PRIVILEGED & CONFIDENTIAL — ATTORNEY-CLIENT COMMUNICATION / ATTORNEY WORK PRODUCT
MEMORANDUM
FROM: Sylvia Hartwell, Specialist Partner (Tax) Calderwood & Harkness LLP One Vanderbilt Avenue, 44th Floor New York, NY 10017
TO: Nicholas Stern, Responsible Partner Owen Fischer, Lead Associate
DATE: November 22, 2023
RE: Tax Structuring Analysis — Management Company Restructuring and Economics Realignment of Ardent Capital Partners III LP
MATTER NO.: 1001-00002
I. Executive Summary
Calderwood & Harkness LLP has been engaged by Ardent Capital GP III LLC (the "General Partner" or "GP"), the sole general partner of Ardent Capital Partners III LP (the "Fund"), a Delaware limited partnership with approximately $2.8 billion in total commitments, to advise on a comprehensive restructuring of its management company, Ardent Capital Management LLC (the "ManCo," an SEC-registered investment adviser, CRD #298417), and the realignment of economics among the Fund's principals. This memorandum sets forth our analysis of the Delaware and federal income tax implications of the proposed restructuring transactions and provides our recommendations with respect to the structuring of each component of the reorganization.
The proposed restructuring involves several interrelated transactions: (a) the formation of a new parent holding company, Ardent Capital Holdings LLC ("HoldCo"), and an intermediate entity, Ardent GP Intermediate LLC ("GP Intermediate"); (b) the contribution of existing GP and ManCo membership interests by the continuing principals into the new holding company structure; (c) the departures of two principals — David Kellner, who is retiring, and Joanna Trask, who is departing voluntarily to join another firm; and (d) the reallocation of carried interest and management fee economics among the remaining principals and two next-generation principals, Elena Marchetti and Samuel Okonkwo.
This memorandum addresses each of these transactions in turn, analyzing the relevant provisions of the Internal Revenue Code of 1986, as amended (the "Code" or "IRC"), the Treasury Regulations promulgated thereunder, applicable IRS guidance, and relevant case law.
Principal Conclusion: If structured as contributions of membership interests by the existing principals to HoldCo in exchange for HoldCo membership interests, the formation of HoldCo should qualify as a tax-free contribution under IRC Section 721(a), resulting in no taxable event at the HoldCo formation level. Significant ancillary tax issues arise with respect to Section 704(b) and 704(c) allocations of built-in gain, the treatment of departing principals' interests under Section 736, the characterization of certain payments made in connection with the departures of Kellner and Trask, and the proper tax treatment of profits interests granted to Marchetti and Okonkwo. Each of these issues is analyzed in detail below.
II. Background and Factual Assumptions
The following factual background and assumptions are based on information provided by the client and our review of the governing documents of the Fund, the GP, and the ManCo, including the Fund's Second Amended and Restated Agreement of Limited Partnership dated as of April 15, 2019 (the "LPA"), the GP's Amended and Restated Limited Liability Company Agreement dated as of January 18, 2019 (the "GP LLC Agreement"), and the ManCo's Amended and Restated Limited Liability Company Agreement dated as of January 18, 2019 (the "ManCo LLC Agreement"). We have also reviewed draft term sheets for the proposed restructuring provided by Marcus Aldridge on behalf of the principals.
A. Existing Structure
The Fund is a Delaware limited partnership formed in 2019, with its final close occurring on April 15, 2019. The Fund pursues a strategy of making control investments in middle-market industrial and business-services companies, primarily in North America. The Fund's aggregate commitments total approximately $2.8 billion from 47 limited partners, which consist of a mix of public and private pension plans, endowments, foundations, sovereign wealth funds, fund-of-funds vehicles, and high-net-worth individuals and family offices.
As of the date of this memorandum, the Fund has called approximately $1.96 billion of its $2.8 billion in total commitments, representing approximately 70% of aggregate commitments. Of the capital called, approximately $1.88 billion has been invested in 11 active portfolio companies, with the balance having been applied to fund management fees, organizational expenses, and other partnership expenses. The Fund has generated realized proceeds of approximately $445 million from partial exits and one full realization.
The Fund's most recent quarterly valuation as of September 30, 2023 reflects an aggregate gross multiple of invested capital ("MOIC") of 1.42x, a net internal rate of return ("IRR") of 14.7%, and aggregate unrealized value of approximately $2.33 billion. These figures are relevant to the determination of built-in gain in the contributed interests, as discussed in Sections IV and V below.
The Fund's term expires on December 31, 2029, subject to two one-year extensions at the discretion of the GP. The investment period under the LPA ends on June 30, 2025, after which the GP may not make new investments but may make follow-on investments in existing portfolio companies and fund capital calls for expenses and reserves.
The GP — Ardent Capital GP III LLC (EIN 84-3291063) — is a Delaware limited liability company. Under the current GP LLC Agreement, the five senior principals of the firm hold direct membership interests in the GP. The GP serves as the sole general partner of the Fund and is responsible for the management and control of the Fund's business and affairs.
The ManCo — Ardent Capital Management LLC (EIN 84-3291070) — is a Delaware limited liability company registered as an investment adviser with the Securities and Exchange Commission under the Investment Advisers Act of 1940, as amended (CRD #298417). The ManCo provides investment advisory and management services to the Fund pursuant to an Investment Management Agreement dated as of April 15, 2019 (the "IMA"). The ManCo's members are the same five senior principals who hold membership interests in the GP.
The Fund's employer identification number is 84-3291057.
B. Current Ownership and Economics
The five principals currently hold direct membership interests in both the GP and the ManCo in the following percentages:
The economics of the Fund are allocated among these principals as follows:
GP Commitment. The GP has committed $42 million to the Fund, representing 1.5% of total Fund commitments. This commitment is funded by the five principals in proportion to their respective membership interests in the GP:
Carried Interest. The Fund provides for carried interest of 20% of net profits (after return of contributed capital and payment of expenses), subject to an 8% per annum preferred return to the limited partners and a 100% GP catch-up until the GP has received 20% of cumulative net profits. Carried interest is allocated among the principals in the same percentages as their membership interests in the GP. As of September 30, 2023, the Fund has accrued carried interest of approximately $87.6 million, which has not yet been distributed. The accrued carried interest is attributable to unrealized appreciation in the Fund's portfolio companies and is subject to change based on subsequent valuations.
