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PRIVILEGED & CONFIDENTIAL ATTORNEY-CLIENT COMMUNICATION / ATTORNEY WORK PRODUCT

MEMORANDUM

FROM: Sylvia Hartwell, Specialist Partner, Tax Calderwood & Harkness LLP 620 Eighth Avenue, 42nd Floor New York, NY 10018

TO: Harrowgate Capital Partners LLC 1200 Concord Pike, Suite 600 Wilmington, DE 19803

Attn: Catherine E. Loomis, General Counsel & CCO Jonathan P. Birch, Partner, Head of Operations & CFO

CC: Graham Sutherland, Responsible Partner, Calderwood & Harkness LLP (Wilmington) Stephen Adler, Lead Associate, Calderwood & Harkness LLP (Wilmington)

DATE: May 5, 2025

RE: Harrowgate Private Equity Fund V LP — Application of Internal Revenue Code Section 1061 to Carried Interest Allocations

MATTER NO.: 1003-00002

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I. Executive Summary

The purpose of this memorandum is to analyze how Internal Revenue Code ("IRC") Section 1061, enacted as part of the Tax Cuts and Jobs Act of 2017 ("TCJA"), applies to the carried interest allocations contemplated in connection with Harrowgate Private Equity Fund V LP ("HPE Fund V," "Fund V," or the "Fund"). This analysis has been prepared at the request of Harrowgate Capital Partners LLC ("HCP" or "Harrowgate") in anticipation of the finalization and distribution of the Fund V limited partnership agreement (the "LPA") to prospective limited partners. This memorandum is intended to serve as a practical guide for the structuring, documentation, and ongoing compliance obligations related to the carried interest provisions in the LPA and the related GP LLC Agreement.

Section 1061 imposes an extended holding period requirement on certain capital gains allocable to an "applicable partnership interest" ("API"). Specifically, Section 1061 recharacterizes net long-term capital gain with respect to an API as short-term capital gain unless the underlying assets generating such gain have been held for more than three years, rather than the standard one-year holding period that generally applies for purposes of determining long-term capital gain treatment under IRC Section 1222. The practical effect of this provision is that carried interest recipients in private equity, venture capital, real estate, and hedge fund structures are subject to a three-year holding period threshold before they may receive the benefit of preferential long-term capital gain rates on their carried interest allocations.

In the context of Fund V, carried interest allocations flow from HPE Fund V LP to Harrowgate Fund V GP LLC (the "GP LLC"), and through the GP LLC to its sole member, Harrowgate Capital Partners LLC, and ultimately to the individual principals. The principal carry recipients and guarantors of the clawback obligation are Marcus J. Harrowgate (Founder, Managing Partner & Chief Investment Officer), Diana R. Castellano (Partner, Co-Head of Investments), and Jonathan P. Birch (Partner, Head of Operations & Chief Financial Officer). Additional carry allocations may be made to Naveen S. Krishnamurthy (Principal) and other members of the investment team pursuant to internal allocation arrangements; the analysis set forth herein applies equally to all carry recipients, though we focus on the three principal guarantors for purposes of illustration.

The carried interest structure for Fund V provides for 20% of net profits above an 8% preferred return (compounded annually) to be allocated to the GP LLC, subject to an 80/20 GP catch-up, with distributions governed by a European-style (whole-fund) waterfall. This structure, while standard for institutional buyout funds, creates specific timing and recharacterization considerations under Section 1061 that require careful attention in both the LPA drafting and the ongoing tax compliance infrastructure.

Our principal recommendations are as follows:

• The LPA and the GP LLC Agreement should include specific defined terms and provisions to track asset-level holding periods, bifurcate gains between those attributable to assets held for more than three years and those held for three years or less, and ensure accurate reporting to carry recipients.

• The European-style whole-fund waterfall creates generally favorable dynamics for Section 1061 compliance because carry distributions are deferred until later in the fund's life, by which time most portfolio investments will have been held for more than three years. However, tax allocations under IRC Section 704(b) may arise prior to cash distributions, requiring robust tax distribution provisions.

• The GP's capital interest (representing the $50,000,000 commitment at hard cap) must be clearly segregated from the carried interest in all allocation and distribution provisions to preserve the capital interest exception under Section 1061(c)(4).

• Clawback provisions should be refined to account for the possibility that recharacterized gains were taxed at ordinary income rates, affecting the "net of taxes" clawback calculation.

• Transfer restrictions should be updated to include representations and acknowledgments regarding Section 1061(d), which governs transfers of APIs to related persons.

This memorandum supplements the broader Tax Structuring Memorandum dated April 21, 2025, and should be read in conjunction with that memorandum and the ERISA Analysis Memorandum dated April 28, 2025. Capitalized terms used but not defined herein have the meanings ascribed to them in the Tax Structuring Memorandum.

II. Background — Fund V Carried Interest Structure

A. Fund Economics Overview

HPE Fund V LP is a Delaware limited partnership organized for the purpose of making private equity investments in North American mid-market and upper-mid-market companies. The Fund has a target hard cap of $2,000,000,000 in aggregate commitments. The general partner of the Fund is Harrowgate Fund V GP LLC, a Delaware limited liability company (the "GP LLC"). The sole member of the GP LLC is Harrowgate Capital Partners LLC, the management company platform through which Marcus J. Harrowgate and his partners conduct their investment management activities.

The GP LLC will make a capital commitment to the Fund of $50,000,000, representing 2.5% of aggregate commitments at hard cap. This GP commitment will be funded on a pro rata basis alongside limited partner capital calls and constitutes a bona fide capital investment made on the same terms and conditions as capital contributions by the limited partners. The GP commitment is an important structural element for purposes of Section 1061 analysis, as gains attributable to the GP's capital interest (as distinguished from the carried interest) are not subject to the three-year holding period requirement.

The management fee payable by the Fund to HCP (or its designee) is 1.75% per annum on committed capital during the Investment Period, which is defined as the five-year period commencing on the date of the Final Close. Following the expiration of the Investment Period, the management fee steps down to 1.50% per annum calculated on invested capital (i.e., the aggregate cost basis of investments then held by the Fund, net of write-downs). Transaction fees, monitoring fees, directors' fees, and other portfolio-related fees received by HCP or its affiliates are subject to a 100% offset against the management fee, consistent with institutional market practice.

B. Carried Interest Terms

The carried interest rate for Fund V is 20% of net profits, which is the standard rate for institutional buyout funds of this size and vintage. The carried interest is subject to a preferred return (hurdle rate) of 8% per annum, compounded annually, on unreturned capital contributions. The preferred return represents the minimum return threshold that must be achieved before any carried interest accrues to the GP LLC.

Once the preferred return has been fully satisfied, the GP LLC is entitled to a catch-up allocation designed to bring its share of cumulative net profits to 20%. The catch-up is structured as an 80/20 split — that is, 80% of incremental net profits above the preferred return are allocated to the GP LLC (with 20% continuing to the limited partners) until the GP LLC has received an amount equal to 20% of cumulative net profits. After the catch-up has been fully satisfied, residual profits are split 80% to the limited partners and 20% to the GP LLC.

The distribution waterfall for Fund V is structured as a European-style (whole-fund) waterfall. Under this structure, carried interest is calculated and distributed only after all contributed capital and the preferred return thereon have been returned to the limited partners across the entire fund, rather than on a deal-by-deal (American-style) basis. The European waterfall is preferred by many institutional investors because it ensures that the GP does not receive carry until the fund as a whole has achieved the preferred return threshold, reducing the risk of over-distribution and clawback.

The GP LLC is subject to a clawback obligation requiring the return of excess carried interest distributions to the extent that, upon final liquidation of the Fund, the GP LLC has received more than 20% of cumulative net profits. The clawback obligation is net of taxes actually paid by the carry recipients on the excess carry distributions. The clawback is guaranteed on a several (not joint) basis by Marcus J. Harrowgate, Diana R. Castellano, and Jonathan P. Birch, in proportion to their respective carried interest allocations. The several (as opposed to joint) nature of the guarantee means that each individual is responsible only for his or her proportionate share of any clawback liability, and is not liable for the obligations of the other guarantors.

C. Carry Distribution Flow

The flow of carried interest from the Fund to the individual carry recipients involves a tiered pass-through structure that is standard for institutional private equity funds. HPE Fund V LP allocates its share of net profits to its partners, including the GP LLC, in accordance with the tax allocation provisions of the LPA. The carried interest portion of the GP LLC's allocation flows through the GP LLC to its sole member, Harrowgate Capital Partners LLC. HCP, in turn, allocates the carry to the individual principals in accordance with the internal carry allocation arrangements set forth in HCP's operating agreement and the GP LLC Agreement.

Each principal's share of the carried interest is determined by the internal allocation percentages established in those governing documents. While the specific internal percentages are subject to modification from time to time by the Managing Partner in consultation with the other principals, the current allocation is approximately as follows: Marcus J. Harrowgate (50%), Diana R. Castellano (25%), and Jonathan P. Birch (15%), with the remaining 10% allocated among Naveen S. Krishnamurthy and other members of the investment team. These internal allocations do not affect the total amount of carried interest payable by the Fund; they only determine the division of that carry among the principals and team members.

For purposes of this memorandum, our analysis applies equally to all carry recipients, regardless of their specific allocation percentages. However, because Marcus J. Harrowgate, Diana R. Castellano, and Jonathan P. Birch are the three guarantors of the clawback obligation and the largest individual carry recipients, we focus our discussion on their particular circumstances.

It should also be noted that Naveen S. Krishnamurthy and other team members who receive carry allocations through the GP LLC or HCP are subject to the same Section 1061 rules. Each such individual should receive appropriate K-1 information and should consult with his or her personal tax advisor regarding the application of Section 1061 to their specific circumstances.

D. Investment Strategy and Holding Period Context

Fund V will pursue a buyout investment strategy focused on North American mid-market and upper-mid-market companies in four primary sectors: industrials, business services, healthcare services, and technology-enabled services. Target equity investments range from $75,000,000 to $250,000,000 per transaction. The Fund is subject to a concentration limit of 20% of aggregate commitments (i.e., $400,000,000 at hard cap) per portfolio investment, ensuring adequate diversification across the portfolio.

The Investment Period extends for five years from the Final Close, providing a robust deployment window. The Fund Term is ten years from the Final Close, with the option for up to three one-year extensions at the discretion of the GP (with LP advisory committee consent for the third extension). This overall fund duration is consistent with institutional market standards and provides adequate time for the investment, growth, and realization of portfolio company investments.

Harrowgate's buyout strategy typically involves holding periods of three to seven years, consistent with the value creation approach (operational improvements, strategic add-on acquisitions, and margin enhancement) that has characterized the firm's prior fund vintages. However, certain investments may be realized within the first one to three years of acquisition due to opportunistic offers, strategic transactions, or other factors. These shorter-hold investments are the primary area of concern under Section 1061, as any gain from a portfolio investment held for three years or less that is allocated as carried interest will be recharacterized as short-term capital gain, taxable at ordinary income rates rather than preferential long-term capital gain rates.

The risk of early exits is not merely theoretical. Harrowgate's prior funds have experienced opportunistic realizations within the first three years of acquisition. For example, an investment by HPE Fund III in a healthcare services platform was sold after approximately 28 months when an unsolicited strategic offer at an exceptionally attractive valuation was received. While such early exits may generate significant returns for the Fund and its limited partners, the Section 1061 implications for the carry recipients must be understood and planned for in advance.

Additionally, partial realizations — including secondary sales of portions of a portfolio company position, dividend recapitalizations, and refinancing transactions that generate distributable proceeds — may also trigger Section 1061 concerns if they occur within the three-year window. Each such transaction must be analyzed on a facts-and-circumstances basis to determine whether the gain generated is subject to recharacterization.

