PRIVILEGED & CONFIDENTIAL ATTORNEY WORK PRODUCT
MEMORANDUM
FROM: Leila Nazari, Associate, and Garrett Simmons, Senior Associate, Calderwood & Harkness LLP
TO: Sylvia Hartwell, Partner, Calderwood & Harkness LLP
DATE: August 6, 2025
RE: Section 1061 Holding Period Analysis for GP Carried Interest in Connection with Pinnacle Continuation Vehicle LP
MATTER NO.: 117443.00001
ENGAGEMENT REF. NO.: 1002-00005
This memorandum is protected by the attorney-client privilege and constitutes attorney work product. It is prepared solely for the use of Calderwood & Harkness LLP and Pinnacle Capital Management LLC in connection with the structuring of Pinnacle Continuation Vehicle LP. This memorandum should not be disclosed to any third party without the prior written consent of Calderwood & Harkness LLP. No person other than the intended recipients should rely on the analysis or conclusions contained herein.
I. Executive Summary
This memorandum analyzes the implications of Section 1061 of the Internal Revenue Code of 1986, as amended (the "Code"), as they relate to the holding period requirements applicable to the carried interest held by the general partner of Pinnacle Venture Fund II LP ("Fund II") in connection with the proposed GP-led secondary transaction and the formation of Pinnacle Continuation Vehicle LP (the "CV"). Specifically, this memorandum addresses whether, and under what conditions, the existing Section 1061 holding period applicable to the Fund II carried interest can be preserved when the GP's carried interest is rolled into the CV, and separately analyzes the holding period that will apply to the new carried interest to be issued in the CV.
The general partner of Fund II is Pinnacle Capital Partners II LLC ("Fund II GP"). Upon formation of the CV, the general partner will be Pinnacle CV Partners LLC ("CV GP," to be formed). The GP principals — Marcus Aldren (62% of GP economics), Diana Tsao (28% of GP economics), and Rafael Montoya (10% of GP economics) — currently hold their carried interest in Fund II through the Fund II GP. The Fund II carried interest provides for a 20% carry over an 8% preferred return (compounded annually) with a 100% GP catch-up and a whole-fund waterfall. This carried interest has been held since December 2019 (Fund II's final close), and the three-year holding period required under Section 1061 was satisfied as of December 2022.
The proposed CV transaction contemplates two distinct carried interest tranches:
(a) A legacy carry tranche (the "Legacy Carry Tranche") designed to inherit the Fund II holding period by means of a Section 721 non-recognition contribution, thereby preserving the long-term capital gain treatment already available under Section 1061; and
(b) A new carry tranche (the "New Carry Tranche") bearing terms of 15% carried interest over a 7% preferred return with a European-style (whole-fund, back-ended) waterfall, which will constitute a new applicable partnership interest ("API") with a fresh holding period commencing at CV closing (target: October 31, 2025).
Key Conclusion. If the transaction is properly structured — in particular, if the legacy carry tranche is contributed to the CV under Section 721 as a non-recognition transaction and the CV limited partnership agreement (the "CV LPA") clearly bifurcates the two carry tranches with distinct allocation and distribution provisions — the Legacy Carry Tranche should preserve the existing Section 1061 holding period dating back to December 2019. The New Carry Tranche, by contrast, will not satisfy the three-year holding period until October 31, 2028. Proper bifurcation in the CV LPA is critical to sustaining this treatment.
Additionally, the GP co-invest of $14 million requires separate analysis to confirm that it qualifies for the capital interest exception under Section 1061(c)(4)(A), thereby exempting it from the three-year holding period requirement. As discussed in Section VII below, we believe the co-invest satisfies the requirements of this exception, provided it is properly documented and participates pro rata with other LP capital.
For context, the aggregate fair market value of the portfolio companies being transferred to the CV is $1.34 billion (comprising $612 million for Luminos Systems Inc., $468 million for ClearArc Software Inc., and $260 million for Vectral Cloud Inc.), against an aggregate cost basis of $138 million, resulting in aggregate unrealized gain of $1.202 billion and an implied gross MOIC of 9.71×. The total CV capitalization is expected to be approximately $1.074 billion, consisting of $680 million from rolling LPs, $380 million from Garrison Secondaries Fund IV LP (the lead secondary buyer), and $14 million in GP co-invest.
The balance of this memorandum sets forth the background and transaction overview, the applicable statutory and regulatory framework, the analysis of the existing Fund II carried interest, the proposed Legacy Carry Tranche and New Carry Tranche structures, the GP co-invest analysis, the interaction between the two carry tranches, relevant risk factors, and our recommendations regarding LPA drafting, transaction timing, and documentation deliverables.
II. Background and Transaction Overview
A. Pinnacle Venture Fund II LP — Existing Fund Structure
Pinnacle Venture Fund II LP ("Fund II") is a Delaware limited partnership (EIN 84-3291067; Delaware LP File No. DE-LP-2019-04817) that held its final close in December 2019, making it a 2019 vintage fund. Fund II was formed for the purpose of making venture capital and growth equity investments in technology companies, with a particular focus on enterprise software, cloud infrastructure, and artificial intelligence.
The general partner of Fund II is Pinnacle Capital Partners II LLC ("Fund II GP"), a Delaware limited liability company (EIN 84-3291104). The management company for Fund II — which provides investment advisory and management services to the fund pursuant to the management agreement — is Pinnacle Capital Management LLC, a Delaware limited liability company (EIN 82-6140538), with its principal office located at 2100 Sand Hill Road, Suite 340, Menlo Park, California 94025.
Fund II's total committed capital is $875 million. As of the date of this memorandum, called capital totals $831.25 million, representing approximately 95% of total commitments drawn. The gross net asset value ("NAV") of the fund as of June 30, 2025 is $1.82 billion, and the net NAV (after deducting accrued fees and the estimated carry) is $1.56 billion. Fund II's investment period ended in December 2024, and the current management fee has stepped down to 1.5% per annum, calculated on invested capital rather than committed capital.
