A private equity fund makes investments in businesses on behalf of individuals and institutions. The fund operates privately, meaning it does not sell shares to the public. A general partner manages the fund, while limited partners, or LP, actually contribute the money invested by the fund. These "unit holders" earn a steady share of partnership income and must declare that income to the Internal Revenue Service.
The IRS and Partnerships
Limited partnerships sell shares or "units" to their partners. They do not pay income tax directly on their earnings, as they "pass through" this income to the unit holders. The IRS requires limited partnerships to file annual reports of their income on Form 1065, Return of Partnership Income. This is similar to a business tax return, on which the partnership reports its income and expenses.
IRS Schedule K-1 reports each partner's share of the taxable earnings, which can include investment interest, dividends, rentals, royalties and capital gains or losses on the sale of assets. The share of income is allocated to each partner according to that partner's percentage of ownership. The partner may not have actually received the income, but she must still report her share each year as the organization earns the money. The K-1 is also filed with the IRS and includes several different categories of taxable income as well as deductions.
If a unit holder receives a distribution from the partnership, the IRS will not levy tax on that distribution if it equals the partner's share of the organization's income as reported on the K-1. If the distribution is greater, the IRS views that as a return of your original investment. While that money is not taxable, the distribution lowers the basis, or original cost, of the units you purchased. Therefore, it contributes to the capital gains you will realize when you finally sell those units, and capital gains are taxable.
Cash Flow and Capital Gains
When you invest in a limited partnership, you're actually investing in the cash flow generated by its businesses. This money is what flows back to you as an investor, and it may exceed the "share of partnership income" reported to you on the K-1. The management of the group will pay out the part of the cash flow that is "distributable." This term includes some accounting maneuvers -- such as including depreciation -- that increase the payout. There's definitely an advantage to avoiding taxes on any surplus distributions, which will eventually become long-term capital gains and generally be taxed at a lower rate.
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