III. Statutory Framework — IRC Section 1061

A. Overview of Section 1061

Section 1061 of the Internal Revenue Code was enacted as part of the Tax Cuts and Jobs Act, Public Law 115-97, signed into law on December 22, 2017, and is effective for taxable years beginning after December 31, 2017. The provision is codified at 26 U.S.C. § 1061. It represents the most significant legislative change to the taxation of carried interest since the inception of the modern private equity industry, although it falls short of the full ordinary income treatment that some legislative proposals had contemplated.

The general rule of Section 1061(a) provides that if one or more applicable partnership interests are held by a taxpayer at any time during the taxable year, the taxpayer's net long-term capital gain with respect to such interests for the taxable year shall not exceed the amount of such net gain that would be computed if only assets held for more than three years were taken into account. To the extent a taxpayer's actual net long-term capital gain with respect to an API exceeds the amount that would result from applying the three-year holding period, the excess is treated as short-term capital gain. Effectively, Section 1061 extends the preferential long-term capital gain holding period from more than one year to more than three years for gains allocable to carried interest holders.

The policy rationale behind Section 1061, as expressed in the legislative history, reflects longstanding concerns that investment fund managers receive a disproportionate benefit from preferential capital gains rates on income that is economically attributable to the performance of services rather than the return on invested capital. Section 1061 represents a compromise position — rather than recharacterizing all carried interest income as ordinary income, it requires a longer holding period to access preferential rates, thereby limiting the benefit to managers who hold investments for extended periods.

B. Applicable Partnership Interest (API) Defined

The scope of Section 1061 is defined by the concept of an "applicable partnership interest." Under Section 1061(c)(1), an API is defined as any interest in a partnership that, directly or indirectly, is transferred to (or 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 that consists, in whole or in part, of (i) raising or returning capital, and (ii) either investing in (or disposing of) specified assets, or identifying specified assets for such investing or disposition.

"Specified assets" are defined broadly in Section 1061(c)(3) to include: (i) securities (as defined in Section 475(c)(2), without regard to the last sentence thereof); (ii) commodities (as defined in Section 475(e)(2)); (iii) real estate held for rental or investment; (iv) cash or cash equivalents; (v) options or derivative contracts with respect to any of the foregoing; and (vi) an interest in a partnership to the extent of the partnership's proportionate interest in any of the foregoing. The breadth of this definition ensures that carried interest in virtually all investment fund structures — including private equity, venture capital, real estate, hedge fund, and credit fund structures — falls within the ambit of Section 1061.

The application of these definitions to Fund V is straightforward. Harrowgate Capital Partners LLC and its investment professionals provide investment management services on a regular, continuous, and substantial basis. These services consist of raising capital from institutional and other investors, identifying and evaluating potential portfolio company investments, executing acquisitions, managing and monitoring portfolio companies, and disposing of portfolio company investments — all of which constitute "investing in (or disposing of) specified assets" within the meaning of Section 1061(c)(2). The carried interest allocations in HPE Fund V LP, flowing through the GP LLC to HCP and ultimately to the individual principals, clearly constitute applicable partnership interests subject to Section 1061.

The Treasury Department and the IRS finalized comprehensive regulations under Section 1061 in January 2021, published as Treasury Regulation Sections 1.1061-1 through 1.1061-6 (the "Final Regulations"). These regulations provide detailed guidance on the definition of APIs, the calculation of recharacterization amounts, reporting requirements, the treatment of tiered partnership structures, exceptions for capital interests, and the treatment of transfers of APIs to related persons. We reference the Final Regulations throughout this memorandum and summarize key provisions in Appendix A.

C. Exceptions to API Treatment

Section 1061(c)(4) provides an important exception for capital interests. An interest in a partnership is not treated as an applicable partnership interest to the extent that the interest is held by a person who has contributed capital to the partnership on the same terms and conditions as are applicable to other partners who do not provide substantial services in the applicable trade or business. This exception is critical for Fund V because the GP LLC will make a capital commitment of $50,000,000 (2.5% of aggregate commitments at hard cap) to the Fund on the same terms and conditions as the limited partners.

The GP commitment of $50,000,000 constitutes a bona fide capital investment. Capital is called from the GP LLC on a pro rata basis alongside limited partner capital calls. Returns on the GP's capital investment are distributed on the same basis as returns on limited partner capital — subject to the same waterfall provisions, including the return of capital and preferred return priorities. The GP's capital interest, therefore, falls squarely within the capital interest exception of Section 1061(c)(4), and gains attributable to this capital interest are not subject to the three-year holding period requirement. They remain eligible for long-term capital gain treatment under the standard one-year holding period applicable to capital assets under IRC Section 1222.

The proper separation of the GP's capital interest returns from the carried interest allocations is a matter of considerable importance. The LPA and the tax allocation provisions must clearly delineate which allocations and distributions are attributable to the GP's capital interest (exempt from Section 1061) and which are attributable to the carried interest (subject to Section 1061). The Final Regulations at Treasury Regulation Section 1.1061-3(c) provide guidance on the capital interest exception, requiring that the capital interest satisfy certain conditions, including that the return on the capital interest is commensurate with other non-service partners' returns on their capital. We address recommended LPA provisions to effectuate this separation in Section V below.

A second exception applies to interests held directly by C corporations. Section 1061(a)(1) provides that the three-year holding period requirement does not apply to any income or gain attributable to an API held by a corporation (other than an S corporation). We note that HGF V blocker Corp., a Delaware C corporation, has been established as a blocker entity for the benefit of certain tax-exempt limited partners and non-U.S. investors to address unrelated business taxable income ("UBTI") and effectively connected income ("ECI") concerns. The blocker corporation is a limited partner in the Fund and is not a carry recipient. The corporate exception under Section 1061 is therefore not relevant to the carry recipients, who are individuals receiving their carry through pass-through entities (the GP LLC and HCP). We mention this exception solely for completeness.

D. The Three-Year Holding Period Requirement

The core operative rule of Section 1061(a) provides that long-term capital gain recognized by a taxpayer with respect to an API is recharacterized as short-term capital gain unless the gain is attributable to an asset held for more than three years. The determination of the three-year holding period is made at the asset level — specifically, at the partnership (fund) level with respect to the underlying portfolio investments — rather than at the partner level.

This asset-level approach means that the relevant inquiry is: how long has the Fund held the underlying portfolio company investment? If the Fund acquires a portfolio company on January 15, 2026, the three-year holding period for that investment is satisfied on January 16, 2029. Any gain realized on a disposition of that investment prior to January 16, 2029 that is allocated as carried interest to the GP LLC (and ultimately to the individual carry recipients) will be recharacterized as short-term capital gain. Conversely, if the disposition occurs after January 16, 2029, the carried interest allocation retains its long-term capital gain character and is eligible for the preferential rate.

This asset-level approach contrasts with the partner-level holding period analysis that would apply in other contexts. For example, a limited partner's holding period in the partnership interest itself is not relevant to the Section 1061 analysis. Similarly, the carry recipient's holding period in the GP LLC interest or the HCP interest is not the relevant holding period. The question is always: how long has the underlying asset (portfolio company) been held by the Fund?

The Treasury Regulations clarify that the holding period of an asset is determined under general principles of IRC Section 1223, with certain modifications. For purposes of Section 1061, the holding period begins on the date the Fund acquires the asset and ends on the date the Fund disposes of the asset. Tacking rules under Section 1223 may apply in certain circumstances — for example, if the Fund acquires an asset in a tax-free exchange, the holding period of the surrendered asset may tack onto the holding period of the acquired asset. However, such tacking rules must be applied carefully and on a case-by-case basis.

E. One-Year / Three-Year Gain Bifurcation

The mechanical application of Section 1061 requires a bifurcation analysis set forth in Treasury Regulation Section 1.1061-4. The regulation requires the calculation of two amounts for each taxable year: the "One Year Gain Amount" and the "Three Year Gain Amount."

The One Year Gain Amount is the taxpayer's net long-term capital gain with respect to the API, calculated using the standard one-year holding period threshold. This is the amount of long-term capital gain that the taxpayer would recognize under general tax principles, without regard to Section 1061.

The Three Year Gain Amount is the taxpayer's net long-term capital gain with respect to the API, calculated as if only assets held for more than three years were taken into account. This amount represents the gain that would qualify for long-term capital gain treatment under the heightened three-year threshold.

The recharacterization amount — the amount that is recharacterized from long-term capital gain to short-term capital gain — is equal to the One Year Gain Amount minus the Three Year Gain Amount. This difference represents the gain on assets held for more than one year but three years or less, which is the "gap" period targeted by Section 1061. Gains on assets held for one year or less are already treated as short-term capital gains under general principles and are not affected by Section 1061.

This bifurcation analysis must be performed annually by each carry recipient (or, in the case of pass-through entities, at the relevant entity level and passed through to the individual taxpayer). The Fund, the GP LLC, and HCP must each maintain records sufficient to support the calculation, and the Schedule K-1 reporting must provide the necessary detail. We discuss the reporting requirements in greater detail in Section V.A below.

F. Lookthrough Rule for Tiered Partnerships

The structure of Fund V involves multiple tiers of pass-through entities: HPE Fund V LP allocates gains to the GP LLC, the GP LLC passes through to HCP, and HCP passes through to the individual principals. Section 1061(c)(4)(A) and Treasury Regulation Section 1.1061-3 provide lookthrough rules that apply to tiered partnership structures of this nature.

Under the lookthrough rules, the Section 1061 recharacterization applies at the individual taxpayer level, looking through the chain of pass-through entities. Each tier in the structure must properly report and pass through the holding period and character information necessary for the ultimate individual taxpayer to perform the Section 1061 calculation. The Fund (as the entity that holds the underlying portfolio investments) is the entity with the most direct information about asset-level holding periods. The Fund must communicate this information through the Schedule K-1 reporting chain to the GP LLC, which in turn must pass it through to HCP, which must pass it through to the individual carry recipients.

Treasury Regulation Section 1.1061-3(b) provides specific rules for "Passthrough Entities" (defined to include partnerships and S corporations) that hold APIs indirectly. These rules ensure that the three-year holding period requirement cannot be circumvented by interposing additional entity tiers between the fund and the carry recipient. The recharacterization applies regardless of the number of entity tiers, and each tier must provide the necessary reporting to enable compliance.

In practice, this means that Pinnacle Fund Services LLC (the Fund's administrator) must maintain asset-level holding period records for each portfolio investment, and Caldwell, Fitch & Hartley LLP (the Fund's auditor) must ensure that the Schedule K-1 reporting at each entity level includes sufficient detail for Section 1061 compliance. We address these practical requirements in the compliance checklist in Section VIII below.

IV. Application to HPE Fund V LP's European-Style Waterfall

A. European (Whole-Fund) Waterfall Mechanics

Under the Fund V LPA, distributions to partners are made in accordance with a European-style (whole-fund) waterfall. This waterfall structure operates as follows:

Tier 1 — Return of Capital. First, 100% of distributions are made to the limited partners until all contributed capital (including capital used to pay management fees and fund expenses) has been returned in full across the entire fund.

Tier 2 — Preferred Return. Second, 100% of distributions are made to the limited partners until they have received a cumulative preferred return equal to 8% per annum (compounded annually) on their unreturned capital contributions, calculated from the date of each capital call to the date of each distribution.

Tier 3 — GP Catch-Up. Third, distributions are allocated 80% to the GP LLC and 20% to the limited partners until the GP LLC has received an amount equal to 20% of cumulative net profits (i.e., until the GP LLC's cumulative distributions equal 20% of the aggregate amount distributed in Tiers 2, 3, and 4).