The carried interest arrangement for Fund II provides for a 20% carried interest (the "Fund II Carry") over an 8% preferred return compounded annually, with a 100% GP catch-up to a 20/80 (GP/LP) split, and a whole-fund waterfall structure. Under the whole-fund waterfall, the GP does not receive carried interest distributions until the LPs have received a return of all contributed capital plus the 8% compounded preferred return. Once the preferred return has been satisfied, the GP receives 100% of subsequent distributions until it has received its 20% catch-up share, and thereafter distributions are split 80/20 between the LPs and the GP.
B. GP Principals and Economics
The GP economics in Fund II are shared among three principals as follows:
• Marcus Aldren — Founder & Managing Partner; 62% of GP economics.
• Diana Tsao — Co-Managing Partner; 28% of GP economics.
• Rafael Montoya — Partner; 10% of GP economics.
All three individuals hold their GP economics through Pinnacle Capital Partners II LLC (the Fund II GP). The allocation percentages among the principals are established in the Fund II GP's operating agreement, and there are no outstanding disputes or side arrangements that would alter these percentages. We understand from our review of the Fund II GP operating agreement that these percentages have been in effect since Fund II's final close in December 2019 and have not been amended.
C. Portfolio Companies to Be Transferred to CV
The CV transaction involves the transfer of Fund II's interests in three portfolio companies to the CV. Each of these companies represents a significant position within Fund II's overall portfolio and collectively accounts for substantially all of the fund's unrealized value. The key details of each portfolio company are summarized below:
1. Luminos Systems Inc.
Luminos Systems Inc. ("Luminos") is a Delaware C-corporation (EIN 47-8823156) that operates an AI-powered revenue operations platform designed for enterprise-scale software-as-a-service companies. Fund II holds a 24.7% fully diluted equity stake in Luminos. Based on the June 2025 Section 409A valuation of Luminos, the company's enterprise value is $2.48 billion, yielding a fair market value for Fund II's stake of approximately $612 million. Fund II's aggregate cost basis in its Luminos shares (acquired through participation in the company's Series B and Series C financing rounds) is $58.5 million. Fund II made its initial investment in Luminos in Q1 2020.
2. ClearArc Software Inc.
ClearArc Software Inc. ("ClearArc") is a Delaware C-corporation (EIN 83-5519274) that provides a cloud-native compliance and audit automation platform serving regulated industries, including financial services, healthcare, and government contracting. Fund II holds a 31.2% fully diluted equity stake in ClearArc. Based on the current valuation, ClearArc's enterprise value is approximately $1.50 billion, yielding a fair market value for Fund II's stake of approximately $468 million. Fund II's aggregate cost basis in ClearArc (acquired through its Series A and Series B financing rounds) is $37.4 million. The initial investment was made in Q2 2020.
3. Vectral Cloud Inc.
Vectral Cloud Inc. ("Vectral") is a Delaware C-corporation (EIN 85-1102847) that provides a multi-cloud infrastructure orchestration and FinOps platform enabling enterprises to optimize their cloud spending and operations across multiple hyperscaler environments. Fund II holds an 18.9% fully diluted equity stake in Vectral. Based on the current valuation, Vectral's enterprise value is approximately $1.376 billion, yielding a fair market value for Fund II's stake of approximately $260 million. Fund II's cost basis in Vectral (acquired through participation in the company's Series B round) is $42.1 million. The initial investment was made in March 2021.
Aggregate Portfolio Summary.
The implied gross MOIC for the transferred portfolio is approximately 9.71× (i.e., $1.34 billion FMV divided by $138 million cost basis).
D. Continuation Vehicle Terms
The Pinnacle Continuation Vehicle LP (the "CV") is a Delaware limited partnership to be formed in connection with the transaction. The general partner of the CV will be Pinnacle CV Partners LLC ("CV GP"), also a Delaware limited liability company to be formed. The key structural terms of the CV are as follows:
• Target Final Close: October 31, 2025 (target first close: October 15, 2025).
• Term: Five (5) years from the final close, with two (2) one-year extension options exercisable at the GP's discretion, subject to LP advisory committee consent.
• Management Fee: 1.25% per annum calculated on the CV's net asset value.
• Carried Interest: 15% over a 7% preferred return (compounded annually), with a European-style (whole-fund, back-ended) waterfall.
• Rolling LP NAV: Approximately $680 million, representing the interests of existing Fund II LPs electing to roll their interests into the CV.
• Cashing-Out LP NAV: Approximately $280 million, representing the interests of Fund II LPs electing to receive liquidity through the secondary transaction.
• New Secondary Capital: $380 million from Garrison Secondaries Fund IV LP ("Garrison"), the lead secondary buyer. Garrison's legal counsel in this transaction is Whitfield & Calloway LLP (Douglas Whitfield, Partner).
• GP Co-Invest: $14 million, funded by the GP principals in proportion to their GP economics (Aldren: $8.68 million; Tsao: $3.92 million; Montoya: $1.40 million).
• Total CV Capitalization: Approximately $1.074 billion ($680M rolling LPs + $380M Garrison + $14M GP co-invest).
• Liquidity Pool for Cashing-Out LPs: $280 million of Garrison's $380 million commitment will be used to provide liquidity to cashing-out LPs; the remaining $100 million will be allocated to follow-on investment reserves and transaction expenses.
The transaction structure involves Fund II contributing its interests in Luminos, ClearArc, and Vectral to the CV. Rolling LPs will exchange their Fund II interests for interests in the CV. Cashing-out LPs will receive cash consideration funded by Garrison's commitment. Garrison will acquire its LP interest in the CV by contributing cash. The GP will contribute its carried interest in Fund II (to the extent allocable to the three portfolio companies) to the CV in exchange for the Legacy Carry Tranche, and will receive the New Carry Tranche in connection with its provision of investment management services to the CV.