The Fund's LPA provides for a 100% joint and several clawback obligation among the GP members, with an individual escrow requirement of 30% of all carried interest distributions. Each principal's escrow balance is proportionate to their share of distributed carry.
Management Fees. The ManCo charges the Fund a management fee equal to 1.75% of committed capital during the investment period, yielding annual management fee revenue of approximately $49 million ($2.8 billion × 1.75%). After the expiration of the investment period on June 30, 2025, the management fee steps down to 1.50% of invested capital (net of write-offs and realizations). The ManCo's profit share — that is, the portion of management fee revenue distributed to the principals as equity owners — is approximately 35% of fee revenue, or approximately $17.15 million per year. The remaining approximately 65% of fee revenue ($31.85 million) is used to fund the ManCo's operating expenses, including employee compensation, rent, technology, travel, and other overhead costs.
C. Proposed Restructuring
The proposed restructuring involves the following steps, which are described in greater detail in the draft term sheet provided by Mr. Aldridge and reviewed by our office:
1. Formation of HoldCo. A new Delaware limited liability company, Ardent Capital Holdings LLC ("HoldCo"), will be formed to serve as the parent holding company for the Ardent Capital platform. HoldCo will have five members: Marcus Aldridge, Priya Narayanan, Robert Hsiao, Elena Marchetti, and Samuel Okonkwo.
2. Formation of GP Intermediate. A new Delaware limited liability company, Ardent GP Intermediate LLC ("GP Intermediate"), will be formed as an intermediate entity between HoldCo and the GP. GP Intermediate will be a wholly owned subsidiary of HoldCo (single-member LLC).
3. Contribution of Interests. The remaining principals (Aldridge, Narayanan, and Hsiao) will contribute their respective membership interests in both the GP and the ManCo to HoldCo in exchange for membership interests in HoldCo. HoldCo will then contribute the GP membership interests to GP Intermediate.
4. Post-Restructuring Ownership. Following the restructuring, HoldCo will be the sole member of the ManCo and the sole member of GP Intermediate. GP Intermediate will be the sole member of the GP. The GP will continue to serve as the sole general partner of the Fund.
5. HoldCo Membership Interests. Post-restructuring, the membership interests in HoldCo will be held as follows:
6. Kellner Retirement. David Kellner will retire effective March 31, 2024. In connection with his retirement, Kellner will withdraw as a member of the GP and ManCo, transition to a Senior Advisor role under a separate advisory agreement with the ManCo, retain 100% of his vested carried interest ($13.14 million, representing 15% of the $87.6 million of accrued carry), and receive an advisory fee of $350,000 per year for two years.
7. Trask Departure. Joanna Trask will depart voluntarily effective April 15, 2024, to join a competing investment firm. In connection with her departure, Trask will withdraw as a member of the GP and ManCo, retain 60% of her vested carried interest ($6,307,200), forfeit 40% of her vested carry ($4,204,800) and 100% of her unvested carry, receive a lump-sum separation payment of $1,250,000, and agree to restrictive covenants including a 12-month non-compete, an 18-month employee non-solicit, and an 18-month limited partner non-solicit.
8. Carry and Fee Reallocation. The carried interest and management fee economics previously held by Kellner and Trask (net of retained vested carry) will be reallocated among the five HoldCo members in accordance with their new HoldCo membership percentages.
III. Tax-Free Formation of HoldCo Under IRC Section 721
The threshold question in the tax analysis of the proposed restructuring is whether the formation of HoldCo and the contribution of existing GP and ManCo membership interests by the continuing principals to HoldCo in exchange for HoldCo membership interests constitutes a taxable event. For the reasons set forth below, we conclude that the formation of HoldCo should qualify as a tax-free contribution under IRC Section 721(a).
A. General Rule — Section 721(a)
Under IRC Section 721(a), no gain or loss shall be recognized to a partnership or to any of its partners in the case of a contribution of property to the partnership in exchange for an interest in the partnership. This nonrecognition rule is the partnership analog to Section 351 in the corporate context, and it reflects the fundamental policy that the formation of a partnership should not be a taxable event because the contributing partners have merely changed the form of their investment without realizing an economic gain or loss.
HoldCo will be organized as a Delaware limited liability company with multiple members. Because HoldCo will not elect to be classified as a corporation under Treasury Regulations Section 301.7701-3 (the so-called "check-the-box" regulations), HoldCo will be treated as a partnership for federal income tax purposes by default. Treasury Regulations Section 301.7701-3(b)(1)(i) provides that a domestic eligible entity with two or more members is classified as a partnership unless it elects to be classified as an association taxable as a corporation. No such election will be made.
The contribution by Aldridge, Narayanan, and Hsiao of their respective membership interests in the GP and ManCo to HoldCo in exchange for HoldCo membership interests constitutes a contribution of property to a partnership in exchange for an interest in the partnership within the meaning of Section 721(a). Each of these principals is transferring an ownership interest in an existing entity (the GP or the ManCo, as applicable) to HoldCo, and each is receiving in return a membership interest in HoldCo. This transaction falls squarely within the scope of Section 721(a).
With respect to Marchetti and Okonkwo, their HoldCo membership interests may be received in exchange for services (as profits interests) rather than in exchange for contributed property. To the extent Marchetti and Okonkwo contribute capital or other property to HoldCo, Section 721(a) would apply to such contributions. To the extent they receive HoldCo interests for services, the analysis under Revenue Procedures 93-27 and 2001-43 and Section 83 of the Code governs, as discussed in Section VIII.C below.