Tier 4 — Residual Split. Fourth, all remaining distributions are allocated 80% to the limited partners and 20% to the GP LLC.

The critical feature of the European-style waterfall, as distinguished from the American-style (deal-by-deal) waterfall, is that carried interest distributions do not commence until all contributed capital and the full preferred return have been returned to the limited partners across the entire fund portfolio. This means that the GP LLC will not receive any carry distributions until the aggregate distributions to the limited partners have satisfied the Tier 1 and Tier 2 priorities for the fund as a whole. In a fund with a $2,000,000,000 hard cap, this requires that the fund generate and distribute at least the full $2,000,000,000 of contributed capital plus the cumulative preferred return before any carry flows to the GP LLC.

B. Timing Implications for Section 1061

The European-style waterfall creates generally favorable timing dynamics for Section 1061 compliance. Because carry distributions are deferred until later in the fund's life — typically beginning in years 7 through 12, after the bulk of the portfolio has been realized — most portfolio investments will have been held for more than three years by the time their gains are distributed as carry. This natural alignment between the waterfall structure and the three-year holding period requirement means that Section 1061 recharacterization risk is somewhat lower in a European-style fund than in a deal-by-deal fund, where carry may be distributed on each realization.

However, this favorable timing dynamic is tempered by two important considerations.

First, the allocation of income for federal income tax purposes occurs annually under IRC Section 704(b) and the regulations thereunder, not only upon distribution of cash. A partner's distributive share of partnership income, gain, loss, deduction, and credit is determined and reported annually, regardless of whether cash is actually distributed. This means that the GP LLC may be allocated a share of the Fund's capital gains on a current basis (e.g., upon the realization of a portfolio investment) even if no carry distributions have yet been made under the waterfall. Such allocations are subject to Section 1061 analysis at the time of allocation, not at the time of distribution. If a portfolio investment is sold within three years of acquisition and the resulting gain is allocated to the GP LLC as carry (even though no cash distribution of carry has yet occurred), the Section 1061 recharacterization applies to that allocation in the year it is recognized.

Second, while the waterfall defers cash distributions of carry, it does not eliminate the possibility that early-realization gains will be allocated to the GP LLC. The tax allocation provisions of the LPA must be carefully coordinated with the economic waterfall to ensure that the GP LLC is not allocated gain on a current basis in a manner that creates unintended Section 1061 exposure. This coordination requires attention to the "target allocation" methodology, the "qualified income offset" provisions, and the minimum gain chargeback rules under the IRC Section 704(b) regulations.

We recommend that the LPA's tax allocation provisions be structured to minimize the allocation of gain to the GP LLC until the economic waterfall conditions for carry distribution have been satisfied, to the extent consistent with the substantial economic effect requirements. This approach, while not eliminating Section 1061 risk, reduces the likelihood of phantom income (gain allocated but not distributed) that is subject to recharacterization.

C. Interaction with Portfolio Company Holding Periods

HPE Fund V's buyout investment strategy, with target equity investments of $75,000,000 to $250,000,000, typically involves holding periods of three to seven years. Harrowgate's investment approach — which emphasizes operational improvements, strategic add-on acquisitions, margin expansion, and market positioning over a multi-year horizon — is inherently aligned with the three-year holding period threshold of Section 1061. The majority of Fund V's portfolio investments are expected to be held for more than three years before realization.

Notwithstanding this general expectation, several risk scenarios could result in realizations within the three-year window:

Early Exits. An unsolicited acquisition offer at an exceptionally attractive valuation, a strategic event (such as a competing transaction in the relevant industry), or a deterioration in market conditions that makes an early exit advisable could lead to a disposition within three years of acquisition. As noted in Section II.D above, Harrowgate's prior funds have experienced such early exits.

Partial Realizations. The Fund may sell a portion of a portfolio company position to a co-investor, secondary buyer, or strategic acquirer within three years of acquisition. Any gain on such a partial realization would be subject to Section 1061 analysis based on the holding period of the sold portion.

Dividend Recapitalizations. The Fund may cause a portfolio company to incur additional leverage and use the proceeds to pay a dividend to the Fund. While a dividend recapitalization is generally structured as a return of capital (non-taxable to the extent of the Fund's basis), it may generate taxable gain in certain circumstances — particularly if the dividend exceeds the Fund's adjusted tax basis in the investment. Any such gain realized within the three-year window would be subject to Section 1061.

Refinancings and Restructurings. Certain refinancing or restructuring transactions may give rise to taxable events if they are treated as deemed dispositions or exchanges for federal income tax purposes. The holding period for any new asset received in such a transaction must be carefully analyzed.

The concentration limit of 20% of aggregate commitments ($400,000,000 at hard cap) per investment means that any single early exit could represent a substantial portion of the Fund's total gains. If, for example, the Fund invests $300,000,000 in a single portfolio company and realizes a $200,000,000 gain within two years, the 20% carry allocation of $40,000,000 on that gain would be recharacterized as short-term capital gain — a significant tax impact for the carry recipients. The concentration limit, while providing diversification benefits, does not eliminate the potential for material Section 1061 exposure on any single investment.

D. Impact of Subscription Facility Borrowings on Holding Period

The Fund has arranged a $500,000,000 revolving subscription credit facility with Ashford National Bank, N.A. (the "Subscription Facility"), bearing interest at SOFR plus 175 basis points. The Subscription Facility is secured by the uncalled capital commitments of the limited partners and is used to bridge timing gaps between the acquisition of investments and the issuance of capital call notices to the limited partners. The use of subscription facilities has become standard practice in the institutional private equity industry, providing operational flexibility and improving certain performance metrics (notably internal rate of return, or IRR, which is calculated from the date of capital call rather than the date of investment acquisition).

The use of the Subscription Facility raises a question regarding the holding period computation for Section 1061 purposes: does the holding period of a portfolio investment begin on the date the Fund acquires the investment (funded by a draw on the Subscription Facility), or on the later date when the capital call is made to the limited partners and the Subscription Facility draw is repaid? This question has been the subject of commentary in the tax practitioner community and has been addressed by the IRS.

Under current guidance, the holding period of the underlying asset begins on the date the Fund acquires the asset, regardless of whether the acquisition was funded by capital calls from the limited partners or by draws on the Subscription Facility. The Subscription Facility borrowing is a liability of the Fund, and the acquisition of the portfolio investment is a separate transaction that establishes the Fund's holding period in that asset. The subsequent capital call and repayment of the Subscription Facility draw does not affect the holding period of the portfolio investment. Accordingly, the use of the Subscription Facility does not adversely affect the three-year holding period computation for Section 1061 purposes.

However, a more nuanced analysis is required if the Subscription Facility is used to fund interim investments, bridge transactions, or temporary cash management positions. The LPA limits the duration of Subscription Facility borrowings to 180 days per draw, and the Fund may use Subscription Facility proceeds to fund short-term investments or bridge positions pending permanent financing or syndication. Any gains on such short-duration holdings would be subject to Section 1061 analysis based on the actual holding period of the short-term position. If, for example, the Fund uses Subscription Facility proceeds to acquire a bridge position that is held for less than three years and generates a gain, the carry allocation on that gain would be recharacterized as short-term capital gain. We recommend that the Fund's investment tracking system distinguish between (i) portfolio investments funded by the Subscription Facility pending capital calls (where the holding period is measured from the date of acquisition) and (ii) interim or bridge investments that may have shorter holding periods.

E. Clawback and Section 1061

The GP clawback obligation is a standard feature of European-style waterfall structures and is designed to ensure that, upon final liquidation of the Fund, the GP LLC has not received carry in excess of 20% of cumulative net profits. The clawback is triggered if, for example, later-realized investments are sold at losses that reduce cumulative net profits below the level implied by prior carry distributions.

The clawback provision in the Fund V LPA provides that the clawback obligation is calculated on a "net of taxes" basis — that is, the amount that the GP LLC (and, by extension, the individual guarantors) is required to return is reduced by the amount of income taxes actually paid on the excess carry distributions. This "net of taxes" concept is critical because it determines the effective economic cost of the clawback to the carry recipients.

Section 1061 introduces a complication to the "net of taxes" clawback calculation. If carried interest was distributed and the carry recipients paid tax on that distribution at ordinary income rates (because Section 1061 recharacterized the gain as short-term capital gain), the "net of taxes" offset should reflect the higher tax rate actually paid. Conversely, if the carried interest retained long-term capital gain character (because the underlying assets were held for more than three years), the "net of taxes" offset should reflect the lower preferential rate.

Under current federal tax rates, the differential between the two scenarios is substantial. Short-term capital gain (recharacterized under Section 1061) is taxed at ordinary income rates, with a top federal rate of 37%. Long-term capital gain is taxed at a preferential rate of 20%, plus the 3.8% net investment income tax under IRC Section 1411, for a combined rate of 23.8%. The difference between 37% and 23.8% is 13.2 percentage points — on a $10,000,000 carry distribution, this equates to a difference of $1,320,000 in taxes paid, which directly affects the clawback amount.

The clawback guarantee is several (not joint) among the three guarantors, meaning each individual's clawback obligation is calculated based on his or her proportionate share of carry distributions and taxes actually paid. Because each guarantor's tax situation may differ — due to differences in state of residence, state income tax rates, the availability of capital loss carryforwards, and other individual tax attributes — the "net of taxes" calculation must be performed separately for each guarantor. We recommend specific LPA and GP LLC Agreement provisions to address these issues, as discussed in Section V.F below.

V. Recommended LPA and GP LLC Agreement Provisions

A. Holding Period Tracking and Reporting

The foundation of Section 1061 compliance is accurate and contemporaneous tracking of the acquisition date and holding period for each portfolio investment. We recommend including a specific provision in the LPA requiring the GP LLC and the Fund's administrator, Pinnacle Fund Services LLC, to maintain detailed records of the acquisition date, cost basis, and holding period for each portfolio investment, including any partial realizations or add-on investments.

This record-keeping requirement should extend to all forms of investments, including:

• Direct equity investments in portfolio companies

• Co-investment positions

• Bridge and interim investments funded by the Subscription Facility

• Follow-on investments and add-on acquisitions (which may have different holding periods than the initial platform investment)

• Short-term cash management investments and money market holdings

• Derivative positions (options, hedging instruments, interest rate swaps) used in connection with portfolio investments

The LPA should further require that the GP LLC provide annual reporting to each carry recipient identifying: (i) investments held for more than three years as of the end of the taxable year, together with the gain or loss attributable to each such investment; (ii) investments held for more than one year but three years or less, together with the gain or loss attributable to each such investment; and (iii) investments held for one year or less, together with the gain or loss attributable to each such investment. This annual report should be provided in conjunction with the Schedule K-1 package to enable each carry recipient to prepare the Section 1061 calculations required for his or her individual income tax return.

With respect to Schedule K-1 reporting, the Fund files IRS Form 1065 (U.S. Return of Partnership Income) annually and issues Schedule K-1s to each partner, including the GP LLC. The Schedule K-1 must include sufficient detail to permit the carry recipients to compute the One Year Gain Amount and the Three Year Gain Amount, as required by the instructions to IRS Form 8949 (Sales and Other Dispositions of Capital Assets) and Schedule D (Capital Gains and Losses). The Final Regulations include specific API reporting requirements, including the use of separate line items on the K-1 for API-related amounts. We recommend that Pinnacle Fund Services LLC work closely with Caldwell, Fitch & Hartley LLP (Robert A. Fonseca, Audit Partner) to ensure that the K-1 reporting for Fund V is fully compliant with these requirements from inception.

