Understanding Partnership Accounting
Understanding Partnership Accounting
Understanding Partnership Accounting
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is Advent Software, Inc. 301 Brannan Street, San Francisco, CA 94107
ISBN: 0-931187-01-X
Part number: PARTUPA2ED
Publication date: March, 2002
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4 Understanding Items of Profit and Loss ............................. 67
What Are Allocation Items? .................................................................... 68
Realized Gain (Loss) Items ...................................................................... 70
Unrealized Gain (Loss) Items .................................................................. 76
Management Fee Items ........................................................................... 77
Other Income and Expenses Items ......................................................... 83
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7 Allocating Layered Gains ................................................. 143
Understanding Tax Lot Layering .......................................................... 144
How Capital Changes Affect Layered Gains ........................................ 147
Allocating Layered Section 1256 Gains ................................................. 150
Allocating Layered Hot Issue Gains ...................................................... 152
Ceiling Rule: Tax Lot Layering Allocation ........................................... 154
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11 Understanding Tax Issues .............................................. 219
Understanding Book To Tax Differences ............................................. 220
Understanding Wash Sales .................................................................... 223
Understanding Straddles ....................................................................... 228
Understanding Short Sales .................................................................... 231
Understanding Constructive Sales ........................................................ 233
Understanding Unrelated Business Taxable Income ............................ 235
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Welcome to
Understanding
Partnership Accounting
(Second Edition)
Welcome to the second edition of Understanding Partnership Accounting, the
investment partnership accounting guide from Advent Software®, Inc. and
the Financial Services Industry Group in the New York office of American
Express® Tax and Business Services Inc. Understanding Partnership Accounting
(Second Edition) discusses the accounting and legal services that investment
partnerships require. It also describes how investment partnerships allocate
the results of their investments to the partners, including tax reallocations
for performance fees, and other tax and reporting issues.
Important: This book is general in nature, and does not represent a legal or
procedural guide for creating an investment partnership, nor does it endorse
or suggest any practices or strategies for investment activity, or for
partnership accounting. Consult the appropriate tax, legal, and investment
professionals for these purposes.
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scalable, they are used by investment organizations of all sizes, from the
single financial planner managing several million dollars, to large enterprise-
wide firms with tens of billions of dollars under management. For more
information about Advent Software, please visit the corporate Web site at
http://www.advent.com.
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About Advent Partner
Advent Partner® is Advent Software’s partnership accounting and
management solution. Advent Partner helps to consistently and accurately
account for a partnership’s activity. Advent Partner also integrates with
Axys®, which tracks the partnership’s ownership in security investments.
Advent Partner provides a powerful, easy-to-use Microsoft®
Windows®-based graphical user interface, simple procedures, a variety of
reports, direct access to Axys files and processes, and helpful utilities.
Advent Software wishes to thank the following Advent Partner team
members who contributed to the research and writing of this guide: Kyle
Stadt, Alternative Investments Manager; Tom McGrath, Advent Partner
Senior Application Engineer; Chris Garner, Principal Writer; Geri Rebstock,
Senior Technical Writer.
For more information about Advent Partner, please contact Kyle Stadt at
(800) 685-7688 or kstadt@advent.com.
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Chapter 2, Setting Up An Investment Partnership, describes the
requirements of limited and general partners, as well as documents needed
to solicit investors and form the partnership; the accounting and tax services
partnerships require; and the legal considerations partnerships must address.
Chapter 3, Understanding Break Periods, explains how partners’ capital
contributions, withdrawals, and assignments create break periods, and how
partnerships record their income and update partners’ capital accounts each
period.
Chapter 4, Understanding Items of Profit and Loss, has been expanded
for this edition. It details how partnerships assign different kinds of income
and expenses to allocation items for tax and reporting purposes. New with
this second edition is a more detailed discussion of management fee
schedules, including examples.
Chapter 5, Understanding Economic Allocations, describes how
partnerships allocate income pro rata each period. It also describes non-pro
rata allocations for hot issues, side pocket investments, and other items.
Chapter 6, Allocating Aggregate Gains, has been revised for this edition.
It describes aggregate methodologies of allocating realized (capital) gains
and losses, including how Advent Partner allocates Section 1256 and hot
issue security gains. This edition includes a brief discussion of Aggregate
with Partial Netting, and an extensive example of Assumption 4.
Chapter 7, Allocating Layered Gains, describes the tax lot layering
methodology of allocating realized (capital) gains and losses, including how
Advent Partner allocates Section 1256 and hot issue security gains.
Chapter 8, Reallocating/Charging Performance Fees, has been
expanded for this edition. It describes the options available for structuring
performance fees, including payout percentages, hurdle rates, and highwater
marks, as well as how to perform a tax reallocation for performance fees.
New with this second edition is a discussion of equalization methodologies
that can be applied in offshore investment corporations.
Chapter 9, Contributing Securities, describes how partners can contribute
securities to partnerships in lieu of cash, and how partnerships handle the
built-in gains, amortization, and accrued interest associated with
contributed securities.
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Chapter 10, Understanding Distributions and Redemptions, explains how
partnerships can deliver out securities to partners in lieu of cash, as well as
Section 754 election and directed gains provisions to handle withdrawing a
partner’s share of appreciated securities.
Chapter 11. Understanding Tax Issues, describes other tax issues
partnerships must address, including book to tax differences, wash sales,
straddles, constructive sales, short sales, and UBTI.
Chapter 12, Understanding Partnership Performance, has been
expanded for this edition. It explains how partnerships calculate
performance, including reporting requirements, annualization, and the
effects of expenses, management fees, and performance fees. Additions to
this second edition include additional performance calculations and related
examples.
Understanding Partnership Accounting (Second Edition) also features a glossary
of terms used in partnership accounting and Advent Partner, including
several new terms. For more detailed information about chapter contents,
refer to the contents page at the beginning of each chapter.
Procedural Conventions
Procedural conventions help identify procedures and tasks to be performed.
❖ Important procedures are always organized as a numbered set of tasks.
❖ Check marks indicate a checklist of general items or tasks.
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Example Conventions
Most examples in this book use tables to organize information in
spreadsheet format. Tables in this edition include shading to highlight
information that is discussed in the example’s explanatory text.
Terminology
Understanding Partnership Accounting (Second Edition) uses the following
specific terminology.
Gain Profit on a securities transaction. Understanding Partnership Accounting
(Second Edition) uses “gain” generically to refer to both profits and losses on
securities transactions. Gain can be either realized (from closing a security
position); or unrealized (the change in market value on a held security
position).
Non-Gain Profits, losses, and expenses not attributable to the change in a
security’s market value. Understanding Partnership Accounting (Second Edition)
also uses the term “income and expenses.” Examples include: dividend
income and expenses; interest income, expenses, and accruals; management
fees; organizational expenses; investment, trade, and business expenses; and
amortization and accretion.
Partnership An “investment partnership,” generally a limited partnership
(or sometimes a limited liability corporation) formed for investment
purposes. More commonly referred to as a “hedge fund,” “privately offered
investment company” (by the Securities and Exchange Commission), or
“securities partnership” (by the Internal Revenue Service).
Performance Fee Compensation to the general partner of an investment
partnership for investment advisory services rendered. This generally is not
a “fee,” but rather a reallocation of a percentage of the partnership’s profit
for the year from the limited partners to the general partner, accomplished
through shifting the partners’ allocation percentages in favor of the general
partner. In offshore funds, performance fee can take the form of an expense
charged to the limited partner. In U.S. partnerships, performance fee may be
also referred to as “performance incentive reallocation,” “performance
reallocation,” or “incentive reallocation.”
For additional terminology, see the Glossary on page page 257.
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Different Types of Notes
When appropriate, notes provide additional information or warnings that
may apply to you. Understanding Partnership Accounting (Second Edition) uses
four types of notes. Each type serves a unique purpose, as defined below.
Note: A note with this format and the heading “Note” provides information
that applies to some users. Notes apply to special situations. For example, a
Note might explain a rule that only applies in certain specific situations.
Important: A note with this format and the heading “Important” provides
information that applies to all users. This type of note provides information
that is essential to the completion of a task. Unlike a Note, Important notes
should not be disregarded.
!
Caution: A note with this format and the heading “Caution” provides
important information that applies to all users. Pay special attention to these
notes.
q
Tip: A note with this format and the heading “Tip” provides useful
information that applies to most users. Although Tips are not essential to
the completion of a task, they provide alternative methods, shortcuts, or
special applications relating to the procedures in the text. All Tips are listed
in the index under the heading “Tips.”
The Advent Partner logo identifies sections that provide information about
Advent Partner and its functionality. These sections explain how Advent
Partner automates specific partnership accounting tasks, or highlight
features of the software.
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How to Learn More About Advent Partner
Advent provides many resources to help you get the most out of your
software. Read the following sections to find out what these resources are,
and how to access them.
Title
Print In your product shipment. You can take printed guides anywhere
Note: To order additional you go.
printed documentation, use
the Learning Products Order
Form on Advent Connection ➤
User Documentation.
xii
Advent Partner Help
As you work with Advent Partner, you can access Help for immediate access
to detailed, step-by-step instructions about Advent Partner tasks.
If you have not used Help before, and you’d like to learn how it works,
choose Help ➤ How to Use Help.
If you’re ready to use Help, follow these steps.
1 With Advent Partner open, press F1, or select one of the following options
from the Help menu.
Choose To
Contents and Index Display the Contents, Index, and Find tabs.
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The Advent Partner Readme File
The Readme file contains any late-breaking information about that became
available after the printed documentation was published. You can view the
Readme file at the end of the installation process, or by following these
steps.
1 Choose Start ➤ Programs ➤ Readme.
Note: If you cannot access the Readme file this way, you can use a text
editor, such as Notepad, to open the file Readme_p.wri, which is located in
your AdvPtr directory (Example: C:\AdvPtr\Readme_p.wri).
2 (Optional) To print the Readme file, choose File ➤ Print.
Advent Connection
Advent’s client Web site, Advent Connection, gives you access to the latest
technical information and support, user documentation, software updates,
training, and industry news. Just point your browser to http://
connection.advent.com/, or, from Advent Partner, choose Help ➤ Advent on
the Web ➤ Advent Connection. A site search feature makes it easy for you
to look up keywords, and find exactly what you need.
Note: The first time you go to Advent Connection, you’ll be asked to set up an
account. Have your Advent copy number and company information ready.
xiv
1 Understanding
Pooled Investment
Structures
This chapter identifies and explains the functions of an investment
partnership’s General Partner(s) and Limited Partner(s). Then, it
presents several different structures that investment partnerships can
take. Each structure is defined and accompanied by a logical,
graphical representation.
In This Chapter
The History of Investment Partnerships................................... 2
Organizing Investment Partnerships......................................... 5
Understanding Pooled Investment Structures .......................... 7
1 Understanding Pooled Investment Structures
Perhaps the single most significant change in hedge funds is the sheer size of
current funds. Relatively few funds operate in the multiple billions of
dollars, but many funds do operate in the hundreds of millions of dollars.
The increased liquidity of the investing public, the investing advantages
funds offer, and the availability of technology have brought more investors
to the hedge fund industry. Although still dwarfed by the mutual fund
industry, the hedge fund industry continues to grow, providing wealthy
individuals and institutions the opportunity to risk their capital in the
pursuit of financial gain.
Investing Advantages
Pooling customers’ funds in an investment partnership provides the
following advantages.
❖ The combined assets of a number of high net worth individuals can be
used to obtain more efficient and economical methods to borrow or
“leverage” cash and/or securities.
❖ Fund managers can direct their research to a particular style of investing.
❖ Investors can diversify their portfolios.
❖ As opposed to a mutual fund, an investment partnership is much more
fair in its allocation and distribution of taxable income.
❖ Managers’ compensation is not limited to a share of commissions or a
percentage of assets under management, but can be based upon a share of
profits.
❖ Depending on the fund, pass-through income/losses may be active or
passive, offering a number of approaches to tax planning.
Investment Strategies
Today, fund managers do not necessarily adhere to the “hedge”
methodology, but instead choose to invest in certain segments of the
investment market. The reasons for forming investment partnerships,
Fund of Funds
A “fund of funds” is a investment partnership whose portfolio consists
principally of investments in other investment partnerships rather than in
individual securities. By investing in multiple funds, the fund of funds
manager can blend the strategies of other fund managers, or pursue a
limited number of strategies based on the performance of those funds and
their managers. By offering these options, a fund of funds (the “investor”
fund) spreads the risk of participation in any one “investee” fund and
provides the limited partner investor with access to a greater number of
investment styles and objectives.
Occasionally, a fund of funds’ organizational documents may provide for the
ability to invest directly in securities. This usually occurs when it receives
securities as a distribution from one of its investee funds, and the investment
generally lasts for a limited period of time.
In a fund of funds structure, the investor fund views the investee fund as an
investment, and the investee fund views the investor fund as a partner. The
fees that an investee fund charges to its investor funds reduce the amount of
appreciation received by those that invest in the investor fund itself.
Therefore, the fees the investor fund charges to its investors are typically
much less than the standard 1% management fee and 20% performance fee
charged by other investment partnerships.
reduced fees
standard fees
Fund of Funds
Investee Fund Investee Fund
(Investor Fund)
Key:
•Solid lines denote investments.
•Dashed lines denote management and performance fees;
arrows point to the entity that receives the reallocated percentage.
Fund of Funds
Investee Fund investment investment Investee Fund
(Investor Fund)
Fund of Funds
Investee Fund partner
(Investor Fund) partner Investee Fund
Key:
•Solid lines denote the direction of monthly appreciation.
•Dotted lines denote the direction of yearly K-1 submissions.
One way for the investor fund to account for the taxable income allocation is
to use a “blended rate” method. This method calculates the percentage of
each individual investor’s share of economic income for the year compared
to the investor fund’s total economic income for the year. The investor fund
then applies that percentage to all elements of the combined taxable income
from all of its investee funds at the end of the year as reported on their
respective Schedule K-1s. The investor fund can allocate realized gains and
losses to investors using pro rata or aggregate methodology. For more
information on aggregate methodology, refer to chapter 6, “Understanding
Aggregate Methodologies” on page 110.
Offshore Funds
In addition to forming domestic limited partnerships, many fund managers
form “offshore” funds (offshore of the United States). Offshore funds are
usually formed as corporations, although they can also be formed as
partnerships. The investors in these funds are usually nonresident aliens but
may also be domestic tax-exempt organizations/investors. An investment in
an offshore fund does not subject the investor to U.S. tax reporting
requirements. U.S. tax-exempt organizations are generally not subject to
unrelated business taxable income (UBTI) on the activities of an offshore
corporation but would be taxed if the fund were a partnership. The
corporate form does not pass through tax attributes from its investments to
its shareholders.
Offshore funds use somewhat different terminology than U.S. investment
partnerships; and some accounting principles have different applications.
This table identifies the terms and principles and explains usage differences.
Term Definition
Term Definition
Gross Net Asset Value The total assets of a fund, class, or series minus its total
(GNAV) liabilities excluding performance fee.
GNAV per share The GNAV of a fund, class, or series divided by the number
of outstanding shares.
Highwater Net Asset Value The amount that the GNAV of a class or series must exceed
(HNAV) before a performance fee can be charged.
HNAV per share The HNAV of a fund, class, or series divided by the number
of outstanding shares.
Net Asset Value (NAV) The total assets of a fund, class, or series minus its total
liabilities including the impact of the performance fee.