B. Characterization of Contributed Interests
The GP and ManCo membership interests that Aldridge, Narayanan, and Hsiao will contribute to HoldCo constitute "property" for purposes of Section 721. The term "property" under Section 721 is broadly defined and encompasses essentially all forms of property, including interests in other partnerships and limited liability companies. Treasury Regulations Section 1.721-1(a) confirms that the nonrecognition rule applies to contributions of all types of property to a partnership, including cash, tangible property, intangible property, and interests in other entities.
However, it is necessary to analyze whether any portion of the contributed interests constitutes "unrealized receivables" or "inventory items" within the meaning of IRC Section 751. The ManCo earns an annual management fee stream of approximately $49 million, a portion of which may constitute accounts receivable or accrued but unbilled fees at the time of contribution. Similarly, the accrued carried interest of $87.6 million represents a right to future distributions that may be characterized as an unrealized receivable. Under Section 751(c), the term "unrealized receivables" includes, among other things, rights to payment for services rendered or to be rendered, to the extent not previously included in income.
The presence of Section 751 "hot assets" does not affect the tax-free nature of the contribution itself under Section 721(a). Section 721(a) applies to contributions of property regardless of whether the property includes hot assets. However, the existence of hot assets bears on subsequent dispositions of the contributed interests or of HoldCo membership interests, as discussed in Section V below. Specifically, any future sale or exchange of a HoldCo membership interest would require a determination of the seller's share of Section 751 hot assets, which would be treated as ordinary income rather than capital gain.
Additionally, the ManCo's management fee stream represents ongoing services income. The contribution of the ManCo interest to HoldCo does not trigger the assignment-of-income doctrine, which generally prevents a taxpayer from assigning earned income to another person for tax purposes. The assignment-of-income doctrine is inapplicable here because HoldCo — and through it, the same individual principals — will continue to perform the advisory services that generate the management fee income. The substance of the arrangement is that the same individuals are performing the same services through a restructured entity framework, and the restructuring does not result in a shifting of income from the earners to a separate, unrelated party. See United States v. Basye, 410 U.S. 441 (1973); Lucas v. Earl, 281 U.S. 111 (1930). The contributing principals will continue to bear the economic burden and benefit of the ManCo's operations through their HoldCo membership interests.
C. Section 721(b) — Investment Company Exception
Section 721(b) provides an exception to the general nonrecognition rule of Section 721(a). Under Section 721(b), the nonrecognition rule does not apply to gain realized on a transfer of property to a partnership that would be treated as an investment company (within the meaning of Section 351) if the partnership were incorporated. Under Section 351(e) and Treasury Regulations Section 1.351-1(c), an investment company is a transferee that, after the transfer, holds more than 80% of its assets in stocks, securities, and certain other investment-type assets, and the transfer results in diversification of the transferors' interests.
This exception is designed to prevent taxpayers from using the partnership formation rules to achieve a tax-free diversification of investment portfolios. The exception is inapplicable to the proposed restructuring because HoldCo is being formed to hold operating management company interests and a general partner interest in an operating private equity fund, not to pool diversified investment assets. The GP and ManCo interests are interests in operating businesses — the GP manages the Fund's portfolio companies and the ManCo provides investment advisory services — and are not stocks, securities, or other passive investment assets within the meaning of Section 351(e).
Accordingly, we conclude that Section 721(b) does not apply to the formation of HoldCo.
D. Disguised Sale Analysis — Section 707(a)(2)(B)
IRC Section 707(a)(2)(B) and the regulations thereunder provide that, under certain circumstances, a contribution of property to a partnership followed by a related distribution from the partnership to the contributing partner (or vice versa) will be recharacterized as a disguised sale of property between the partner and the partnership. Treasury Regulations Section 1.707-3(b)(1) provides a rebuttable presumption that transfers occurring within a two-year period are part of a sale, while transfers occurring more than two years apart are presumed not to be part of a sale.
In the proposed restructuring, the contributing principals (Aldridge, Narayanan, and Hsiao) will contribute their GP and ManCo membership interests to HoldCo in exchange for HoldCo membership interests. No distributions from HoldCo to the contributing principals are contemplated in connection with or as part of the contribution transaction. The restructuring involves contributions of interests and a reallocation of economics, but the contributing principals are not receiving cash, property, or other consideration from HoldCo (other than HoldCo membership interests) in connection with the contribution.
The separation payment to Trask ($1,250,000) and the advisory fee to Kellner ($350,000 per year for two years) are payments made by the ManCo (or, post-restructuring, through HoldCo), but these payments are not distributions to the contributing partners (Aldridge, Narayanan, and Hsiao). Rather, they are payments to departing principals in connection with their separation from the firm. These payments are addressed separately in Sections VI and VII below and are not treated as partnership distributions for purposes of the disguised sale analysis.
Accordingly, we conclude that no disguised sale concerns arise with respect to the HoldCo formation contributions.
E. Conclusion on HoldCo Formation
Based on the foregoing analysis, we conclude that the formation of HoldCo and the contribution of GP and ManCo membership interests by Aldridge, Narayanan, and Hsiao to HoldCo in exchange for HoldCo membership interests should constitute a non-taxable event under IRC Section 721(a). No gain or loss should be recognized at either the entity level or the partner level as a result of the contribution. This conclusion is contingent on the proper documentation of the contribution transaction, including the execution of an assignment and assumption agreement for each contributed interest, the adoption of a HoldCo LLC agreement reflecting the contribution and the membership interests issued in exchange, and compliance with the structural requirements described throughout this memorandum.
We note that the formation of GP Intermediate and the subsequent contribution by HoldCo of the GP membership interests to GP Intermediate would similarly qualify as a tax-free contribution under Section 721(a) if GP Intermediate were a partnership. However, because GP Intermediate will be a single-member LLC wholly owned by HoldCo, it will be treated as a disregarded entity for federal income tax purposes, and the contribution to GP Intermediate will be disregarded — HoldCo will be treated as the direct owner of the GP interest for tax purposes.
IV. Basis and Holding Period Consequences
The tax-free treatment of the HoldCo formation under Section 721(a) is accompanied by a system of carryover and substituted basis rules designed to preserve the built-in gain or loss in the contributed property for future recognition. These rules are set forth in Sections 722, 723, and 1223 of the Code.