B. Gain Bifurcation Provisions

The LPA should include specific tax allocation provisions that separately track and allocate gains based on the holding period of the underlying assets. We recommend the following approach:

Gains attributable to assets held for more than three years should be separately identified and allocated. These gains, when allocated as carried interest, retain their long-term capital gain character and are eligible for the preferential 20% federal rate (plus the 3.8% net investment income tax). The LPA should provide that such gains are allocated to the GP LLC's carried interest account and reported as "Three Year Gain" on the Schedule K-1.

Gains attributable to assets held for three years or less should also be separately identified and allocated. When such gains are allocated as carried interest, they are subject to recharacterization as short-term capital gain under Section 1061. The LPA should provide that these gains are allocated to the GP LLC's carried interest account and flagged as "Recharacterizable Gain" on the Schedule K-1. The actual recharacterization occurs at the individual taxpayer level (after looking through the GP LLC and HCP), but the Fund-level reporting must provide the necessary information.

In addition, the GP LLC's capital interest — representing the $50,000,000 commitment at hard cap — must be clearly distinguished from the carried interest in all allocation and distribution provisions. We recommend the creation of a defined term in the LPA, "Section 1061 Capital Interest," to isolate the GP's capital interest from the API. The Section 1061 Capital Interest should be treated as a separate allocation class for purposes of the tax allocation provisions, with returns on the capital interest allocated in the same manner as returns to the limited partners (i.e., subject to the standard one-year holding period and not subject to Section 1061 recharacterization). Appendix C includes recommended defined term language for inclusion in the LPA.

The gain bifurcation provisions should be coordinated with the existing tax allocation provisions of the LPA, including the Section 704(b) capital account maintenance rules, the "qualified income offset" provision, the minimum gain chargeback rules, and the curative and remedial allocation provisions. The bifurcation should not alter the economic waterfall or the total amount of carry allocable to the GP LLC; it should only determine the character (long-term vs. short-term) of the carry for Section 1061 purposes.

C. European Waterfall — Tax Distribution Provisions

As discussed in Section IV.B above, the European-style waterfall may result in the allocation of carry income to the GP LLC for tax purposes before any cash distributions of carry have been made. This creates a potential "phantom income" situation in which the carry recipients owe taxes on income they have not yet received in cash. The risk of phantom income is exacerbated by Section 1061, which may recharacterize the allocated gain as short-term capital gain, thereby increasing the tax rate and the phantom income burden.

To address this risk, we recommend including a tax distribution provision in the LPA that allows the GP LLC to receive advance distributions sufficient to cover income tax liabilities arising from allocated but undistributed carry. The key elements of the recommended tax distribution provision are:

Tax Distribution Amount. The tax distribution should be calculated using the highest combined marginal federal and applicable state and local income tax rate applicable to short-term capital gain. At current rates, this is 37% for federal income tax purposes. The use of the short-term rate (rather than the long-term rate) is appropriate because Section 1061 may recharacterize carry-related gain as short-term capital gain, and the tax distribution should be sufficient to cover the worst-case tax liability. If individual carry recipients are subject to state and local income taxes (e.g., New York State and New York City income taxes for Marcus J. Harrowgate), the tax distribution should be grossed up to account for the combined federal and state/local rate.

Treatment as Advance Against Carry. Tax distributions to the GP LLC should be treated as advances against future carried interest distributions, not as additional economic allocations. When carry cash distributions commence under the waterfall, prior tax distributions should be credited against the GP LLC's carry entitlement. This ensures that the limited partners are not economically disadvantaged by the advance tax distributions.

Ordering and Priority. The tax distribution provision should specify its priority within the overall distribution waterfall. We recommend that tax distributions be made prior to the application of Tier 1 (Return of Capital) to the extent funded from realized gains, but subject to the LP advisory committee's review and approval to the extent the aggregate tax distributions exceed a specified threshold (e.g., 3% of committed capital). This structure balances the carry recipients' need for tax liquidity with the limited partners' interest in prompt return of capital.

Coordination with LP Counsel. The tax distribution provision will require negotiation with counsel to the Fund's anchor limited partners, including Aldworth & McBride LLP (representing Northmoor Pension Fund), Pelham Chambers LLP (representing Kingsbridge Endowment), and Ramsden Clarke International LLP (representing Tidewater Institutional Partners). We anticipate that the tax distribution provision will be a point of negotiation in the LPA process and recommend engaging with LP counsel early in the drafting process to secure agreement on the key terms.

D. Disposition Sequencing and Harvesting Considerations

While the LPA cannot and should not dictate the timing of investment dispositions — as such decisions must be made in the exercise of the GP's fiduciary duties and investment judgment — we recommend including permissive language that authorizes the GP LLC to consider Section 1061 implications in the timing and sequencing of portfolio dispositions.

Specifically, we recommend language providing that the GP LLC may, in its reasonable discretion, consider the federal income tax consequences of a proposed disposition, including the application of Section 1061, as one factor (among others) in determining the timing and structure of the disposition. This language does not impose a mandatory three-year hold period — which could conflict with the GP's fiduciary obligation to maximize returns for the Fund's limited partners — but it does provide a governance basis for the GP to weigh tax efficiency in its decision-making process.

We note that the Investment Period (five years from Final Close) and the Fund Term (ten years from Final Close, plus up to three one-year extensions) provide adequate runway for most investments to exceed the three-year holding period threshold. Even an investment made late in the Investment Period (e.g., month 58) would typically have at least five years of remaining fund term (plus extensions) to reach the three-year holding period. However, investments made late in the Investment Period may face pressure for early exit if the Fund Term approaches its expiration, particularly in the absence of extensions. The Fund's extension provisions — which allow up to three one-year extensions — provide additional flexibility to hold investments beyond the three-year threshold if needed.

E. Section 1061(d) — Transfers of APIs

Section 1061(d) provides special rules for transfers of applicable partnership interests. Under Section 1061(d)(1), if a taxpayer transfers any API, directly or indirectly, to a person who is a related person with respect to the taxpayer, the taxpayer shall include in gross income (as short-term capital gain) so much of the taxpayer's net long-term capital gain with respect to such interest for the taxable year as is attributable to the transferred interest and is not otherwise treated as short-term capital gain under Section 1061(a). The term "related person" is defined broadly under Section 1061(d)(2) to include family members (as defined in Section 318(a)(1)), and any person who performed a service within the applicable trade or business at any time during the two-year period ending on the date of the transfer.

This provision is relevant to Fund V because it restricts the ability of carry recipients to transfer their carried interest to family members, family trusts, estates, or other related persons without triggering short-term capital gain recognition. Such transfers are common in estate planning and succession planning contexts. For example, if Marcus J. Harrowgate were to transfer a portion of his carried interest to a trust for the benefit of his children, Section 1061(d) would cause him to recognize short-term capital gain on the transfer to the extent of gain not otherwise treated as short-term under Section 1061(a).

We recommend the following provisions in the LPA and GP LLC Agreement to address Section 1061(d):

Transfer Notification. Any carry recipient who proposes to transfer any portion of his or her carried interest — whether by sale, gift, assignment, or estate planning transfer — must provide written notice to the GP LLC and to HCP at least 30 days prior to the proposed transfer. The notice must identify the transferee, the relationship between the transferor and the transferee, and the nature of the transfer.

Section 1061(d) Acknowledgment. The transferring carry recipient must acknowledge in writing that he or she has consulted with a personal tax advisor regarding the application of Section 1061(d) to the proposed transfer, and that the GP LLC, HCP, and the Fund shall have no liability for any adverse tax consequences arising from the transfer.

Form of Transfer Agreement. The Form of Transfer (Assignment) Agreement, which is typically attached as an exhibit to the LPA and the GP LLC Agreement, should include representations by the transferor that the transfer has been evaluated for compliance with Section 1061(d) and that any applicable short-term capital gain has been or will be recognized.

Restrictions on Transfers. The LPA and GP LLC Agreement already contain standard transfer restrictions (consent requirements, rights of first refusal, drag-along/tag-along rights). We recommend that the Section 1061(d) transfer provisions be integrated into the existing transfer restriction framework, rather than creating a separate overlay.

F. Clawback Provision Refinements

As discussed in Section IV.E above, Section 1061 creates specific issues for the "net of taxes" clawback calculation. We recommend the following refinements to the clawback provision in the LPA and the GP LLC Agreement:

Explicit Section 1061 Reference. The clawback provision should explicitly reference Section 1061 and acknowledge that carried interest distributions may have been subject to recharacterization as short-term capital gain, resulting in tax liability at ordinary income rates rather than preferential long-term capital gain rates.

Actual Tax Rate. The "net of taxes" calculation should be based on the actual income tax rate paid by each carry recipient on the clawed-back carry, rather than a uniform assumed rate. This requires each guarantor to maintain and produce, upon request, records of income tax payments attributable to carried interest distributions. If a guarantor cannot produce such records, the clawback should be calculated using the lowest potentially applicable rate (i.e., the long-term capital gain rate), to ensure that the limited partners are not disadvantaged by the guarantor's failure to maintain records.

Individual Calculation. Because the clawback guarantee is several (not joint) among Marcus J. Harrowgate, Diana R. Castellano, and Jonathan P. Birch, the "net of taxes" calculation must be performed separately for each individual guarantor. Each guarantor's state of residence, marginal tax rate, and individual tax attributes (such as capital loss carryforwards, AMT status, and net investment income tax status) may result in different effective tax rates on the same carry distribution. The GP LLC should maintain a schedule showing each guarantor's cumulative carry distributions, the character of those distributions (long-term vs. short-term/recharacterized), and the tax payments attributable thereto.

Reserve and Escrow. We recommend considering a clawback escrow or reserve mechanism, funded by a portion of each carry distribution (e.g., 15% of each carry distribution held in escrow), to ensure that clawback obligations can be satisfied without relying solely on the personal assets of the guarantors. The escrow calculation should take into account the Section 1061 recharacterization risk — if a significant portion of carry was taxed at ordinary rates, the "net of taxes" offset will be larger, reducing the effective clawback amount and therefore the required escrow.

VI. Impact on Predecessor Fund Analysis

Before concluding our analysis of Fund V, we note briefly the relevance of Section 1061 to Harrowgate's predecessor funds. Section 1061 is effective for taxable years beginning after December 31, 2017, meaning that it has applied to all of Harrowgate's funds for taxable years 2018 through the present.

HPE Fund I (2012 vintage) has been fully realized. Given the fund's vintage and typical hold period, the majority of Fund I's investments were held for more than three years before realization, and Section 1061 recharacterization was minimal.

HPE Fund II (2015 vintage) is substantially realized. Similar to Fund I, the buyout strategy and extended holding periods have generally resulted in most gains qualifying for the more-than-three-year holding period. However, certain early exits may have triggered Section 1061 recharacterization in the 2018-2020 taxable years.

HPE Fund III (2018 vintage) is currently in its harvesting phase. Investments made in 2018 and 2019 have now crossed the three-year holding period threshold, reducing Section 1061 exposure for those positions. However, any investments made in late 2022 or thereafter that are realized before the three-year anniversary remain at risk.

HPE Fund IV (2021 vintage) is in the harvesting phase, with approximately 82% of committed capital deployed as of December 31, 2024. Fund IV performance metrics as of December 31, 2024 — TVPI of 1.4x and Net IRR of 18.2% — indicate that the fund is performing well, and several realizations are anticipated in the near term. Any investments made in 2022 or later that are realized before their respective three-year anniversaries will provide a real-time example of Section 1061 application. We recommend that the Fund IV Section 1061 experience inform the compliance infrastructure for Fund V.

