How Should a Crypto Fund handle Carried Interests?

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How Should a Crypto Fund handle Carried Interests?

 

In 2017, the law applicable to carried interests was changed so that GPs didn’t get long term capital gain unless the underlying asset had been held for 3 years (instead of one year).  In addition, it was recently proposed that such holding period should be increased to 5 years and measured from the later of the date the fund was substantially invested and the date the asset was acquired.  That proposal does not look like it will become law soon, but it will likely continue to be a part of future proposals.

 

So what can a fund do to minimize the tax paid by its GPs?  One solution is to never sell an asset that has less than a three year holding period.  That might work for VC funds or PE funds, but it doesn’t work for funds that need to sell assets to fund redemptions or for funds that continually rebalance their portfolio.  In that case, even if 20% of the fund’s gain results from sales of 3 year assets, the fund cannot simply allocate those gains to the GP and allocate the gains from other assets to the LPs.  That kind of allocation would not have “substantial economic effect.”[1]  However, if a fund distributed cash to the LPs and equity to the GP, it may be able to avoid allocating any less than 3 year gain to the GP.

 

So for example, let’s assume that in the course of the year the fund generates $1,000 of gain and 80% of that is from assets held less than three years.  If the fund does nothing, the GP is allocated $200 of income and $160 of that is taxed as short term capital gain.  If instead, the fund sold only the $800 of less than 3 year assets and distributed $200 worth of more than 3 year assets to the GP, the GP would not be allocated any taxable income (it would have no capital account to which its share of the $800 of income would be allocated (all of it should be allocated to the LPs)).  Instead, when the GP sold the distributed assets, all $200 would be Long Term Capital Gain.  A similar principle might be applied to a VC fund, but since it’s difficult to value the unsold fund assets, it’s likely too hard to make that work.

 

The question then is mechanics.  The simplest solution is for the fund to distribute tokens to the GP on December 30 with a value equal to 25% of the gain realized during the year.  (25% because the GP should get 20% of the taxable gain realized during the year plus 20% of the gain on the distributed assets, December 30 because the distribution has to happen before the fund allocates income among its partners.)  Unfortunately, that’s not really consistent with providing the GP (and the LPs) with maximum benefit from the fund’s asset management program (because the GP is suddenly selling 25% more tokens than the Fund thought was prudent.)  In addition, it might be too naked an end run.

 

Alternatively, the Fund might resolve that whenever it’s selling 3 year assets, it will be deemed to have distributed to the GP a portion of those assets equal to the GP’s share of all income realized during the previous taxable year plus the anticipated income from the sale of those assets.  (e.g., if on May 1 it was going to sell $100 of 3 year assets, and during the first 4 months of the year it had generated $300 of gain, it would distribute $80 of the 3 year assets to the GP and only sell $20 of those assets.)  That would still leave the GP exposed if the last sales of the year were all less than 3 year assets, but it would at least absorb a substantial portion of the income.  In theory, the fund might even retain legal title to those tokens and sell them as nominee for the GP – but that makes it much more likely that the IRS says the whole program is illusory.  (I would strongly recommend actually transferring the tokens to the GP’s own wallet and letting the GP make the sale decision itself.)

 

Does this work?  As with most things, details matter.  If the GP holds the distributed tokens and makes an independent decision to sell them a week or even a day after the fund does, that’s a good fact.  If the GP sells them at the same instant as the fund does, that’s a bad fact.  And while technically this should work, we all know that the IRS is likely to bring a much greater level of scrutiny and hold funds to a much higher standard if the underlying asset is crypto.  Ultimately, I'd be much more comfortable if from time to time during the year the fund made in kind distributions to the GP that weren’t so linearly connected with the fund’s taxable income, but more aggressive approaches should work too.

 

 


[1]                Note, most funds provide that gain is first allocated to redeeming LPs up to the amount of their previously unrecognized profit (a so-called “stuffing provision”), but any gain in excess of that amount must be allocated among all the partners – with any 3 year gain being allocated pro rata.

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