NAV per share The NAV of a fund, class, or series divided by the number
of outstanding shares.
the fund’s NAV. In other words, the partner in a U.S. investment partnership
incurs performance fee based on already allocated profit, but the
shareholder in an offshore fund incurs performance fee based on the
number of shares it holds in proportion to the total number of shares
purchased. Depending on when the offshore shareholder subscribes to the
fund, it may incur performance fee even if it makes no profit or takes a loss
on its investment. To offset this inequity, an offshore fund may utilize a
method of equalization when calculating and charging performance fee. For
more information on equalization, see “Performance Fees in Offshore
Funds” on page 177.
Offshore funds are typically set up in tax haven countries such as Bermuda,
the Cayman Islands, the British Virgin Islands, the Netherlands Antilles, or
Luxembourg, all of which grant tax holidays to the funds.
There are a number of structures an offshore fund can take, including side-
by-side and master-feeder. These two structures are explained below.
Investment
1% mgmt. fee Manager 1% mgmt. fee
U.S. Domestic Offshore
Limited Partnership (advisor for 20% perf. fee Corporation
both sides)
fund taxed as a U.S. partnership, the U.S. limited partnership will receive
“pass-through” treatment for its share of the master-feeder’s income.
For a master-feeder with both U.S. and offshore feeders, there can be a
number of tax-related complexities with advantages and disadvantages on
both sides. The advantages include the following.
❖ The master-feeder structure reduces trading costs because there is no need
to “split” trades into tax lots.
❖ The general partner’s performance fee will be able to maintain the
underlying fee attributes from onshore feeders.
❖ The fund’s combined assets can be used to obtain greater financing
benefits (for example, greater leverage or lower interest rates).
The disadvantages include:
❖ An offshore fund is generally subject to 30% withholding tax on U.S.
dividends. If a fund tries to avoid such transactions, it incurs increased costs
that it otherwise would not experience.
❖ Investing strategies may not offer advantages to all investors at all times.
For example, long term capital gain is beneficial for U.S. participants but
taxes are not a concern of offshore participants, so investing at the master
level may create conflicts.
❖ Some investment types, such as REITS and mutual funds, are not
appropriate for offshore investors but have no consequences for U.S.
investors.
❖ Allocations (such as hot issue versus non-hot issue) and tax accounting can
become cumbersome, negating the time savings gained from easier trade
administration.
The structure of a master-feeder fund with U.S. and offshore feeders is
shown below.
Key:
•Solid lines identify the direction of contributions/subscriptions.
•Dotted lines represent fees and identify the entity to whom the expense is charged.
•Dashed lines represent fees and identify the entity that receives the reallocation.
In order to protect its interest, the PE/VC fund will generally place a
representative on the investee company’s board of directors. The fund’s only
sources of information may come from board meetings and informal
discussions with management.
A PE/VC fund’s investments may take on different forms, such as common
stock, preferred stock that may be convertible, or debt that may be
convertible. These investments are usually accompanied by warrants, which
are out of the money at time of issuance but are expected to appreciate over
time.
Limited Partner(s) General Partner(s)
Privately Held
Company
Key:
•Solid lines denote investment commitments (capital calls).
•Dashed lines denote fees and identify the entity that receives the reallocation.
Due to the nature of the holding period for investments, most PE/VC funds
are “lock-ups.” This means that they include only the original partners who
joined at the time the fund was formed and that these partners do not have
withdrawal rights. When a fund is formed, each investor agrees to
contribute a specific sum to the fund over a specific period of time, and this
becomes its capital commitment. During the life of the fund, the fund
manager will occasionally call a percentage of the commitment. A capital
call usually occurs when the fund is contemplating a new investment, to
earmark the call’s proceeds for the acquisition. The capital call may also
occur at predetermined dates as specified in the fund’s offering documents.
In This Chapter
Forming an Investment Partnership .......................................22
Investment Company Act of 1940...........................................24
Investment Partnership Documentation ................................26
Accounting and Tax Issues......................................................34
Partnership Classification ........................................................41
Other Legal Issues ...................................................................43
2 Setting Up An Investment Partnership
Team Required
The team required to form and manage an investment partnership consists
of a general partner, an attorney, and an accountant. Additionally, most
investment partnerships utilize the services of a prime broker.
❖ General partner: The general partner is the partnership’s responsible
party. The general partner establishes the policies that the fund will follow,
and sells limited partnership interests to investors. Often, the general
partner has only an idea of the kind of fund to be formed and an investment
philosophy and approach. The experienced accountant and attorney then
review the various issues that the general partner must address and assist
in making specific determinations.
❖ Attorney: The attorney must understand the laws and regulations
regarding securities, partnerships, and taxation. The attorney translates
the general partner’s policies into a limited partnership agreement and, if
the general partner is offering limited partnership interests to more than
a limited few investors, prepares an offering memorandum, a subscription
document, and any other required documents. The memorandum
summarizes the general partner’s objectives and the important provisions
of the limited partnership agreement, and identifies risks, tax, and other
important legal matters. For more information, see “Investment
Partnership Documentation” on page 26.
❖ Accountant: The accountant reviews the limited partnership agreement
and other partnership documents to ensure that:
❖ The documents express the general partner’s intent.
❖ The tax provisions are consistent with tax laws.
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Tip: If you manage your partnership’s investment portfolio(s) with Axys,
you can use Advent’s Rex™ automated reconciliation service to reconcile
with your custodians. For details, contact an Advent sales representative.
The remaining sections in this chapter discuss specific legal, tax, and
accounting issues involved in creating and running an investment
partnership.
Note: Funds with more than 100 partners must consider certain tax issues. In
particular, the IRS may consider the fund a publicly traded partnership (PTP).
A fund can rely on certain exceptions, or safe harbors, to avoid PTP status.
The fund should discuss issues related to the above matters with the
appropriate professionals, including its counsel.
Integration Rule
The SEC’s “Integration Rule” requires that, if a general partner manages
several funds with the same investing style and other substantially similar
characteristics, all of those funds’ beneficial interests count towards the 100
interests for the funds’ Section 3(c)(1) exemptions. However, a Section
3(c)(7) fund and a related Section 3(c)(1) fund are not integrated. A fund
manager can have a Section 3(c)(1) fund with a similar investment style to a
Section 3(c)(7) fund without counting the Section 3(c)(7) fund’s investors as
beneficial interests in the Section 3(c)(1) fund.
Section 3(c)(1) funds must also use a “look-through” test to determine the
number of beneficial interests of the fund. The fund must count all of the
beneficial interests of a limited partner as beneficial interests of the fund if
the limited partner:
❖ Is an investment company, or would be an investment company except
for its exclusion under Sections 3(c)(1) or 3(c)(7).
and
❖ Has an interest that exceeds 10% of the fund’s net assets.
The fund should consult counsel on this issue.
Investment Objective
The partnership’s investment objective addresses the following
considerations.
❖ The general partner’s investment philosophy and style of investing. For
example, it could state that the fund intends to:
❖ Hold a diversified portfolio.
❖ Hold a portfolio concentrated in one industry sector.
❖ Utilize leverage.
❖ The types of securities that the fund may, or may not, invest in, such as:
❖ Futures and forward contracts.
❖ Other investment partnerships.
❖ Fixed income securities.
❖ Distressed securities or “junk” bonds.
❖ Real estate.
❖ The investment parameters that the general partner intends to follow,
such as:
❖ Limits on the percentage of the partnership’s capital that the general
partner can invest in one issuer.
❖ The amount of leverage, if any, that the general partner can employ.
❖ The amount of assets, if any, that the general partner can allocate to
other investment advisers.
Management Fees
Investment partnerships typically pay a fee (called a “management fee”) to a
management company, which is usually an entity related to the general
partner. The fee is generally calculated as a percentage of each limited
partner’s capital (typically .75% to 2% annually), and is often collected
quarterly.
The management fee generally covers the overhead expenses of the general
partner, such as rent, computers, and personnel. Typically, the fund itself
bears direct expenses, such as professional fees and research.
For more information about allocating management fees, see “Management
Fee Items” on page 77.
Contributed Securities
The LPA specifies whether the partnership accepts contributions in kind;
that is, contributions of appreciated securities in lieu of (or in addition to)
cash. If the LPA allows investors to contribute securities, the accountant
should advise the general partner that generally, contributing securities is a
taxable event, with the contributing partner subject to tax on the difference
between the partner’s tax basis in the securities and their fair market value
on the date of the contribution. The IRS believes that the change in risk
resulting from exchanging securities for a partnership interest
(diversification) constitutes a taxable economic event.
The IRS provides guidance for determining when contributions diversify the
partner’s portfolio, triggering a taxable event. For details, see “When Are
Built-In Gains Taxable?” on page 191. For general information about
contributed securities, see Chapter 9, Contributing Securities.
Important: Include the appropriate professionals in any discussions
regarding non-taxability of contributed securities. From an accounting
viewpoint, the partnership must credit the contributing partner for the fair
market value of the contributed securities, less any charges for liquidating
the position (as provided for in the partnership agreement).
Capital Withdrawals
The LPA should provide for specific withdrawal dates (for example, on the
last day of any month, quarterly, semiannually, or annually). The general
partner limits the periods when limited partners can make withdrawals
because of investment considerations.
❖ Length of notice: LPAs should provide for a reasonable period of time for
the limited partners to give notice to the general partner to request a
withdrawal of capital. The general partner must consider the length of
time needed to liquidate positions to raise cash without adversely
impacting the performance of the fund or the balance of the fund’s
portfolio. Generally, 30 to 60 days is considered a reasonable period of
time.
❖ Full withdrawals: The LPA should permit full withdrawals from the fund
only at year end, so that the partnership can have audited financial
information from which to calculate a partner’s capital account. Funds
that permit full withdrawals do so subject to a retention amount.
Note: A full withdrawal in the form of cash from a partnership is a taxable
event to a partner, with gain or loss measured by the difference between
the cash distributed to the partner and the partner’s tax basis in the
partnership (generally, the unrealized gains in the partner’s capital
account). A withdrawing partner recognizes gain or loss in the year when
the partner receives the cash. If the partner receives cash for a December
31, 1998 withdrawal in January 1999, the partner recognizes gain or loss
in 1999. The partnership should advise a partner who fully withdraws, in
either the partner’s capital letter or a supplemental memo, that the
partner’s withdrawal is a taxable event.
❖ Retention amount: LPAs should allow the partnership to retain 10% to
20% of a withdrawing partner’s capital account balance in the fund. This
amount is not subject to market risk, and is distributed to the partner after
the partnership receives its audited financial statements and can verify the
partner’s final capital account balance. The partnership should calculate
the performance reallocation paid by the withdrawing partner as of the
Valuation of Securities
Investment partnerships account for their portfolio of securities on a
market-value basis (mark-to-market). The methods of valuation should
follow the provisions of the LPA and conform with generally accepted
accounting principles as outlined in paragraphs AAG-INV 2.27-2.34 of the
AICPA’s Investment Company Guide, which provides basic methods of
valuing securities.
Reports to Partners
The LPA should provide for the partnership to send an annual audited
financial statement to each partner along with a schedule of the partner’s
capital account. Some agreements state that the partnership deliver these
reports, along with the related tax information, to limited partners by a
specified date.
The agreement should also provide for the preparation of the partnership
tax return and the forwarding of IRS Form 1065, Schedule K-1 and such
other information necessary for a partner to prepare a federal and (where
appropriate) state income tax return.
The LPA also generally provides for the general partner to send interim
information to the partners. Such information can be in the form of a letter
to limited partners, or interim financial statements. In practice, most
agreements do not specify the form of interim information, and general
partners typically send the letter form.
Fiscal Years
LPAs specify the year end adopted by the partnership. Investment
partnerships generally adopt a calendar year, but can elect to adopt a fiscal
Tax Elections
The LPA should contain a provision that authorizes the general partner to
make all tax elections permitted by the Internal Revenue Code. This
authorizes the general partner to make a number of minor elections in the
ordinary conduct of the partnership’s business. In addition, it authorizes the
general partner to make the Section 754 election. This election increases the
cost basis of securities the partnership holds by the amount of unrealized
appreciation paid to a withdrawing partner.
Important: Tax accounting for the Section 754 election can be extremely
complex and costly. Before a fund elects Section 754, the general partner
should speak with the appropriate professional to discuss its ramifications.
For information on how Advent Partner handles Section 754 election, see
“Electing Section 754” on page 209.
Directed Gains
If the partnership does not elect Section 754, the LPA usually includes a
provision that allows the general partner to allocate an amount of the
partnership’s taxable realized gains to a withdrawing partner, equal to the
amount of unrealized appreciation in the withdrawing partner’s capital
account. The general partner then allocates the withdrawing partner’s
unrealized gains to the remaining partners. For more information, see
“Directing Gains” on page 212.
!
Caution: It is currently unclear whether directed gains satisfy the
“substantial economic effect” test required of allocations by Internal
Revenue Code Section 704(b). Partnerships should exercise caution in
implementing directed gains.
Termination
LPAs generally provide for a specific life for the partnership. Such life should
be at least 20 years, unless special circumstances make a shorter period
meaningful.
LPAs typically provide for the dissolution of the partnership, or for a
substitute general partner, in the event that the general partner is unable to
perform its duties. The agreement also specifies that, in the event of
termination, the fund’s assets will be distributed in the to the following
individuals in the order listed.
1 Creditors of the partnership other than creditors who are partners.
2 Creditors who are partners.
3 Partners according to their capital balance ratios.
If the partnership has more than one general partner, the agreement should
provide for the continuance of the partnership when one general partner
withdraws, with the right of limited partners to withdraw when they receive
notice. Although not a part of the LPA, the partnership should also have an
agreement covering transfers or purchases of interests between general
partners (called a “buy-sell” agreement).
Other provisions may affect the accounting, tax reporting and
administration of the partnership. The accountant should read the entire
agreement to be sure that there are no other matters that cannot be
administered or that cause conflict.
Debit Credit
Other 50
Accounting Services
1 Reconciling due to/from broker balances and portfolio positions: The
broker reconciliation accounts for all cash activity within the fund,
including amounts due.
Chapter Title
4 Understanding Items of Profit and Loss
5 Understanding Economic Allocations
6 Allocating Aggregate Gains
7 Allocating Layered Gains
8 Reallocating/Charging Performance Fees
Dealers
A dealer is one who, like any other merchant, purchases securities and resells
them to the public for a profit. In theory, the dealer’s profit is the market
appreciation based on cost. Dealers:
❖ Are required to inventory their securities.
❖ Are not subject to the wash sale rules.
❖ Treat as ordinary income any gain or loss on the sale of their inventory of
securities.
Dealers are generally required to mark-to-market their dealer securities at
year end. Most hedge funds should generally not be classified as dealers.
Partnership Classification 41
2 Setting Up An Investment Partnership
42 Partnership Classification
Setting Up An Investment Partnership
2
precedent that is difficult to change. The partnership can include a
statement in its LPA or offering memorandum that it intends to be a trader,
but only its actual trading activity can determine its status.
Partnerships should analyze their actual trades executed during the year
with the appropriate tax and legal professionals to determine their status.
Whether the partnership’s assets are “Investment by Pension Plans and IRAs”
considered “plan assets” under ERISA on page 45.
Whether the partnership must file SEC “SEC Filings” on page 46.
form 13D
In 1998, the SEC amended rule 205-3 of the Advisers Act. The amended rule
provides that:
❖ A fund associated with a RIA can charge performance fees only to limited
partners whose partnership contribution is at least $750,000, or whose net
worth exceeds of $1,500,000. (These amounts were increased from
$500,000 and $1,000,000, respectively.)
❖ General partners can receive performance fees from individual partner
accounts on performance measured over a period of less than one year.