Harrowgate's track record of holding investments for extended periods, consistent with its buyout strategy and value creati

PRIVILEGED & CONFIDENTIAL ATTORNEY-CLIENT COMMUNICATION / ATTORNEY WORK PRODUCT
MEMORANDUM
FROM: Sylvia Hartwell, Specialist Partner, Tax Calderwood & Harkness LLP 620 Eighth Avenue, 42nd Floor New York, NY 10018
TO: Harrowgate Capital Partners LLC 1200 Concord Pike, Suite 600 Wilmington, DE 19803
Attn: Catherine E. Loomis, General Counsel & CCO Jonathan P. Birch, Partner, Head of Operations & CFO
CC: Graham Sutherland, Responsible Partner, Calderwood & Harkness LLP (Wilmington) Stephen Adler, Lead Associate, Calderwood & Harkness LLP (Wilmington)
DATE: May 5, 2025
RE: Harrowgate Private Equity Fund V LP — Application of Internal Revenue Code Section 1061 to Carried Interest Allocations
MATTER NO.: 1003-00002
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I. Executive Summary
The purpose of this memorandum is to analyze how Internal Revenue Code ("IRC") Section 1061, enacted as part of the Tax Cuts and Jobs Act of 2017 ("TCJA"), applies to the carried interest allocations contemplated in connection with Harrowgate Private Equity Fund V LP ("HPE Fund V," "Fund V," or the "Fund"). This analysis has been prepared at the request of Harrowgate Capital Partners LLC ("HCP" or "Harrowgate") in anticipation of the finalization and distribution of the Fund V limited partnership agreement (the "LPA") to prospective limited partners. This memorandum is intended to serve as a practical guide for the structuring, documentation, and ongoing compliance obligations related to the carried interest provisions in the LPA and the related GP LLC Agreement.
Section 1061 imposes an extended holding period requirement on certain capital gains allocable to an "applicable partnership interest" ("API"). Specifically, Section 1061 recharacterizes net long-term capital gain with respect to an API as short-term capital gain unless the underlying assets generating such gain have been held for more than three years, rather than the standard one-year holding period that generally applies for purposes of determining long-term capital gain treatment under IRC Section 1222. The practical effect of this provision is that carried interest recipients in private equity, venture capital, real estate, and hedge fund structures are subject to a three-year holding period threshold before they may receive the benefit of preferential long-term capital gain rates on their carried interest allocations.
In the context of Fund V, carried interest allocations flow from HPE Fund V LP to Harrowgate Fund V GP LLC (the "GP LLC"), and through the GP LLC to its sole member, Harrowgate Capital Partners LLC, and ultimately to the individual principals. The principal carry recipients and guarantors of the clawback obligation are Marcus J. Harrowgate (Founder, Managing Partner & Chief Investment Officer), Diana R. Castellano (Partner, Co-Head of Investments), and Jonathan P. Birch (Partner, Head of Operations & Chief Financial Officer). Additional carry allocations may be made to Naveen S. Krishnamurthy (Principal) and other members of the investment team pursuant to internal allocation arrangements; the analysis set forth herein applies equally to all carry recipients, though we focus on the three principal guarantors for purposes of illustration.
The carried interest structure for Fund V provides for 20% of net profits above an 8% preferred return (compounded annually) to be allocated to the GP LLC, subject to an 80/20 GP catch-up, with distributions governed by a European-style (whole-fund) waterfall. This structure, while standard for institutional buyout funds, creates specific timing and recharacterization considerations under Section 1061 that require careful attention in both the LPA drafting and the ongoing tax compliance infrastructure.
Our principal recommendations are as follows:
• The LPA and the GP LLC Agreement should include specific defined terms and provisions to track asset-level holding periods, bifurcate gains between those attributable to assets held for more than three years and those held for three years or less, and ensure accurate reporting to carry recipients.
• The European-style whole-fund waterfall creates generally favorable dynamics for Section 1061 compliance because carry distributions are deferred until later in the fund's life, by which time most portfolio investments will have been held for more than three years. However, tax allocations under IRC Section 704(b) may arise prior to cash distributions, requiring robust tax distribution provisions.
• The GP's capital interest (representing the $50,000,000 commitment at hard cap) must be clearly segregated from the carried interest in all allocation and distribution provisions to preserve the capital interest exception under Section 1061(c)(4).
• Clawback provisions should be refined to account for the possibility that recharacterized gains were taxed at ordinary income rates, affecting the "net of taxes" clawback calculation.
• Transfer restrictions should be updated to include representations and acknowledgments regarding Section 1061(d), which governs transfers of APIs to related persons.
This memorandum supplements the broader Tax Structuring Memorandum dated April 21, 2025, and should be read in conjunction with that memorandum and the ERISA Analysis Memorandum dated April 28, 2025. Capitalized terms used but not defined herein have the meanings ascribed to them in the Tax Structuring Memorandum.
II. Background — Fund V Carried Interest Structure
A. Fund Economics Overview
HPE Fund V LP is a Delaware limited partnership organized for the purpose of making private equity investments in North American mid-market and upper-mid-market companies. The Fund has a target hard cap of $2,000,000,000 in aggregate commitments. The general partner of the Fund is Harrowgate Fund V GP LLC, a Delaware limited liability company (the "GP LLC"). The sole member of the GP LLC is Harrowgate Capital Partners LLC, the management company platform through which Marcus J. Harrowgate and his partners conduct their investment management activities.
The GP LLC will make a capital commitment to the Fund of $50,000,000, representing 2.5% of aggregate commitments at hard cap. This GP commitment will be funded on a pro rata basis alongside limited partner capital calls and constitutes a bona fide capital investment made on the same terms and conditions as capital contributions by the limited partners. The GP commitment is an important structural element for purposes of Section 1061 analysis, as gains attributable to the GP's capital interest (as distinguished from the carried interest) are not subject to the three-year holding period requirement.
The management fee payable by the Fund to HCP (or its designee) is 1.75% per annum on committed capital during the Investment Period, which is defined as the five-year period commencing on the date of the Final Close. Following the expiration of the Investment Period, the management fee steps down to 1.50% per annum calculated on invested capital (i.e., the aggregate cost basis of investments then held by the Fund, net of write-downs). Transaction fees, monitoring fees, directors' fees, and other portfolio-related fees received by HCP or its affiliates are subject to a 100% offset against the management fee, consistent with institutional market practice.
B. Carried Interest Terms
The carried interest rate for Fund V is 20% of net profits, which is the standard rate for institutional buyout funds of this size and vintage. The carried interest is subject to a preferred return (hurdle rate) of 8% per annum, compounded annually, on unreturned capital contributions. The preferred return represents the minimum return threshold that must be achieved before any carried interest accrues to the GP LLC.
Once the preferred return has been fully satisfied, the GP LLC is entitled to a catch-up allocation designed to bring its share of cumulative net profits to 20%. The catch-up is structured as an 80/20 split — that is, 80% of incremental net profits above the preferred return are allocated to the GP LLC (with 20% continuing to the limited partners) until the GP LLC has received an amount equal to 20% of cumulative net profits. After the catch-up has been fully satisfied, residual profits are split 80% to the limited partners and 20% to the GP LLC.
The distribution waterfall for Fund V is structured as a European-style (whole-fund) waterfall. Under this structure, carried interest is calculated and distributed only after all contributed capital and the preferred return thereon have been returned to the limited partners across the entire fund, rather than on a deal-by-deal (American-style) basis. The European waterfall is preferred by many institutional investors because it ensures that the GP does not receive carry until the fund as a whole has achieved the preferred return threshold, reducing the risk of over-distribution and clawback.
The GP LLC is subject to a clawback obligation requiring the return of excess carried interest distributions to the extent that, upon final liquidation of the Fund, the GP LLC has received more than 20% of cumulative net profits. The clawback obligation is net of taxes actually paid by the carry recipients on the excess carry distributions. The clawback is guaranteed on a several (not joint) basis by Marcus J. Harrowgate, Diana R. Castellano, and Jonathan P. Birch, in proportion to their respective carried interest allocations. The several (as opposed to joint) nature of the guarantee means that each individual is responsible only for his or her proportionate share of any clawback liability, and is not liable for the obligations of the other guarantors.
C. Carry Distribution Flow
The flow of carried interest from the Fund to the individual carry recipients involves a tiered pass-through structure that is standard for institutional private equity funds. HPE Fund V LP allocates its share of net profits to its partners, including the GP LLC, in accordance with the tax allocation provisions of the LPA. The carried interest portion of the GP LLC's allocation flows through the GP LLC to its sole member, Harrowgate Capital Partners LLC. HCP, in turn, allocates the carry to the individual principals in accordance with the internal carry allocation arrangements set forth in HCP's operating agreement and the GP LLC Agreement.
Each principal's share of the carried interest is determined by the internal allocation percentages established in those governing documents. While the specific internal percentages are subject to modification from time to time by the Managing Partner in consultation with the other principals, the current allocation is approximately as follows: Marcus J. Harrowgate (50%), Diana R. Castellano (25%), and Jonathan P. Birch (15%), with the remaining 10% allocated among Naveen S. Krishnamurthy and other members of the investment team. These internal allocations do not affect the total amount of carried interest payable by the Fund; they only determine the division of that carry among the principals and team members.
For purposes of this memorandum, our analysis applies equally to all carry recipients, regardless of their specific allocation percentages. However, because Marcus J. Harrowgate, Diana R. Castellano, and Jonathan P. Birch are the three guarantors of the clawback obligation and the largest individual carry recipients, we focus our discussion on their particular circumstances.
It should also be noted that Naveen S. Krishnamurthy and other team members who receive carry allocations through the GP LLC or HCP are subject to the same Section 1061 rules. Each such individual should receive appropriate K-1 information and should consult with his or her personal tax advisor regarding the application of Section 1061 to their specific circumstances.
D. Investment Strategy and Holding Period Context
Fund V will pursue a buyout investment strategy focused on North American mid-market and upper-mid-market companies in four primary sectors: industrials, business services, healthcare services, and technology-enabled services. Target equity investments range from $75,000,000 to $250,000,000 per transaction. The Fund is subject to a concentration limit of 20% of aggregate commitments (i.e., $400,000,000 at hard cap) per portfolio investment, ensuring adequate diversification across the portfolio.
The Investment Period extends for five years from the Final Close, providing a robust deployment window. The Fund Term is ten years from the Final Close, with the option for up to three one-year extensions at the discretion of the GP (with LP advisory committee consent for the third extension). This overall fund duration is consistent with institutional market standards and provides adequate time for the investment, growth, and realization of portfolio company investments.
Harrowgate's buyout strategy typically involves holding periods of three to seven years, consistent with the value creation approach (operational improvements, strategic add-on acquisitions, and margin enhancement) that has characterized the firm's prior fund vintages. However, certain investments may be realized within the first one to three years of acquisition due to opportunistic offers, strategic transactions, or other factors. These shorter-hold investments are the primary area of concern under Section 1061, as any gain from a portfolio investment held for three years or less that is allocated as carried interest will be recharacterized as short-term capital gain, taxable at ordinary income rates rather than preferential long-term capital gain rates.
The risk of early exits is not merely theoretical. Harrowgate's prior funds have experienced opportunistic realizations within the first three years of acquisition. For example, an investment by HPE Fund III in a healthcare services platform was sold after approximately 28 months when an unsolicited strategic offer at an exceptionally attractive valuation was received. While such early exits may generate significant returns for the Fund and its limited partners, the Section 1061 implications for the carry recipients must be understood and planned for in advance.
Additionally, partial realizations — including secondary sales of portions of a portfolio company position, dividend recapitalizations, and refinancing transactions that generate distributable proceeds — may also trigger Section 1061 concerns if they occur within the three-year window. Each such transaction must be analyzed on a facts-and-circumstances basis to determine whether the gain generated is subject to recharacterization.
III. Statutory Framework — IRC Section 1061
A. Overview of Section 1061
