Private Equity

Private Equity Funds — Tax and Legal Guide for Sponsors and Investors

1. Typical fund structure (high level)

Most private equity funds are formed as pooled partnerships (a limited partnership or an LLC taxed as a partnership) with two primary classes of participants:

General Partner / Sponsor (GP) — manages the fund, sources and executes investments, and usually receives the management fee and the carried interest.
Limited Partners (LPs) — institutional and high-net-worth investors who make capital commitments and are passive for management purposes.

Legally the fund is the partnership entity, but for federal income tax purposes the partners (not the partnership) are subject to tax — the fund files an information return (Form 1065) and issues K-1s to partners showing each partner’s allocable share of income, gain, loss, deduction and credits. The partners then report those items on their own returns.

2. Steps in fund formation (practical roadmap)

Sponsor planning and capitalization — determine GP legal vehicle, sponsor economics (management fee, carried interest %, GP commitment), tax residence and blocking factors for cross-border investors.
Deal team and placement strategy — selection of target investor base, formation of placement materials (teaser, confidential information memorandum).
Entity formation — create the fund entity (LP or LLC), formation of the GP entity (often a separate management company and GP LLC), and formation of any feeder vehicles (US, offshore).
Drafting the LPA / LP Agreement (or Operating Agreement) — negotiate economics (capital commitments, management fees, carried interest), distribution waterfall, GP rights, GP removal, transfer restrictions, key-man provisions, clawbacks, indemnities, reporting and audit rights, side-letter terms.
Offering documentation and subscriptions — create private placement memorandum (PPM), subscription agreement and investor due diligence questionnaire; obtain accredited/institutional investor qualifications and execute subscription agreements.
Banking, custody, and service providers — engage administrator, custodian, auditor and counsel; set up capital-call mechanics and subscription lines (if used).
First close and capital calls — accept initial investor commitments (first close), begin investment period, make capital calls as deals are sourced and approved.
Ongoing governance and wind-up — investment management, value-creation activities, exits, final distributions, returns of capital, final reports, and final audit/clean-up and dissolution.

At formation, careful coordination among legal, tax and fund administration teams avoids structural mistakes that are costly later (e.g., undesired U.S. tax consequences for non-U.S. investors, or ambiguity in carried interest mechanics).

3. Tax basics — pass-through taxation and reporting

Because funds are typically partnerships for U.S. federal tax purposes, the partnership generally does not pay income tax; instead the partnership allocates taxable items to its partners and files an information return (Form 1065). Each partner pays tax on its allocable share, whether or not cash distributions are made. Partnerships with foreign partners must also consider withholding under §1446 and information reporting rules.

This pass-through taxonomy means that fund documents must support (and be consistent with) the intended tax allocations and reporting mechanics — e.g., allocations of taxable gains, tax credits, withholding obligations, and special allocations to the GP for carried interest.

4. What is “carried interest” and how is it taxed?

Carried interest (the “carry”) is the GP’s share of investment profits above a specified return to LPs — typically 20% of the fund’s profits after LPs receive a preferred return or return of capital. The carry is an economic allocation of partnership profits to the GP (often subject to vesting and clawback) rather than a conventional salary.

Tax treatment. Historically and under current U.S. federal law, carried interest that represents a share of the fund’s net capital gains is generally taxed to the recipient as capital gains, subject to the applicable long-term capital gains rate and the 3.8% net investment income tax (if applicable). Since the 2017 tax legislation, the relevant holding period for carried interest to qualify as long-term capital gain is generally three years for certain partnership interests (a holding period longer than the old one-year test). Whether carry qualifies as long-term capital gain depends on the nature of the underlying income realized by the partnership and the applicable holding period rules.

Practical notes:

Management fees and related compensation are ordinary income (not capital).
Carried interest is frequently the subject of proposed reform, but as of enactment of the One Big Beautiful Bill Act, Congress did not convert carried interest into ordinary compensation at the federal level; carried interest taxation remains a live public-policy discussion but unchanged in the new statute.

5. The distribution “waterfall” — mechanics and custom tiers

A private equity fund’s LPA normally sets out a waterfall — the prioritized sequence in which distributable cash and proceeds are returned to LPs and the GP. Typical waterfall stages (simplified):

Return of capital — return contributed capital to LPs.
Preferred return (hurdle) — pay LPs a fixed preferred return (e.g., 8% IRR) on invested capital.
Catch-up — allocate a disproportionate share of subsequent profits to the GP until the GP has “caught up” to the agreed economic split.
Carried interest split — thereafter split remaining profits (e.g., 80/20 LP/GP) — this 20% is carry.
Clawback / true-up at fund wind-up — final reconciliation that may require the GP to return previously distributed carry if LPs did not receive agreed economics over the life of the fund.

Waterfalls can be deal-by-deal, fund-wide, or hybrids, and are often defined using IRR hurdles, multiples of invested capital (MOIC), or both. The LPA must precisely align the waterfall with tax allocations and timing so that the taxable allocations reflected on K-1s mirror the economic distributions (or are otherwise defensible under §704(b)/(c) rules).

