Coping With Clawbacks and Defaulting LP's

Joseph W. Bartlett, Founder of VC

Current Tax Issues (OID; § 305; Defaulting LPs)

Murray Alter, Tax Partner, New York Office, PricewaterhouseCoopers LLP, gave a first rate talk entitled, "Coping with Clawbacks & Defaulting Partners," at a recent VC Roundatable. To be considered for an invitation (these events are GP-only and by exclusive invitation, e-mail Herewith a summary of some of the tax issues (indeed, tax traps) Murray raised.

The first issue arises when a partner in a private equity fund defaults and the general partner elects to impose one of the typical penalties general partners typically command, as set forth in the partnership agreement. The general partner has the ability to haircut the defaulting limited partners' existing capital account, usually by fifty percent. The problem is that a recaptured capital account has to go somewhere . and, presumably, that means it goes to the remaining, non-defaulting limited partners pro rata in accordance with their existing capital accounts or capital commitments . all as the partnership agreement provides. However, if a capital account is transferred from Partner A to Partner B, the rule is generally thought to be that the transfer is taxable income to Partner B . phantom income, of course, at the time of the transfer but, nonetheless, taxable income. One way to postpone tax is to take the following return position, as described by Murray in his formal presentation.

"Forfeited capital: Capital forfeited by the defaulting partner and the reallocated to the GP/LPS, has a return position of not being income to the recipient partners. Under Sec 61, this is not income. The concern is that under 704(b) prior allocations of income may be held to lack substantial economic effect since distributions on the forfeited capital don't follow them. There is support for the position that this is not the case because 1.721-1b)(1) deals with compensation and this was not related to comp. Ideally, this is a transaction between defaulting partner and remaining partner where the remaining partners pay "0" for the forfeited interest."

A second way is to provide in the agreement that, in lieu of (or perhaps in addition to) the GP's right to haircut capital accounts in the case of a default, the defaulting limited partner is compelled to sell to one or more of the remaining limited partners her entire interest (including her capital account) for, say, $1.00. This is a penalty and, therefore, presumably it does not provoke a tax on the occasion of the purchase.

The second issue Murray raises is one that has been around for a while . i.e., the question of original issue discount, meaning in turn phantom income when a debt instrument is bundled as a unit with warrants. Bridge financings are quite popular in today's environment, the private equity fund investing in exchange for a note, sometimes a convertible note and/or a note bundled with warrants. Whether or not the warrants are well in the money (the exercise price of a penny per share, for example) or "at the money," meaning the exercise price is deemed fair market value per common share, a Black Scholes calculation comes up with a value for the warrants, which is then subtracted from the debt . and OID (original issue discount) tax results. The advantage of debt with warrants vs. convertible debt is that one can get, hypothetically at least, the debt repaid and keep the warrants. However, an inadvertent and unexpected tax impact on the fund's limited partners could be enough to tip the balance in favor of convertible debt.

The next issue has to do with FAS 150 vis-…-vis preferred redeemable at the option of the holder. The question is whether a preferred stock might be finally deemed a debt instrument for tax purposes, driven by the recent FASB pronouncement. If this is the case (and, of course, debt vs. equity is not a simple, one factor test), then the question which Murray addressed is whether, say, 3 x participating preferred stock redeemable at the option of the holder could be construed under I.R.C. Section 305 as entailing an unreasonable conversion privilege entailing in turn phantom tax to the holder. Murray did not think that FAS 150 would turn the tide, noting that the Service is more concerned with relabeling debt instruments as equity rather than equity instruments as debt.

Please, however, consult directly with Murray Alter on these issues raised in this Flash Report. He is the recognized guru on the questions. Note the 305 issue is a non-issue if the issuer does not enjoy earnings and profits.

To access Murray's discussion, VC Experts subscribers can go to and all hands are invited to contact Murray directly at PriceWaterhouseCoopers LLP, 1177 Avenue of the Americas, New York, New York 10036 (646- 394-2556) or