Section 1061 of the Internal Revenue Code was enacted as part of the Tax Cuts and Jobs Act, Public Law 115-97, signed into law on December 22, 2017, and is effective for taxable years beginning after December 31, 2017. The provision is codified at 26 U.S.C. § 1061. It represents the most significant legislative change to the taxation of carried interest since the inception of the modern private equity industry, although it falls short of the full ordinary income treatment that some legislative proposals had contemplated.
The general rule of Section 1061(a) provides that if one or more applicable partnership interests are held by a taxpayer at any time during the taxable year, the taxpayer's net long-term capital gain with respect to such interests for the taxable year shall not exceed the amount of such net gain that would be computed if only assets held for more than three years were taken into account. To the extent a taxpayer's actual net long-term capital gain with respect to an API exceeds the amount that would result from applying the three-year holding period, the excess is treated as short-term capital gain. Effectively, Section 1061 extends the preferential long-term capital gain holding period from more than one year to more than three years for gains allocable to carried interest holders.
The policy rationale behind Section 1061, as expressed in the legislative history, reflects longstanding concerns that investment fund managers receive a disproportionate benefit from preferential capital gains rates on income that is economically attributable to the performance of services rather than the return on invested capital. Section 1061 represents a compromise position — rather than recharacterizing all carried interest income as ordinary income, it requires a longer holding period to access preferential rates, thereby limiting the benefit to managers who hold investments for extended periods.
B. Applicable Partnership Interest (API) Defined
The scope of Section 1061 is defined by the concept of an "applicable partnership interest." Under Section 1061(c)(1), an API is defined as any interest in a partnership that, directly or indirectly, is transferred to (or 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 that consists, in whole or in part, of (i) raising or returning capital, and (ii) either investing in (or disposing of) specified assets, or identifying specified assets for such investing or disposition.
"Specified assets" are defined broadly in Section 1061(c)(3) to include: (i) securities (as defined in Section 475(c)(2), without regard to the last sentence thereof); (ii) commodities (as defined in Section 475(e)(2)); (iii) real estate held for rental or investment; (iv) cash or cash equivalents; (v) options or derivative contracts with respect to any of the foregoing; and (vi) an interest in a partnership to the extent of the partnership's proportionate interest in any of the foregoing. The breadth of this definition ensures that carried interest in virtually all investment fund structures — including private equity, venture capital, real estate, hedge fund, and credit fund structures — falls within the ambit of Section 1061.
The application of these definitions to Fund V is straightforward. Harrowgate Capital Partners LLC and its investment professionals provide investment management services on a regular, continuous, and substantial basis. These services consist of raising capital from institutional and other investors, identifying and evaluating potential portfolio company investments, executing acquisitions, managing and monitoring portfolio companies, and disposing of portfolio company investments — all of which constitute "investing in (or disposing of) specified assets" within the meaning of Section 1061(c)(2). The carried interest allocations in HPE Fund V LP, flowing through the GP LLC to HCP and ultimately to the individual principals, clearly constitute applicable partnership interests subject to Section 1061.
The Treasury Department and the IRS finalized comprehensive regulations under Section 1061 in January 2021, published as Treasury Regulation Sections 1.1061-1 through 1.1061-6 (the "Final Regulations"). These regulations provide detailed guidance on the definition of APIs, the calculation of recharacterization amounts, reporting requirements, the treatment of tiered partnership structures, exceptions for capital interests, and the treatment of transfers of APIs to related persons. We reference the Final Regulations throughout this memorandum and summarize key provisions in Appendix A.
C. Exceptions to API Treatment
Section 1061(c)(4) provides an important exception for capital interests. An interest in a partnership is not treated as an applicable partnership interest to the extent that the interest is held by a person who has contributed capital to the partnership on the same terms and conditions as are applicable to other partners who do not provide substantial services in the applicable trade or business. This exception is critical for Fund V because the GP LLC will make a capital commitment of $50,000,000 (2.5% of aggregate commitments at hard cap) to the Fund on the same terms and conditions as the limited partners.
The GP commitment of $50,000,000 constitutes a bona fide capital investment. Capital is called from the GP LLC on a pro rata basis alongside limited partner capital calls. Returns on the GP's capital investment are distributed on the same basis as returns on limited partner capital — subject to the same waterfall provisions, including the return of capital and preferred return priorities. The GP's capital interest, therefore, falls squarely within the capital interest exception of Section 1061(c)(4), and gains attributable to this capital interest are not subject to the three-year holding period requirement. They remain eligible for long-term capital gain treatment under the standard one-year holding period applicable to capital assets under IRC Section 1222.
The proper separation of the GP's capital interest returns from the carried interest allocations is a matter of considerable importance. The LPA and the tax allocation provisions must clearly delineate which allocations and distributions are attributable to the GP's capital interest (exempt from Section 1061) and which are attributable to the carried interest (subject to Section 1061). The Final Regulations at Treasury Regulation Section 1.1061-3(c) provide guidance on the capital interest exception, requiring that the capital interest satisfy certain conditions, including that the return on the capital interest is commensurate with other non-service partners' returns on their capital. We address recommended LPA provisions to effectuate this separation in Section V below.
A second exception applies to interests held directly by C corporations. Section 1061(a)(1) provides that the three-year holding period requirement does not apply to any income or gain attributable to an API held by a corporation (other than an S corporation). We note that HGF V blocker Corp., a Delaware C corporation, has been established as a blocker entity for the benefit of certain tax-exempt limited partners and non-U.S. investors to address unrelated business taxable income ("UBTI") and effectively connected income ("ECI") concerns. The blocker corporation is a limited partner in the Fund and is not a carry recipient. The corporate exception under Section 1061 is therefore not relevant to the carry recipients, who are individuals receiving their carry through pass-through entities (the GP LLC and HCP). We mention this exception solely for completeness.
D. The Three-Year Holding Period Requirement
The core operative rule of Section 1061(a) provides that long-term capital gain recognized by a taxpayer with respect to an API is recharacterized as short-term capital gain unless the gain is attributable to an asset held for more than three years. The determination of the three-year holding period is made at the asset level — specifically, at the partnership (fund) level with respect to the underlying portfolio investments — rather than at the partner level.
This asset-level approach means that the relevant inquiry is: how long has the Fund held the underlying portfolio company investment? If the Fund acquires a portfolio company on January 15, 2026, the three-year holding period for that investment is satisfied on January 16, 2029. Any gain realized on a disposition of that investment prior to January 16, 2029 that is allocated as carried interest to the GP LLC (and ultimately to the individual carry recipients) will be recharacterized as short-term capital gain. Conversely, if the disposition occurs after January 16, 2029, the carried interest allocation retains its long-term capital gain character and is eligible for the preferential rate.
This asset-level approach contrasts with the partner-level holding period analysis that would apply in other contexts. For example, a limited partner's holding period in the partnership interest itself is not relevant to the Section 1061 analysis. Similarly, the carry recipient's holding period in the GP LLC interest or the HCP interest is not the relevant holding period. The question is always: how long has the underlying asset (portfolio company) been held by the Fund?
The Treasury Regulations clarify that the holding period of an asset is determined under general principles of IRC Section 1223, with certain modifications. For purposes of Section 1061, the holding period begins on the date the Fund acquires the asset and ends on the date the Fund disposes of the asset. Tacking rules under Section 1223 may apply in certain circumstances — for example, if the Fund acquires an asset in a tax-free exchange, the holding period of the surrendered asset may tack onto the holding period of the acquired asset. However, such tacking rules must be applied carefully and on a case-by-case basis.
E. One-Year / Three-Year Gain Bifurcation
The mechanical application of Section 1061 requires a bifurcation analysis set forth in Treasury Regulation Section 1.1061-4. The regulation requires the calculation of two amounts for each taxable year: the "One Year Gain Amount" and the "Three Year Gain Amount."
The One Year Gain Amount is the taxpayer's net long-term capital gain with respect to the API, calculated using the standard one-year holding period threshold. This is the amount of long-term capital gain that the taxpayer would recognize under general tax principles, without regard to Section 1061.
The Three Year Gain Amount is the taxpayer's net long-term capital gain with respect to the API, calculated as if only assets held for more than three years were taken into account. This amount represents the gain that would qualify for long-term capital gain treatment under the heightened three-year threshold.
The recharacterization amount — the amount that is recharacterized from long-term capital gain to short-term capital gain — is equal to the One Year Gain Amount minus the Three Year Gain Amount. This difference represents the gain on assets held for more than one year but three years or less, which is the "gap" period targeted by Section 1061. Gains on assets held for one year or less are already treated as short-term capital gains under general principles and are not affected by Section 1061.
This bifurcation analysis must be performed annually by each carry recipient (or, in the case of pass-through entities, at the relevant entity level and passed through to the individual taxpayer). The Fund, the GP LLC, and HCP must each maintain records sufficient to support the calculation, and the Schedule K-1 reporting must provide the necessary detail. We discuss the reporting requirements in greater detail in Section V.A below.
F. Lookthrough Rule for Tiered Partnerships
The structure of Fund V involves multiple tiers of pass-through entities: HPE Fund V LP allocates gains to the GP LLC, the GP LLC passes through to HCP, and HCP passes through to the individual principals. Section 1061(c)(4)(A) and Treasury Regulation Section 1.1061-3 provide lookthrough rules that apply to tiered partnership structures of this nature.
Under the lookthrough rules, the Section 1061 recharacterization applies at the individual taxpayer level, looking through the chain of pass-through entities. Each tier in the structure must properly report and pass through the holding period and character information necessary for the ultimate individual taxpayer to perform the Section 1061 calculation. The Fund (as the entity that holds the underlying portfolio investments) is the entity with the most direct information about asset-level holding periods. The Fund must communicate this information through the Schedule K-1 reporting chain to the GP LLC, which in turn must pass it through to HCP, which must pass it through to the individual carry recipients.
Treasury Regulation Section 1.1061-3(b) provides specific rules for "Passthrough Entities" (defined to include partnerships and S corporations) that hold APIs indirectly. These rules ensure that the three-year holding period requirement cannot be circumvented by interposing additional entity tiers between the fund and the carry recipient. The recharacterization applies regardless of the number of entity tiers, and each tier must provide the necessary reporting to enable compliance.
In practice, this means that Pinnacle Fund Services LLC (the Fund's administrator) must maintain asset-level holding period records for each portfolio investment, and Caldwell, Fitch & Hartley LLP (the Fund's auditor) must ensure that the Schedule K-1 reporting at each entity level includes sufficient detail for Section 1061 compliance. We address these practical requirements in the compliance checklist in Section VIII below.
IV. Application to HPE Fund V LP's European-Style Waterfall
A. European (Whole-Fund) Waterfall Mechanics
Under the Fund V LPA, distributions to partners are made in accordance with a European-style (whole-fund) waterfall. This waterfall structure operates as follows:
Tier 1 — Return of Capital. First, 100% of distributions are made to the limited partners until all contributed capital (including capital used to pay management fees and fund expenses) has been returned in full across the entire fund.
Tier 2 — Preferred Return. Second, 100% of distributions are made to the limited partners until they have received a cumulative preferred return equal to 8% per annum (compounded annually) on their unreturned capital contributions, calculated from the date of each capital call to the date of each distribution.
Tier 3 — GP Catch-Up. Third, distributions are allocated 80% to the GP LLC and 20% to the limited partners until the GP LLC has received an amount equal to 20% of cumulative net profits (i.e., until the GP LLC's cumulative distributions equal 20% of the aggregate amount distributed in Tiers 2, 3, and 4).
Tier 4 — Residual Split. Fourth, all remaining distributions are allocated 80% to the limited partners and 20% to the GP LLC.
