Do You Know How Private Equity Impacts Your Taxes?

As finances evolve, so do the complexities of investing. Many investors start with publicly traded securities—often through an employer’s 401(k), an online brokerage account, or a financial advisor. For new investors, the tax implications of investing can be an afterthought. Fortunately, reporting the taxable activity of publicly traded investments on a tax return is relatively straightforward.

For investors who have grown accustomed to the reporting of publicly traded securities, the tax implications of private equity investments can bring unexpected surprises. Through the rest of this Viewpoint, we’ll explain what to expect as a first-time investor in private equity, and how your experience will be different from investing in publicly traded securities.

Tax Forms

• Publicly Traded Securities: Most public companies are structured as C corporations, which pay taxes at the corporate level. The corporations issue dividends to investors, and investors are taxed at the individual level. Investors receive a form 1099 reporting the dividends and sales transactions that occurred during the year.

• Private Equity: Private Equity investments are typically structured as partnerships (or LLCs taxed as partnerships), which are considered “pass-through entities.” Unlike C corporations, partnerships do not pay any tax at the entity level. Instead, they report the taxable income or losses that flow to investors, and the tax is paid at the individual level. Investors receive a form K-1 that reports their proportionate amount of taxable activity.

Timing

• Publicly Traded Securities: Taxable events (e.g., receiving dividends, selling stock) occur independently of corporate tax filings. As a result, tax forms are usually available before the end of February.

• Private Equity: K-1s depend on the completion of the partnership’s tax return. Bookkeeping, auditing, and other adjustments can cause these returns to be delayed. Because of this, investors may not receive K-1s before the individual April filing deadline, often requiring them to file an extension.

Tax Rates

• Publicly Traded Securities: The most common sources of income from publicly traded securities, dividends and capital gains, have unique tax rates. Certain holding thresholds need to be met, but “qualified” dividends and “long-term” capital gains are taxed at preferential rates (between 0% and 23.8%).

• Private Equity: While primarily producing dividends and capital gains to their investors, private equity investments can potentially distribute ordinary business income as well. Ordinary income is taxed at an investor’s marginal tax rate, which ranges up to 37%.

State Implications

• Publicly Traded Securities: Publicly traded companies often have operations in multiple states. Despite this, the dividends they pay to investors are only taxable in the investor’s resident state. For investors living in states without an income tax, there may be no state tax implications to holding publicly traded securities.

• Private Equity: Investors are responsible for state taxes based on where the partnership operates, potentially requiring multiple state tax filings. Since the income flows through to the individual, an investor may have individual state filing requirements in multiple states. While partnerships do not pay any federal tax, some states do allow for partnerships to file “composite” returns where the partnership submits state taxes on behalf of investors.

Other Complications

• Foreign Reporting: Some private equity investments trigger foreign disclosure requirements. Failure to file forms such as 8865, 5471 or 8621 could result in significant penalties.

• Unpredictable Cashflow: Unlike dividends, which are taxed based on cash received, partnerships are taxed on total taxable income, whether distributed or not. For example, an investor may owe tax on $5,000 of income despite receiving only $3,000 in cash. This “phantom income” makes tax planning more challenging.

• Tax Preparation: Beyond what’s previously been listed, private equity can trigger complications with UBTI, section 754 depreciation, qualified business income deduction, and the carried interest rules. For investors who had previously self-prepared returns, the addition of private equity may require the need to hire a tax professional. For investors who were already using a tax professional, the fees associated with preparing their return will likely increase to reflect the additional time spent to report the activity of the private equity K-1.

The Bottom Line 

Private equity can offer strong returns and diversification, but it also brings additional tax considerations. Truepoint’s tax specialists can help you understand these implications to avoid surprises during tax time and better equip you to manage through the added complexity.