If you’re an accredited investor with access to private equity deals, you’re already familiar with the opportunity they offer for outsized returns. But what often gets overlooked is how these investments can also help you significantly reduce your tax burden. Private equity investing strategy isn’t just about what you earn—it’s also about what you keep.
In this article, we’ll explore how private equity structures can provide key tax advantages, including the use of carried interest, Qualified Small Business Stock (QSBS), and offshore strategies that align with current tax codes. If you’re seeking to grow and protect wealth while minimizing tax drag, these approaches could give you the edge you’ve been looking for.
Carried Interest: The Tax-Friendly Compensation Tool
If you’ve been around private equity circles, you’ve probably heard of “carried interest.” It’s the portion of profits that fund managers receive as compensation, typically around 20% of any upside they generate for investors. But what makes it truly interesting is how it’s taxed.
Carried interest isn’t treated like salary or earned income—which could be taxed at rates as high as 37%. Instead, it qualifies as long-term capital gains, which are taxed at a maximum federal rate of 20% (plus the 3.8% Net Investment Income Tax, where applicable). That’s a significant difference.
While there have been political efforts to eliminate or alter this treatment, carried interest remains one of the more effective tax-advantaged structures in private equity. And it doesn’t just benefit fund managers. In certain co-investment structures or when you establish your own fund or investment vehicle, this same framework could apply to you—if structured correctly.
For high-net-worth investors looking to build generational wealth, understanding and leveraging carried interest is a cornerstone of a smart private equity investing strategy.
QSBS: Qualified Small Business Stock
If you invest in a U.S. C corporation that qualifies as a small business under IRS Code Section 1202, you may be eligible for up to 100% exclusion of capital gains on those shares—up to $10 million or 10 times your basis, whichever is greater. You’ll need to meet certain guidelines, such as holding the stock for at least five years. Also, the company must meet specific criteria, such as having less than $50 million in assets at the time of issuance and being engaged in an active trade or business. The shares must be purchased directly from the company, not on the secondary market.
So how does this apply to private equity? Many private equity firms focus on growth-stage investments in businesses that meet QSBS criteria. If you invest early and directly through a fund or as an angel investor, you could receive this benefit. When it is used with other tax mitigation tools, such as trusts or tax-efficient wealth transfer techniques, there could be potential to save more on taxes.
Offshore Structuring for Tax Efficiency
If your private equity portfolio includes international investments, offshore structuring might be an option to consider. You’ll want to be aware that it is a complex area that requires experienced legal and tax guidance. If you work with a knowledgeable advisor, offshore entities could provide advantages related to tax deferral and estate planning.
For instance, offshore funds domiciled in jurisdictions like the Cayman Islands or Luxembourg are commonly used by global investors. These structures don’t eliminate tax obligations, but they may allow for benefits such as the following:
- Tax deferral on income until repatriated.
- Favorable treatment of investment income in lower-tax jurisdictions.
- Access to foreign tax credits that reduce U.S. tax liability on international income.
Additionally, offshore structures can be combined with trusts or insurance wrappers to enhance estate planning and reduce exposure to estate and gift taxes. For U.S. taxpayers, compliance is key. It’s important to know that these structures must be fully disclosed, and there are certain reporting requirements you’ll need to follow.
Deferral Strategies and the Timing of Liquidity Events
Another often-overlooked benefit of private equity is the natural deferral of income. Unlike public market investments that produce annual taxable dividends or capital gains distributions, private equity investments typically don’t generate taxable events until a liquidity event occurs—such as a sale, merger, or IPO.
This means you may be able to defer taxes for years while your investment grows. You could benefit from gains through compounding over the years. And when an exit does take place, the gains may be taxed as long-term capital gains, which are more favorable than ordinary income.
By aligning your private equity investing strategy with your broader tax plan, you may also be able to time exits in low-income years or match them against capital losses. For investors with variable income or recent liquidity events, this flexibility can create additional tax advantages.
Structuring Your Investments for Maximum Efficiency
The tax tools I’ve explained, including carried interest, QSBS, offshore planning, and deferral strategies, can be enhanced by how you structure your investment vehicles. For instance, investing through an LLC taxed as a partnership could allow you to flow through depreciation or other losses that offset gains in your portfolio.
There are additional options to consider including:
- Trusts: When set up correctly, these vehicles could be used to pass gains to heirs in a tax-efficient way.
- Pairing private equity with charitable giving: If set up correctly, this could reduce your current year’s tax liability and also provide future tax efficiencies.
- Insurance structures: There are options like PPLI (Private Placement Life Insurance) which create benefits like tax deferrals.
The right structure for you will depend on your situation and goals. If you’re an accredited investor and you haven’t yet explored how to integrate private equity into your tax strategy, it may be time for a second look. Keep in mind that these techniques require careful planning and expert guidance. It will be important for you to work with a tax professional who understands both the nuances of private equity investing and the tax code. The earlier you start, the more opportunity you’ll have to defer, reduce, or eliminate taxes on your gains.