The critical feature of the European-style waterfall, as distinguished from the American-style (deal-by-deal) waterfall, is that carried interest distributions do not commence until all contributed capital and the full preferred return have been returned to the limited partners across the entire fund portfolio. This means that the GP LLC will not receive any carry distributions until the aggregate distributions to the limited partners have satisfied the Tier 1 and Tier 2 priorities for the fund as a whole. In a fund with a $2,000,000,000 hard cap, this requires that the fund generate and distribute at least the full $2,000,000,000 of contributed capital plus the cumulative preferred return before any carry flows to the GP LLC.
B. Timing Implications for Section 1061
The European-style waterfall creates generally favorable timing dynamics for Section 1061 compliance. Because carry distributions are deferred until later in the fund's life — typically beginning in years 7 through 12, after the bulk of the portfolio has been realized — most portfolio investments will have been held for more than three years by the time their gains are distributed as carry. This natural alignment between the waterfall structure and the three-year holding period requirement means that Section 1061 recharacterization risk is somewhat lower in a European-style fund than in a deal-by-deal fund, where carry may be distributed on each realization.
However, this favorable timing dynamic is tempered by two important considerations.
First, the allocation of income for federal income tax purposes occurs annually under IRC Section 704(b) and the regulations thereunder, not only upon distribution of cash. A partner's distributive share of partnership income, gain, loss, deduction, and credit is determined and reported annually, regardless of whether cash is actually distributed. This means that the GP LLC may be allocated a share of the Fund's capital gains on a current basis (e.g., upon the realization of a portfolio investment) even if no carry distributions have yet been made under the waterfall. Such allocations are subject to Section 1061 analysis at the time of allocation, not at the time of distribution. If a portfolio investment is sold within three years of acquisition and the resulting gain is allocated to the GP LLC as carry (even though no cash distribution of carry has yet occurred), the Section 1061 recharacterization applies to that allocation in the year it is recognized.
Second, while the waterfall defers cash distributions of carry, it does not eliminate the possibility that early-realization gains will be allocated to the GP LLC. The tax allocation provisions of the LPA must be carefully coordinated with the economic waterfall to ensure that the GP LLC is not allocated gain on a current basis in a manner that creates unintended Section 1061 exposure. This coordination requires attention to the "target allocation" methodology, the "qualified income offset" provisions, and the minimum gain chargeback rules under the IRC Section 704(b) regulations.
We recommend that the LPA's tax allocation provisions be structured to minimize the allocation of gain to the GP LLC until the economic waterfall conditions for carry distribution have been satisfied, to the extent consistent with the substantial economic effect requirements. This approach, while not eliminating Section 1061 risk, reduces the likelihood of phantom income (gain allocated but not distributed) that is subject to recharacterization.
C. Interaction with Portfolio Company Holding Periods
HPE Fund V's buyout investment strategy, with target equity investments of $75,000,000 to $250,000,000, typically involves holding periods of three to seven years. Harrowgate's investment approach — which emphasizes operational improvements, strategic add-on acquisitions, margin expansion, and market positioning over a multi-year horizon — is inherently aligned with the three-year holding period threshold of Section 1061. The majority of Fund V's portfolio investments are expected to be held for more than three years before realization.
Notwithstanding this general expectation, several risk scenarios could result in realizations within the three-year window:
Early Exits. An unsolicited acquisition offer at an exceptionally attractive valuation, a strategic event (such as a competing transaction in the relevant industry), or a deterioration in market conditions that makes an early exit advisable could lead to a disposition within three years of acquisition. As noted in Section II.D above, Harrowgate's prior funds have experienced such early exits.
Partial Realizations. The Fund may sell a portion of a portfolio company position to a co-investor, secondary buyer, or strategic acquirer within three years of acquisition. Any gain on such a partial realization would be subject to Section 1061 analysis based on the holding period of the sold portion.
Dividend Recapitalizations. The Fund may cause a portfolio company to incur additional leverage and use the proceeds to pay a dividend to the Fund. While a dividend recapitalization is generally structured as a return of capital (non-taxable to the extent of the Fund's basis), it may generate taxable gain in certain circumstances — particularly if the dividend exceeds the Fund's adjusted tax basis in the investment. Any such gain realized within the three-year window would be subject to Section 1061.
Refinancings and Restructurings. Certain refinancing or restructuring transactions may give rise to taxable events if they are treated as deemed dispositions or exchanges for federal income tax purposes. The holding period for any new asset received in such a transaction must be carefully analyzed.
The concentration limit of 20% of aggregate commitments ($400,000,000 at hard cap) per investment means that any single early exit could represent a substantial portion of the Fund's total gains. If, for example, the Fund invests $300,000,000 in a single portfolio company and realizes a $200,000,000 gain within two years, the 20% carry allocation of $40,000,000 on that gain would be recharacterized as short-term capital gain — a significant tax impact for the carry recipients. The concentration limit, while providing diversification benefits, does not eliminate the potential for material Section 1061 exposure on any single investment.
D. Impact of Subscription Facility Borrowings on Holding Period
The Fund has arranged a $500,000,000 revolving subscription credit facility with Ashford National Bank, N.A. (the "Subscription Facility"), bearing interest at SOFR plus 175 basis points. The Subscription Facility is secured by the uncalled capital commitments of the limited partners and is used to bridge timing gaps between the acquisition of investments and the issuance of capital call notices to the limited partners. The use of subscription facilities has become standard practice in the institutional private equity industry, providing operational flexibility and improving certain performance metrics (notably internal rate of return, or IRR, which is calculated from the date of capital call rather than the date of investment acquisition).
The use of the Subscription Facility raises a question regarding the holding period computation for Section 1061 purposes: does the holding period of a portfolio investment begin on the date the Fund acquires the investment (funded by a draw on the Subscription Facility), or on the later date when the capital call is made to the limited partners and the Subscription Facility draw is repaid? This question has been the subject of commentary in the tax practitioner community and has been addressed by the IRS.
Under current guidance, the holding period of the underlying asset begins on the date the Fund acquires the asset, regardless of whether the acquisition was funded by capital calls from the limited partners or by draws on the Subscription Facility. The Subscription Facility borrowing is a liability of the Fund, and the acquisition of the portfolio investment is a separate transaction that establishes the Fund's holding period in that asset. The subsequent capital call and repayment of the Subscription Facility draw does not affect the holding period of the portfolio investment. Accordingly, the use of the Subscription Facility does not adversely affect the three-year holding period computation for Section 1061 purposes.
However, a more nuanced analysis is required if the Subscription Facility is used to fund interim investments, bridge transactions, or temporary cash management positions. The LPA limits the duration of Subscription Facility borrowings to 180 days per draw, and the Fund may use Subscription Facility proceeds to fund short-term investments or bridge positions pending permanent financing or syndication. Any gains on such short-duration holdings would be subject to Section 1061 analysis based on the actual holding period of the short-term position. If, for example, the Fund uses Subscription Facility proceeds to acquire a bridge position that is held for less than three years and generates a gain, the carry allocation on that gain would be recharacterized as short-term capital gain. We recommend that the Fund's investment tracking system distinguish between (i) portfolio investments funded by the Subscription Facility pending capital calls (where the holding period is measured from the date of acquisition) and (ii) interim or bridge investments that may have shorter holding periods.
E. Clawback and Section 1061
The GP clawback obligation is a standard feature of European-style waterfall structures and is designed to ensure that, upon final liquidation of the Fund, the GP LLC has not received carry in excess of 20% of cumulative net profits. The clawback is triggered if, for example, later-realized investments are sold at losses that reduce cumulative net profits below the level implied by prior carry distributions.
The clawback provision in the Fund V LPA provides that the clawback obligation is calculated on a "net of taxes" basis — that is, the amount that the GP LLC (and, by extension, the individual guarantors) is required to return is reduced by the amount of income taxes actually paid on the excess carry distributions. This "net of taxes" concept is critical because it determines the effective economic cost of the clawback to the carry recipients.
Section 1061 introduces a complication to the "net of taxes" clawback calculation. If carried interest was distributed and the carry recipients paid tax on that distribution at ordinary income rates (because Section 1061 recharacterized the gain as short-term capital gain), the "net of taxes" offset should reflect the higher tax rate actually paid. Conversely, if the carried interest retained long-term capital gain character (because the underlying assets were held for more than three years), the "net of taxes" offset should reflect the lower preferential rate.
Under current federal tax rates, the differential between the two scenarios is substantial. Short-term capital gain (recharacterized under Section 1061) is taxed at ordinary income rates, with a top federal rate of 37%. Long-term capital gain is taxed at a preferential rate of 20%, plus the 3.8% net investment income tax under IRC Section 1411, for a combined rate of 23.8%. The difference between 37% and 23.8% is 13.2 percentage points — on a $10,000,000 carry distribution, this equates to a difference of $1,320,000 in taxes paid, which directly affects the clawback amount.
The clawback guarantee is several (not joint) among the three guarantors, meaning each individual's clawback obligation is calculated based on his or her proportionate share of carry distributions and taxes actually paid. Because each guarantor's tax situation may differ — due to differences in state of residence, state income tax rates, the availability of capital loss carryforwards, and other individual tax attributes — the "net of taxes" calculation must be performed separately for each guarantor. We recommend specific LPA and GP LLC Agreement provisions to address these issues, as discussed in Section V.F below.
V. Recommended LPA and GP LLC Agreement Provisions
A. Holding Period Tracking and Reporting
The foundation of Section 1061 compliance is accurate and contemporaneous tracking of the acquisition date and holding period for each portfolio investment. We recommend including a specific provision in the LPA requiring the GP LLC and the Fund's administrator, Pinnacle Fund Services LLC, to maintain detailed records of the acquisition date, cost basis, and holding period for each portfolio investment, including any partial realizations or add-on investments.
This record-keeping requirement should extend to all forms of investments, including:
• Direct equity investments in portfolio companies
• Co-investment positions
• Bridge and interim investments funded by the Subscription Facility
• Follow-on investments and add-on acquisitions (which may have different holding periods than the initial platform investment)
• Short-term cash management investments and money market holdings
• Derivative positions (options, hedging instruments, interest rate swaps) used in connection with portfolio investments
The LPA should further require that the GP LLC provide annual reporting to each carry recipient identifying: (i) investments held for more than three years as of the end of the taxable year, together with the gain or loss attributable to each such investment; (ii) investments held for more than one year but three years or less, together with the gain or loss attributable to each such investment; and (iii) investments held for one year or less, together with the gain or loss attributable to each such investment. This annual report should be provided in conjunction with the Schedule K-1 package to enable each carry recipient to prepare the Section 1061 calculations required for his or her individual income tax return.
With respect to Schedule K-1 reporting, the Fund files IRS Form 1065 (U.S. Return of Partnership Income) annually and issues Schedule K-1s to each partner, including the GP LLC. The Schedule K-1 must include sufficient detail to permit the carry recipients to compute the One Year Gain Amount and the Three Year Gain Amount, as required by the instructions to IRS Form 8949 (Sales and Other Dispositions of Capital Assets) and Schedule D (Capital Gains and Losses). The Final Regulations include specific API reporting requirements, including the use of separate line items on the K-1 for API-related amounts. We recommend that Pinnacle Fund Services LLC work closely with Caldwell, Fitch & Hartley LLP (Robert A. Fonseca, Audit Partner) to ensure that the K-1 reporting for Fund V is fully compliant with these requirements from inception.
B. Gain Bifurcation Provisions
The LPA should include specific tax allocation provisions that separately track and allocate gains based on the holding period of the underlying assets. We recommend the following approach:
