Key Takeaways
Understand why the structure of a private equity fund matters for liability, tax, and investor expectations.
Learn the tax advantages and risks of Limited Partnerships and Limited Liability Companies (LLCs).
Discover how to choose the right structure to protect assets and maximize after-tax returns.
Why Entity Structure Shapes Private Equity Success
Many U.S. businesses use private equity to access growth capital, bring in specialized expertise, or buy out existing owners while maintaining some degree of control.
Private equity is essentially investment capital pooled from institutions and high-net-worth individuals. But how you set up your fund is more than a formality – it’s critical to protect your business and investors from unnecessary tax exposure, legal risks, and compliance issues.
Whether you form a Limited Partnership (LP) or a Limited Liability Company (LLC), your decision affects everything from liability protection to how profits are taxed and distributed.
In this guide, we’ll break down the most common private equity structures, their advantages and drawbacks, and how to approach your tax planning with confidence.
What Are the Most Common Private Equity Structures?
Private equity funds are usually set up as either Limited Partnerships or Limited Liability Companies (LLCs) because these structures combine tax efficiency with liability protection.
Both are known as pass-through entities for tax purposes. This means the fund itself doesn’t pay corporate income tax. Instead, any profits or losses flow straight to the investors, who report them on their own tax returns.
Even though they share this feature, Limited Partnerships and LLCs work differently when it comes to liability, management, and how investors view them.
When you set up a private equity fund, your investors generally play one of two roles. They either provide funding in exchange for a share of profits without getting involved in daily decisions, or they take on active management responsibilities and a bigger share of the risk. In other words, their role in your structure can be either as a General Partner (GP) or a Limited Partner (LP), Each has different rights, obligations, and tax outcomes.
Limited Partnerships and LLCs: How They Work
Limited Partnerships (LPs) have two types of partners who work together to run the fund.
- General Partners manage daily operations and make investment decisions, taking on full legal responsibility if something goes wrong.
- Limited Partners provide most of the funding but don’t participate in daily management, and their losses are limited to the amount they invest.
LPs are common because they’re widely accepted and help General Partners qualify for lower capital gains tax rates on their share of profits.
Limited Liability Companies (LLCs), on the other hand, give everyone involved, including managers, limited liability protection. This means each member’s personal assets are generally shielded from business debts or lawsuits.
LLCs also offer more flexibility in how profits and voting rights are divided. For example, an LLC’s operating agreement can be drafted so that a member who contributes less capital still holds a larger share of voting rights or management control. Members can choose to reward a manager’s skills by giving them more authority, regardless of how much they invested financially.
However, LLCs require careful planning to ensure any special profit-sharing arrangements (like carried interest, which rewards managers with a share of the profits) are structured properly for tax purposes.
Ready to set up your private equity fund with the right structure? Contact us for help.
The table below shows the key differences between each structure in terms of how it handles liability, taxation, and management.
| Limited Partnership | LLC | |
|---|---|---|
| Liability Protection | LPs limited; GPs unlimited | All members have limited liability |
| Tax Treatment | Pass-through income; carried interest as capital gains | Pass-through or elect corporate taxation |
| Management Structure | GPs manage; LPs are passive investors | Flexible. Members or managers |
| Investor Familiarity | Most common structure in private equity | Increasingly popular alternative |
| Administrative Complexity | High (multiple agreements, filings) | Moderate (fewer formal roles required) |
How Entity Choice Impacts Your Tax Strategy
The structure you select affects how income and distributions are taxed for both the fund and investors. Here’s what to consider:
- Flow-Through Taxation. Both LPs and LLCs usually avoid income tax at the entity level. Instead, profits pass directly to partners or members, so the entity is protected from double taxation.
- Carried Interest Treatment. LPs commonly use carried interest, where managers’ share of profits is taxed as long-term capital gains (often a lower rate). LLCs can get similar treatment, but your operating agreement must be carefully drafted to allow for this, and be in line with IRS rules.
- State Taxes and Franchise Fees. Some states impose additional franchise or filing fees on LLCs or require composite tax filings on behalf of non-resident members. LPs can be subject to similar requirements, but rules differ depending on the jurisdiction.
Tax efficiency is affected both by entity type, but also by how agreements are drafted and how income is allocated.
What Should You Consider When Structuring Your Fund?
Before you settle on an LP or LLC, think through these critical questions:
- Liability Protection: How much personal exposure are general partners willing to take on?
- Investor Preferences: Do your target investors expect a familiar LP structure?
- Tax Goals: Are you optimizing for capital gains treatment and avoiding double taxation?
- Administrative Burden: Can you maintain the compliance requirements of an LP?
- Exit Strategy: Will the entity support a future sale?
Partner with an Expert
Because fund structures have lasting legal and tax consequences, it pays to work with advisors who understand the nuances of private equity. An experienced CPA and legal team can help you:
- Draft agreements that protect your interests.
- Set up accounting systems to track allocations correctly.
- Stay compliant with evolving tax rules.
At Fusion CPA, we can help you plan your private equity funds to suit your goals. Contact us for help.
Frequently Asked Questions
- What is the main difference between an LLC and an LP in private equity?
The key difference is liability and management. In an LP, general partners manage the fund and have unlimited liability, while limited partners are passive investors. In an LLC, all members have limited liability, and management and profit-sharing arrangements are more flexible. - Does an LLC always qualify for carried interest tax treatment?
No. While LLCs can offer carried interest, the operating agreement must be carefully structured to meet IRS requirements. If not handled properly, profits may be taxed as ordinary income instead of long-term capital gains. - Can I switch from an LLC to an LP later?
Yes, but changing your entity structure can trigger tax consequences and require new agreements and filings. It’s important to consult with an advisor before making any changes.
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This blog article is not intended to be the rendering of legal, accounting, tax advice, or other professional services. We base articles on current or proposed tax rules at the time of writing and do not update older posts for tax rule changes. We expressly disclaim all liability regarding actions taken or not taken based on the contents of this blog as well as the use or interpretation of this information. This information is not all-inclusive.