The Advisers Act also requires that a registered general partner provide
quarterly information to the limited partners. General partners normally
provide such information in their quarterly letters.
Finally, the Advisers Act provides that the fund may be subject to the
custody rules of Treasury Regulation Section 206 (4)-2. This regulation
provides for an annual surprise count (confirmation) of fund securities and
cash and an audit of the adviser’s financial statements.
Whether or not an investment partnership is subject to this provision is a
matter of legal interpretation. As an alternative to the count and the audit,
the fund can enter a “disbursement procedure agreement” with its broker(s)
or other persons who hold securities or funds of the partnership. Under such
an agreement, the custodian does not make payments of cash or transfer
funds or securities to the general partner or related entities unless an
independent representative issues an agreed-upon procedures letter
(commonly known as a “Bennett” letter) to the custodian.
Commodity Transactions
If a fund trades commodities, OEX options, futures, or other similar
investment items subject to the rules of the Commodity Futures Trading
Commission (CFTC), the general partner may be required to register with
the CFTC as a commodity pool operator. The fund then becomes a
commodity pool (CP), subject to additional disclosure and reporting rules
and position limits. A fund of funds investing in a partnership which is a CP
is also subject to CFTC rules. The CFTC can grant an exemption to full CP
reporting requirements, however. The fund’s attorney should advise it as to
the applicability of these rules.
SEC Filings
Any person or group that acquires over 5% of any class of equity securities
registered under the Securities Exchange Act of 1934 (Exchange Act) must
file Form 13D within 10 days after the acquisition. If a general partner
manages more than one fund, and those funds cumulatively acquire over 5%
of the securities, that general partner must file Form 13D. For details, see
Rule 13D-1 of the Exchange Act.
Circumstances that require a general partner to file a report on Form 13F
with the SEC include:
❖ Its fund(s) hold securities with an aggregate fair market value of $100
million or more on the last trading day of any month of any calendar year.
or
❖ It manages investments in total of $100 million or more.
The general partner must file Form 13F:
❖ Within 45 days after the last day of such calendar year.
and
❖ Within 45 days after the last day of each of the first 3 calendar quarters of
the subsequent calendar year.
Foreign Partners
If a foreign partner is a member of an investment partnership, the fund must
withhold tax on certain interest income earned and dividend income. The
partnership is deemed to have distributed interest and dividends to partners
quarterly, when it allocates such amounts to the partners’ capital accounts.
Partnerships must charge the withholding taxes to the affected partner’s
account, and transmit the withholding to the Treasury quarterly through
the depository system on Form 8109. The partnership must file Form 1042,
an information return, no later than March 15 of the following year.
The Internal Revenue Code and treaties between the United States and
other countries determine which items require withholding and the
In This Chapter
What Is a Break Period?...........................................................50
Understanding Capital Changes..............................................51
Recording Income and Expenses ............................................56
Recording Realized and Unrealized Gain/Loss ......................63
Interim and Final Periods In Advent Partner ..........................64
3 Understanding Break Periods
Tax lot layering “How Withdrawals Affect Layered Gains” on page 147.
Elect IRC Section 754 to adjust the cost basis of “Electing Section 754” on page 209.
securities.
Include a directed gains provision (also called a “Directing Gains” on page 212.
“stuffing” or “fill up” provision) in the
partnership agreement, to substitute realized
gain for unrealized gain.
During the break period, the partnership earns $100 in appreciation. At the
end of the period, the partners make the following capital changes.
❖ Partner A contributes $50 to the partnership.
❖ Partner B withdraws $25 from the partnership.
❖ Partner C assigns 30% of its interest in the partnership to Partner D
(30% X $125 = $38).
The partners’ new capital account balances and capital percentages are:
Partner
You can represent this formula as a line (called the accretion line) that begins
at the bond’s purchase date and original cost, and ends at the bond’s
maturity date and par value.
Example: The following diagram shows the accretion line of a coupon-
bearing bond that matures on 1/1/2015. The partnership purchases the bond
at 90 on 1/1/1997, then sells the bond on 1/1/2005 when the accretion line
has reached 94.
Par
e
on lin
Accreti
94
e
on lin
Accreti Partnership’s accretion
90
Recording Amortization
If a partnership purchases a taxable bond at a premium (that is, at a price
above the bond’s face value), the partnership can elect to adjust the cost
basis of the bond downward towards its par value until it sells the bond. This
process is called amortization. The partnership records the amount the bond
amortizes (that is, the difference between its original and adjusted cost) as
negative interest income.
Important: The IRS does not allow you to adjust interest income for
amortization on tax-free bonds, such as municipal bonds. You must adjust
the cost basis of these bonds, however, for purposes of calculating your
capital gain/loss when you sell them.
The amount by which the partnership adjusts the bond’s cost basis at any
time while the partnership holds the bond is shown in this formula.You can
Number of days in period the partnership holds the bond -
------------------------------------------------------------------------------------------------------------------------------------------------------- × Market premium
Number of days from the purchase date of the bond to maturity
represent this formula as a line (called the amortization line) that begins at the
110
Amort
izatio
n line
Partnership’s amortization
104 Amort
izatio
n line
Par
As of 1/1/2005, the bond has amortized from 110 to 104. The partnership
records this difference as negative interest income, and uses 104 as the
bond’s cost basis for determining capital gain/loss from the sale.
Note: Partnerships must use the “yield-to-maturity” method (sometimes
referred to as “scientific” or “constant yield”) to amortize the premium. For
demonstration purposes, however, this example uses “straight-line”
amortization.
Because the partners’ interests in the bond change with their capital
percentages, the partnership must allocate the amortization incrementally
each break period. When the partnership sells the bond, it subtracts the
bond’s adjusted cost basis from its sale price to determine the amount of
gain/loss it recognizes.
Example: On 2/1/1999, a partnership purchases a $10,000 bond that matures
on 1/1/2015 (5,813 days to maturity) at 110 ($11,000, or a $1,000 premium).
1 The break period when the partnership buys the bond ends on 3/31/1999,
59 days after it purchases the bond. The partnership records 59/5,813 ×
$1,000 = $10 of amortization and allocates it to the partners in this period
as negative interest income.
2 The next break period ends on 6/30/1999, 91 days after the end of the
previous break period. The partnership records 91/5,813 × $1,000 = $16
of amortization and allocates it to the partners in this period as negative
interest income.
3 The partnership sells the bond on 8/1/1999, 32 days after the end of the
previous break period, at 109.75 ($10,975). The partnership records:
❖ 32/5,813 × $1,000 = $5 of amortization, and allocates it to the
partners in this period as negative interest income.
❖ The difference between the sale price ($10,975) and the adjusted cost
($11,000 – $10 – $16 – $5 = $10,969) as $6 of realized gain.
Note: In the break period when the coupon payment actually occurs, the
partnership only allocates the portion of the payment that has not yet
accrued. If the coupon payment does not occur on the last day of the break
period, the partnership also allocates the amount of the next coupon
payment that accrues during the break period.
Example: On 2/1/1999, a partnership purchases a $10,000 bond with an 8%
coupon that pays on January 1 and July 1 (182 days in the current coupon
period, each coupon pays $400). The break period ends on 3/31/1999, 59
days after the partnership purchased the bond. The partnership must allocate
59/182 × $400 = $129.67 of accrued interest to the partners.
2 When the partnership sells the security, it allocates the realized gain as
follows.
❖ Aggregate methodology: The partnership allocates the realized gain
according to the partners’ aggregate account balances (which
represent their historical interest in the partnership’s unrealized gain),
or their current capital percentages, or both, depending on how the
partnership’s realized gains compare to its aggregate account balance.
❖ Tax lot layering methodology: The partnership calculates the gain
realized in the current break period (that is, the difference between
the price at the end of the previous period and the actual sale price),
and allocates it according to the partners’ current capital percentages.
The partnership then allocates the remaining realized gain according
to the partners’ interests in the security’s unrealized gain in historical
break periods.
Note: Aggregate and tax lot layering are the only two methodologies
approved by the IRS for allocating realized gains. The following chapters
describe these methodologies in more detail.
In This Chapter
What Are Allocation Items? ....................................................68
Realized Gain (Loss) Items ......................................................70
Unrealized Gain (Loss) Items ..................................................76
Management Fee Items ...........................................................77
Other Income and Expenses Items..........................................83
4 Understanding Items of Profit and Loss
Assigning individual Axys income and expense mapping income and expenses.
transactions to specific allocation items
Assigning allocation item amounts to Form 1065 mapping items to Form 1065/
and Schedule K-1 lines K-1 lines.
Reporting partners’ tax basis and capital accounts Partners’ Capital Balances report,
including items in tax basis.
Security See
Hot issue securities “Hot Issue Realized Gain (Loss) Items” on page 71.
Section 1256 contracts “Section 1256 Realized Gain (Loss) Items” on page 71.
Tax lot layering methodology “Allocating Layered Section 1256 Gains” on page 150.
❖ January 1, 1998
Market value of long positions $3,200
Cost of long securities $3,000
Unrealized gain $200
Market value of short positions -$1,150
Proceeds of securities sold short -$1,250
Unrealized gain $100
Total unrealized gain at 1/1/98 $300
GP $100,000 .55% 0% $0
Note: In this example, the allocation does not use the partners’ capital
percentages, but rather realigns the percentages of the partners participating
in the allocation to 100%.
The following examples demonstrate these two billing schedules, and the
affects of in contributions and withdrawals on each.
Partner A Partner B
Partner A Partner B
Dividends
Partnerships report income from dividends on Schedule K-1 (Form 1065), as
follows.
❖ Investor partnerships report dividend income on line 4(b), ordinary
dividends.
❖ Trader partnerships report dividend income on line 1, Ordinary income
(loss) from trade or business activities.
In addition, both trader and investor partnerships must report foreign
dividend income on line 17(c), Total gross income from sources outside the
United States.
(For details on trader and investor partnerships, see “Traders and Investors”
on page 41.)
Partnerships should create separate items for dividends from domestic and
foreign securities. This also allows partnerships to report foreign dividends
net and gross of withholding taxes. Partnerships can also create separate
allocation items for dividends that qualify for the dividends received
deduction (“DRD”), and dividends from hot issue securities (if they have
partners excluded from hot issue income).
Interest Income
Partnerships categorize interest income in a number of ways. Partnerships
can create four items to record interest income according to the tax
treatment of the interest, as shown in the table below.
Organizational Expenses
Investment partnership organizational expenses generally include:
❖ Legal costs to write the private placement memorandum (PPM), limited
partnership agreement (LPA), and related documents.
❖ Accounting consulting costs in connection with preparing the PPM and
LPA.
❖ Document printing costs.
❖ Advertising the formation of the partnership in a legal publication.
The partnership itself usually pays organizational costs, although in some
circumstances the general partner pays for all or part of the costs. The
Internal Revenue Code provides that partnerships can elect to amortize
organizational costs over a period of not less than 60 months. The
partnership must make this election on the first tax return it files. If the
partnership elects to amortize organizational costs for tax purposes, it
generally does so for accounting purposes as well.
In 1998, the AICPA issued Statement of Position 98-5, Reporting on the
Costs of Start-Up Activities. This SOP requires that “start-ups:”
❖ Expense organizational costs incurred after June 30, 1998 as incurred.
❖ Write off any unamortized start-up costs at the beginning of the fiscal year
in which they first adopt the SOP.
Investment partnerships are exempt from the second provision. Partnerships
should consult the appropriate professionals about adopting these
provisions going forward from June 30, 1998. Partnerships must capitalize
and amortize costs incurred prior to this date as fund assets.
Other Expenses
Other expenses of an investment partnership include:
❖ Accounting, auditing, and legal fees, generally paid directly by the fund.
❖ Management, investment advisory, administrative, and overhead fees,
paid either directly by the fund or to the general partner or a company
controlled by the general partner.
Note: In New York City, a fee paid to a general partner operating in the form
of a partnership or a limited liability company may result in the imposition of
New York City unincorporated business tax (UBT). A recent amendment to
the UBT law provides for segregating trading income (which is not subject to
UBT under certain conditions) from fee income (which is subject to UBT).
New York City general partners should have the fee paid to a separate entity
(such as a management company), in order to segregate the fee from the
trading income. Partnerships should consult an appropriate tax professional
when structuring this entity.
❖ Some partnerships do not pay investment advisory and administrative
fees. The general partner absorbs such expenses.
❖ If the partnership is on the accrual basis, and pays fees to any related entity
(such as a partner or a management company controlled by a partner) that
is on the cash basis, the partnership must pay those fees before year end.
This allows the partners who are charged to deduct the expense. Fees paid
to general partners that are considered guaranteed payments are
deductible in the year to which they are related.
Amortization
Section 171(e) of the IRC specifies that amortization of bond premiums be
treated as an offset to interest income, rather than an expense item. To
assign amortization to an allocation item, partnerships should either:
❖ Include amortization in the appropriate interest income item, or
❖ Create a separate amortization income item with a negative amount, but
include this item as an adjustment to ordinary income on their Schedule
K-1s.
For details about recording amortization, see “Recording Amortization” on
page 60.
Note: For municipal bonds, partnerships calculate realized gains based on
the bond’s adjusted cost (original cost – amortization), but the partnership
does not reduce its interest income for amortization.
Foreign Taxes
Partnerships should separately allocate taxes paid on investments in foreign
securities, such as withholding taxes, for Schedule K-1 (Form 1065), line 17e.
In This Chapter
What Are Economic Allocations? ...........................................90
How Do Tax and Economic Allocations Differ?.....................93
Allocating Hot Issue Gains ......................................................96
Allocating Side Pocket Investments ........................................98
Advent Partner’s Uneven Methodologies .............................100
5 Understanding Economic Allocations
Period Economic
Income
Total $70
2 Second Quarter
3 Third Quarter
4 Fourth Quarter
Partnerships must consider the following factors when selecting their gain
allocation methodology.
❖ Aggregate method may be more appropriate for funds that:
❖ Actively trade securities.
❖ Have a high rate of portfolio turnover.
❖ Do not hold many positions long-term.
❖ Layering method may be more appropriate for funds that:
❖ Hold securities long-term.
❖ Have a low rate of portfolio turnover.
The following chapters discuss these two gain allocation methodologies.
Issue
Hot
Issue
Non-hot
Issue
Hot
Issue
Non-hot
Issue
Hot
GP $100 4% $16 $16 15%
LP1 $500 $500 19% 33% $76 $33 $109 22%
LP2 $600 $600 23% 40% $92 $40 $132 22%
LP3 $1,000 39% $156 $156 16%
LP4 $400 $400 15% 27% $60 $27 $87 22%
Total $2,600 $1,500 100% 100% $400 $100 $500 19%
For details on how Advent Partner handles hot issue gains, see the following
sections.
Allocates hot issue gains with aggregate “Allocating Aggregate Hot Issue Gains”
methodology on page 138.
Allocates hot issue gains with tax lot layering “Allocating Layered Hot Issue Gains” on
methodology page 152.
Note: The partnership does not mark the side pocket investment to
market, so it does not record unrealized gains for the investment.
2 Limited Partner 3 joins the partnership on 1/1/1998. Later that year, the
partnership closes the side pocket investment, and realizes a $200 gain.
(The total proceeds is $250.)
Balance
Capital
Percentage
Capital
Allocation
Balance
Designated
Percentage
Designated
Allocation
Allocation
Return
Capital
Ending
GP $125 $120 8% $25 $5 10% $20 $45 36% $170
LP1 $500 $480 33% $99 $20 40% $80 $179 36% $679
LP2 $625 $600 42% $124 $25 50% $100 $224 36% $849
LP3 $250 $250 17% $52 - - $52 21% $302
Total $1,500 $1,450 100% $300 $50 100% $200 $500 33% $2,000
q
Tip: You can exclude a partner from an item (for example, a general partner
who does not receive dividends from hot issue securities) by:
❖ Partners A and B each receive 10% off the top, and participate in the
remainder.