Gains attributable to assets held for more than three years should be separately identified and allocated. These gains, when allocated as carried interest, retain their long-term capital gain character and are eligible for the preferential 20% federal rate (plus the 3.8% net investment income tax). The LPA should provide that such gains are allocated to the GP LLC's carried interest account and reported as "Three Year Gain" on the Schedule K-1.
Gains attributable to assets held for three years or less should also be separately identified and allocated. When such gains are allocated as carried interest, they are subject to recharacterization as short-term capital gain under Section 1061. The LPA should provide that these gains are allocated to the GP LLC's carried interest account and flagged as "Recharacterizable Gain" on the Schedule K-1. The actual recharacterization occurs at the individual taxpayer level (after looking through the GP LLC and HCP), but the Fund-level reporting must provide the necessary information.
In addition, the GP LLC's capital interest — representing the $50,000,000 commitment at hard cap — must be clearly distinguished from the carried interest in all allocation and distribution provisions. We recommend the creation of a defined term in the LPA, "Section 1061 Capital Interest," to isolate the GP's capital interest from the API. The Section 1061 Capital Interest should be treated as a separate allocation class for purposes of the tax allocation provisions, with returns on the capital interest allocated in the same manner as returns to the limited partners (i.e., subject to the standard one-year holding period and not subject to Section 1061 recharacterization). Appendix C includes recommended defined term language for inclusion in the LPA.
The gain bifurcation provisions should be coordinated with the existing tax allocation provisions of the LPA, including the Section 704(b) capital account maintenance rules, the "qualified income offset" provision, the minimum gain chargeback rules, and the curative and remedial allocation provisions. The bifurcation should not alter the economic waterfall or the total amount of carry allocable to the GP LLC; it should only determine the character (long-term vs. short-term) of the carry for Section 1061 purposes.
C. European Waterfall — Tax Distribution Provisions
As discussed in Section IV.B above, the European-style waterfall may result in the allocation of carry income to the GP LLC for tax purposes before any cash distributions of carry have been made. This creates a potential "phantom income" situation in which the carry recipients owe taxes on income they have not yet received in cash. The risk of phantom income is exacerbated by Section 1061, which may recharacterize the allocated gain as short-term capital gain, thereby increasing the tax rate and the phantom income burden.
To address this risk, we recommend including a tax distribution provision in the LPA that allows the GP LLC to receive advance distributions sufficient to cover income tax liabilities arising from allocated but undistributed carry. The key elements of the recommended tax distribution provision are:
Tax Distribution Amount. The tax distribution should be calculated using the highest combined marginal federal and applicable state and local income tax rate applicable to short-term capital gain. At current rates, this is 37% for federal income tax purposes. The use of the short-term rate (rather than the long-term rate) is appropriate because Section 1061 may recharacterize carry-related gain as short-term capital gain, and the tax distribution should be sufficient to cover the worst-case tax liability. If individual carry recipients are subject to state and local income taxes (e.g., New York State and New York City income taxes for Marcus J. Harrowgate), the tax distribution should be grossed up to account for the combined federal and state/local rate.
Treatment as Advance Against Carry. Tax distributions to the GP LLC should be treated as advances against future carried interest distributions, not as additional economic allocations. When carry cash distributions commence under the waterfall, prior tax distributions should be credited against the GP LLC's carry entitlement. This ensures that the limited partners are not economically disadvantaged by the advance tax distributions.
Ordering and Priority. The tax distribution provision should specify its priority within the overall distribution waterfall. We recommend that tax distributions be made prior to the application of Tier 1 (Return of Capital) to the extent funded from realized gains, but subject to the LP advisory committee's review and approval to the extent the aggregate tax distributions exceed a specified threshold (e.g., 3% of committed capital). This structure balances the carry recipients' need for tax liquidity with the limited partners' interest in prompt return of capital.
Coordination with LP Counsel. The tax distribution provision will require negotiation with counsel to the Fund's anchor limited partners, including Aldworth & McBride LLP (representing Northmoor Pension Fund), Pelham Chambers LLP (representing Kingsbridge Endowment), and Ramsden Clarke International LLP (representing Tidewater Institutional Partners). We anticipate that the tax distribution provision will be a point of negotiation in the LPA process and recommend engaging with LP counsel early in the drafting process to secure agreement on the key terms.
D. Disposition Sequencing and Harvesting Considerations
While the LPA cannot and should not dictate the timing of investment dispositions — as such decisions must be made in the exercise of the GP's fiduciary duties and investment judgment — we recommend including permissive language that authorizes the GP LLC to consider Section 1061 implications in the timing and sequencing of portfolio dispositions.
Specifically, we recommend language providing that the GP LLC may, in its reasonable discretion, consider the federal income tax consequences of a proposed disposition, including the application of Section 1061, as one factor (among others) in determining the timing and structure of the disposition. This language does not impose a mandatory three-year hold period — which could conflict with the GP's fiduciary obligation to maximize returns for the Fund's limited partners — but it does provide a governance basis for the GP to weigh tax efficiency in its decision-making process.
We note that the Investment Period (five years from Final Close) and the Fund Term (ten years from Final Close, plus up to three one-year extensions) provide adequate runway for most investments to exceed the three-year holding period threshold. Even an investment made late in the Investment Period (e.g., month 58) would typically have at least five years of remaining fund term (plus extensions) to reach the three-year holding period. However, investments made late in the Investment Period may face pressure for early exit if the Fund Term approaches its expiration, particularly in the absence of extensions. The Fund's extension provisions — which allow up to three one-year extensions — provide additional flexibility to hold investments beyond the three-year threshold if needed.
E. Section 1061(d) — Transfers of APIs
Section 1061(d) provides special rules for transfers of applicable partnership interests. Under Section 1061(d)(1), if a taxpayer transfers any API, directly or indirectly, to a person who is a related person with respect to the taxpayer, the taxpayer shall include in gross income (as short-term capital gain) so much of the taxpayer's net long-term capital gain with respect to such interest for the taxable year as is attributable to the transferred interest and is not otherwise treated as short-term capital gain under Section 1061(a). The term "related person" is defined broadly under Section 1061(d)(2) to include family members (as defined in Section 318(a)(1)), and any person who performed a service within the applicable trade or business at any time during the two-year period ending on the date of the transfer.
This provision is relevant to Fund V because it restricts the ability of carry recipients to transfer their carried interest to family members, family trusts, estates, or other related persons without triggering short-term capital gain recognition. Such transfers are common in estate planning and succession planning contexts. For example, if Marcus J. Harrowgate were to transfer a portion of his carried interest to a trust for the benefit of his children, Section 1061(d) would cause him to recognize short-term capital gain on the transfer to the extent of gain not otherwise treated as short-term under Section 1061(a).
We recommend the following provisions in the LPA and GP LLC Agreement to address Section 1061(d):
Transfer Notification. Any carry recipient who proposes to transfer any portion of his or her carried interest — whether by sale, gift, assignment, or estate planning transfer — must provide written notice to the GP LLC and to HCP at least 30 days prior to the proposed transfer. The notice must identify the transferee, the relationship between the transferor and the transferee, and the nature of the transfer.
Section 1061(d) Acknowledgment. The transferring carry recipient must acknowledge in writing that he or she has consulted with a personal tax advisor regarding the application of Section 1061(d) to the proposed transfer, and that the GP LLC, HCP, and the Fund shall have no liability for any adverse tax consequences arising from the transfer.
Form of Transfer Agreement. The Form of Transfer (Assignment) Agreement, which is typically attached as an exhibit to the LPA and the GP LLC Agreement, should include representations by the transferor that the transfer has been evaluated for compliance with Section 1061(d) and that any applicable short-term capital gain has been or will be recognized.
Restrictions on Transfers. The LPA and GP LLC Agreement already contain standard transfer restrictions (consent requirements, rights of first refusal, drag-along/tag-along rights). We recommend that the Section 1061(d) transfer provisions be integrated into the existing transfer restriction framework, rather than creating a separate overlay.
F. Clawback Provision Refinements
As discussed in Section IV.E above, Section 1061 creates specific issues for the "net of taxes" clawback calculation. We recommend the following refinements to the clawback provision in the LPA and the GP LLC Agreement:
Explicit Section 1061 Reference. The clawback provision should explicitly reference Section 1061 and acknowledge that carried interest distributions may have been subject to recharacterization as short-term capital gain, resulting in tax liability at ordinary income rates rather than preferential long-term capital gain rates.
Actual Tax Rate. The "net of taxes" calculation should be based on the actual income tax rate paid by each carry recipient on the clawed-back carry, rather than a uniform assumed rate. This requires each guarantor to maintain and produce, upon request, records of income tax payments attributable to carried interest distributions. If a guarantor cannot produce such records, the clawback should be calculated using the lowest potentially applicable rate (i.e., the long-term capital gain rate), to ensure that the limited partners are not disadvantaged by the guarantor's failure to maintain records.
Individual Calculation. Because the clawback guarantee is several (not joint) among Marcus J. Harrowgate, Diana R. Castellano, and Jonathan P. Birch, the "net of taxes" calculation must be performed separately for each individual guarantor. Each guarantor's state of residence, marginal tax rate, and individual tax attributes (such as capital loss carryforwards, AMT status, and net investment income tax status) may result in different effective tax rates on the same carry distribution. The GP LLC should maintain a schedule showing each guarantor's cumulative carry distributions, the character of those distributions (long-term vs. short-term/recharacterized), and the tax payments attributable thereto.
Reserve and Escrow. We recommend considering a clawback escrow or reserve mechanism, funded by a portion of each carry distribution (e.g., 15% of each carry distribution held in escrow), to ensure that clawback obligations can be satisfied without relying solely on the personal assets of the guarantors. The escrow calculation should take into account the Section 1061 recharacterization risk — if a significant portion of carry was taxed at ordinary rates, the "net of taxes" offset will be larger, reducing the effective clawback amount and therefore the required escrow.
VI. Impact on Predecessor Fund Analysis
Before concluding our analysis of Fund V, we note briefly the relevance of Section 1061 to Harrowgate's predecessor funds. Section 1061 is effective for taxable years beginning after December 31, 2017, meaning that it has applied to all of Harrowgate's funds for taxable years 2018 through the present.
HPE Fund I (2012 vintage) has been fully realized. Given the fund's vintage and typical hold period, the majority of Fund I's investments were held for more than three years before realization, and Section 1061 recharacterization was minimal.
HPE Fund II (2015 vintage) is substantially realized. Similar to Fund I, the buyout strategy and extended holding periods have generally resulted in most gains qualifying for the more-than-three-year holding period. However, certain early exits may have triggered Section 1061 recharacterization in the 2018-2020 taxable years.
HPE Fund III (2018 vintage) is currently in its harvesting phase. Investments made in 2018 and 2019 have now crossed the three-year holding period threshold, reducing Section 1061 exposure for those positions. However, any investments made in late 2022 or thereafter that are realized before the three-year anniversary remain at risk.
HPE Fund IV (2021 vintage) is in the harvesting phase, with approximately 82% of committed capital deployed as of December 31, 2024. Fund IV performance metrics as of December 31, 2024 — TVPI of 1.4x and Net IRR of 18.2% — indicate that the fund is performing well, and several realizations are anticipated in the near term. Any investments made in 2022 or later that are realized before their respective three-year anniversaries will provide a real-time example of Section 1061 application. We recommend that the Fund IV Section 1061 experience inform the compliance infrastructure for Fund V.
Harrowgate's track record of holding investments for extended periods, consistent with its buyout strategy and value creati

PRIVILEGED & CONFIDENTIAL ATTORNEY-CLIENT COMMUNICATION / ATTORNEY WORK PRODUCT

MEMORANDUM

MATTER NO.: 1003-00002

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