E. Advisor Landscape (Relevant to This Analysis)
The following advisors are engaged in connection with the CV transaction and are relevant to the tax structuring analysis:
• Calderwood & Harkness LLP (this firm): Fund-level tax structuring counsel. This engagement encompasses the Section 1061 holding period analysis set forth in this memorandum, the Section 721 non-recognition analysis, the Section 704(c) allocation methodology analysis, the QSBS preservation analysis, and the preparation of a closing tax opinion letter (Sylvia Hartwell, signing partner).
• Hawthorne Reid LLP (Vanessa Liu, Partner): Fund formation and corporate counsel responsible for drafting the CV LPA and related organizational documents. The tax provisions of the CV LPA, including the bifurcated carry provisions, will require coordination between Hawthorne Reid and our team.
• Kessler Pratt LLP (David Kessler, Managing Partner): Independent valuation firm engaged to provide a fairness opinion and to establish the fair market value of each portfolio company as of the contribution date. The engagement fee is $850,000 (flat fee), and delivery of the fairness opinion is targeted for September 22, 2025. The Kessler Pratt valuation will be the basis for the Legacy Gain / New Gain bifurcation.
• Andover & Strauss LLP (Patricia Clemons, Audit Partner): Fund auditor and tax return preparer for both Fund II and the CV. Andover & Strauss will be responsible for preparing the Schedule K-1s for the CV and must be briefed on the dual-tranche carry reporting requirements.
III. Statutory Framework — Section 1061
A. Overview of Section 1061
Section 1061 of the Code was enacted as part of the Tax Cuts and Jobs Act of 2017 ("TCJA"), Public Law No. 115-97, and is effective for taxable years beginning after December 31, 2017. Section 1061 addresses the tax treatment of certain partnership interests — commonly referred to as "carried interests" — that are received by fund managers and other investment professionals in connection with the performance of investment management services.
Prior to the enactment of Section 1061, gains allocable to a carried interest in a partnership (including a venture capital or private equity fund) were eligible for long-term capital gain treatment if the underlying assets generating the gain had been held for more than one year, consistent with the general capital gains holding period rules under Sections 1(h) and 1222 of the Code. This treatment was the subject of significant political debate, as it resulted in investment fund managers paying capital gains rates (currently a maximum of 20% federal, plus the 3.8% net investment income tax under Section 1411) on their carried interest income, rather than ordinary income rates (currently a maximum of 37% federal, plus the 3.8% NIIT).
Section 1061 did not eliminate long-term capital gain treatment for carried interests. Instead, it extended the holding period required for favorable capital gains treatment from more than one year to more than three years for gains allocable to an "applicable partnership interest" (an "API"). Specifically, Section 1061(a) provides that, in the case of a taxpayer that holds an API, the taxpayer's net long-term capital gain with respect to such interest is reduced by the amount of the taxpayer's "net long-term capital gain" determined by substituting "3 years" for "1 year" each place it appears in Section 1222(3) (which defines the term "long-term capital gain"). The excess — that is, the net long-term capital gain attributable to assets held for more than one year but not more than three years — is recharacterized as short-term capital gain and taxed at ordinary income rates (up to 37% federal plus the 3.8% NIIT, for a combined federal rate of up to 40.8%).
In effect, Section 1061 imposes a three-year holding period requirement on long-term capital gains attributable to carried interests. If the holding period requirements are satisfied — both at the partnership interest level and at the underlying asset level — the gain retains its long-term capital gain character and is taxed at the favorable rate.
B. Applicable Partnership Interest Defined — Section 1061(c)
Section 1061(c)(1) defines an "applicable partnership interest" as any interest in a partnership which, directly or indirectly, is transferred to (or is held by) the taxpayer in connection with the performance of substantial services by the taxpayer, or any other related person, in any "applicable trade or business." The term "applicable trade or business" is defined in Section 1061(c)(2) as any activity conducted on a regular, continuous, and substantial basis which consists, in whole or in part, of:
(i) raising or returning capital; and
(ii) either (A) investing in (or disposing of) specified assets, or (B) developing specified assets.
"Specified assets" are defined in Section 1061(c)(3) to include securities (as defined in Section 475(c)(2)), commodities (as defined in Section 475(e)(2)), real estate held for rental or investment, cash or cash equivalents, options or derivative contracts with respect to any of the foregoing, and an interest in a partnership to the extent of the partnership's proportionate interest in any of the foregoing.
Venture capital fund interests held by fund managers clearly qualify as APIs. The management activities of Pinnacle Capital Management LLC — which include raising capital from investors, investing fund capital in portfolio company securities (venture-stage equity interests in technology companies), and managing those investments with the objective of generating returns for fund investors — constitute an "applicable trade or business" within the meaning of Section 1061(c)(2). The carried interest held by the GP principals through Pinnacle Capital Partners II LLC was transferred to them in connection with the performance of substantial investment management services. Accordingly, the Fund II Carry is an API, and the New Carry Tranche in the CV will also constitute an API.
C. Capital Interest Exception — Section 1061(c)(4)
Section 1061(c)(4)(A) provides that an applicable partnership interest does not include an interest held by a person to the extent that the interest is a "capital interest" in the partnership which provides the taxpayer with a right to share in partnership capital commensurate with:
(i) the amount of capital contributed directly by that taxpayer to the partnership; or
(ii) the value of services provided to the partnership by that taxpayer, to the extent that such interest is not dependent on the overall income or gain of the partnership.
In other words, a partnership interest that represents actual capital contributed by the taxpayer — and that participates in partnership profits and losses in proportion to that capital contribution (on the same basis as other capital contributors) — is not an API and is therefore not subject to the three-year holding period requirement of Section 1061. This exception is commonly referred to as the "capital interest exception."