❖ Partner C receives 10% off the top, but does not participate in the
remainder.
❖ Partner D receives no off-the-top allocation, but participates in the
remainder.
❖ Partner E, the general partner, is excluded from hot issue dividends.
C $2,000 8% 10% no
E $10,000 40% 0% no
C $10 $0 $10
D $0 $13.46 $13.46
E $0 $0 $0
q
Tip: You can exclude a partner from an item (for example, a general partner
who does not receive hot issue dividends) by allocating the partner a 0%
uneven percentage and not having the partner participate in the remainder.
❖ Partners A and B each receives 10% off the top, and participates in the
remainder.
❖ Partner C receives 10% off the top, but does not participates in the
remainder.
❖ Partner D receives no off the top, but participates in the remainder.
❖ Partner E, the general partner, is excluded from hot issue dividends.
C $2,000 8% 10% no
E $10,000 40% 0% no
C $10.00 $10.00
D $7.00 $7.00
E $0
Total $66.40
2 Calculates the total uneven amount as the item amount × the sum of the
uneven percentages.
3 Realigns the remaining (and participating uneven) partners’ economic
percentages to 100%.
4 Reduces the allocations to the remaining and participating uneven
partners by their realigned percentage of the total uneven amount.
5 Distributes the uneven amounts to the uneven partners, according to their
uneven percentages.
Example: A partnership has five partners. In allocating dividends:
❖ Partners A and B each receive 10% off the bottom, and participate in the
remainder.
❖ Partner C receives 10% off the bottom, but does not participate in the
remainder.
❖ Partner D receives no off-the-bottom percentage, but participates in the
remainder.
❖ Partner E, the general partner, receives no off-the-bottom percentage and
does not participate in the remainder.
C $2,000 8% 10% no
E $10,000 40% 0% no
In This Chapter
Understanding Aggregate Methodologies ............................110
Understanding Aggregate Assumptions................................112
Aggregate With Book Gains, Full Netting ............................120
Aggregate, Full Netting .........................................................128
Aggregate With Partial Netting ............................................133
How Capital Changes Affect Aggregate Accounts ...............133
Allocating Aggregate Section 1256 Gains..............................136
Allocating Aggregate Hot Issue Gains ..................................138
Ceiling Rule: Aggregate Allocation .......................................142
6 Allocating Aggregate Gains
1 The partnership allocates the current period’s book gains (realized gains +
change in unrealized gains) to each partner’s aggregate account according
to its tax percentages.
2 The partnership allocates realized gain according to the updated (called
interim) aggregate balances.
3 The partnership subtracts the partners’ tax allocations of realized gain
from their aggregate account balances.
For details, see “Aggregate With Book Gains, Full Netting” on page 120.
IF AND THEN
All Partners Have The Partnership’s
Aggregate
Beginning
Account Balance is
ASSUMPTION 1
IF AND THEN
All partners have The Partnership’s
Aggregate
Beginning
Account Balance is
ASSUMPTION 2
Positive beginning Less than the Realized gain or loss is first allocated
or interim account partnership’s net to each partner based on the
balances realized gain, partner’s proportionate share of the
partnership’s beginning account
Negative beginning Less than the balance, with any excess allocated in
or interim account partnership’s net accordance with the partner’s current
balances realized loss, economic percentage.
IF AND THEN
All Partners Have The Partnership
Realizes a Net
ASSUMPTION 3
Assumption 1
Allocate according to Assumption 1:
If
❖ The partnership realizes a net gain less than or equal to the partnership’s total
aggregate account balance.
Or
❖ The partnership realizes a net loss less than or equal to the partnership’s total
aggregate account balance.
Assumption 2
Allocate according to Assumption 2:
If
❖ The partnership realizes a net gain greater than the partnership’s total aggregate
account balance.
❖ The partnership realizes a net loss greater than the partnership’s total aggregate
account balance.
Assumption 3
Allocate according to Assumption 3:
If
Or
If And
Period 1
In the first period, the partnership records $20 of realized gain + $500 change
in unrealized gain = $520 book gain.
Because all of the partners’ interim aggregate account balances are positive,
and the amount of gain the partnership realizes ($20) is less than the
partnership’s total interim aggregate balance ($520), the partnership uses
Assumption 1 to perform its tax allocation.
According to Assumption 1, the partnership allocates the realized gain
according to the partners’ tax or interim aggregate percentages (Partner A:
20%; Partner B: 80%).
The following table shows the results of the period 1 tax allocation on the
partners’ capital and aggregate accounts.
Period 2
In the second period, a third partner (C) joins the partnership with a
contribution of $1,000. The partnership records $300 of realized gain + $0
change in unrealized gain = $300 book gain.
Because all of the partners’ interim aggregate account balances are positive,
and the amount of gain the partnership realizes ($300) is less than the
partnership’s total interim aggregate balance ($800), the partnership
performs its tax allocation using Assumption 1.
According to Assumption 1, the partnership allocates the realized gain
according to the partners’ aggregate percentages (Partner A: 19%; Partner B:
76%; Partner C: 5%).
The following table shows the results of the period 2 tax allocation
Period 4
At the beginning of the fourth period, Partner A contributes $500 to the
partnership. The partnership records -$200 of realized loss + $100 change in
unrealized gain = -$100 book loss.
Because all of the partners’ aggregate account balances are positive, and the
partnership realized a net loss, the partnership performs its tax allocation
using Assumption 3.
According to Assumption 3, the partnership allocates the realized gain
according to the partners’ tax percentages (Partner A: 20%; Partner B: 67%;
Partner C: 13%).
The following table shows the results of the period 4 tax allocation.
A $200 29%
B $200 29%
C $300 42%
Aggregate Gains
Percentage of
Allocation
Short-term Gain
Allocation
Long-term Gain
Percent
Tax
Total
A $200 .29 × $300 = $87 $287 28.7% .287 × -$200 = -$57 .287 × -$1,200 = -$344
B $200 .29 × $300 = $87 $287 28.7% .287 × -$200 = -$57 .287 × -$1,200 = -$344
C $300 .42 × $300 = $126 $426 42.6% .426 × -$200 = -$86 .426 × -$1,200 = -$512
Total $700 $300 $1,000 -$200 $1,200
Period 1
In period 1, the partnership records $20 of realized gain + $500 change in
unrealized gain = $520 book gain.
Because one or more partners’ aggregate account balances is zero, the
partnership allocates according to Assumption 4.
According to Assumption 4, because neither of the partners has a positive
aggregate account balance, the partnership allocates the realized gain
according to the partners’ tax percentages (capital percentages adjusted for
performance fees) (Partner A: 20%; Partner B: 80%).
The following table shows the results of the period 1 tax allocation on the
partners’ capital and aggregate accounts.
Period 2
In period 2, a third partner (C) joins the partnership with a contribution of
$1,000. The partnership records $300 realized gain + $0 change in unrealized
gain = $300 book gain.
Because one of the partners’ (C) aggregate account balances is zero, the
partnership performs its tax allocation using Assumption 4.
According to Assumption 4, the partnership allocates the realized gain to the
partners with positive aggregate balances (A and B), according to their
(realigned) aggregate percentages (Partner A: 20%; Partner B: 80%).
Because the partnership’s total aggregate balance exceeds the realized gain,
no gain remains to be allocated according to tax percentages.
The following table shows the results of the period 2 tax allocation.
Period 3
In period 3, the partnership records $600 of realized gain + $100 change in
unrealized gain = $700 book gain.
Because all of the partners’ aggregate account balances are positive, and the
realized gain ($600) exceeds the partnership’s total aggregate balance ($500),
the partnership uses Assumption 2 to perform its tax allocation.
According to Assumption 2, the partnership allocates realized gain up to the
partnership’s total aggregate account balance ($500) according to the
partners’ aggregate balances, then allocates the remainder ($100) according
to their tax percentages (Partner A: 16%; Partner B: 70%; Partner C: 14%).
The following table shows the results of the period 3 tax allocation.
Period 4
At the beginning of period 4, Partner A contributes $500 to the partnership.
The partnership records -$200 realized loss + $100 change in unrealized gain
= -$100 book loss.
Because all of the partners’ aggregate account balances are positive, and the
partnership realized a net loss, the partnership uses Assumption 3 to
perform its tax allocation.
According to Assumption 3, the partnership allocates the realized loss
according to partners’ tax percentages (Partner A: 20%; Partner B: 67%;
Partner C: 13%).
The following table shows the results of the period 4 tax allocation.
shares of unrealized gains, which in turn increases the taxable realized gains
allocated to the partners when the partnership sells securities.
Example: A partnership has three partners with capital balances and
percentages, and aggregate account balances, as follows.
Distributing Partner C’s aggregate account balance does not affect the
remaining partners’ capital balances or percentages; it only assigns them
more historical unrealized gains.
2 In period 2, the partnership records $200 of realized gain from Section 1256
securities, and allocates it as follows.
Notice that the net realized gain allocated in period 2 ($40 short-term +
$60 long-term = $100) matches the change in gain in period 2
($200 period 2 realized gain – $100 period 1 unrealized gain).
receives a 20% performance reallocation from all items (including hot issue
gains) each period. The partnership uses the aggregate with book gains, full
netting methodology.
In period 1, the partnership records $100 realized hot issue gain + $500
change in unrealized hot issue gain = $600 hot issue book gain.
1 The partnership allocates the $600 of hot issue book gain to the limited
partners, according to their economic percentages, realigned to 100%.
4 Because all of the partners’ hot issue interim aggregate account balances
are positive, and the total aggregate balance exceeds the amount of
realized gain, the partnership allocates using Assumption 1. According to
assumption 1, the partnership uses the partners’ aggregate percentages to
allocate the realized gain.
The following table shows the results of the tax allocation.
In This Chapter
Understanding Tax Lot Layering ..........................................144
How Capital Changes Affect Layered Gains.........................147
Allocating Layered Section 1256 Gains .................................150
Allocating Layered Hot Issue Gains......................................152
Ceiling Rule: Tax Lot Layering Allocation ...........................154
7 Allocating Layered Gains
2 In the second period, a third partner (C) joins the partnership, changing
the partners’ capital percentages to: A: 33%; B: 33%; C: 34%. The security’s
price rises $1 to $13, for an unrealized gain of $1/share × 100 shares =
$100. The partnership allocates this unrealized gain in the second layer as
follows.
3 In the third period, the partnership sells the security for $13/share, for a
realized (capital) gain of ($13 price – $10 cost) × 100 shares = $300. The
partnership allocates this gain as follows.
2 Allocates the second layer ($13 period 2 price – $12 period 1 price × 100
shares = $100 gain) to the partners according to their historical tax
percentages in period 2 (33% to partners A and B, 34% to Partner C).
3 Totals the partners’ layers of gain (including the current layer) to
determine how to allocate the $300 realized gain ($13 proceeds – $10 cost
× 100 shares = $300 realized gain).
If the partnership had allocated the realized gain according to the
partnership’s current tax percentages in the period when it sold the security,
their allocations would have been: A: $100; B: $100; C: $100.
Advent Partner allocates each period’s layers of unrealized gains to the
partners. When the partnership closes a security position, it must “reverse
out” these unrealized gains by allocating each partner a negative amount of
unrealized gain equal to the total of their historical layers of unrealized gain
in that position, excluding the current layer.
Example: In the prior example, Advent Partner would have allocated $133 of
unrealized gain to Partner A’s capital account ($100 in period 1, and $33 in
period 2). When the partnership sold the security in period 3, it would have
allocated $133 of unrealized loss to Partner A, to “reverse out” this unrealized
gain, at the same time that it allocated the partner $133 of realized gain.
A 25% 33%
B 35% 33%
C 40% 34%
When the partnership closes any security positions it held during periods 1
or 2, it allocates the layers of gain for those periods to partners A and B
according to their realigned percentages.
Important: The withdrawing partner is generally taxed on withdrawal in
excess of its tax basis as capital gains. If the partnership liquidates securities
to pay out the withdrawing partner in cash, or when it ultimately sells the
securities in which the withdrawing partner had a historical interest, those
taxable gains are allocated to the partners. Therefore, the partner’s
withdrawal effectively increases the tax burden on the remaining partners.
Chapter 10, Understanding Distributions and Redemptions, describes
several ways that partnerships can minimize this effect, as defined in their
partnership agreement.
C 33.3%
Notice that the $60 – $57 = $3 change in Partner A’s unrealized gain matches
the 5% assignment of Partner A’s $60 of unrealized gains in the security.
Example: A partnership has three partners with tax percentages: LP1: 25%;
LP2: 25%; GP: 50%.
1 At the end of period 1, the partnership records $200 of unrealized gain
from Section 1256 contracts, and allocates it as follows.
2 In period 2, the partnership records $300 of realized gain from Section 1256
contracts, and allocates it as follows.
Notice that the net realized gain allocated in period 2 ($40 short-term +
$60 long-term = $100) matches the change in gain in period 2
($300 period 2 realized gain – $200 period 1 unrealized gain).
q
Tip: If the partnership agreement also excludes the general partner from a
performance fee on hot issue gains, the partnership’s tax allocation of hot
issue gains uses the participating partners’ realigned capital (rather than tax)
percentages.
The general partner does not participate in hot issue gains, but receives a
20% performance fee from all items (including hot issue gains). The
partnership realigns the limited partners’ tax percentages as follows.
Layer
Partner Period 1 Period 1 Period 2 Period 2 Realized
Unrealized Adjusted Unrealized Adjusted Gain
Gain Unrealized Gain Unrealized
Gain Gain
Period 1
2 At the beginning of the second period, Partner C joins the partnership. All
three partners have equal economic percentages. The security’s price
drops to $12, at which point the partnership sells it. The realized loss in
period 2 is ($12/share sale price – $30/share previous closing price) × 100
shares = $1,800.
Period 1 Period 2
Partner Layer UGain RGain
A 1 $1,000 $1,000
2 -$600
Partner A Total $400
B 1 $1,000 $1,000
2 -$600
Partner B Total $400
C 2 -$600
Total for layer $2,000 $200
In This Chapter
Understanding Performance Incentive Reallocations...........158
Selecting Reallocation Dates .................................................159
Calculating Target Capital ....................................................163
Calculating Tax Percentages and Carve-Outs.......................169
Reallocating Profit Items.......................................................173
Performance Fees in Offshore Funds ....................................177
8 Reallocating/Charging Performance Fees
Understanding Performance
Incentive Reallocations
General partners of investment partnerships generally receive compensation
based upon the partnership’s performance. If the partnership’s performance
meets the provisions for incentive compensation in the limited partnership
agreement, the partnership “reallocates” to the general partner a portion of
the appreciation allocated to the limited partners.
As described in previous chapters, the performance incentive reallocation
(often called a “performance fee”) is not a separate allocation. Instead, it is
embedded in the tax allocation. The partnership decreases the capital
percentages of the limited partners subject to the reallocation, and increases
the general partner’s capital percentage, to “reallocate” the limited partners’
appreciation to the general partner. The adjusted percentages used in the tax
allocation are called tax percentages.
Partnerships usually perform their performance incentive reallocation at the
end of the fiscal year. If a limited partner withdraws capital at an interim
date, however, the partnership generally charges the withdrawing partner at
that time, based on its net appreciation on the date of its withdrawal.
Partnerships generally include a performance reallocation structure in their
partnership agreement. The sections in this chapter describe how to set up
and implement performance fees as follows.
