Holding Period Issues
Pass-through entities elevate holding period concerns to a high level because they offer the option of exiting at either the asset level (sale by the entity of its assets, which may include equity interests in subsidiaries) or the equity level (sale by the owners of their shares in the S corporation or partnership interests in the partnership). This decision generally does not impact the quantum of the gain recognized in the transaction (although it can be relevant when inside/outside basis differences exist), but can impact the character of the gain recognized.
Example: Company A is a portfolio company owned by Fund that is taxable as a partnership. Fund invested into Company A five years ago. Throughout its holding period, Company A has grown, in part, through acquisitions of the stock of two tuck-in businesses, including Business B, which was acquired two years ago and Business C, which was acquired six months ago. These acquisitions have been executed through additional leverage borrowed by Company A and Fund has not invested any additional capital into Company A since acquisition.
If Fund exits through a sale of membership interests of Company A, its holding period for purposes of computing the nature of its capital gain will be determined by reference to the initial acquisition date. Because that date was five years ago, any capital gain will be long-term for both the limited partners and the carried interest.
If Fund exits through a sale of assets by Company A (including the stock of Businesses B and C), any gain will be recognized at the Company A level (and will flow through to the Fund), necessitating a holding period computation at the Company A level. In this situation, a purchase price allocation and gain computation will need to be performed with respect to each asset sold by Company A. Any gain attributable to Company C, which was acquired six months ago, would be short-term capital gain (taxable at ordinary income rates rather than the preferential 20% long-term capital gain rate) for both the limited partners and the carried interest. Any gain attributable to Company B, which was acquired two years ago, would be long-term capital gain for the limited partners, but would be short-term capital gain for the carried interest.
The reverse situation may exist where additional capital is contributed to a portfolio company taxable as a partnership to fund operations (a portion of the portfolio company’s holding period may be short-term, while the Portfolio Company may have a long-term holding period in all of its assets). And in many situations, both an asset sale and an equity sale may result in a short-term holding period and it’s important to assess which situation results in the smallest allocation to such short-term assets. Regardless, your friendly Acta tax professional is available to discuss your situation and optimize your exit structure in order to minimize the impact of short-term holding periods on your tax position.
