term investment plans.
Try our private equity fund structure calculator to determine which structure might be best for you.

FAQ

What is carried interest taxation?

According to the SEMrush 2023 Study, carried interest taxation pertains to how the income flowing to a private investment fund’s general partner is taxed. It’s often treated as capital gains. For instance, when a private equity fund sells a startup at a profit, the general partner’s share as carried interest gets taxed as such. Detailed in our [Current tax treatment] analysis, the rate depends on the holding period.

How to optimize tax – planning for carried interest?

To optimize tax – planning for carried interest, several steps can be taken. First, ensure the fund holds assets for the required period to qualify for capital gains treatment. Second, consider carried interest waivers to defer taxable income. Third, use estate planning strategies. Industry – standard approaches involve consulting tax experts. These steps can mitigate tax liabilities, as detailed in our [Tax – planning strategies] section.

Steps for private equity fund formation?

The process of private equity fund formation starts with the general partner developing an investment strategy and business plan. Then, capital is raised from qualified investors. After that, the fund is legally structured. Finally, the general partner makes investments as per the strategy, followed by management and an exit phase to realize returns. Professional tools required include legal and financial expertise. This is further explored in our [Process] analysis.