The GP co-invest of $14 million in the CV is intended to constitute a capital interest, not an API, to the extent it represents actual capital contributed by the GP principals and participates pro rata with LP capital in the distribution waterfall. As discussed in greater detail in Section VII below, the $14 million GP co-invest should qualify for the capital interest exception, provided it is properly structured and documented. The standard one-year holding period under Section 1222 — rather than the extended three-year period under Section 1061 — would apply to gains allocable to the co-invest interest.
D. Three-Year Holding Period Requirement
Under Section 1061(a), long-term capital gain with respect to an API is determined by reference to a holding period of more than three years, rather than the standard more-than-one-year requirement that applies to capital gains generally. This extended holding period applies at two levels:
First, the API itself must be held by the taxpayer for more than three years. This is the "interest-level" holding period requirement. The holding period of the API commences when the taxpayer receives the interest (i.e., at the time of the fund's closing or when the carried interest is first granted or allocated to the taxpayer). If the API is disposed of within three years of its receipt, any gain recognized on the disposition would be short-term capital gain.
Second, under the Treasury Regulations promulgated under Section 1061, the underlying assets generating the gain within the partnership must also have been held for more than three years. Treasury Regulation Section 1.1061-4(a)(1) establishes a "look-through" framework requiring the partnership to determine, at the asset level, whether each item of gain allocated to an API holder arises from assets held for more than three years. This is the "asset-level" holding period requirement.
Together, these two requirements create a "dual holding period test." For a gain allocated to a carried interest to receive long-term capital gain treatment, both (i) the carried interest must have been held for more than three years and (ii) the underlying partnership asset generating the gain must have been held for more than three years. If either condition is not met, the gain is recharacterized as short-term capital gain.
In the context of the CV transaction, this dual holding period test requires analysis of both the holding period of the carried interest itself (the Legacy Carry Tranche and the New Carry Tranche) and the holding period of the underlying portfolio company interests (Luminos, ClearArc, and Vectral) held at the CV level.
E. Transfer and Tacking Rules
The general tacking rules under Section 1223 of the Code are relevant to the analysis of whether the Legacy Carry Tranche can inherit the holding period of the Fund II Carry. Section 1223(1) provides that, in determining the period for which the taxpayer has held property received in an exchange, there shall be included the period for which the taxpayer held the property exchanged if the property received has the same basis, in whole or in part, as the property exchanged, and the property exchanged is a capital asset or a Section 1231 asset. In the context of a Section 721 contribution of property to a partnership, the contributing partner's holding period in the partnership interest received includes the holding period of the property contributed, provided the contribution qualifies for non-recognition treatment under Section 721(a).
Treasury Regulation Section 1.1061-4(b)(7) provides specific rules for determining the holding period of an API received in certain non-recognition transactions. This regulation addresses the situation where a taxpayer transfers an API in a non-recognition transaction (including a contribution under Section 721) and receives a new partnership interest in exchange. Under this regulation, the holding period of the received API generally includes the holding period of the transferred API, consistent with the general tacking rule of Section 1223(1). This tacking rule is essential to our analysis, as it provides the regulatory basis for the position that the Legacy Carry Tranche in the CV can inherit the holding period of the Fund II Carry.
Specifically, if the Fund II GP contributes its carried interest in Fund II — itself a partnership interest — to the CV under Section 721, the holding period of the resulting CV interest (the Legacy Carry Tranche) should include the holding period of the Fund II carried interest, dating back to December 2019. Because the three-year Section 1061 holding period for the Fund II Carry was satisfied in December 2022, the Legacy Carry Tranche would also satisfy the three-year requirement as of the CV closing date.
The tacking analysis is subject to certain conditions and limitations, which are discussed in detail in Section V.C below.
IV. Analysis of Existing Fund II Carried Interest
A. Fund II Carry Terms
As described in Section II.A above, the Fund II Carry provides for the following economic terms:
• Carry Percentage: 20% of net profits.
• Preferred Return: 8% per annum, compounded annually.
• Catch-Up: 100% GP catch-up to a 20/80 split.
• Waterfall Structure: Whole-fund waterfall (i.e., distributions to the GP in respect of the carry do not commence until LPs have received a return of all contributed capital plus the 8% compounded preferred return, and thereafter the GP receives 100% of distributions until the catch-up is satisfied, with subsequent distributions split 80/20 between LPs and the GP).
• Holding Entity: Pinnacle Capital Partners II LLC (EIN 84-3291104).
• Allocation Among GP Principals: Marcus Aldren — 62%; Diana Tsao — 28%; Rafael Montoya — 10%.
The Fund II Carry is an applicable partnership interest within the meaning of Section 1061(c), as it was transferred to the GP principals in connection with the performance of substantial investment management services in an applicable trade or business (venture capital fund management). There is no dispute regarding the API characterization of the Fund II Carry.
B. Section 1061 Holding Period Status
The Fund II Carry has been held since December 2019, the date of Fund II's final close. Under the rules of Section 1061, the three-year holding period applicable to the Fund II Carry commenced in December 2019 and was satisfied as of December 2022. Accordingly, any gains currently allocated to the GP's carried interest from Fund II that are attributable to assets held for more than three years would qualify for long-term capital gain treatment under Section 1061, subject to applicable tax rates (i.e., the maximum federal rate of 20% plus the 3.8% NIIT under Section 1411, for a combined maximum federal rate of 23.8%).
The asset-level holding period requirement is also satisfied for all three portfolio companies to be transferred to the CV. Luminos was initially acquired in Q1 2020 (more than five years ago), ClearArc was initially acquired in Q2 2020 (more than five years ago), and Vectral was initially acquired in March 2021 (more than four years ago). In each case, the asset-level holding period exceeds three years as of the date of this memorandum and will continue to exceed three years as of the targeted CV closing date of October 31, 2025.
In sum, the Fund II Carry currently satisfies both prongs of the dual holding period test under Section 1061: the interest-level holding period has exceeded three years (since December 2022), and the asset-level holding period for each of the three portfolio companies has also exceeded three years. If the CV transaction were not contemplated, gains allocated to the Fund II Carry upon any exit of Luminos, ClearArc, or Vectral would receive long-term capital gain treatment without any Section 1061 recharacterization.
