Secondary transactions (or “Secondaries” as they’re known) involve the buying and selling of pre-existing investments in private funds or stakes in the portfolio companies those funds own. Secondaries are typically traded before the fund or business is sold in a traditional way—essentially, being the resale market for private investments. A variety of platforms now facilitate the buying and selling of shares in privately held companies, making secondary transactions more accessible than ever.

As dynamic as the secondary market may be, secondaries come with complex tax implications that can significantly impact returns if not properly managed. In this comprehensive guide, we’ll explore the core tax principles at play regarding secondaries, the specific tax challenges faced by buyers and sellers, and examine effective tax strategies for optimizing your investments.

Table of Contents

  1. What is the secondary market?
  2. What are the tax implications of secondary transactions?
  3. What are the tax challenges in secondary transactions?
  4. What tax strategies optimize secondary investments?
  5. What does the future hold for secondary market taxation?
  6. How Harness can help
  7. FAQs on Secondaries

What is the secondary market? 

The secondary market for private equity and other alternative investments has moved from being a fringe practice to a mainstream component of the private financial markets system. The secondary market involves several key transaction types as well as participants. 

Types of secondary transactions

LP-led secondaries: LP-led secondaries involve existing limited partners (LPs) selling their interests in a private equity fund to another investor. There are many reasons for LP sales, but some include an LP seeking liquidity or an exit from a fund that’s underperforming. Other reasons involve changes in investment strategy, portfolio rebalancing, or a simple desire to exit a specific asset class.

GP-led secondaries: In these situations, the general partner (GP) of a fund initiates the secondary transaction, often involving a restructuring of the existing fund. This can include a “continuation fund” where the GP transfers some or all of the portfolio companies into a new vehicle, offering existing LPs the option to cash out or roll their investment into the new fund. 

GP-led secondaries can also encompass “stapled transactions” where the sale of the existing fund interest is linked to an allocation in a new fund managed by the same GP. These transactions are often used to provide liquidity and extend the life of successful investments.

Direct secondaries: This type of secondary transaction involves the purchase of a portfolio company directly from another private equity fund or investor, rather than a fund interest. Although these transactions are less common than LP- or GP-led secondaries, they can offer buyers a number of advantages. Some of them include targeted exposure to specific investments, greater potential control, and the opportunity to negotiate favorable terms.  

The key participants in the secondary market

Sellers in secondary markets can be anyone from existing LPs in private equity funds, GPs seeking to restructure their funds, to ‌private equity funds or investors that own portfolio companies (in direct secondaries).

Buyers in secondary markets will also invest in special secondary funds. Additionally, they may be part of institutional investor groups (pension funds, endowments, sovereign wealth funds), family offices, and high-net-worth individuals.

Buyers and sellers in the secondary market often use specialized platforms to trade private company shares, whether in pre-IPO startups or private equity fund interests. These platforms centralize financial and legal details to facilitate transactions, but tax considerations remain a key factor regardless of where the sale occurs.

What are the tax implications of secondary transactions? 

Optimizing the performance of secondary transactions requires an in-depth understanding of tax principles, particularly those regarding partnership taxation, capital gains, and the allocation of income and losses. 

Partnership taxation

Most private equity funds—and therefore secondary funds—are structured as limited partnerships (LPs) or limited liability companies (LLCs) taxed as partnerships. A key feature of partnership taxation is “pass-through” taxation. 

Pass-through taxation means that the fund itself is not subject to federal income tax. Instead, ‌partners (investors) are taxed directly on their share of the fund’s income, gains, losses, and deductions, regardless of whether those amounts are actually distributed. Each partner receives a Schedule K-1, which reports their share of the fund’s tax items.

Capital gains versus ordinary income

The distinction between capital gains and ordinary income is key in secondary transactions. Capital gains can result from the sale or exchange of capital assets, such as fund interests or portfolio company stock. They are also generally taxed at lower rates than ordinary income, which includes items like interest income, dividends, and business profits. 

The holding period of the asset determines whether the gain is short-term (held for one year or less) or long-term (held for more than one year). This is important as long-term capital gains are typically taxed at more favorable rates than short-term gains.

Allocation of income and losses

In a partnership, income and losses are allocated among the partners according to the partnership agreement. This allocation is typically based on the partners’ ownership percentages or other agreed-upon formulas. 

