# Subchapter K — Partnership Taxation

Palace Fund, structured as a California LLC with multiple members, is taxed as a partnership under Subchapter K of the Internal Revenue Code (sections 701-761). This is the default classification for a multi-member LLC that does not elect corporate taxation.

## Core Principle: Pass-Through Taxation

The fund itself pays no federal income tax. Instead, all items of income, gain, loss, deduction, and credit pass through to the members in accordance with the operating agreement. Each member reports their share on their own tax return.

- The fund files Form 1065 (US Return of Partnership Income) annually
- Each member receives a Schedule K-1 reporting their distributive share
- Filing deadline: March 15 (calendar year partnership), with 6-month extension available

## Tax Classification

The LLC must not elect to be taxed as a corporation. Confirm the fund has not filed Form 8832 (Entity Classification Election) electing corporate status. A multi-member LLC defaults to partnership treatment under the check-the-box regulations (Treas. Reg. 301.7701-3).

## Allocations — Section 704(b)

The operating agreement controls how income and losses are allocated among members. However, allocations must have "substantial economic effect" under section 704(b) to be respected by the IRS.

**Three requirements for substantial economic effect:**
1. Capital accounts maintained in accordance with Treasury regulations
2. Liquidating distributions made in accordance with positive capital account balances
3. Members with deficit capital accounts must restore the deficit (or a qualified income offset applies)

### Carried Interest Allocations

Palace Fund's waterfall (preferred return to LPs, then carried interest to the manager) must be structured so that:
- The preferred return allocation has economic effect (actual capital account credit)
- The carried interest allocation reflects the manager's right to profits, not just a fee disguised as an allocation
- Section 1061 applies: carried interest held for less than 3 years is taxed as short-term capital gain regardless of the underlying holding period. The 3-year holding period applies to the manager's carried interest, not the underlying assets.

## Special Allocations and Anti-Abuse Rules

**Section 704(c)**: When a member contributes appreciated or depreciated property, the built-in gain or loss must be allocated to the contributing member. This prevents shifting pre-contribution gains to other members.

**Section 707(a)(2)(A)**: Disguised fee arrangements. If the manager receives an allocation and distribution that is really compensation for services, the IRS can recharacterize it as a guaranteed payment or fee subject to ordinary income tax.

**Section 707(a)(2)(B)**: Disguised sales. If a member contributes property and receives a related distribution, it may be treated as a sale.

## Tax Basis and Distributions

**Outside basis** (member's basis in their LLC interest):
- Starts with capital contribution
- Increases by share of income and additional contributions
- Decreases by share of losses and distributions
- Includes share of partnership liabilities (section 752)

**Distributions**:
- Generally tax-free to the extent of outside basis (section 731)
- Cash distributions exceeding basis trigger gain
- No loss recognition on distributions except in liquidation

## International Members — Korean Investors

Korean investors who are non-resident aliens face additional tax considerations:

**Effectively Connected Income (ECI)**:
- A non-US partner's share of partnership income that is ECI is taxed at regular graduated rates
- The fund must withhold tax on ECI allocable to foreign partners under section 1446
- Withholding rate: 37% for non-corporate foreign partners (highest individual rate) on ECI
- Withholding is done on an estimated basis quarterly or at the time of distribution

**FIRPTA income**: See [FIRPTA](firpta.md) for withholding on US real property gains

**Section 1446(f)**: When a foreign partner transfers their partnership interest, the transferee must withhold 10% of the amount realized unless an exception applies

**Treaty considerations**: The US-Korea tax treaty may reduce withholding rates on certain types of income. Korean investors should consult Korean tax advisors about credits for US taxes paid.

## Fund-Level Tax Elections

The manager should make or consider the following elections:

| Election | Code Section | Purpose |
|---|---|---|
| Section 754 election | 754 | Adjust inside basis on transfer of interest or distribution. Important for secondary purchases. |
| Tax year | 706 | Calendar year required if any partner is an individual |
| Accounting method | 446 | Typically accrual method for investment fund |
| Mark-to-market | 475(f) | Generally not elected for long-term investment funds |

The section 754 election is particularly important: once made, it applies to all future transfers and distributions and cannot be revoked without IRS consent. Consider making it from inception.

## California Tax

California imposes:
- $800 minimum annual franchise tax
- Additional LLC fee based on total income ($250K-$5M+ graduated schedule)
- California taxes its residents on worldwide income, including K-1 pass-through
- Non-resident members: California taxes their share of California-source income
- Fund must withhold 7% of California-source income distributed to nonresident members (R&TC section 18662) or obtain a waiver

## K-1 Reporting and Timing

Schedule K-1s must be issued to all members by the filing deadline (March 15, or September 15 if extended). For Korean investors, the K-1 is essential for:
- Filing US tax returns (Form 1040-NR if they have ECI)
- Claiming foreign tax credits on their Korean tax returns
- Documenting withholding credits

Late K-1s create serious problems for investors. Budget adequate time and resources for tax preparation.

## Action Items

1. Confirm LLC has not elected corporate tax treatment (no Form 8832 filed)
2. Structure operating agreement allocations to satisfy section 704(b) substantial economic effect
3. Address section 1061 three-year holding period for carried interest in the agreement
4. Implement section 1446 withholding procedures for Korean investors' ECI
5. Decide on section 754 election before first transfer of interests
6. Engage a tax preparer experienced with partnership returns and international members
7. Set up quarterly withholding estimates for foreign partner ECI
8. Budget for California franchise tax and LLC fee
9. Establish a timeline to deliver K-1s by March 15 (or extended deadline)