C. Implications for the CV Transaction
The foregoing analysis highlights the critical importance of preserving the existing Section 1061 holding period in connection with the CV transaction. If the Fund II Carry were simply terminated upon the closing of the CV and replaced with a new carried interest in the CV, the Section 1061 holding period would reset to the date of the CV closing (October 31, 2025), and no gain allocated to the new carried interest would qualify for long-term capital gain treatment until October 31, 2028.
This result would be highly adverse to the GP principals. The three portfolio companies to be transferred to the CV carry aggregate unrealized gain of approximately $1.202 billion. The GP's economic share of this gain under the Fund II Carry — which, under a simplified calculation assuming the preferred return and catch-up have been or will be satisfied on the $831.25 million of called capital — could be as high as approximately $240 million (i.e., 20% of the $1.202 billion of aggregate unrealized gain). If this approximately $240 million of carried interest were treated as short-term capital gain due to a reset of the Section 1061 holding period, the incremental federal tax cost to the GP principals could be as much as approximately $40.8 million (representing the difference between the 23.8% long-term capital gain rate and the 40.8% short-term capital gain / ordinary income rate, applied to $240 million — i.e., 17 percentage points × $240 million = $40.8 million).
This approximately $40.8 million incremental tax cost, allocated among the GP principals in proportion to their GP economics (Aldren: approximately $25.3 million; Tsao: approximately $11.4 million; Montoya: approximately $4.1 million), would be a substantial and entirely avoidable cost if the transaction is properly structured. Furthermore, this estimate does not account for applicable state taxes, which could increase the incremental cost further.
Accordingly, structuring the CV transaction to preserve the existing Section 1061 holding period on the GP's share of built-in gain in the three portfolio companies is a first-order tax structuring objective. The mechanism for achieving this objective — the bifurcated carry structure with a Legacy Carry Tranche that tacks to the Fund II holding period — is analyzed in detail in Section V below.
V. Proposed Legacy Carry Tranche — Structure and Analysis
A. Structural Design
We recommend that the CV LPA bifurcate the GP's carried interest into two separate and distinct tranches, each with its own allocation and distribution mechanics:
Legacy Carry Tranche. The Legacy Carry Tranche relates to the GP's share of gain attributable to the portfolio company interests contributed from Fund II to the CV — specifically, the existing $1.202 billion of aggregate unrealized gain on Luminos, ClearArc, and Vectral as of the contribution date. The Legacy Carry Tranche should carry economic terms that mirror the Fund II Carry to the maximum extent feasible (20% over 8% preferred return, whole-fund waterfall), and should be structured as a continuation of the Fund II carried interest, contributed to the CV under Section 721 as a non-recognition transaction.
New Carry Tranche. The New Carry Tranche relates to new value creation in the CV — that is, appreciation in the portfolio company values above the contribution date FMV of $1.34 billion, plus any returns on follow-on investments funded from the $100 million reserve. The New Carry Tranche will carry the negotiated CV terms (15% over 7% preferred return, European-style waterfall) and will constitute a new API with a fresh holding period commencing at CV closing.
This bifurcated structure serves two distinct functions. First, it preserves the tax-favorable treatment of the built-in gain that accrued during the Fund II holding period by ensuring that the Legacy Carry Tranche inherits the Fund II's Section 1061 holding period. Second, it accurately reflects the distinct economic bargain between the GP and its investors: the Legacy Carry Tranche compensates the GP for the value it has already created in the portfolio companies (under the original Fund II Carry terms), while the New Carry Tranche compensates the GP for any additional value it creates going forward (under the new CV terms, which reflect the GP's reduced negotiating leverage in a continuation vehicle context and the market-standard terms demanded by Garrison as the lead secondary buyer).
B. Section 721 Contribution Mechanics
Section 721(a) of the Code provides the general rule of non-recognition for contributions of property to partnerships:
"No gain or loss shall be recognized to a partnership or to any of its partners in the case of a contribution of property to the partnership in exchange for an interest in the partnership."
Under this provision, the GP would contribute its Fund II carried interest — which is itself a partnership interest in Fund II — to the CV in exchange for a limited partnership interest in the CV (the Legacy Carry Tranche). The contribution would qualify as a non-recognition transaction under Section 721(a), meaning that no gain or loss would be recognized by either the GP or the CV upon the contribution.
Under Section 722, the GP's basis in the CV interest received (the Legacy Carry Tranche) would equal the GP's basis in the Fund II carried interest contributed. Under Section 723, the CV's basis in the contributed Fund II interest would equal the GP's basis in that interest immediately prior to the contribution.
Critically, under Section 1223(1), the holding period of the CV Legacy Carry interest would include the holding period of the Fund II carried interest contributed — that is, the holding period would tack back to December 2019 (Fund II's final close). This tacking rule is the cornerstone of the holding period preservation strategy for the Legacy Carry Tranche.
It bears noting that the applicability of Section 721 to the contribution of a carried interest (a profits interest) requires careful analysis. A carried interest in a partnership is generally treated as a partnership interest — it is a property interest that gives the holder a right to share in the income, gain, loss, deduction, and credit of the partnership. For Section 721 purposes, a partnership interest (including a profits interest) is generally treated as "property" that can be contributed to another partnership in a non-recognition transaction. This treatment is consistent with Revenue Ruling 99-5 and the general principles underlying the partnership contribution rules.
C. Regulatory Support for Tacking
Treasury Regulation Section 1.1061-4(b)(7) provides specific rules governing the holding period of an API received in a non-recognition transaction. The regulation addresses the scenario in which a taxpayer holds an API in one partnership (the "Transferred API") and contributes it to another partnership in exchange for a new partnership interest (the "Received API") in a transaction qualifying for non-recognition treatment under Section 721. Under these rules, the holding period of the Received API generally includes the holding period of the Transferred API, consistent with the general tacking rules of Section 1223(1).