❖ Reallocated appreciation retains its tax ❖ General partner taxed on the fee as
character (short-term, long-term, ordinary income.
ordinary, or non-taxable (unrealized).
Note: Except where noted, this chapter assumes that partnerships apply a
single performance fee structure to all of the limited partners, and that a
single general partner receives the performance reallocation. Partnerships
can, however, apply different structures to each partner, have several general
partners, or can allocate a portion of the performance fee to selected limited
partners (called “special limited partners”), as defined in their partnership
agreement.
✔ How frequently during the year the partnership performs the reallocation.
Advent Partner can also estimate fees for break periods when the
partnership does not charge a fee, in order to provide more accurate tax
estimates to the limited partners. For more information, see “Estimating
Performance Fees” on page 162.
Frequency
In order to prepare its Schedule K-1s, a partnership must perform a final
allocation for tax purposes at the end of its fiscal year (typically 12/31). Once
the partnership closes the period ending the fiscal year, it cannot reallocate
appreciation later to charge a performance fee. Therefore, most partnerships
charge their performance fee as part of the allocation for the last period of
their fiscal year.
Limited partnership agreements can also specify other performance
incentive reallocation dates, such as quarterly, monthly, or at every break
period. Because performance fees are part of an allocation of appreciation,
however, the charge date will correspond with a break period, even if no
other capital changes occur on that date, because charging the fee changes
the partners’ interests in the partnership.
The partnership, however, must reallocate the $20 performance fee out of
1999’s appreciation of $50. Therefore, the performance fee charged on
3/31/1999 is $20 / $50 = 40% of the appreciation out of which the
partnership reallocates the performance fee.
Days since
Capital balance ± Capital changes × 1 + Hurdle × ---------------------------
last charge-
after last charge since last charge rate Days in year
Days since
Current
× 1 + rate × ----------------------------
Contributions Hurdle last charge
highwater +
mark since last charge Days in year
proportionate effect upon that partner’s highwater mark and target capital
as follows.
Clawback Provisions
In addition to performance fee hurdle rates and highwater marks that set a
level of performance for the partnership, a partnership agreement can also
contain a clawback provision. Clawback provisions refund all or part of the
performance fee to the limited partners if the partnership’s profits fall below
a certain level.
✔ If the partnership has more than one general partner, or if any limited partners
also receive a portion of the fee, an agreement should be in place that
defines the percentage of the fee (called the carve-out) that each special
partner receives.
Economic × 1 – Payout
percentage percentage
After the partnership has determined the limited partners’ tax percentages
for the period, it can:
❖ Reallocate the performance fees on non-gain items from the limited
partners to the general partner. For details, see “Allocating Non-Gain
Items” on page 173.
❖ Allocate realized and unrealized gains using its chosen gains allocation
methodology.
❖ For aggregate methodology, see “Allocating Gains with Aggregate
Methodologies” on page 174.
❖ For tax lot layering methodology, see “Allocating Gains with Tax Lot
Layering” on page 175.
The partner is subject to a 10% × $100 profit above target capital = $10
performance fee charge. The partner’s tax percentage is ($200 profit – $10
performance fee) / $400 total partnership profit = 47.5%.
Assigning Carve-Outs
If the partnership has more than one general partner, each general partner
receives a share of the performance fee. The partnership must specify, in its
agreement or private placement memorandum, the percentages, or carve-
Methodology See
Tax lot layering “Allocating Layered Section 1256 Gains” on page 150.
For See
Tax lot layering “Allocating Layered Section 1256 Gains” on page 150.
q
Tip: Offshore funds use different terminology than U.S. investment
partnerships. Before reading this section, you may want to review the list of
terms in “Offshore Funds” on page 11. You can also consult the glossary on
page 257.
Offshore funds calculate and charge performance fees differently from U.S.
limited partnerships. Typically, an offshore fund is set up as a corporation.
Share- Subscrip. Beg Units Units Cap % Period 1 FY End Cap Accrued End Cap
holder Cap Purch. Held P&L P&L Before Perf. Fee After
Accrued Accrued
Perf. Fee Perf. Fee
A $100,000 $100,000 1,000 1,000 100% $400,000 $400,000 $500,000 *-$80,000 $420,000
B -- -- -- -- -- -- -- -- -- --
C -- -- -- -- -- -- -- -- -- --
Fund $100,000 $100,000 0 1,000 100% $400,000 $400,000 $500,000 -$80,000 $420,000
Total
*Shareholder A’s 1,000 units comprise 100% of the fund for period 1, so it accrues 100% of the performance fee.
Period 2
Share- Subscrip. Beg Cap Units Units Cap % Period 2 FY End Cap YTD End Cap
holder Purch. Held P&L P&L Before Accrued After
Accrued Perf. Fee Accrued
Perf. Fee Perf. Fee
B $420,000 $420,000 1,000 1,000 50% -$250,000 -$250,000 $170,000 $40,000 $210,000
Period 2
Share- Subscrip. Beg Cap Units Units Cap % Period 2 FY End Cap YTD End Cap
holder Purch. Held P&L P&L Before Accrued After
Accrued Perf. Fee Accrued
Perf. Fee Perf. Fee
C -- -- -- -- -- -- -- -- -- --
Fund $420,000 $840,000 1,000 2,000 100% -$500,000 -$100,000 $340,000 $80,000 $420,000
Total
Period 3
Share- Subscrip. Beg Cap Units Units Cap % Period 3 FY End Cap Charged End Cap
holder Purch. Held P&L P&L Before Perf. Fee After
Accrued Accrued
Perf. Fee Perf. Fee
C $210,000 $210,000 1,000 1,000 33% $200,000 $200,000 $410,000 -$33,333 $376,667
Fund $210,000 $630,000 1,000 3,000 100% $600,000 $500,000 1,230,000 -$100,000 1,130,000
Total
Equalization
There are a number of different equalization methods a fund can use. These
include, but are not limited to, performance fee deposits, multiseries shares,
and average performance fee. There may be variations on each method,
depending on the fund’s offering document.
The goal of each method is to more fairly administer the performance fee so
that it is based on the profit each shareholder/subscription earns, à la U.S.
partnership accounting.
This discussion focuses on the multiseries shares method, because it most
closely resembles U.S. partnership accounting and is one of the easiest
methods for investors to understand.
Period 1
Series Share- Sub- Beg Cap % Period FY End Cap YTD End Cap
holder scrip. Cap P&L P&L Before Accrued After
Accrued Perf. Fee Accrued
Perf. Fee Perf. Fee
1 B -- -- -- -- -- -- -- --
2 C -- -- -- -- -- -- -- --
Fund Total $100,000 $100,000 100% $400,000 $400,000 $500,000 -$80,000 $420,000
Period 1
1 B -- -- -- -- -- --
2 C -- -- -- -- -- --
Shareholder B joins the fund in period 2 and the fund creates a new series of
shares: Series 1. Shareholder B makes a subscription of $500,000 to purchase
1,000 shares of Series 1 at $500/share (the fund’s ending GNAV/share from
period 1). The fund has a loss of -$500,000 during period 2, so Shareholder
A’s period 2 loss is -$250,000 and Shareholder B’s loss is -$250,000.
Series 0’s GNAV ($250/share) exceeds its HNAV ($100/share), so it accrues
performance fee for period 2. Series 1’s GNAV ($250/share), however, is less
than its HNAV ($500/share), so it does not accrue performance fee for the
period. Series 0’s ending NAV is $220/share. Series 1’s ending NAV is $250/
share.
Period 2
Series Share- Sub- Beg Cap % Period FY End Cap YTD End Cap
holder scrip. Cap P&L P&L Before Accrued After
Accrued Perf. Fee Accrued
Perf. Fee Perf. Fee
2 C -- -- -- -- -- -- -- --
Fund Total $500,000 $1,000,000 100% -$500,000 -$100,000 $500,000 $30,000 $470,000
Period 2
2 C -- -- -- -- -- --
Shareholder C joins the fund in period 3 and the fund creates another new
series of shares: Series 2. Shareholder C makes a subscription of $250,000 to
purchase 1,000 shares of Series 1 at $250/share (the fund’s ending GNAV/
share from period 2).
The fund has a profit of $600,000 during period 3, so Shareholder A’s period
3 profit is $200,000; Shareholder B’s profit is $200,000; and Shareholder C’s
profit is $200,000.
Period 3
Series Share- Sub- Beg Cap % Period FY End Cap Charged End Cap
holder scrip. Cap P&L P&L Before Perf. Fee After
Perf. Fee Perf. Fee
Because the end of period 3 is also the fiscal year end, the fund charges
performance fee. With the equalization method, performance fee is
calculated at the shareholder/subscription level. Shareholder A pays a fee of
-$70,000, which is 20% of the $350,000 fiscal year profit from its Series 0
shares. Shareholder C pays a fee of -$40,000, which is 20% of the $200,000
fiscal year profit from its Series 2 shares. Notice that Shareholders A and C
are charged different fees because they had differing profits from the shares
in their series; Shareholder B is charged no fee, because it had a loss from its
Series 1 shares.
Because Shareholder C’s Series 2 shares have been charged a fee, they are
converted to (rolled into) Series 0 shares. To convert the shares, Shareholder
C’s ending capital of $410,000 is divided by Series 0’s ending NAV/share:
$410,000 / $380 = 1,078.947, so Shareholder C is given 1,078.947 shares of
Series 0. Series 0 now has a total 2,078.947 shares purchased (Shareholder C’s
conversion of 1078.947 plus the original purchase of 1,000 shares made by
Shareholder A); and Series 2 has 0 shares purchased.
Period 1 1,000
Period 2 2,000
Series Conversion
Period 3 3,000
Year End
In This Chapter
Accepting Contributed Securities..........................................190
Understanding Built-In Gains................................................191
Contributing Fixed-Income Securities ..................................195
9 Contributing Securities
✔ Record the price the contributing partner originally paid for the security
(called the security’s original cost).
✔ Record the security’s fair market value at the time the partner contributes
it (called the security’s contributed cost).
✔ Allocate the security’s “built-in” gains (the difference between its original
cost and contributed cost) separately to the contributing partner when the
partnership sells the security.
Methodology See
Tax lot layering “Ceiling Rule: Tax Lot Layering Allocation” on page 154.
The partnership records $2,200 in the partner’s capital account. When the
partnership sells the security:
Less than original The built-in gain to the contributing partner, and the difference
cost + built-in between the built-in gain and the actual gain (or loss) as a loss to
unrealized gain all of the partners in the partnership.
Less than original The built-in gain to the contributing partner, and the difference
cost between the built-in gain and the actual loss as a loss to all of
the partners in the partnership.
110 110
Partnership’s
realized gain
105 Amortizatio 105
n line
Partnership’s amortization
103
Par
Contributing
partner’s
built-in gain
e
on lin
91 Accreti
90 Contributing partner’s 90
accretion at contribution
110 110
Partnership’s
realized gain
105 Amortizatio Partnership’s amortization 105
n line
(allocated to contributing
partner or to all partners)
103
Par
Contributing
partner’s
built-in gain
94
e
on lin
Accreti Contributing partner’s
91 91 accretion in partnership
90 Contributing partner’s 90
accretion at contribution
In This Chapter
Understanding Distributions and Redemptions....................204
Distributing Securities ...........................................................205
Electing Section 754...............................................................209
Directing Gains......................................................................212
10 Distributions and Redemptions
Electing IRC Section 754 to adjust the tax basis of security “Electing Section 754”
positions by the withdrawing partner’s interest in them. on page 209.
Distributing Securities
Partnerships can distribute appreciated securities to fully liquidating
partners in lieu of cash. The partnership gives the withdrawing partner
securities with:
❖ A market value equal to the partner’s capital balance.
❖ Unrealized gains (market value – original cost) equal to or exceeding the
partner’s share of the partnership’s unrealized gains.
❖ Sells the security at a later date, it recognizes the proceeds of the sale –
$150 tax basis as realized gain/loss.
Distributing securities in lieu of cash allows both the partner and the
partnership to defer their tax liability from the withdrawal.
❖ The partner is not immediately better or worse off than if it had received
cash, although if it holds the security, it may gain a tax advantage from a
longer holding period, but also exposes itself to changes in the security’s
market value.
Note: If the partnership distributes a security that it has held for longer
than one year, the partner gains the advantage of automatically realizing
long-term capital gains when it sells the security.
❖ The partnership’s remaining partners are not taxed on the distribution of
securities in liquidation of the withdrawing partner’s interest, whereas
they would be taxed if they had to sell positions to generate the required
cash. The remaining partners’ interests in the distributed security “leave”
the partnership, but their interests in the partnership’s remaining securities
are realigned (to allocate the interests that the withdrawing partner “left
behind”), so that their total unrealized gain remains unchanged (assuming
that the unrealized gain in the distributed securities equals or exceeds the
unrealized gain in the withdrawing partner’s capital account). The
remaining partners are not taxed on this unrealized gain until they
ultimately withdraw or the partnership sells the securities.
1 At the end of the first period, the partnership allocates the $1,200 to the
partners according to their capital percentages ($400 each). This changes
the partners’ capital accounts as follows.
Tax Basis (from contribution) $100
Unrealized gain allocation $400
Capital account balance $500
other positions, the remaining partners will have a larger tax liability
for the realized gains ($850 instead of $800).
❖ Distributes position 3 to the withdrawing partner instead of cash, the
partner receives a greater amount of unrealized security gain ($450)
than the partner had in the partnership ($400). Because the
withdrawing partner’s tax basis of $100 becomes its basis in the
security, it is only taxed on $400 of the unrealized gain it withdraws.
When the partnership sells the other positions, the remaining
partners will have a smaller tax liability for realized gains ($750
instead of $800).
Partnerships’ distributions of property are subject to certain limitations,
including:
❖ The “anti-abuse” regulations in Treasury Regulations Sections 1.701-2.
These ensure that partnerships are formed for substantive business
purposes, and that the partners’ tax consequences properly reflect the
partnership’s economic activity.
❖ Partnerships cannot distribute securities if they have elected IRC Section
754.
❖ Partners must recognize gain upon the distribution of appreciated
securities that qualify under IRC Section 731(c) or Section 751(b).
For more information on these concepts, consult your tax advisor.
Note: If a partner withdraws completely from the partnership, the
partnership must adjust the remaining partners’ layers in the remaining
securities, or aggregate accounts, by the withdrawing partner’s interest in
them, as described in the following sections.
Tax lot layering methodology “How Withdrawals Affect Layered Gains” on page 147.
3 In period 2, the partnership sells the security at $22 per share, for a realized
gain of ($22 price – $13 adjusted cost) × 10 shares = $90 ($60 from period
1; $30 from period 2). The partnership allocates each remaining partner
$45 of realized gain.
Note: If the partnership had not elected Section 754, it would have
realized ($22 price – $10 cost) × 10 shares = $120 of gain ($90 from
period 1; $30 from period 2), and allocated each remaining partner $60 of
realized gain. The $30 of unrealized gain withdrawn by Partner A would
have been taxed again as realized gains allocated to partners B and C.
Change in unrealized gain attributable to the Sec. 754 Adjustment for UG754L
withdrawn partner’s interest in the security Unrealized Gain (Layering)
2 In period 2, the partnership sells the security at $22 per share, for a realized
gain of ($22 price/share – $10 cost/share) × 10 shares = $120 ($90 from
period 1; $30 from period 2). The partnership allocates:
❖ Layer 1 of realized gains (in which Partner A had an interest) to the
partners according to their unrealigned percentages.
❖ The remaining realized gains in layer 1 (Partner A’s interest) to the
partners according to their realigned percentages, as non-taxable
realized gains.