6. Private equity LPA features that differ from operating-company partnership agreements

A private equity LPA routinely includes fund-specific provisions you won’t typically find (or won’t find in the same form) in a standard operating partnership agreement:

GP commitment and lock-ups — sponsor invests a carried interest and a GP capital commitment (usually 1–5%).
Management fee and fee offsets — annual fee based on committed or invested capital with defined offsets against transaction fees or monitoring fees.
Carried interest mechanics — detailed carry percentages, vesting, allocation mechanics, tax distribution clauses to help GP meet tax liabilities, and clawback provisions.
Capital call / default mechanics — strict subscription and default rules (e.g., dilution or penalty interest for uncured defaults).
Investment period and recycling — defined period (commonly 3–5 years) for making new investments and rules for recycling returned capital.
Key-man and concentration limits — triggers if named managers leave or investment concentration thresholds are exceeded.
Side letters and investor-specific concessions — preferential reporting, fee caps, or advisory seats provided to specific LPs (and the need to manage pari passu concerns).
Exit/third-party approval and co-investment rights — co-investment windows for LPs and transfer/assignment restrictions to preserve LP base.

Because private equity funds revolve around pooled investment economics and exit-timing, the LPA is more prescriptive about distributions, investor protections, and GP economics than an operating partnership agreement for a running business.

For tax and operational reasons, the LPA should also set out how taxable items (capital gains, dividend-equivalent income, section 1231 gains, ordinary income items) will flow through and how the fund will treat tax distributions (i.e., cash to cover estimated taxable allocations). Cooley+1

7. Key tax and administrative considerations for funds

K-1 timing and accuracy — fund tax accounting and cost basis tracking must be carefully administered; late or inaccurate K-1s create investor reporting headaches.
Withholding for foreign investors — funds with non-U.S. partners generally must withhold on effectively connected income under IRC §1446.
Form of carry allocation and tax character — verify whether carry is structured as a profits interest (often capital gains) or as a capital account allocation that generates ordinary income (rare but possible depending on the facts and drafting).
Clawbacks and tax gross-ups — LPs and GPs negotiate the mechanisms to unwind excess carry distributions in final fund settlement.
Valuation and unrealized gains — interim allocations can create book-tax differences, and the fund’s valuation policy affects tax reporting and estimated tax distributions.

8. What the One Big Beautiful Bill Act (OBBBA) changed (and did not)

The OBBBA (signed into law in 2025) contains several provisions relevant to partnerships and private funds:

Qualified Business Income (§199A) — the bill made the §199A deduction permanent and adjusted certain phase-in ranges and thresholds, providing more planning certainty for pass-through investors. This permanence and threshold adjustment can affect sponsor and investor planning where QBI rules apply.
Partnership-specific changes — the Act included at least one partnership-specific technical change (e.g., recharacterization mechanics under §707 dealing with disguised sales or related party payments), which is self-executing and affects certain partnership payments’ characterization. Practitioners should review these modified §707 mechanics for fund structuring and side-letter arrangements.
Carried interest — the Act did not materially change the federal tax character of carried interest (i.e., carried interest continues to be taxed as capital gain where applicable). Proposed major reforms to reclassify carry as ordinary compensation did not become law in the final Act. Fund sponsors should however continue to monitor legislation and state-level developments that may affect treatment in particular jurisdictions. Cohen & Company

Because OBBBA also extended or made permanent many TCJA-era provisions, funds will want to revisit planning that depends on bonus depreciation, capital expensing, and QBI interplay with partnership income.

9. Practical tax-planning tips for sponsors and LPs

Design carry and vesting carefully — match legal carry vesting with tax allocations and capital account mechanics to avoid mismatch and later disputes.
Maintain paper trail for profits interest grants — if carry is issued as a profits interest, document the issuance to support capitalization and tax treatment.
Coordinate distribution waterfalls with taxable allocations — reduce mismatch between K-1 allocations and cash distributions where possible (or provide tax distributions to cover partner tax liabilities).
Consider §754 election in certain cases — if the fund expects significant secondary-market transfers or step-up planning for incoming partners, a §754 election may be appropriate to adjust inside basis for purchasers. (Note: §754 interplay was not a central change in OBBBA but remains a useful tool in many funds.)
Plan for foreign investor withholding — early withholding and Form W-8/B-K diligence reduces surprises. IRS
Model carry timing and tax outcomes — because carry is often capital gains (with a three-year holding period requirement for certain favorable rates), model investment hold periods and exit timing to optimize long-term capital gains treatment.

How Vanguard Legal PLLC can help

Vanguard Legal PLLC has experience advising fund sponsors, managers and institutional investors on:

Fund formation and choice of entity (U.S. LP/LLC, feeder structures, offshore feeders),
Drafting and negotiating LPAs and related subscription and side-letter documentation,
Designing carried interest mechanics, distribution waterfalls, clawbacks and GP economics,
Coordinating with tax counsel and auditors on complex partnership allocations, §199A/QBI planning and withholding obligations, and
Advising on the operational and regulatory intrafund matters that affect tax outcomes and investor relations.

We work with your tax accountants to model after-tax economics for sponsors and LPs, ensure documentation supports intended tax results, and help implement elections or procedures (e.g., §754, tax distributions, withholding regimes) required by the fund’s investor base.

Vanguard Legal also assists Texas-based portfolio companies with daily corporate operations, contract negotiation, employment matters, and risk mitigation—delivering efficient, cost-effective solutions that align with business goals.