This regulatory provision directly supports the position that the CV Legacy Carry Tranche (the Received API) should inherit the holding period of the Fund II Carry (the Transferred API). The regulation contemplates the precise type of transaction at issue here: a profits interest in one partnership is contributed to another partnership in exchange for a profits interest, and the resulting API inherits the holding period of the contributed API.
An important subsidiary question is whether the Fund II carried interest constitutes "property" for purposes of Section 721. Profits interests in partnerships have historically presented classification challenges. However, Revenue Procedure 93-27 established that the receipt of a profits interest for services is generally not a taxable event if certain conditions are met, and Revenue Procedure 2001-43 further provided a safe harbor for the tax-free receipt of profits interests. In the context of Section 721 contributions, a profits interest that has already been received and is held by the contributing partner should be treated as a partnership interest (and therefore as property) that can be contributed to another partnership. The IRS has not issued guidance suggesting that a profits interest, once received, is not eligible for Section 721 non-recognition treatment when contributed to a new partnership.
We are not aware of any published authority — whether in the form of Treasury Regulations, revenue rulings, or court decisions — that would deny Section 721 treatment to the contribution of a carried interest (profits interest) from one partnership to another. While the regulatory framework under Section 1061 is relatively new and there is limited guidance addressing carried interest rollovers in the specific context of continuation vehicles, we believe the weight of authority supports the position that the contribution qualifies for non-recognition treatment and that the holding period tacking rules apply.
This position will be more fully developed in the Section 721 tax opinion letter to be delivered at closing (with Sylvia Hartwell as signing partner), which will address the non-recognition and tacking issues at an "at least more likely than not" confidence level.
D. Calculation of Legacy Carry Amount
The Legacy Carry Tranche should be calibrated to reflect the GP's accrued but undistributed carried interest attributable to the three portfolio companies being transferred to the CV. The calculation of this amount requires application of the full Fund II waterfall to the built-in gain in the contributed portfolio companies.
The key inputs for this calculation are:
• Aggregate unrealized gain on the three portfolio companies: $1.202 billion ($1.34 billion FMV less $138 million cost basis).
• Fund II called capital: $831.25 million.
• Fund II preferred return: 8% per annum, compounded annually.
• Fund II vintage: December 2019 (approximately 5.8 years to the CV closing date of October 31, 2025).
• Fund II whole-fund waterfall structure with 100% GP catch-up.
A detailed waterfall calculation is beyond the scope of this memorandum and will be prepared separately as part of the closing deliverables. However, for purposes of this analysis, the GP's economic share of the $1.202 billion of built-in gain is estimated to be approximately $240 million (representing 20% of the aggregate unrealized gain, on a simplified basis assuming the preferred return and catch-up have been satisfied). The actual amount will depend on the precise application of the Fund II waterfall, including the compounding of the preferred return and the allocation of prior distributions (if any).
The Legacy Carry Tranche in the CV should be structured to replicate the GP's economic entitlement under the Fund II waterfall, as applied to the contributed portfolio companies. The gain attributable to the Legacy Carry Tranche should equal the GP's share of gain that would have been allocated under the Fund II Carry had Fund II sold the three portfolio companies at their contribution date FMVs.
The allocation among the GP principals is straightforward and mirrors the Fund II GP economics:
• Marcus Aldren: 62% of Legacy Carry Tranche.
• Diana Tsao: 28% of Legacy Carry Tranche.
• Rafael Montoya: 10% of Legacy Carry Tranche.
E. Interaction with Cashing-Out LP Distributions
The treatment of cashing-out LPs requires careful coordination with the Legacy Carry analysis. Cashing-out LPs — representing approximately $280 million of Fund II NAV — will receive liquidity funded by Garrison's $380 million commitment. The manner in which the cash-out transaction is structured has implications for the Section 1061 analysis.
Scenario 1: Cash-Out at the Fund II Level (Distribution Before Contribution). If the transaction is structured such that Fund II first distributes cash (or in-kind interests) to cashing-out LPs before contributing the remaining portfolio interests to the CV, the cash-out transaction occurs at the Fund II level. In this scenario, to the extent Fund II recognizes gain on the deemed disposition of interests attributable to the cashing-out LPs, the GP's carry on that gain would be governed by the Fund II Carry, and the three-year Section 1061 holding period has already been satisfied (since December 2022). There would be no Section 1061 recharacterization issue with respect to the carry on the cash-out gain.
Scenario 2: Direct Sale Within the CV. If the transaction is structured such that Garrison acquires its interest in the CV by purchasing (directly or indirectly) the interests of the cashing-out LPs, the tax analysis differs. In this scenario, the cash-out transaction effectively occurs at the CV level (or as a secondary transfer), and the allocation of gain between the Fund II Carry and the CV Carry — and between the Legacy Carry Tranche and the New Carry Tranche — must be analyzed in the context of the overall transaction structure.
The transaction structure for the cash-out must be coordinated with Hawthorne Reid LLP (Vanessa Liu) and with the broader transaction working group. We recommend that the cash-out be structured, to the extent feasible, as a Fund II-level event (Scenario 1) to simplify the Section 1061 analysis and to ensure that the GP's carry on the cash-out gain benefits from the satisfied three-year holding period.
VI. New Carry Tranche — Analysis
A. Terms of New CV Carry
The New Carry Tranche in the CV will carry the following economic terms, as negotiated between the GP and Garrison (the lead secondary buyer):
• Carry Percentage: 15% of net profits (reduced from the Fund II carry rate of 20%, reflecting the GP's reduced negotiating leverage in a continuation vehicle context and the established market standard for GP-led secondary transactions).
• Preferred Return: 7% per annum, compounded annually (reduced from the Fund II preferred return of 8%).