❖ Layer 2 of realized gains (in which Partner A had no interest) to the
partners according to their current percentages
❖ The security’s change in unrealized gains (-$90) in the same way that
it allocated layer 1 of the realized gains: -$60 for the remaining
partners’ unrealigned shares, and -$30 (Partner A’s withdrawn
unrealized gains) as a Section 754 adjustment item.
The partnership realizes $120 from the security, but only allocates $90 to
the remaining partners ($45 to each partner) as taxable realized gain. This
matches the remaining partners’ pre-withdrawal layers of gain from
period 1 ($60) plus their layers of gain from period 2 ($30).
Partner
Layer
Directing Gains
A directed gains provision (sometimes called a “fill-up,” “fill-down,” or
“stuffing” provision) in a partnership’s limited partnership agreement allows
the partnership to allocate realized gains to a withdrawing partner in place
of unrealized gains that the partner would otherwise withdraw. The
partnership reallocates realized gain equal to the amount of unrealized gain
that the partner would withdraw from the remaining partners to the
withdrawing partner. The partnership then:
❖ Credits the withdrawing partner’s unrealized gains to the remaining
partners’ capital accounts according to their current realigned tax
percentages.
!
Caution: It is currently unclear whether directed gains satisfy the
“substantial economic effect” test required of allocations by Internal
Revenue Code Section 704(b). Partnerships should exercise caution and
consult their tax advisors before implementing a directed gains agreement.
Important: The partnership cannot direct gains if it has elected Section 754.
The following table shows the partners’ capital accounts after the
partnership allocates period 3, but before Partner C withdraws:
The following table shows the partners’ capital accounts after the
partnership directs gains.
Note: If the holding period for security 3 is less than one year, but the holding
period for securities 1 or 2 (when the partnership sells them) is greater than
one year, directing gains effectively reduces Partner A and B’s tax burdens by
directing short-term capital gain to Partner C while directing long-term
realized gain to B and C.
Note: If the holding period for security 3 is less than one year, but the holding
period for securities 1 or 2 (when the partnership sells them) is greater than
one year, directing gains effectively reduces Partner A and B’s tax burdens by
directing short-term capital gain to Partner C while directing long-term
realized gain to B and C.
In This Chapter
Understanding Book To Tax Differences .............................220
Recording Tax Adjustments and Reversals...........................222
Understanding Wash Sales ....................................................223
Understanding Straddles........................................................228
Understanding Short Sales.....................................................231
Understanding Constructive Sales ........................................233
Understanding Unrelated Business Taxable Income ............235
11 Understanding Tax Issues
Item Amount
Several of the tax issues described in this chapter and elsewhere require
partnerships to enter tax adjustments or reversals. The following table
identifies these sections.
Adjustment See
Section 1233 short positions covered but “Covered Shorts Not Settled At Year End”
not settled at year end on page 231.
For more information about tax allocations, see “How Do Tax and
Economic Allocations Differ?” on page 93.
Date Amount
Notice that, when the partnership closes final for the year on 12/31, only the
12/5 deferral remains in effect: it has already reversed all of the other
deferrals. If the partnership only records those deferrals that affect its tax
returns (that is, are still open at year end), it would record the following tax
adjustment transactions for its dividend income allocation item.
Date Amount
The Internal Revenue Code Section 1091 requires that if a wash sale occurs,
the investor must defer recognizing the loss from the sell transaction. This
requirement is known as the “wash sale rule,” and it is designed to prevent
the investor from recognizing a loss for tax purposes while remaining in the
same economic (usually long or short) position.
When the partnership identifies a wash sale, it adds the amount of the
disallowed loss to the cost basis of the open position. Additionally, the
partnership treats the new position as though it were opened on the opening
date of the original position. This effectively defers the loss until the
partnership closes the open position that created the wash sale, and stays out
of that position for 30 days before or after the sale.
Notice that:
❖ Without a wash sale, this investor would have recognized a $1,000 loss in
1999, but still held the same position at year end. The investor has the
Example: In the following example, opening one new share creates a wash
sale. This represents 1 open share / 100 closed shares = 1% of the shares that
create the wash sale. In this case, 1% × $100 = $1 of the loss must be washed
into the cost of the open position, giving it a $2 cost for tax purposes, even
though its book cost is only $1.
The first sale, which creates a wash sale of $1,000 is absorbed into the gain
on the second sale (which exceeds the original loss). Consequently, only the
buy on 04/06/1999 creates a wash sale.
Example: The following example shows a loss followed by a gain.
.
Even though the first sell creates a wash sale, the second sell’s gains more
than offset it, so that the final buy does not create a wash sale.
Contributed Securities
The wash sale rules follow the security, not the entity that holds it.
Therefore, if a partnership receives a tax-free contribution of a security, it
must:
❖ Consider that security’s original cost basis (rather than its contributed cost)
when it closes the security, to determine whether it realizes a loss on the
security, and possibly triggers a wash sale when it opens another position
in the security.
❖ Count the contributed security among its open positions for determining
wash sales when it closes another position in the same security at a loss.
If the contribution is taxable, however, the contributing partner recognizes
any loss on the security, so if the partnership opens a position in the security,
it does not trigger a wash sale. The partnership must still count the
contributed security among its open positions if it closes another position at
a loss within 30 days before or after the contribution.
Important: Issues arising from wash sales involving contributed securities
are complex, and partnerships should consult the appropriate professionals.
Understanding Straddles
Internal Revenue Code Section 1092 defines a straddle as holding offsetting
positions in actively traded personal property. An “offsetting” position is one
Convertible bond Related equity (depending on the amount of the conversion premium)
Long equity swap Long put option and short call option on the same equity
The partnership treats the original position as if it had sold it at its fair
market value on the date it entered the offsetting position, that is, it
recognizes the realized gain at its fair market value at that time. When the
partnership closes the position, it reduces its gain (or increases its loss) by
the amount it has already realized.
Example: On 10/15/1998, a partnership opens a long equity position. On 11/
15/1998, the partnership opens a short position of the same security. The
market value of the long position on 11/15/1998 has increased $100 from the
partnership’s original cost (that is, the position has $100 of unrealized gain).
On 12/15/1998, the partnership sells the long position at $120 over its
original cost (that is, it realizes a $120 gain on the position). The partnership
must enter the following tax adjustments.
❖ On 11/15/1998, when the partnership opens the offsetting position:
❖ $100 to realized gain (to the increase in market value at the time of
the constructive sale)
❖ -$100 to unrealized gain
❖ On 12/15/1999, when the partnership closes the original position:
❖ -$100 to realized gain (so that the partnership does not count the gain
recognized from the constructive sale)
❖ $100 to unrealized gain
Note: A partnership does not need to record a constructive sale if it:
❖ Closes the offsetting position within 30 days after the end of the taxable
year.
and
❖ Holds the original position “naked” (without holding an offsetting
position) for 60 days after closing the offsetting position.
In This Chapter
Calculating Partnership Performance ...................................240
How Expenses and Fee Reallocations Affect Performance ..246
Differences in Tax Performance Between Partners ..............249
Disclosures and Issues to Consider When Reporting
Performance ..........................................................................255
12 Understanding Partnership Performance
1 2.75% 1.0275
3
1.25%
(2%)
1.0125
.98
} 1.95%
$20.00 profit
$0.00 profit
For the first period, the capital account had $20 profit; for the second period,
the account had $0 profit, so the total profit for the two periods is $20.
The account’s ACB for the year is: 100 + (100,000 × (183 / 365)) = 50,237
($50,237.00).
The account’s ACB IRR for the year is: $20 / 50,237 × 100 = .0398%.
Compare a TWR calculation for the same year: the account’s SRR for the
first period is 20%, and reduced to a multiplier of 1.2. The SRR for the
second period is 0%, reduced to a multiplier of 1.0. Therefore, the
calculation is: ((1.2 × 1.0) – 1) × 100 = 20%.
$20.00 profit
$0.00 profit
$20.00 profit
$0.00 profit
The account’s ACB for the year is: 100 + (100,000 × (183 / 365)) = $50,237.
The account’s ACB IRR (gross of fees) for the year is: $20 / 50,237 ×
100 = .0398%.
For a “net of fees” calculation, the performance fee is subtracted from the
partner’s profit. Therefore: $20 × .20 = $16.
and the account’s ACB IRR (net of fees) for the year is: $16 / 50,237 ×
100 = .0318%.
Periods Per Year is the number of the given period that makes up one year.
For example, the number of one-year periods per year is 1 (1/1); the number
of two-year periods per year is .5 (1/2); the number of three-year periods per
year is .33 (1/3), and so on.
The TWR formula for Annualized Return is:
ARR = ((1 + TWR / 100) Periods Per Year – 1) × 100
and the IRR formula for Annualized Return is:
ARR = ((1 + IRR / 100) Periods Per Year – 1) × 100
where the TWR or IRR is divided by 100 then added to 1 to produce a
multiplier. That multiplier is raised to the power of Periods Per Year.
Subtracting 1 and multiplying by 100 converts the number into a percentage.
Note: The partner’s economic and tax TWRs for the two periods match.
show the economic and tax allocation and performance for the second
period.
Notice that, even though the partners’ capital percentages change, their
economic performance remains the same (100%). Partner A’s contribution,
however, causes its profit to be divided into a larger tax capital base. This
lowers its performance (relative to Partner B, who made no contribution)
until the partnership next charges the performance fee, at which time
Partner A’s economic and tax capital again match.
257
aggregate A method of allocating realized gains and losses. Unlike tax lot
methodology layering methodology, aggregate methodology looks at a partner’s
share of unrealized appreciation in the partnership’s portfolio as a
whole. Realized gains and losses are aggregated, and then allocated
to the partners according to the aggregate unrealized gain or loss
that has been allocated to their aggregate accounts.
aggregate A given partner’s percentage of an investment partnership’s total
percentage aggregate account balance. Partnerships use aggregate percentages
in certain aggregate assumptions.
allocation item An investment partnership's items of profit and loss. Partnerships
can use a different allocation methodology for each item, or break
items out on reports or Schedule K-1s.
allocation The method an investment partnership uses to allocate a profit
methodology item to its partners. See also aggregate methodology; even
methodology; manual methodology; side pocket methodology;
system methodology; tax lot layering methodology.
anniversary date The date on which a limited partner joins an investment
partnership. A general partner registered under the Investment
Advisors Act of 1940 must wait 12 months before charging a
performance fee. Partnerships can interpret how to apply this
anniversary date in several ways.
assignment of The act of one partner transferring some or all of its interest in an
interest investment partnership to another partner. This assignment
includes a proportionate amount of the assigning partner’s capital
account balance, tax basis, and aggregate account balance or layers
of unrealized gains.
assumption See aggregate assumption.
benchmark See hurdle rate.
book allocation See economic allocation.
258
book gain The total of an investment partnership’s realized and unrealized
gains in a given period. Partnerships that use an aggregate
methodology allocate book gains economically, adjusted for
performance fees, to calculate partners’ aggregate account balances
and tax allocations of realized and unrealized gains.
break period A period during which there are no cash flows into or out of an
investment partnership. The partnership allocates its profits during
the break period according to the partners’ capital percentages
during that period.
built-in gain A security’s unrealized gain at the time the partner contributes it.
The contributing partner’s allocation of realized gain is said to be
“built into” the security at the time of contribution. When the
contributing partner sells the security, the built-in gain is allocated
to the partner, and the remaining gain is allocated to the
partnership as a whole.
capital account An account established for each partner that tracks capital changes
(such as contributions and withdrawals), as well as allocations of
profit to each partner.
capital percentage A given partner’s percentage of an investment partnership’s capital.
This capital percentage is the partner’s capital account balance.
carve-out The portion of the performance fee a partner receives if the
partnership has more than one general partner, or if any limited
partners receive part of the fee.
ceiling rule According to Internal Revenue Code Section 704-3(b)(1), the rule
which states that no individual partner may receive gain or loss
greater than that recognized by the overall investment partnership.
In theory, tax lot layering methodology and allocation
methodology can produce violations of the ceiling rule.
259
commodity pool If an investment partnership trades any commodity options or
operator futures, the general partner(s) must register as a commodity pool
operator (CPO) with the Commodity Futures Trading Commission
(CFTC), unless they receive an exemption from the CFTC.
constructive sale According to the Internal Revenue Code Section 1259, a taxable
event in which an investor must recognize gain on an open position
of stock, certain debt instruments, or partnership interests at the
time the investor opens an offsetting security position.
contributed See contribution, in-kind.
securities
contribution, cash Money, contributed by a partner to the partnership, that increases
the partner’s capital account and tax basis interest in the
partnership.
contribution, in- A property contribution, usually in the form of stocks or securities,
kind by a partner to a partnership that increases the partner’s capital
account and tax basis interest in the partnership. Also called
contributed securities.
designated capital Capital, contributed by a partner, to fund a side pocket investment.
designated A partner’s capital contribution to a side pocket investment, divided
percentage by the total of all partners’ contributions. Designated percentages
are used to allocate the investment’s profits.
directed gains The realized gains allocated to a withdrawing partner, and the
unrealized gains (equivalent to the realized gains allocated to the
withdrawing partner) allocated to the remaining partners. A
partnership that allows its general partner to direct gains must
include a directed gains provision in its partnership agreement.
distribution, cash Cash distributed to a partner in order to partially or completely
liquidate the partner’s interest in an investment partnership.
distribution, Stocks or securities distributed to a partner in order to partially or
property completely liquidate the partner’s interest in an investment
partnership.
260
economic An allocation of an investment partnership’s economic results
allocation (profit or appreciation) to the partners’ capital accounts.
Partnerships usually perform an economic allocation in proportion
to the partners’ economic percentages.
economic capital A partner’s capital in an investment partnership, not counting
performance fee estimates or other tax adjustments.
economic A partner’s economic capital account balance as a percentage of the
percentage investment partnership’s total capital.
ERISA (Advent Partner) The Employee Retirement Income Security Act of
1974. ERISA establishes a comprehensive federal regulatory
framework for employee benefit plans sponsored by private
employers in the United States. If more than 25% of an investment
partnership’s capital comes from retirement funds regulated by
ERISA, the partnership’s manager has additional duties,
requirements, and restrictions.
even Allocation pro rata according to partners’ capital percentages.
methodology
fill up/fill down See directed gains.
provision
fund of funds An investment fund (such as an investment partnership) that invests
its capital in a number of other partnerships or money management
vehicles. Some funds of funds retain a portion of their capital to
invest directly for their own accounts.
general partner A member of an investment partnership who manages the business
of the partnership, and is personally liable for the fund’s debts. A
limited partnership must have at least one general partner.
261
highwater mark An amount equal to the greatest value of a partner’s capital
account, adjusted for contributions and withdrawals. An investment
partnership uses the highwater mark to calculate a limited partner’s
target capital for performance fee charges.
hot issue Securities that are part of a public distribution (such as an initial
public offering) that trades at a premium in the secondary market
immediately after the distribution begins. Members of the National
Association of Securities Dealers, Inc. (NASD) cannot sell hot issue
securities to an account in which a member or person affiliated
with, or related to, a member of the NASD has an interest
(“restricted” members or affiliates). Investment partnerships cannot
allocate gains from hot issue securities to restricted partners.