A. Basis of Contributed Property — Section 723
Under IRC Section 723, the basis of property contributed to a partnership by a partner is the adjusted basis of such property to the contributing partner at the time of the contribution, increased by the amount (if any) of gain recognized under Section 721(b) on such contribution. Because no gain is recognized on the contribution (as concluded in Section III above), HoldCo takes a carryover basis in each contributed GP and ManCo membership interest equal to the contributing partner's adjusted basis in that interest immediately prior to the contribution.
Each contributing principal's adjusted basis in their GP and ManCo membership interests must be determined as of the date of the contribution. The adjusted basis of each principal's interest in the GP includes the principal's initial capital contribution to the GP (funded through capital calls), plus the principal's allocable share of GP-level income items, minus the principal's allocable share of GP-level deduction and loss items, minus distributions received. Similarly, the adjusted basis of each principal's ManCo interest reflects the principal's initial capital contribution (if any), plus allocated income, minus allocated deductions and distributions.
We recommend that a detailed basis calculation be prepared for each contributing principal as of the anticipated contribution date, coordinated with Heathrow Whitman & Co., the Fund's tax compliance provider.
B. Basis of HoldCo Interests Received — Section 722
Under IRC Section 722, the basis of an interest in a partnership acquired by a contribution of property, including money, to the partnership is the amount of money contributed plus the adjusted basis of the property contributed at the time of the contribution. Each contributing principal therefore takes a substituted basis in their HoldCo membership interest equal to the adjusted basis of the property contributed — that is, the aggregate adjusted basis of their GP and ManCo interests at the time of contribution.
Importantly, no step-up in basis occurs at the HoldCo level upon formation. If the fair market value of the contributed GP and ManCo interests exceeds the contributing principals' adjusted bases in those interests (which is likely the case given the Fund's unrealized appreciation and accrued carry), the built-in gain is preserved in both the contributed interests (at the HoldCo level, under Section 723) and in the HoldCo membership interests (at the partner level, under Section 722). This built-in gain will be subject to the allocation rules of Section 704(c), discussed in Section V below.
C. Holding Period — Section 1223(1) and 1223(2)
The holding period of the contributed property in the hands of HoldCo includes the period during which the contributing partner held the property, under IRC Section 1223(2). This tacking rule ensures that the character of any gain recognized on a future disposition of the contributed interests by HoldCo will be determined by reference to the contributing principal's holding period, not merely HoldCo's post-contribution holding period.
Similarly, each contributing principal's holding period in their HoldCo membership interest includes the period during which the principal held the contributed GP and ManCo interests, under IRC Section 1223(1). Because the GP was formed in January 2019 and the ManCo was formed at approximately the same time, each of the contributing principals will have a holding period of at least four years in their HoldCo interests as of the anticipated contribution date, satisfying the long-term holding period requirement for capital gains purposes.
We note that the holding period analysis may become more complex to the extent any portion of the HoldCo membership interests received by the contributing principals is attributable to services (rather than property contributions). However, based on the current transaction structure, the contributing principals are receiving their HoldCo interests solely in exchange for contributed property, and the tacking rules of Section 1223 apply in full.
V. Section 704(b) and 704(c) Allocation of Built-In Gain
A. Overview of the Issue
At the time of contribution to HoldCo, the GP and ManCo membership interests may have fair market values that differ from their adjusted tax bases. This disparity between fair market value and tax basis creates "built-in gain" (or, less likely in this case, "built-in loss") that must be accounted for under the partnership allocation rules of Sections 704(b) and 704(c) of the Code.
Several factors contribute to the potential book-tax disparity in the contributed interests. First, the Fund's accrued carried interest of $87.6 million as of September 30, 2023 represents a significant component of the GP's fair market value that may not be fully reflected in the contributing principals' tax bases. Second, the Fund's unrealized portfolio value of approximately $2.33 billion, to the extent reflected in the GP's interest in the Fund, contributes to the value of the GP interest. Third, the ManCo's ongoing management fee revenue stream of approximately $49 million per year, and the associated going-concern value of the ManCo as a registered investment adviser, may result in a fair market value of the ManCo interests that exceeds their adjusted tax bases.
The Section 704(b) and 704(c) rules are designed to ensure that (i) book allocations of partnership items correspond to the economic deal among the partners, and (ii) tax allocations of built-in gain or loss are properly assigned to the contributing partner who contributed the property with built-in gain or loss, rather than being shifted to non-contributing partners.
B. Section 704(b) — Book Allocations
Upon formation of HoldCo, the members' capital accounts must be established in accordance with the rules of Treasury Regulations Section 1.704-1(b)(2)(iv). Under Treasury Regulations Section 1.704-1(b)(2)(iv)(d), when property is contributed to a partnership, the contributing partner's capital account is credited with the fair market value of the contributed property (net of liabilities), rather than its tax basis. This "book-up" or revaluation at contribution ensures that each partner's capital account reflects the economic value of the partner's contribution.
Accordingly, upon formation of HoldCo, each contributing principal's capital account will be established at the fair market value of the GP and ManCo membership interests contributed by such principal. A fair market value determination will be necessary for each contributed interest, and we recommend engaging an independent valuation firm to prepare a contemporaneous appraisal of the GP and ManCo interests as of the contribution date. The valuation should take into account the accrued carried interest, the unrealized portfolio value, the management fee revenue stream, the going-concern value of the ManCo, and any applicable discounts (e.g., minority interest discounts, lack of marketability discounts) as appropriate.
Following the establishment of capital accounts at fair market value, book income, gain, loss, and deduction of HoldCo must be allocated in accordance with the members' respective percentage interests: Aldridge 42%, Narayanan 36%, Hsiao 14%, Marchetti 4%, and Okonkwo 4%. The HoldCo LLC agreement must contain provisions ensuring that these book allocations have "substantial economic effect" within the meaning of Treasury Regulations Section 1.704-1(b)(2).