In secondary transactions, however, the allocation of income and losses can be complex, especially in GP-led secondaries where existing LPs may have different participation levels in the continuation fund. 

What are the tax challenges in secondary transactions?

Secondary transactions present a specific set of tax challenges due to the nature of the investments and the structures involved. 

Unrelated Business Taxable Income (UBTI)

UBTI is income generated by a tax-exempt organization from an unrelated trade or business. Tax-exempt investors, such as pension funds and endowments, are generally not taxed on their investment income. However, if a secondary fund generates UBTI, it is taxable to these investors, potentially reducing their returns. Common UBTI-generating activities in secondary transactions can include:

Effectively Connected Income (ECI)

ECI is income earned by a non-U.S. investor from a U.S. trade or business. Foreign investors in secondary funds can be subject to ECI on income gained from U.S. business activities. This can result in U.S. tax filing obligations and potential tax liabilities for the foreign investor. 

Determining whether income is ECI can be problematic, depending largely on the specific circumstances of the income. Mitigating ECI risk often involves the structuring of the fund and its investments.

Foreign Investment in Real Property Tax Act (FIRPTA)

FIRPTA is a U.S. tax law that imposes a tax on foreign investors’ gains from the sale of U.S. property interests. If a secondary fund invests in U.S. real estate, foreign investors may be subject to FIRPTA tax on their share of the gains from the sale of those property interests. 

FIRPTA also covers indirect investments in U.S. real estate, including investments made through partnerships or Real Estate Investment Trusts (REITs). As FIRPTA applies to these transactions, certain withholding tax rules may need to be followed. 

Publicly Traded Partnership (PTP) status

If a secondary fund is deemed a PTP, it will be taxed as a corporation, which removes the tax benefits of partnership taxation, and can also potentially reduce returns for investors. A partnership is considered a Publicly Traded Partnership (PTP) if its ownership interests are traded on a recognized stock exchange or are easily bought and sold on a secondary market (even if it’s not a formal exchange). 

Avoiding PTP status requires careful attention to the transferability of fund interests and restricting certain marketing activities that could make the fund appear as if it’s publicly traded.

State and local taxes

Secondary funds and their investors may face various state and local taxes, including income tax, franchise tax, and property tax. These taxes can vary significantly depending on the location of the fund, its investors, and its investments. 

For example, state tax planning strategies can involve the selection of favorable jurisdictions for fund formation and investment activities.

Carried interest considerations

Carried interest, also known as a “performance fee,” is the share of profits that the general partner (GP) of a fund receives—the taxation of which has been the subject of much debate and potential tax law changes. 

While generally taxed as capital gains, there have been proposals to tax carried interest at higher rates or as ordinary income regardless of the holding period. Understanding the current tax rules and any potential changes is crucial for both GPs and LPs in secondary funds.  

What tax strategies optimize secondary investments? 

As should be clear by now, effective tax planning is essential to minimizing tax liabilities in secondary market investments. Successful tax planning involves a multifaceted approach that may include several key strategies.

Fund structuring

The choice of fund structure can significantly impact the tax efficiency of secondary investments. Limited partnerships (LPs) and limited liability companies (LLCs) are common structures for private equity funds, including secondary funds. 

Additional structures that can increase tax efficiency include:

Blocker corporations

Blocker corporations shield certain investors in secondary funds from Unrelated Business Taxable Income (UBTI) and Effectively Connected Income (ECI). This is achieved by structuring the investment so that a taxable “blocker” corporation directly invests in the UBTI/ECI-generating asset or activity, while the secondary fund invests in the blocker corporation itself, rather than the underlying asset.

This separates the UBTI/ECI-generating activity from the tax-exempt or non-U.S. investor. The blocker corporation pays corporate income tax on its profits, but the tax-exempt or non-U.S. investor only receives dividends or capital gains from their investment in the blocker, which are typically not considered UBTI or ECI. 

This layered structure effectively blocks the UBTI of ECI from flowing through to the tax-exempt investor, preserving their tax-advantaged status.

Offshore fund structures

Offshore fund structures, once a common tax-minimization tool, are less common today due to stricter tax laws and increased scrutiny. While they may still be beneficial in specific circumstances—such as investments uniquely advantaged by a particular jurisdiction’s laws (and not simply used for tax avoidance)—their use is rare. 