• Waterfall Structure: European-style waterfall (whole-fund, back-ended). Under this structure, the GP does not receive carry distributions until the end of the fund's term or upon a final liquidation, unless interim carry distributions are permitted subject to a GP clawback obligation. The European-style waterfall provides greater LP protection than the whole-fund waterfall used in Fund II, which is a typical concession in continuation vehicle transactions.
• Applicability: The New Carry Tranche applies to appreciation above the contributed portfolio FMV of $1.34 billion and to returns on follow-on investments funded from the $100 million follow-on reserve.
B. Section 1061 Holding Period for New Carry
The New Carry Tranche constitutes a new applicable partnership interest issued in connection with the performance of investment management services by the GP principals. Unlike the Legacy Carry Tranche, the New Carry Tranche cannot inherit the holding period of the Fund II Carry, because it does not represent a continuation of the Fund II carried interest. Rather, it is a new profits interest issued to the GP in exchange for its commitment to provide management services to the CV. Accordingly, the holding period for the New Carry Tranche commences at the time the interest is issued — which will be the CV closing date, targeted for October 31, 2025.
Under Section 1061(a), the three-year holding period for the New Carry Tranche will be satisfied on October 31, 2028. Any gains allocated to the New Carry Tranche and distributed to the GP principals before October 31, 2028 would be recharacterized as short-term capital gain (taxed at ordinary income rates of up to 37% federal, plus the 3.8% NIIT, for a combined federal rate of up to 40.8%). Gains allocated to the New Carry Tranche and distributed on or after October 31, 2028 would qualify for long-term capital gain treatment (taxed at the maximum federal rate of 20%, plus the 3.8% NIIT, for a combined federal rate of 23.8%).
C. Practical Implications
The practical implications of the Section 1061 holding period for the New Carry Tranche are significant and should inform the GP's exit planning for the portfolio companies.
The CV has a proposed term of five years from the final close (October 31, 2025 through October 31, 2030), with two one-year extension options. The first three years of the CV's life — from closing through October 31, 2028 — represent a window during which any gains allocated to the New Carry Tranche would be subject to short-term capital gain treatment. If any of the three portfolio companies (Luminos, ClearArc, or Vectral) is sold or undergoes a liquidity event (such as an IPO with a subsequent lock-up release and sale of shares) during this three-year period, the GP's share of gain under the New Carry Tranche would be treated as short-term capital gain.
However, the adverse consequences of an exit during this period are mitigated by the bifurcated carry structure. Gains attributable to built-in gain at the time of contribution to the CV — up to the $1.202 billion of aggregate unrealized gain — are allocated to the Legacy Carry Tranche, which has a satisfied three-year holding period. Only gains in excess of the contribution date FMV (i.e., appreciation occurring after the contribution) would be allocated to the New Carry Tranche and potentially subject to short-term capital gain treatment.
For example, if Luminos were sold in 2027 for $750 million (against a contribution date FMV of $612 million), the $553.5 million of built-in gain (FMV of $612 million less cost basis of $58.5 million) would be allocated to the Legacy Carry Tranche and would qualify for long-term capital gain treatment. Only the $138 million of post-contribution appreciation ($750 million sale price less $612 million contribution date FMV) would be allocated to the New Carry Tranche, and the GP's 15% share of that gain (approximately $20.7 million, before application of the preferred return) would be subject to short-term capital gain treatment if the exit occurred before October 31, 2028.
Nevertheless, to the extent feasible, exit planning for the portfolio companies should take the October 31, 2028 milestone into account. All else being equal, a portfolio company exit after October 31, 2028 would be more tax-efficient for the GP principals than an exit before that date, because both the Legacy Carry and the New Carry would receive long-term capital gain treatment. Of course, investment considerations — including market conditions, company readiness, and LP liquidity expectations — may override tax planning considerations, and the decision of when to exit a portfolio company should ultimately be driven by the GP's fiduciary duties to the CV's investors.
D. Allocation Among GP Principals
The New Carry Tranche will be allocated among the GP principals in the same proportions as the Fund II GP economics:
• Marcus Aldren: 62% of the New Carry Tranche.
• Diana Tsao: 28% of the New Carry Tranche.
• Rafael Montoya: 10% of the New Carry Tranche.
Each principal's individual Section 1061 holding period for the New Carry Tranche begins on the CV closing date (October 31, 2025) and will be satisfied on October 31, 2028. The principals should be advised of this timeline and should factor it into their personal tax planning.
VII. GP Co-Invest Analysis — Capital Interest Exception
A. Structure of GP Co-Invest
In addition to their carried interest, the GP principals will contribute $14 million in capital to the CV as a co-investment alongside LP capital. The co-invest will be funded by the GP principals in proportion to their GP economics:
• Marcus Aldren: $8.68 million (62% of $14 million).
• Diana Tsao: $3.92 million (28% of $14 million).
• Rafael Montoya: $1.40 million (10% of $14 million).
The GP co-invest is structured to participate pro rata with LP capital in the CV's distribution waterfall. Specifically, the co-invest capital shares in the 7% preferred return on the same basis as LP capital, participates in capital returns alongside LP capital, and is subject to the same terms and conditions as LP capital with respect to distributions. The co-invest does not receive any preferential treatment relative to LP interests, nor does it receive any allocation of carried interest. The co-invest interest is intended to be economically identical to an LP interest in the CV of the same size.
B. Application of Section 1061(c)(4) Exception
We believe the $14 million GP co-invest should qualify for the capital interest exception under Section 1061(c)(4)(A) for the following reasons:
First, the co-invest represents actual capital contributed by the GP principals. The $14 million is being funded from the personal resources of Aldren, Tsao, and Montoya (or through personal credit facilities), not from carried interest distributions or fee waivers. The capital contribution is real and substantive.
Second, the co-invest provides the GP principals with a right to share in partnership capital commensurate with the amount of capital contributed. The co-invest participates in CV distributions on the same pro rata basis as LP capital — for every dollar of capital contributed by the GP as co-invest, the GP receives the same return as an LP contributing the same dollar. There is no leveraged or asymmetric return structure that would distinguish the co-invest from ordinary LP capital.