(NASD Rules of Fair Practice)
hub and spoke See master-feeder fundmaster-feeder fund.
fund
hurdle rate The amount a limited partner’s capital account must appreciate
before it is subject to a performance fee charge. Hurdle rates are
defined as an annual percentage of the partner’s highwater mark (or
beginning capital account balance for the performance fee charge
period). See also target capital.
incentive See performance fee.
allocation,
incentive fee
262
knowledgeable An executive officer, or other manager, of an investment fund. All
employee of an investment partnership’s investors must be either
knowledgeable employees or qualified funds purchasers for the
partnership to qualify as a Section 3(c)(7) fund. (Investment
Company Act of 1940, amended.)
layering See tax lot layering methodology.
limited liability An entity that combines certain characteristics of corporation law
company (LLC) with certain characteristics of partnership law. LLCs offer their
owners limited liability, full management capability, and flow-
through gains and losses similar to a limited partnership. They are
considered partnerships for tax purposes, thereby avoiding two
layers of taxation. Many investment partnerships structure their
general partner as an LLC.
limited partner A member of a limited partnership, who contributes capital without
liability for the fund’s debts beyond the loss of its investment. A
limited partnership must have at least one limited partner.
limited A type of partnership that incorporates limited liability
partnership characteristics of a corporation, but retains the pass-through
characteristics of a partnership. A limited partnership must have at
least one general partner, who is liable for the partnership’s debts,
and one limited partner, who is liable only for its capital investment.
limited The legal agreement between the limited partner(s) and general
partnership partner(s) in a limited partnership. The agreement usually includes
agreement performance fee and management fee structures, powers of the
general partners, descriptions of allocation formulas, and other
legal considerations.
263
management fee A fee used to fund the operating expenses of an investment
partnership, such as rent, salaries, and office supplies. Partnerships
usually calculate management fees as a percentage of the net asset
value of the partnership at a certain time, usually quarterly. A
typical management fee structure is 1% of the partnership’s net
asset value, paid quarterly in advance (that is, .25% of net asset
value at the beginning of each quarter).
manual An allocation methodology that allows the general partner to
methodology determine the amount of an item allocated to each partner.
mark-to-market To adjust the valuation of securities or portfolios to reflect current
market values. Investment partnerships mark Section 1256
securities to market at the end of each year or reporting period, and
allocate the gains as if they had sold the securities, 60% long-term
and 40% short-term gain, regardless of the actual holding period.
264
payout percentage The percentage of a limited partner’s appreciation that an
investment partnership reallocates to the general partner as a
performance fee. Partnerships can also charge performance fees
“above the hurdle,” in which case the payout represents the
percentage of the limited partner’s appreciation above its target
capital that the partnership reallocates.
265
restricted partner A member of an investment partnership who is affiliated with, or
related to, a member of the National Association of Securities
Dealers, Inc. (NASD). Under the NASD Rules of Fair Practice,
members of the NASD cannot sell hot issue securities to the
accounts of restricted investors.
revalue account See aggregate account.
RIA See registered investment advisor (RIA).
Schedule K-1 A schedule of IRS Form 1065 (Partner’s Share of Income, Credits,
Deductions, etc.) used to report to a partner its share of an
investment partnership’s income, deductions, gains, and losses.
Section 1256 The section of the Internal Revenue Code that specifies that lots of
regulated futures contracts, foreign currency contracts, non-equity
options, and dealer equity options must be marked-to-market at the
end of the year or other reporting period, and allocated as if sold,
60% long-term and 40% short-term gain, without regard to actual
holding period.
Section 3(c)(1) A type of fund that can avoid registration as a mutual fund with the
fund Securities and Exchange Commission (SEC) under the Investment
Company Act of 1940. A Section 3(c)(1) fund must have no more
than 100 investors, at least 65% of whom are accredited investors.
Section 3(c)(7) A type of fund that can avoid registration as a mutual fund with the
fund Securities and Exchange Commission (SEC) under the Investment
Company Act of 1940. All Section 3(c)(7) fund investors must be
either qualified funds purchasers or knowledgeable employees.
Section 754 The section of the Internal Revenue Code that allows investment
election partnerships to adjust the tax basis of securities they hold by the
difference between the economic (book) basis and the tax basis (that
is, unrealized gain) of partners who have withdrawn 100% of their
capital account balance from the partnership.
266
Section 988 The section of the Internal Revenue Code that defines gains and
losses from foreign currency movement as ordinary income.
Section 988 overlaps with Section 1256, however, regarding
regulated futures contracts in a foreign currency, foreign currency
contracts, and non-equity options on foreign currencies. Investment
partnerships can elect to treat these instruments as either ordinary
income, or as 60% long-term and 40% short-term capital gain.
system Allocation instructions for specific items built into Advent Partner.
methodology Examples include the tax lot layering and aggregate gain
reallocations of multiple historical periods.
target capital The amount that a limited partner’s capital account balance must
exceed for the partner to be subject to a performance fee charge. A
partner’s target capital is the partner’s highwater mark (or
beginning capital account balance), plus the partner’s hurdle rate.
267
tax basis The net amount of a partner’s contributions to and withdrawals
from an investment partnership, plus all taxable and tax-free profit
that the partnership has allocated to the partner.
tax capital A partner’s capital in an investment partnership, including
performance fee charges or estimates and other tax adjustments.
tax lot layering A method of allocating realized gains and losses that specifically
methodology tracks a partner’s share of unrealized gains and losses in each
security tax lot in a partnership’s portfolio. When the partnership
sells a security, it allocates realized gain and loss to the partners
based on their historic unrealized gain or loss.
tax percentage A partner’s economic percentage, adjusted for performance fees.
tax reallocation/ A restatement of one or more economic allocations for tax
tax allocation purposes. Tax allocations include adjustments for tax lot layering or
aggregate allocations of gains, wash sales and other gain deferrals
or holding period adjustments, Section 1256 and other mark-to-
market securities, and directed gains. These allocations typically
include the performance fee in the item amounts allocated to each
partner.
underwater A term used to describe a partner whose highwater mark exceeds
his or her capital account balance.
uneven An allocation methodology that allocates items of profit and loss
methodology unevenly, yet according to a set formula. Advent Partner supports
off-the-top literal, off-the-top realigned, and off-the-bottom uneven
methodologies.
unrealized memo See aggregate account.
account
268
unrelated Income earned by a tax-exempt organization that is derived, either
business taxable directly or through a partnership, from any trade or business
income (UBTI) regularly carried on that is substantially unrelated to the exercise or
performance of the organization’s exempt purpose or function.
Internal Revenue Code Section 511 states that tax-exempt
organizations are subject to tax on this income. The trade or
business unrelated to its tax-exempt purpose can also lead to
revocation of the organization’s exempt status.
wash sale A realized loss, within 30 days of which (prior to or after the loss)
the investor opens a position in a substantially identical security.
Internal Revenue Code Section 1091 states that investors must defer
such losses for tax purposes.
withdrawal A decrease in the amount of money, or appreciated securities, in a
partner’s capital account in an investment partnership. The
partner’s tax basis in the partnership also decreases by the amount
of the withdrawal, though never below zero.
269
270
Index accrued interest 84
book to tax differences 220
built-in 200
calculating 62
recording 62
acquisition indebtedness 236
adjusted book gain 121, 129
defined 257
Numerics adjusted cost basis 52, 57, 60, 61, 195
Advent Connection Web site xiv
1933 Act. See Securities Act of 1933 Advent corporate Web site xiii
1934 Act. See Securities Exchange Act of 1934 Advent Partner vii
1974 Act. See Employee Retirement Income aggregate allocation items 128
Security Act of 1974 aggregate methodologies 111
1996 Act. See National Securities Markets annualizing performance 245
Improvement Act of 1996 book and tax capital 162
1997 Act. See Taxpayer Relief Act of 1997 covered shorts not settled at year
80% asset test 191 end 231
defining allocation items 69
documentation set xii
A even methodology 261
final periods 65
accounting services 22, 36-38 fund of funds 11
allocating profit and loss 38 help xiii
preparing annual financial hot issue aggregate gain items 139
statements 38 hot issue gain allocation 97
reconciling broker balances and hot issue layering gain items 153
positions 36-38 importing contributed securities 190
reconciling net asset value 38 interest income allocation items 85
accredited investor 24, 25 interim periods 64
defined 257 layering allocation items 147
accretion management fee module 83
allocation items for 87 manual methodology 264
built-in 195-200 non-pro rata formulas for management
methods 58 fees 83
recording 57-60 Partners’ Capital Balances report 56
accrual Section 1256 aggregate gain items 137
of management fees 78 Section 1256 allocation adjustments 72
accrual basis accounting 40, 56, 86, 200, 220 Section 1256 layering gain items 151
accrued dividends, book to tax Section 754 election with layering 210
differences 220 side pocket investments 100
system methodology 269
271
uneven allocation 92, 100-107 hot issue 138
Wash Sale Wizard 225 AICPA
Advent resources xiv Statement of Position 95-2 9
Advent Technical Support xiv allocation
Adviser’s Act. See Investment Adviser’s Act of aggregate methodologies 110-142
1940 economic 90-107
aggregate accounts 63, 64, 112 effect of capital changes 50
aggregate assumptions 115-120 hot issues 96-97
aggregate performance methodologies, defined 258
reallocation 174 non-pro rata 68, 96-107
defined 257 off-the-bottom 105-107
distributing 134, 135 off-the-top literal 103-105
effect of assignments 136 off-the-top realigned 101-103
effect of withdrawals 134-136 side pocket 98-100
full netting methodology 111 tax allocation 93-94, 110-177
hot issue 138 tax lot layering methodology 144-155
understanding 110-111 tax percentages 169-173
with book gains, full netting uneven 68, 92, 100-107
methodology 111 allocation items 68-88
aggregate allocation 63, 93, 110-142 accretion 87
aggregate accounts 110 amortization 87
assumptions 112-120 defined 258
ceiling rule 142 dividends 83
change in unrealized gains 112 excluding from performance fee 177
contributed securities 190 foreign taxes 87
defined 258 FX gains 73
directing gains 214, 216-217 hot issues 71
full netting 111 interest and dividend expenses 84
hot issue gains 138-141 interest income 84
methodology, defined 258 investment, trade, and business
performance fee 174-175 expenses 88
Section 1256 gains 136-138 management fees 77
tax percentages 110 organizational expenses 85
understanding 110-112 realized gains and losses 70-75
with book gains, full netting Section 1256 contracts 71-73
methodology 111 tax adjustments 223
aggregate assumptions 112-120, 174 unrealized gains and losses 76
defined 257 American Institute of Certified Public
table 114 Accountants 32, 38, 85
aggregate percentages 110, 112 American Institute of Certified Public
aggregate assumptions 115-120 Accountants (AICPA) 9
defined 258 amortization
272
allocation items for 87 cost basis 57, 60
built-in 195-200 market discount 57
methods 61 market discount accretion 59
recording 60-62 maturity date 61
amortizing organizational costs 85 original issue discount accretion 59
anniversary date 160 par value 57, 60, 196
defined 258 premium 60
annualized return 245-246 tax-free 60
assignments of interest 50, 54 book allocation. See economic allocation
aggregate accounts 136 book gains 128
defined 258 aggregate performance
effect on highwater marks 167, 168 reallocation 174
layering 148-150 defined 259
performance fee 54, 161 book income. See economic allocation
assumption. See aggregate assumptions book to tax differences 220
attorney 22 break periods 50-65
Audit and Accounting Guide, AICPA 32, 38 capital changes 51-55
audit, annual 23, 35, 44 defined 259
audited financial statement 30, 32 economic allocations 90
Axys vii, 24, 69, 85, 190, 231 effect of capital changes 50
final 65
interim 64
B layering gains 144
recording accretion 57-60
beginning capital changes 51 recording amortization 60-62
benchmark. See hurdle rate recording income and expenses 56-62
Bennett letter 44 recording interest accrual 62
billing in arrears management fee accrual recording realized and unrealized
method gain 63-64
example 81 brokers
in flows 81 hot issue gains 96
out flows 81 reconciling balances 36-38
bonds selling clearing 96
accretion 57-60, 87 built-in gains 52, 190, 191-195
accrued interest 62, 200 ceiling rule 192
adjusted cost basis 195 defined 259
amortization 60-62, 195-200 holding period 192
built-in accretion for taxability 191
contributed 195-200 business expenses, allocation items for 88
constructive sale 233
contributed cost 195
contributing 195-201
273
C defined 259
general partner’s contribution 29
class 11
capital account 50, 52, 54, 136, 148 defined 260
allocating income and expenses 56 clawback provision 19
defined 259 clawback provisions 169
highwater mark 165, 167 defined 260
hurdle rate 164, 167 clearing broker 96, 234
target capital 163 closing methods 74
tax basis 55 Commodity Exchange Act 9
under water 167 Commodity Futures Trading
capital changes 50, 51-55 Commission 8, 44
effect on tax performance 249, 251-252 commodity pool
example 55 registration 9
capital commitment 18 commodity pool operator 44
capital gains. See realized gains defined 260
capital income. See realized gains commodity, constructive sale 233
capital percentages 52, 54, 56, 61, 63, 64, constant yield accretion 58
68, 121, 128 constant yield amortization 61
allocating management fees 78 constructive sales 233-235
defined 259 defined 260
designated capital excluded from 98 offsetting positions 233
economic allocations 90 short against the box 234
capital, designated. See designated capital 98 contributed securities 190-201
carryforward losses 178 as capital contributions 52
carryforward. See highwater mark built-in accrued interest 200
carve-out built-in amortization and
defined 259 accretion 195-200
carve-outs built-in gains 191-195
assigning 172 ceiling rule 192
cash basis accounting 40, 201 contributed cost 190, 195, 228
cash, constructive sale 233 fixed-income 195-201
ceiling rule holding period 192
aggregate allocation 142 limited partnership agreement 29
built-in gains 192 wash sales 228
defined 259 contributions 50, 52
directing gains 214 capital towards designated
layering allocation 154-155 investments 98
CFTC. See Commodity Futures Trading contributing securities 189, 190
Commission defined 260
charge dates 159 effect on highwater marks 167
check-the-box 5, 13 in kind. See contributed securities
274
limited partnership agreement 29 dividends
cost basis 57, 60 allocation items for expenses 84
accretion 57-60, 195-200 allocation items for income 83
adjusting 195 income withholding tax 46
amortization 60-62, 195-200 recording income 56
contributed securities 190, 228 short sales 232
covered shorts not settled at year end 39, UBTI from 235
231 documentation
CTFC Regulation 4.22(c)(5) 8 conventions ix-xi
custodian 23, 24, 44 on the Web xiv
D E
275
equalization method
of performance fee 14 example 79
equalization of performance fee 14, 178, in flows 79
181-188 out flows 79