These structures can introduce major complexity into the tax equation, requiring costly legal and tax advice, and are subject to higher audit risk.  

FIRPTA planning using a U.S. holding company

Structuring a U.S. real estate investment through a domestic corporation can potentially reduce FIRPTA taxes for foreign investors. While a foreign investor selling shares in a U.S. corporation that holds U.S. property is generally subject to FIRPTA, certain exceptions and tax planning strategies exist. 

If the corporation qualifies as a “U.S. real property holding corporation,” and specific ownership thresholds are met, the sale of stock may not be subject to FIRPTA. This structure can offer greater flexibility and potential tax advantages compared to direct ownership of U.S. real estate.

However, managing the complexities of these rules requires careful consideration of several factors, including the corporation’s assets, ownership structure, and applicable tax treaties. Professional tax advice is highly advisable when determining the suitability of FIRPTA strategies and their implementation.

Due diligence

Irrespective of specific investment strategies, thorough tax due diligence is essential in all secondary transactions. Due diligence involves the following:

Negotiating tax provisions in transaction documents

The tax provisions in the transaction documents, such as the purchase agreement and the partnership agreement, are key to allocating tax risks and responsibilities. Key provisions include:

Tax treaty planning

Tax treaties can be used to reduce or eliminate withholding taxes on US-source income for foreign investors. It’s essential to understand the provisions of relevant tax treaties and how to maintain compliance with treaty requirements. When these are taken into consideration, you can optimize after-tax returns for foreign investors in secondary funds. 

That said, tax treaties vary widely in scope and application, as some contain limitations on benefits (LOB) clauses. These types of clauses can prevent treaty “shopping” by requiring investors to have a substantial business presence in their home country. In any event, the use of tax treaties requires careful analysis and professional tax advice.

State and local tax planning

State and local taxes can significantly impact investment returns, making it important to structure funds and transactions in jurisdictions with favorable tax laws. 

Choosing tax-friendly jurisdictions: Certain states have more favorable tax laws for funds and investors. States like Florida, Texas, and Nevada don’t impose state income tax, making them attractive for fund formation—with Delaware also being a preferred jurisdiction due to its business-friendly legal framework and tax advantages.

Managing nexus issues:  “Nexus” describes the connection between a fund or investor and a state that creates tax obligations. A fund’s presence (operations, investors, or assets) in a state can trigger income, franchise, or sales tax liabilities. Unintentional nexus, often caused by remote employees, physical offices, or investments in in-state assets, can lead to unexpected tax burdens.

Qualified Opportunity Funds (QOFs)

QOFs offer the potential to defer or eliminate capital gains taxes by investing in designated Qualified Opportunity Zones. While QOFs are primarily focused on direct investments in operating businesses and real estate, they may also be relevant in certain secondary transactions. 

However, QOFs come with specific eligibility requirements and investment restrictions that need to be carefully considered—the applicability of QOFs to secondaries is still an evolving field and often limited in scope.

What does the future hold for secondary market taxation?

The inherent complexity of taxation in secondaries isn’t helped by the fact that the field is also in a state of constant flux. Staying informed about changes and emerging trends is therefore central to tax planning success.

The impact of regulatory changes

Changes such as the Inflation Reduction Act (IRA) of 2022, introduced a 15% Corporate Alternative Minimum Tax (CAMT), which could affect certain secondary fund structures investing in large corporations. While proposed reforms to carried interest taxation were removed from the final bill, future legislative efforts may still impact fund managers.

Globally, initiatives like Pillar Two of the OECD’s Base Erosion and Profit Shifting project are reshaping international tax rules, and affect cross-border secondary transactions in particular. Pillar Two establishes a global minimum tax, which may impact private equity and secondary funds investing in multinational companies operating in low-tax jurisdictions. 

Additionally, the rise of digital assets within private markets introduces new tax complexities. Funds investing in tokenized securities or blockchain-based assets must manage fast-changing regulations, with varying tax treatments across jurisdictions and increased regulatory scrutiny on crypto reporting.

Adapting to change

The future of secondary market taxation demands adaptability. Two key factors will shape how investors manage the shifting secondaries: the increasing reliance on technology for efficient tax management, and the potential for significant future developments in tax law and regulation.

The role of technology: Technology is increasingly the foundation of efficient tax compliance.  