To satisfy the substantial economic effect test, the HoldCo LLC agreement should contain the following provisions, consistent with the "economic effect" safe harbor of Treasury Regulations Section 1.704-1(b)(2)(ii)(b):
(i) Capital accounts must be maintained in accordance with Treasury Regulations Section 1.704-1(b)(2)(iv);
(ii) Liquidating distributions must be made in accordance with positive capital account balances; and
(iii) Any member with a deficit capital account balance following the liquidation of such member's interest must be unconditionally obligated to restore such deficit.
Alternatively, if the members are unwilling to accept an unlimited deficit restoration obligation, the HoldCo LLC agreement may rely on the "alternate test for economic effect" under Treasury Regulations Section 1.704-1(b)(2)(ii)(d), which requires (i) maintenance of capital accounts, (ii) liquidating distributions in accordance with capital account balances, and (iii) a "qualified income offset" provision that allocates items of income and gain to any member who unexpectedly receives an adjustment, allocation, or distribution that causes or increases a deficit in such member's capital account.
C. Section 704(c) — Tax Allocations of Built-In Gain/Loss
Section 704(c)(1)(A) of the Code provides that income, gain, loss, and deduction with respect to property contributed to a partnership shall be shared among the partners so as to take into account the variation between the adjusted basis of such property to the partnership and its fair market value at the time of contribution. The purpose of Section 704(c) is to prevent the shifting of pre-contribution gain or loss from the contributing partner to non-contributing partners.
In the context of the HoldCo formation, the built-in gain in the GP and ManCo interests at the time of contribution must be tracked and allocated to the contributing partners (Aldridge, Narayanan, and Hsiao). To the extent gain is subsequently recognized by HoldCo on a disposition of the contributed interests, or to the extent income is recognized that reflects the built-in gain (such as the realization of accrued carried interest), the tax allocation of such gain or income must be made first to the contributing partners to the extent of their respective built-in gains, before any allocation to Marchetti and Okonkwo.
This rule is particularly important in the present case because Marchetti and Okonkwo are receiving their HoldCo interests partly in exchange for services. If the Section 704(c) allocations are not properly made, Marchetti and Okonkwo could be allocated a share of the pre-contribution built-in gain, effectively shifting income from the contributing partners to the next-generation principals. Section 704(c) prevents this result.
Treasury Regulations Section 1.704-3 provides three permissible methods for making Section 704(c) allocations:
(1) The Traditional Method (Treasury Regulations Section 1.704-3(b)): Under this method, the partnership allocates tax items to the non-contributing partners only to the extent of their shares of book items. The contributing partner is allocated the remainder. This method is subject to the "ceiling rule," which limits the total amount of tax gain, loss, or deduction that can be allocated with respect to contributed property to the amount actually realized by the partnership. The ceiling rule can create distortions when the partnership's tax items are insufficient to eliminate the book-tax disparity.
(2) The Traditional Method with Curative Allocations (Treasury Regulations Section 1.704-3(c)): This method permits the partnership to make additional tax allocations of other items (not related to the contributed property) to cure ceiling rule distortions. The curative allocations must be "reasonable" — that is, they must not exceed the amount necessary to offset the ceiling rule limitation, and the character and source of the curative items must be consistent with the character and source of the items affected by the ceiling rule.
(3) The Remedial Method (Treasury Regulations Section 1.704-3(d)): Under this method, the partnership creates notional tax items (remedial items) to eliminate ceiling rule distortions. The partnership allocates a remedial item of income or gain to the contributing partner and a corresponding remedial item of deduction or loss to the non-contributing partner, or vice versa. The remedial method provides the most flexibility and prevents ceiling rule limitations from creating any distortion in the allocation of tax items.
Methodology Recommendation. Given the complexity of the contributed interests and the significant built-in gain attributable to the accrued carried interest and unrealized portfolio value, we recommend that the HoldCo LLC agreement adopt the remedial method under Treasury Regulations Section 1.704-3(d). The remedial method provides the greatest assurance that the Section 704(c) allocations will accurately reflect the economic deal among the partners and will not result in the shifting of pre-contribution gain to Marchetti and Okonkwo. The remedial method also avoids the need to identify specific curative allocation items, which may be difficult given the nature of HoldCo's income (primarily carried interest and management fee distributions flowing through from the GP and ManCo).
A detailed analysis of the optimal Section 704(c) methodology, including illustrative calculations of the built-in gain allocation under each method, will be provided in a separate Section 704(b)/704(c) analysis memorandum.
D. Reverse Section 704(c) Layers
Treasury Regulations Section 1.704-1(b)(2)(iv)(f) provides that a partnership may revalue its assets and adjust its members' capital accounts to reflect the fair market value of partnership property upon the occurrence of certain events, including the admission of a new member or additional capital contributions by existing members. Upon any such revaluation, "reverse Section 704(c)" layers are created, reflecting the difference between the revalued book value of partnership property and its tax basis at the time of the revaluation.
The HoldCo LLC agreement should contemplate future revaluations and the creation of reverse Section 704(c) layers. These layers must be tracked separately from the initial Section 704(c) layers created at formation. The accounting complexity of maintaining multiple layers of book-tax disparities should not be underestimated, and we recommend that the HoldCo LLC agreement specify the method of accounting for reverse Section 704(c) layers (which may differ from the method used for initial Section 704(c) layers, subject to reasonableness requirements).
VI. Treatment of David Kellner's Retirement
A. Overview
David Kellner will retire from Ardent Capital Partners effective March 31, 2024. In connection with his retirement, Kellner will: (i) withdraw as a member of the GP and ManCo; (ii) transition to Senior Advisor status under a separate advisory agreement with the ManCo; (iii) retain 100% of his vested carried interest ($13.14 million, representing 15% of $87.6 million of accrued carry); and (iv) receive an advisory fee of $350,000 per year for two years ($700,000 total).
The tax treatment of Kellner's retirement involves several distinct issues: the characterization of payments made in connection with his withdrawal under Section 736; the treatment of his retained carried interest as either a continuing partnership interest or a liquidating distribution; the characterization of his advisory fee as independent contractor compensation versus a guaranteed payment; and the impact of the GP commitment reallocation on his outside basis under Section 752.