multiseries shares 181 forward currency contracts, constructive
multiseries shares method 183 sales 233
equities fund of funds 7
constructive sales 233 accounting 9
short sales 232 defined 261
staddles 229 diagram 8, 10
ERISA. See Employee Retirement Income fees 7
Security Act of 1974 tax considerations 10
even methodology, defined 261 fund of funds entity relationships
Exchange Act. See Securities Exchange Act of diagram 10
1934 futures contracts 71, 73
expenses constructive sales 233
effect on performance 246 FX gains, allocation items for 73
recording 56
tax allocation (performance fee) 173
G
F gain
defined x
federally taxable interest income 84 gain allocation
FIFO closing method 74 aggregate 110-142
fill up/fill down provision. See directed gains aggregate tax allocation 174-175
final periods 65 built-in gains 191-195
financial statement, audited 30, 32 directing gains 212-217
financial statements, preparing 38 layering 144-155
fiscal year 32 layering tax allocation 175
performance fee 160 selecting a methodology 39
fixed-income securities. See bonds general partner 22
foreign (non-U.S.) partners 46, 47 carve-outs 172
foreign currency contracts 71, 73 commodity pool operator 44
foreign taxes, allocation items for 87 defined 6, 261
Form 1042 46 excluding from allocations 177
Form 1065 13, 39, 68 investment objective 27
See also Schedule K-1 investment parameters 28
Form 13D 46 management fees 77
Form 13F 46 organizational costs 85
Form 8109 46 performance fee 157, 158
forward billing management fee accrual private placement memorandum 28
276
registered investment adviser 43, 45 layering gain allocation 152-154
reporting 32 performance fee 96, 176
restricted from hot issue gains 139 hurdle rate
tax percentages 172 applying 164-165, 167
withdrawing from partnership 34 compounding 164
GNAV per share defined 263
defined 12, 262 payout above 169, 171-172
good faith investment valuation 19
grandfather box 235
Gross Net Asset Value
I
defined 12
gross net asset value (GNAV) incentive allocation or fee. See performance fee
defined 262 income items, tax allocation (performance
fee) 173
initial public offering 96
H See also hot issues
Integration Rule 26
hedge fund interest
defined 262 accrual, recording 62
See also investment partnerships expense allocation items 84
high cost closing method 74 income allocation items 84
highwater mark 164, 183 income withholding tax 46
applying 165-167 income, recording 56
defined 262 short sales 232
effect of assignments 167, 168 straddles, expenses from 230
effect of contributions 167 UBTI from 235
effect of withdrawals 167-168 interim aggregate account balance and
Highwater Net Asset Value percentage 121
defined 12 interim periods 64
highwater net asset value (HNAV) Internal Revenue Code 46
defined 262 amortizing organizational expenses 85
HNAV per share Section 1045 17
defined 12, 262 Section 1091 wash sales 224
holding period Section 1092 straddles 228-230
for short sales 232 Section 1202(c) 17
straddles 230 Section 1233 short sales 231
hot issues 96-97 Section 1256 contracts 71-73, 136-138,
aggregate gain allocation 138-141 150-152, 267
allocating gains 92 Section 1259 constructive sales 233
allocation items 71 Section 1276 87
defined 262 Section 1446 47
general partners 139 Section 162 88
277
Section 163 88 accounting services 22, 35, 36-38
Section 171(e) 87 accrual basis accounting 57
Section 351 191, 192 attorney 22
Section 368 192 dealer 41
Section 511(a) 235 fund of funds 7
Section 512 235 general partner 22
Section 514 236 history 2-4
Section 67 88 investing advantages 4
Section 704 63, 93 investor 41-43
Section 704(b) directed gains 33, 213 management fees 28
Section 704(c) 191 master-feeder 15
Section 721 190, 191 offshore funds 11-14
Section 721(b) 191, 192 organizational costs 85
Section 731(c) 208 organizing 5-7
Section 734 209 prime broker 23
Section 751(b) 208 private equity funds 17-19
Section 754 election 33, 53, 205, 208, strategies 4-5
209-212, 213, 268 tax services 35, 39-40
Section 988 73, 268 trader 41-43, 47
trader and investor partnerships 41 UBTI 236
Internal Revenue Service 26, 64 venture capital funds 17-19
bond amortization 60 investor 41-43
book to tax differences 220 investor fund 7-11
check-the-box 5 defined 263
classifying investment funds 5, 13 IPO. See initial public offering or hot issues
contributed securities 29 IRAs
diversification 29 contributions from 45
Form 1042 46 UBTI 235
Form 1065 13, 39 IRC. See Internal Revenue Code
Form 8109 46 IRS. See Internal Revenue Service
offshore funds 13 items. See allocation items
Schedule K-1 32, 39, 40, 68, 83, 87, 160
investee fund 7-11
defined 263
J
Investment Adviser’s Act of 1940 43, 160
investment company 191 Jones, A.W. 2
avoiding registration as 24
contributed securities 191 K
Investment Company Act of 1940 24-26
investment expenses, allocation items for 88
investment objective 27 knowledgeable employee, defined 263
investment partnerships
278
L look-through test 26
LPA. See limited partnership agreement
279
memo account. See aggregate account offshore funds 11-14, 177
methodology. See aggregate allocation, equalization of performance fee 14
allocation, hot issues, side pocket management fee 13
allocation, tax lot layering allocation, master-feeder 15
uneven allocation performance fee 13, 14, 177-188
miscellaneous deductions 88 terminology 11
multiseries shares conversion 182 off-the-bottom allocation 105-107
multiseries shares method off-the-top literal allocation 103-105
defined 181-183 off-the-top realigned allocation 101-103
example 183 online help xiii
municipal bonds 60, 87 option straddles 229
ordinary income 41, 47, 73, 77, 83, 87, 88
organizational expenses
N allocation items for 85
amortizing 85
National Association of Securities Dealers, Inc. organizing investment partnerships 5-7
(NASD) 96 original issue discount (OID) bond 59
National Securities Markets Improvement Act
of 1996 25
NAV per share
P
defined 12, 265
Net Asset Value par value 57, 60, 196
defined 12, 265 participation in uneven allocation 100, 101,
net asset value (NAV), reconciling 38 103, 105
New York City unincorporated business partners
tax 86 accrual basis accounting 57
non-equity options 72, 73 aggregate accounts 63, 64, 110, 112
non-gain aggregate percentages 110, 112
defined x anniversary date 160
non-pro rata allocations 96-107 assignments 136, 148-150, 161, 167,
168
calculating tax percentages 170-171
O capital accounts 50, 52, 54, 56, 136,
148, 163, 164, 165, 167
offering document capital percentages 52, 54, 56, 61, 63,
defined 12, 265 64, 68, 78, 90, 121, 128
offering memorandum. See private placement contributions 167
memorandum economic percentage 101, 103, 105
offsetting position. See straddle or constructive entry date 160
sale excluding from off-the-top literal
offshore fund structures allocations 104
side-by-side 14 excluding from off-the-top realigned
280
allocations 101 defined x, 12, 266
foreign (non-U.S.) 46, 47 effect of assignments on highwater
hot issue gains 92, 96 marks 167, 168
layering allocation 144 effect of contributions on highwater
side pocket investments 92, 98 marks 167
tax basis 55 effect of withdrawals on highwater
tax percentages 110, 169-173, 175 marks 167-168
UBTI 236 effect on performance 247
uneven (non-pro rata ) allocation to 100 equalization 14, 178, 181-188
withdrawals 147-148, 161, 167-168, estimating 162
204 excluding items 177
partnership expense vs. reallocation 12
defined x, 265 highwater mark 164, 165-167
See also investment partnerships hot issue gains 96, 176
passive foreign investment company hurdle rate 164, 164-165, 167
activity 39 in offshore funds 13, 177-188
pass-through interim vs. final periods 64
defined 265 payout above target capital
payout percentage 162, 169-172 (hurdle) 171-172
above target capital (hurdle) 169, payout percentage 162, 169-172
171-172 profit since last charge 162
defined 266 reallocating aggregate gains 174-175
pension plans reallocating income and expenses 173
contributions from 45 reallocating layered gains 175
UBTI 235 target capital 162, 163-169
performance tax percentages 169-173
reporting 255 withdrawals 54, 158, 161
tax differences 249-254 PFIC. See passive foreign investment company
performance calculations activity
annualized return 245-246 plan assets 45
effect of expenses 246 pooled investment structures
effect of management fees 246 understanding 7-19
effect of performance fees 247 positions, reconciling 36-38
performance fee 94, 157-177 premium, amortizing 60
aggregate allocation 121, 128 prepaid expenses, book to tax
anniversary date 160 differences 220
assignments of interest 54, 161 prime broker 23, 37
carve-outs 172 private equity funds 17
charge dates 159 private equity/venture capital fund
charge dates, affect tax diagram 18
performance 252-254 private equity/venture capital funds
clawback provisions 169 management fees 19
281
private placement memorandum (PPM) 26 revaluation account. See aggregate account
investment objective 27 Rex 24
organizational expense for 85 RIA. See registered investment adviser
preparing 22
trader/investor status 43
profit items. See allocation items
S
publicly traded partnerships (PTPs) 26
safe harbor practices for offshore funds. See
Ten Commandments
Q Schedule K-1 10, 13, 32, 39, 65, 68, 83, 87,
160
qualified eligible participant, defined 266 line 1, ordinary income (loss) from trade
qualified funds purchaser 24 or business activities 83, 88
defined 266 line 10, deductions related to portfolio
qualified small business stock 17 income 88
line 17(c), total gross income from sources
outside the United States 83
R line 17(e) 87
line 4(b), ordinary dividends 83
real estate investment trust (REIT) 16 line 4(d), net short-term capital gain
realized gain (loss) 70, 73
aggregate allocation 110-142 line 4(e), net long-term capital gain
aggregate tax allocation 174-175 (loss) 70, 73
allocating 39, 93 line 7, other income (loss) 70, 73
constructive sales 233 preparing 40
directing 212-217 scientific accretion 58
distributed securities 206 scientific amortization 61
layering allocation 144-155 SEC. See Securities and Exchange Commission
layering tax allocation 175 Section 1.351-1(c) 192
recording 63-64 Section 1.471-5 41
short against the box 235 Section 1.701-2 (anti-abuse regulations) 208
short positions 75, 232 Section 1.704-3(b)(1) 142, 154
tax basis 56 Section 1.704-3(e)(3) 93
redemption Section 1091 wash sales 224
defined 12, 266 Section 1092 straddles 228-230
registered investment adviser 43, 45, 160 Section 1233 short sales 231
defined 267 Section 1256 contracts 39
hot issue gains 96 allocating aggregate gains 136-138
Regulation D exemption 24, 25 allocating layered gains 150-152
restricted partner, defined 267 allocation items 71-73
retention amount, for withdrawals 30 defined 267
retirement funds, contributions from 45 Section 1259 constructive sales 233
282
Section 1276 87 investment objective 27
Section 1446 47 offsetting positions for constructive
Section 162 88 sales 233
Section 163 88 offsetting positions for straddles 228
Section 171(e) 87 short sales 231-233
Section 206 (4)-2 44 short sales of substantially identical 232
Section 3(c)(1) fund 24, 25 straddle positions 228-230
converting to a Section 3(c)(7) fund 25 UBTI from 236
defined 267 valuation 32
integration rule 26 wash sales of substantially identical 223
Section 3(c)(7) fund 24-26 Securities Act of 1933 24
converting from a Section 3(c)(1) Securities and Exchange Commission 2, 3,
fund 25 7, 19, 24, 25, 26, 43
defined 267 Form 13D 46
integration rule 26 Form 13F 46
Section 351 191, 192 Section 404.04 19
Section 368 192 Securities Exchange Act of 1934 24, 46
Section 404.04 19 selling broker 96
Section 511(a) 235 series
Section 512 235 defined 12, 268
Section 514 236 shareholder
Section 67 88 defined 12, 268
Section 704 63, 93 short sales 231-233
Section 704(b) directed gains 33, 213 against the box 234
Section 704(c) 191 covered but not settled at year end 231
Section 721 190, 191 holding period 232
Section 721(b) 191, 192 interest and dividend expenses 84
Section 731(c) 208 interest and dividend payments 232
Section 734, implementing Section 754 209 purchasing substantially identical
Section 751(b) 208 securities 232
Section 754 election 53, 209-212 settlement date 75
defined 268 side pocket investment
directing gains and 213 allocating 92, 98-100
effect on distributing securities 205, 208 allocation methodology, defined 268
limited partnership agreement 33 defined 268
tax lot layering 210-212 understanding 98
Section 988 73 side pocket investments 10
defined 268 side-by-side offshore fund 14
securities diagram 15
adjusting tax basis through Section 754 state taxable interest income 84
election 209 straddles 39, 228-230
distributing 205-208 deferring loss 229
283
defined 268 defined 269
holding period 230 withdrawals in excess of 204-217
interest expenses 230 tax basis, calculating 55
offsetting positions 228 tax capital 162
straight-line accretion 58 defined 269
straight-line amortization 61 tax elections 33
stuffing. See directed gains amortizing organizational costs 85
subscription market discount accretion 57
defined 12, 269 premium amortization 60
substantial economic effect. See Section 704(b) Section 988/1256 overlap 73
directed gains See also Section 754 election
substantially identical securities tax lot layering 63, 93, 144-155
for short sales 232 ceiling rule 154-155
for wash sales 223 directing gains 214, 215-216
syndication expenses 86 distributing gains 147
system methodologies, defined 269 effect of assignments 148-150
effect of withdrawals 147-148
example 144-146
T hot issue gains 152-154
methodology, defined 269
target capital 162, 169 performance fee 175
aggregate allocation 121, 128 Section 1256 gains 150-152
calculating 163-169 Section 754 election 210-212
effect of assignments on highwater understanding 144-150
marks 167, 168 tax percentage 94, 110, 138, 169-173
effect of contributions on highwater aggregate allocation 113
marks 167 aggregate assumptions 116-120
effect of withdrawals on highwater aggregate tax reallocation 174
marks 167-168 calculating 170-171
highwater mark 165-167 defined 269
hurdle rate 164-165, 167 general partners 172
payout above 171-172 layering allocation 144
target capital, defined 269 layering, allocating hot issue gains 152
tax adjustments layering, realigning after
allocating 222-223 assignments 149
allocation items for 223 layering, realigning after
for book to tax differences 220 withdrawals 147
tax allocation. See tax reallocation reallocating income and expenses 173
tax basis 52, 53, 54 Section 1256 gains 150, 175
adjusting through Section 754 tax performance, differences 249-254
election 209 tax reallocation 94
calculating 68 interim vs. final periods 64
284
Section 1256 contract gains 72 U
See also aggregate allocation, performance
fee, tax lot layering
Tax Reform Act of 1986 88 U.S. investment partnerships (vs. offshore
tax returns, preparing 40 funds) 11-17
tax services 39-40 U.S. Securities and Exchange
allocating taxable amounts 39-40 Commission 17
preparing partnership tax returns 40 UBTI. See unrelated business taxable income
transmitting Schedule K-1s 40 Understanding Partnership Accounting (Second
tax to book differences 220 Edition)
taxability of interest income 84 overview vii
taxes underwater, defined 269
foreign 87 uneven allocation 68, 92, 100-107
on withdrawals of unrealized gains 53, methodology, defined 270
148 off-the-bottom 105-107
tax-exempt off-the-top literal 103-105
contributed securities 191 off-the-top realigned 101-103
UBTI 11, 45, 235 unincorporated business tax 86
tax-free bonds 60 unrealized gain
Taxpayer Relief Act of 1997 13, 47, 234 aggregate allocation 110-142
Ten Commandments 13 aggregate tax allocation 174-175
Tips allocating 39, 93
allocating layered hot issue gains 152 assignments of interest 54, 136, 148
number of break periods per year 51 calculating aggregate 112
off-the-top literal allocations, excluding layering allocation 144
partners 104 layering tax allocation 175
off-the-top realigned allocations, recording 63-64
excluding partners 101 withdrawing 53, 204-217
using Rex to automate reconciliation 24 unrealized memo account. See aggregate
trade expenses, allocation items for 88 account
trader 41-43 unrelated business taxable income
trader partnerships 47 (UBTI) 11, 39, 235-237
Treasury Regulation defined 270
Section 1.351-1(c) 192 ERISA rules for 45
Section 1.471-5 41
Section 1.704-3(b)(1) 142, 154 V
Section 1.704-3(e)(3) 93
Section 206 (4)-2 44
venture capital funds 17, 17-19
Sections 1.701-2 208
versus purchase closing method 74
Treasury Regulations
Section 1.471-5 41
trial balance 36
285
W
yield-to-maturity accretion 58
yield-to-maturity amortization 61
286
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