Potential future developments: Several trends are worth keeping a keen eye on:

With secondary markets becoming more accessible, a growing number of investors are navigating complex tax implications when selling private company shares. Proper tax planning is essential to optimizing returns and avoiding unexpected liabilities.

How Harness can help

In this guide, we’ve offered a comprehensive overview of key tax considerations for secondaries, from fundamental principles to specific challenges related to UBTI, ECI, FIRPTA, and PTP status. While this guide provides valuable information, it’s certainly not a substitute for professional tax advice.

At Harness, we connect individuals and businesses with innovative tax advisory firms. Our network of qualified tax advisors can provide the personalized tax guidance needed to address specific circumstances and investment objectives in the secondary market. With a tax advisor from Harness, you can build more tax-efficient secondary investment strategies, no matter how the secondary arena may change. 

Find your tax advisor at Harness

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FAQs on Secondaries

Below are answers to the most commonly asked questions about taxes on secondaries.

What are private equity secondaries?

Private equity secondaries are transactions in which existing investors in private equity funds sell their investments to other investors before the fund’s typical liquidation or distribution. Secondaries can involve the sale of limited partner interests in a fund or the sale of direct stakes in portfolio companies.

What is withholding tax?

Withholding tax is when a portion of a payment is deducted and sent directly to the government as tax. It ensures taxes are paid, even if the recipient might not otherwise do so, providing governments with a reliable way to collect revenue.

What is pass-through taxation?

Pass-through taxation is a method of taxation where business income is not taxed at the business level but instead “passes through” and is taxed at the individual owner’s level. This means the business itself doesn’t pay corporate income tax. Instead, the owners report their share of the business’s profits and losses on their personal income tax returns. 

What is the secondary market?

The secondary market is where investors buy and sell existing securities or assets, rather than directly from the original issuer. You can think of it like a resale market. In the context of private equity, the secondary market allows investors to trade their pre-existing investments in private funds or stakes in portfolio companies before those investments would normally be realized through a sale or IPO.  

What is UBTI?

Unrelated Business Taxable Income (UBTI) is income earned by a tax-exempt organization (like a pension fund or endowment) from a business activity that is not substantially related to its tax-exempt purpose. These organizations are generally not taxed on their investment income. But, UBTI is taxable as it’s seen as the organization engaging in a separate, for-profit venture. 

What is FIRPTA?

The Foreign Investment in Real Property Tax Act (FIRPTA) is a U.S. tax law that imposes income tax on foreign investors who sell or exchange U.S. real property interests. This means that if a foreign person (individual, corporation, or other entity) sells a property located in the United States, they may be subject to FIRPTA tax on any gains from that sale. FIRPTA also covers indirect investments in U.S. real estate, such as those made through partnerships or REITs.

What is Effectively Connected Income (ECI)?

Effectively Connected Income (ECI) is income earned by a non-U.S. individual or entity that’s connected to a trade or business conducted in the United States. This means that if a foreign investor is involved in a U.S. business activity, the income generated from that activity may be considered ECI and subject to U.S. taxation. 

What is a primary market?

A primary market is where new securities, such as stocks or bonds, are issued and sold directly to investors, often through public offerings the New York Stock Exchange, for example). Unlike the secondary market, securities are purchased directly from the issuer, not traded among investors.

How does the secondary market work for private equity assets?

Unlike the stock market, the private equity secondary market allows investors to trade securities representing existing, illiquid private equity assets before fund liquidation. This provides liquidity and access to established private equity funds, distinct from primary fundraisers within the private equity industry.

Are secondary transactions similar to trading mutual funds?

While both involve investors trading securities, private equity secondary market transactions differ significantly from trading liquid mutual funds on the stock market. Private equity assets are illiquid, requiring complex negotiations and valuations, in contrast to readily priced mutual funds.

What are the tax implications of secondary transactions involving private equity assets?

Secondary transactions in the private equity market trigger capital gains/losses when investors trade securities representing ownership in private equity funds. The tax treatment is often complex, depending on the holding period, investor type, and fund structure, unlike simpler stock market transactions.

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Secondary Market Risks: (1) lliquidity – Private equity is intrinsically illiquid compared to public assets. Once invested, it can be difficult to exit the investment prior to the fund’s completion. (2) Complex valuation. Companies’ valuations can be challenging to determine, and the assets’ actual value may differ from the price paid.