B. Withdrawal from GP and ManCo — Section 736 Analysis
Kellner's withdrawal from the GP (which is treated as a partnership for federal income tax purposes) is governed by IRC Section 736, which provides rules for determining the tax treatment of payments made to a retiring or withdrawing partner in liquidation of the partner's interest in the partnership. Section 736 distinguishes between two categories of payments:
Section 736(b) Payments. Section 736(b)(1) defines "payments made in exchange for the interest of such partner in partnership property" as payments for the withdrawing partner's share of partnership property, including the partner's share of the partnership's unrealized appreciation, accrued income, and capital. Payments described in Section 736(b) are treated as distributions by the partnership under Section 731 (which generally provide for nonrecognition of gain unless the distribution exceeds the partner's outside basis) or, if applicable, as sales or exchanges under Section 751(b) to the extent the payment is attributable to the withdrawing partner's share of "hot assets" (unrealized receivables and substantially appreciated inventory).
However, Section 736(b)(2) provides two exceptions. Section 736(b)(2)(A) excludes payments for unrealized receivables as defined in Section 751(c) from the definition of Section 736(b) payments — such payments are instead treated as Section 736(a) payments. Section 736(b)(2)(B) excludes payments for goodwill of the partnership (except to the extent the partnership agreement provides for a payment with respect to goodwill) from Section 736(b). These exceptions apply only where capital is not a material income-producing factor for the partnership. Because the GP of a private equity fund is a service partnership in which capital is arguably not a material income-producing factor, these exceptions may apply to Kellner's withdrawal.
Section 736(a) Payments. Section 736(a) treats any payments to the withdrawing partner that are not described in Section 736(b) as either (i) a distributive share of partnership income, if the amount of the payment is determined with regard to the income of the partnership, under Section 736(a)(1), or (ii) a guaranteed payment under Section 707(c), if the amount of the payment is determined without regard to the income of the partnership, under Section 736(a)(2). Section 736(a) payments are included in the withdrawing partner's ordinary income and are generally deductible by the remaining partners (as a reduction in the partnership's income allocable to them).
The analysis must determine what portion, if any, of the payments made to Kellner in connection with his retirement constitutes Section 736(b) payments versus Section 736(a) payments. This determination depends on the characterization of each component of the economic arrangement.
C. Retained Carry Interest — Continuing Partnership Interest vs. Liquidation
The most significant economic component of Kellner's retirement is his retention of 100% of his vested carried interest, valued at $13.14 million (15% of the Fund's $87.6 million of accrued carry as of September 30, 2023). This retained carry is not a fixed payment but rather a right to future profit distributions based on the performance of the Fund's portfolio. Kellner will continue to receive distributions of carried interest as and when the Fund realizes gains on its portfolio investments and distributes carried interest to the GP.
The tax treatment of Kellner's retained carry raises a fundamental characterization question: is Kellner withdrawing entirely from the partnership and receiving a liquidating distribution (or series of liquidating distributions) of his carried interest, or is he retaining a continuing partnership interest — specifically, a profits interest — in the GP/Fund structure?
We believe the better analysis treats Kellner as retaining a continuing profits interest in the GP for the following reasons:
(i) The retained carry is not a fixed or determinable payment. It is contingent on the Fund's future performance — specifically, on the realization of gains on portfolio investments and the satisfaction of the preferred return and catch-up provisions. There is no guarantee that any carry will be distributed or that Kellner will receive the full $13.14 million.
(ii) The retained carry is not a liquidating distribution of capital. Carried interest is a share of partnership profits, not a return of contributed capital. Kellner's economic interest in future carry distributions is functionally equivalent to a continuing profits interest.
(iii) The partnership agreement (or the modified agreement effective upon restructuring) will continue to allocate a portion of the GP's profits to Kellner. So long as Kellner is entitled to receive allocations of partnership income, he is a partner in the partnership for tax purposes. See Commissioner v. Culbertson, 337 U.S. 733 (1949) (partner status depends on the intent of the parties to share in profits and losses).
If Kellner retains a continuing profits interest, his retirement does not trigger a complete liquidation of his partnership interest under Section 736. Instead, his retirement constitutes a partial liquidation — his capital interest and his share of management fee economics are liquidated, while his profits interest (carry) continues. The partial liquidation of his capital interest is governed by Section 736, but the continuing profits interest remains subject to the ordinary partnership allocation and distribution rules of Subchapter K.
The carry escrow of $3,942,000 (30% of $13.14 million) remains in place for three years post-retirement, as required by the Fund's LPA. Amounts held in escrow are generally not treated as distributed to the partner until actually or constructively received. The escrow does not change Kellner's basis in his partnership interest until the escrowed amounts are released. Upon release, the amounts are treated as partnership distributions under Section 731.
D. Clawback Obligation
Kellner's clawback obligation continues for three years following his retirement. Under the Fund's LPA, Kellner is jointly and severally liable with the other GP members for any clawback obligation owed to the limited partners. The clawback obligation is a contingent liability that does not create current income or deduction for any party. The obligation is only triggered if the Fund's aggregate returns decline below the level at which the GP would be entitled to the carried interest previously distributed.
Upon any actual clawback payment by Kellner, the payment would be treated as a contribution back to the partnership, increasing Kellner's outside basis in his partnership interest. If Kellner has previously recognized gain on carry distributions, the clawback payment may give rise to a loss or a refund claim, subject to the applicable statute of limitations and the specific provisions of the partnership agreement governing clawback mechanics.
E. Advisory Fee — $350,000/Year
Kellner will receive $350,000 per year for two years ($700,000 total) under a Senior Advisor Agreement with the ManCo. Under the terms of the advisory agreement, Kellner will provide advisory services to the ManCo, including advising on portfolio company matters, participating in annual meetings and investor conferences, and assisting with transition and knowledge transfer. Kellner's time commitment will not exceed 10 hours per month.
Tax Characterization. The advisory fee should be treated as compensation for services rendered by Kellner in his capacity as an independent contractor (not as a partner in the ManCo or any related entity). The payment should be reported by the ManCo on Form 1099-NEC, and Kellner should include the payment in his gross income as self-employment income.