Third, the return on the co-invest is not contingent on the overall income or gains of the partnership beyond the co-invest's pro rata share. The co-invest does not participate in the carried interest waterfall, does not receive any enhanced allocation of income or gain, and does not benefit from any priority distribution that is unavailable to LP interests.
Because the co-invest satisfies each of these requirements, gains allocable to the $14 million co-invest are not subject to the three-year holding period requirement of Section 1061. Instead, the standard one-year holding period under Section 1222 applies. Accordingly, gains on the co-invest will qualify for long-term capital gain treatment if the co-invest is held for more than one year from the date of contribution (i.e., after October 31, 2026).
It is important to note that the capital interest exception applies only to the extent the co-invest represents a bona fide capital contribution and is not a disguised carry allocation. If the IRS were to recharacterize any portion of the co-invest as a carried interest — for example, because the co-invest were funded through a fee waiver or because the co-invest received a disproportionate allocation of income relative to its capital contribution — that portion would be subject to the three-year holding period under Section 1061. Proper documentation and arm's-length structuring of the co-invest are essential to sustaining the capital interest exception.
C. Documentation Requirements
To ensure that the capital interest exception under Section 1061(c)(4) is properly documented and defensible, the following steps should be taken:
1. LPA Designation. The CV LPA should include a specific provision identifying the GP co-invest as a "Capital Interest" that is distinct from both the Legacy Carry Tranche and the New Carry Tranche. The provision should state that the co-invest constitutes a capital interest within the meaning of Section 1061(c)(4)(A) and participates pro rata with LP capital in the CV's distribution waterfall.
2. Separate Capital Accounts. The CV should maintain separate capital accounts for the GP co-invest, distinct from the capital accounts maintained for the Legacy Carry Tranche and the New Carry Tranche. This segregation ensures that allocations and distributions attributable to the co-invest can be clearly traced and distinguished from carry allocations.
3. Allocation and Distribution Provisions. The CV LPA's allocation and distribution provisions should clearly distinguish between returns on the co-invest capital and carry distributions. Returns on the co-invest should be allocated and distributed in the same manner as returns to LP interests, without any enhancement or preferential treatment.
4. Tax Reporting. Andover & Strauss LLP (the fund auditor and tax return preparer, Patricia Clemons) should be instructed to track and report the co-invest separately on each GP principal's Schedule K-1. The K-1 should clearly distinguish between items of income, gain, loss, and deduction attributable to the co-invest (subject to the standard one-year holding period) and items attributable to the carry tranches (subject to the three-year holding period under Section 1061).
VIII. Interaction Between Legacy and New Carry Tranches
A. Bifurcation Mechanics in the LPA
The success of the proposed structure depends critically on the CV LPA's ability to clearly delineate the allocation of gains between the Legacy Carry Tranche and the New Carry Tranche. Without precise drafting, the IRS may challenge the allocation, and the tax benefits of the bifurcated structure could be lost.
Built-in gain at the time of contribution ($1.202 billion in the aggregate) should be allocated to the rolling LP capital accounts and to the Legacy Carry Tranche under the principles of Section 704(c) of the Code. Section 704(c) requires that items of income, gain, loss, and deduction with respect to contributed property be allocated in a manner that takes into account the difference between the property's fair market value at the time of contribution and its adjusted basis. The application of Section 704(c) to the contributed portfolio company interests ensures that the built-in gain is allocated to the appropriate partners (rolling LPs and the GP, through the Legacy Carry Tranche) and is not allocated to Garrison or other new investors who did not benefit from the pre-contribution appreciation.
We recommend the use of the remedial allocation method under Treasury Regulation Section 1.704-3(d) for purposes of the Section 704(c) allocations, as analyzed in our separate Section 704(c) memorandum. The remedial method provides the most precise allocation of built-in gain and is well-suited to the substantial disparities between fair market value and basis that exist for the three portfolio companies.
Post-contribution appreciation — i.e., gains in excess of the contribution date FMV — should be allocated to LP capital accounts and to the New Carry Tranche under the CV's 15% over 7% waterfall. This allocation is straightforward and does not implicate Section 704(c), as post-contribution appreciation arises after the date of contribution and is shared among all CV investors in accordance with the CV's economic terms.
To implement this bifurcation, the CV LPA should define two categories of gain:
• "Legacy Gain" should be defined as gain attributable to unrealized appreciation in the contributed portfolio company interests as of the contribution date, measured as the excess of the contribution date FMV over the adjusted tax basis of the contributed interests. For the aggregate portfolio, Legacy Gain equals $1.202 billion (i.e., $1.34 billion FMV less $138 million cost basis). On a per-company basis, Legacy Gain is as follows: Luminos — $553.5 million; ClearArc — $430.6 million; Vectral — $217.9 million.
• "New Gain" should be defined as gain attributable to appreciation in the contributed portfolio company interests in excess of the contribution date FMV, plus any gain from investments made with the $100 million follow-on reserve. New Gain is computed by reference to the excess of the actual sale price (or other realization amount) over the contribution date FMV for each portfolio company.
The LPA should specify that Legacy Gain is allocated to the Legacy Carry Tranche (under the Fund II carry terms of 20% over 8%) and that New Gain is allocated to the New Carry Tranche (under the CV carry terms of 15% over 7%). This dual-waterfall structure must be drafted with precision, and we recommend close coordination with Vanessa Liu at Hawthorne Reid LLP to ensure the LPA language accurately implements the intended economics and tax treatment.
B. Ordering Rules for Distributions
The CV's distribution provisions should account for the different Section 1061 holding periods applicable to the Legacy Carry Tranche and the New Carry Tranche. This is particularly important for portfolio company exits that generate both Legacy Gain and New Gain — i.e., exits at a value that exceeds the contribution date FMV.