However, because Kellner is treated as retaining a continuing partnership interest in the GP/Fund structure (due to his carry retention, as discussed in Section VI.C above), there is a risk that the IRS could recharacterize the advisory fee as a guaranteed payment under IRC Section 707(c). Under Section 707(c), a guaranteed payment is a payment to a partner for services rendered to the partnership, determined without regard to the income of the partnership. If the advisory fee were recharacterized as a guaranteed payment, it would be treated as a distributive share of partnership income to Kellner (rather than as independent contractor compensation), and the ManCo/GP would treat the payment as a deductible expense at the partnership level.
The practical difference between independent contractor compensation and a guaranteed payment is primarily one of reporting and administrative convenience, as both are treated as ordinary income to Kellner. However, there may be differences in the timing of inclusion, the applicability of withholding requirements, and the deductibility at the entity level.
To support the characterization of the advisory fee as non-partner compensation rather than a guaranteed payment, the Senior Advisor Agreement should:
(i) Clearly establish that Kellner is acting as an independent contractor, not as a partner, member, or employee of the ManCo or any related entity;
(ii) Define specific services to be performed and a maximum time commitment (not to exceed 10 hours per month);
(iii) Provide that the compensation is determined at arm's length and is reasonable for the services performed;
(iv) Specify that Kellner has no management or voting authority with respect to the ManCo or any related entity in his capacity as Senior Advisor;
(v) Confirm that Kellner's sole continuing economic interest in the Ardent Capital structure is his retained carried interest in the GP/Fund, which is separate and distinct from his advisory engagement.
Self-Employment Tax. Regardless of whether the advisory fee is characterized as independent contractor compensation or a guaranteed payment, it will be subject to self-employment tax under IRC Section 1402. The self-employment tax rate is 15.3% on the first $160,200 of self-employment income (for 2023) and 2.9% on self-employment income in excess of that amount, plus the 0.9% Additional Medicare Tax on earned income in excess of $200,000 for single filers ($250,000 for married filing jointly).
F. GP Commitment — Kellner's Share
Kellner's total GP commitment is $6,300,000 (15% of the $42 million GP commitment). As of the date of this memorandum, Kellner has funded $4,410,000 of his commitment (70% of $6,300,000). The remaining unfunded commitment of $1,890,000 will be assumed by the remaining HoldCo members pro rata in accordance with their post-restructuring HoldCo membership percentages (Aldridge 42%, Narayanan 36%, Hsiao 14%, Marchetti 4%, Okonkwo 4%).
The assumption of Kellner's unfunded commitment by other partners does not create a taxable event for Kellner. The unfunded commitment represents a future obligation to contribute capital to the Fund when called by the GP — it is not an asset in Kellner's hands but rather a contingent obligation. The assumption of this obligation by the remaining HoldCo members does not result in a sale, exchange, or disposition of property by Kellner.
However, the assumption of the unfunded commitment has implications under IRC Section 752, which governs the treatment of partnership liabilities. Under Section 752(b), a decrease in a partner's share of partnership liabilities is treated as a distribution of money to the partner. If the unfunded GP commitment is treated as a partnership liability (or as an item that affects the partners' shares of partnership liabilities), the reduction of Kellner's share of the unfunded commitment by $1,890,000 could be treated as a deemed distribution of $1,890,000 to Kellner, which would reduce his outside basis in his partnership interest under Section 733.
The characterization of unfunded commitments under Section 752 is not entirely settled. Some commentators have argued that an unfunded commitment to contribute capital is not a "liability" within the meaning of Section 752 because it is an obligation to contribute capital rather than a liability of the partnership. Others have argued that the assumption of the obligation by the remaining partners creates an economic risk of loss that should be reflected in the Section 752 analysis. A complete analysis of the Section 752 implications of the commitment reallocation is required and will be provided under separate cover.
G. Health Insurance Continuation
Kellner will receive 24 months of COBRA-equivalent health insurance coverage, with an estimated cost of $52,000 ($26,000 per year). This is a de minimis benefit that should be treated as compensation income to Kellner, includible in his gross income under IRC Section 61(a)(1). The ManCo (as the payor) should deduct the cost of the health insurance coverage as a business expense under Section 162. The ManCo should report the health insurance benefit on Form 1099-NEC (if Kellner is treated as an independent contractor) or on a Schedule K-1 (if the benefit is treated as a guaranteed payment).
VII. Treatment of Joanna Trask's Departure
A. Overview
Joanna Trask is departing voluntarily effective April 15, 2024, to join a competing investment firm. In connection with her departure, Trask will: (i) withdraw as a member of the GP and ManCo; (ii) retain 60% of her vested carried interest, valued at $6,307,200 (60% of $10,512,000, where $10,512,000 is 12% of the $87.6 million of accrued carry); (iii) forfeit 40% of her vested carry ($4,204,800) and 100% of her unvested carry; (iv) receive a lump-sum separation payment of $1,250,000, payable within 30 days of departure; and (v) agree to restrictive covenants, including a 12-month non-compete, an 18-month non-solicit of employees, and an 18-month non-solicit of limited partners.
Trask's departure raises several distinct tax issues, including the tax treatment of the carry forfeiture, the characterization of the retained carry, the characterization of the separation payment, and the impact of the GP commitment reallocation on her outside basis.
B. Carry Forfeiture — Tax Implications
Trask will forfeit 40% of her vested carry ($4,204,800) and 100% of her unvested carry. The tax treatment of these forfeitures depends on the manner in which Trask originally received her carried interest and whether she made a Section 83(b) election.
Vested Carry Forfeiture. Trask's vested carried interest was originally received as a profits interest in the GP in connection with her admission as a partner. If Trask's carried interest was received as a profits interest and she received no prior distributions attributable to the forfeited portion, the forfeiture does not generate a deduction for Trask. A profits interest, by definition, has no liquidation value at the time of grant — its value is derived entirely from the right to share in future partnership profits. If no income has been recognized with respect to the forfeited interest (because no carry distributions have been made), the forfeiture of a right to future income does not create a loss.
The forfeited carry reverts to the partnership (GP), effectively increasing the remaining partners' shares of future carry allocations. The remaining partners do not recognize income upon receiving the benefit of the forfeiture. Their shares simply increase on a going-forward basis, and they will recognize income when carry is actually distributed to them.
Unvested Carry Forfeiture. The tax treatment of the unvested carry forfeiture depends critically on whether Trask made a Section 83(b) election with respect to the unvested portion of her carried interest.
If Trask made a Section 83(b) election, she would have included the fair market value of the unvested carry in her gross income at the time of grant (which, for a profits interest with no liquidation value, would have been zero). Under the last sentence of Section 83(b)(1), if property for which a Section 83(b) election was made is subsequently forfeited, no deduction is allowed. Accordingly, if a Section 83(b) election was made, the forfeiture of the unvested carry does not generate a deduction for Trask.
If Trask did not make a Section 83(b) election, the unvested carry would not yet have been includible in her gross income under Section 83(a) (because the property was subject to a substantial risk of forfeiture and had not been transferred in a manner that would trigger inclusion). The forfeiture of property that has not yet been included in income has no tax consequence — Trask did not previously recognize any income with respect to the unvested carry, and the forfeiture does not create a loss.
Recommendation. We recommend confirming whether Trask made a Section 83(b) election with respect to any portion of her carried interest. This information should be available from the firm's records or from Trask's personal tax advisors. The answer does not change the ultimate conclusion (no deduction on forfeiture), but it affects the proper reporting of the forfeiture.
C. Retained Carry Interest — $6,307,200
Trask will retain 60% of her vested carried interest, valued at $6,307,200. The analysis of Trask's retained carry parallels the analysis of Kellner's retained carry in Section VI.C above. Trask retains a continuing profits interest in the GP/Fund for her retained carry, and she is not treated as fully liquidating her partnership interest. Her departure constitutes a partial liquidation of her capital interest and management fee economics, with a continuing profits interest for the retained carry.
Carry Escrow Adjustment. Trask's carry escrow will be adjusted to reflect her reduced retained carry. Under the Fund's LPA, the escrow requirement is 30% of carried interest distributions. Trask's adjusted escrow obligation is $1,892,160 (30% of $6,307,200). Trask's existing escrow balance is $3,150,000 (reflecting 30% of her total vested carry of $10,512,000, assuming all accrued carry has been escrowed). The excess of the existing escrow balance over the adjusted requirement is $1,257,840 ($3,150,000 minus $1,892,160).
The release of the excess escrow amount of $1,257,840 constitutes a distribution to Trask from the partnership. Under IRC Section 731(a)(1), gain is not recognized on a partnership distribution to the extent the distribution does not exceed the partner's outside basis in the partnership interest. If the distribution of $1,257,840 does not exceed Trask's outside basis, no gain is recognized. If the distribution exceeds her outside basis, the excess is recognized as gain (generally capital gain under Section 731(a)(1)). A determination of Trask's outside basis as of the distribution date will be necessary to evaluate this issue.
Clawback. Trask's clawback obligation continues for two years post-departure on her retained carry, in accordance with the separation terms.
D. Separation Payment — $1,250,000
Trask will receive a lump-sum separation payment of $1,250,000, payable within 30 days of her departure date of April 15, 2024. The separation payment is made in connection with a comprehensive separation agreement that includes Trask's agreement to restrictive covenants and a mutual general release of claims.
Characterization Issue. The characterization of the separation payment is the most complex tax issue arising from Trask's departure. The payment could be characterized under several alternative theories, each of which has different consequences for the timing and character of income to Trask and the deductibility and reporting obligations of the ManCo/GP:
(i) Section 736(a) payment. If the separation payment is treated as a payment to a withdrawing partner that is not in exchange for partnership property, it would be classified as a Section 736(a) payment. Under Section 736(a)(2), because the payment is a fixed amount determined without regard to partnership income, it would be treated as a guaranteed payment. The payment would be included in Trask's ordinary income for the taxable year in which it is received and would be deductible by the partnership (reducing the remaining partners' distributive shares of income). The payment would be reported on Schedule K-1.
(ii) Section 736(b) payment. If the separation payment is treated as a payment for Trask's share of partnership property — for example, as payment for her capital account balance or her share of partnership assets — it would be classified as a Section 736(b) payment and treated as a distribution under Section 731. To the extent the payment does not exceed Trask's outside basis, no gain would be recognized. To the extent it exceeds basis, gain would be recognized (generally capital gain).
(iii) Restrictive covenant consideration. If the separation payment (or a portion thereof) is treated as consideration for the restrictive covenants to which Trask has agreed — including the 12-month non-compete, the 18-month employee non-solicit, and the 18-month LP non-solicit — the payment would be treated as ordinary income to Trask. See IRC Section 1234A; Tomerlin v. Commissioner, T.C. Memo 2017-69. For the payor, the consideration allocated to restrictive covenants would be amortizable over the covenant period (15 years under Section 197 if the covenant is entered into in connection with the acquisition of a business, or ratably over the covenant period if Section 197 does not apply).
(iv) Release consideration. If the separation payment (or a portion thereof) is treated as consideration for the mutual general release of claims, the tax character depends on the nature of the underlying claims being released. If the released claims relate to compensation or employment-type disputes, the payment would generally be treated as ordinary income. If the released claims relate to property rights or capital interests, the payment might receive capital gain treatment.
Recommended Characterization and Documentation. We recommend that the separation agreement explicitly allocate the $1,250,000 separation payment among the various components. A reasonable allocation, based on the relative value of each component and supported by arm's-length analysis, might be as follows:
The specific allocation should be negotiated between the parties and documented in the separation agreement. An allocation that is agreed upon by the parties in an arm's-length negotiation is generally respected for tax purposes, provided it is reasonable and not clearly inconsistent with the underlying economic substance. See Commissioner v. Danielson, 378 F.2d 771 (3d Cir. 1967) (parties to a transaction are generally bound by their agreed allocation absent fraud, duress, or undue influe