Federal Tax Rules for GP-Led Continuation Funds

July 9, 2026  | By Erik Lincoln

GP-led secondaries have moved from the margins of private equity into the mainstream. Sponsors now routinely use continuation funds to extend hold periods on performing assets, bring in fresh capital, provide liquidity to investors who want an exit, and reset fund economics, all without forcing a premature sale.

The business case is straightforward. The tax analysis is not.

A single continuation fund transaction can trigger gain recognition, restart holding periods, and create withholding obligations across multiple investor classes. Getting it wrong can cost carry holders their long-term capital gain rates, expose new investors to audit liabilities from prior fund years they never participated in, and create unexpected withholding obligations for non-U.S. limited partners.

This article works through each layer of that analysis — covering the partnership division rules, nonrecognition analysis, disguised sale treatment, and carried interest consequences — and identifies the diligence items that sponsors and their tax advisors should work through before closing.

What Is a Continuation Fund Transaction?

A continuation fund transaction involves a fund sponsor forming a new vehicle to acquire one or more assets from an existing fund it manages. No two deals are identical, but most follow a sequence like the following:

  1. The existing fund contributes one or more portfolio interests to the newly formed continuation fund in exchange for limited partner interests in the continuation fund.
  2. The portion of those continuation fund interests attributable to investors who are selling, rather than rolling, is contributed to a separate “seller partnership,” typically a Delaware limited partnership created for this purpose.
  3. The existing fund distributes continuation fund interests to rolling investors and the GP and distributes seller partnership interests to the selling investors.
  4. New investors contribute cash to the continuation fund.
  5. The continuation fund redeems the seller partnership’s interest using the new investor cash, and the seller partnership distributes that cash through to the selling investors.

Tax Treatment

The tax analysis of a continuation fund transaction proceeds in three layers: characterization of the division under IRC § 708 (including whether the continuation fund is treated as a new partnership or a continuation of the existing fund), nonrecognition analysis of the deemed contribution and distribution steps, and treatment of the cash redemption leg under the disguised sale rules.

Overview of the Partnership Division Rules and Continuation Status Under IRC § 708

The threshold question in any continuation fund transaction is how the partnership division rules under IRC § 708 apply to characterize the transaction for federal income tax purposes.

When the existing fund transfers assets to the newly formed continuation fund, the applicable Treasury Regulations generally treat the transaction as an “assets over” division.1 Under this form, the existing fund is deemed to (i) contribute the transferred assets to the continuation fund in a transaction governed by IRC § 721, followed by (ii) a distribution of the continuation fund interests back to the partners of the existing fund in a transaction governed by IRC § 731. These two steps are deemed to occur in that specific sequence and are analyzed separately — each step must clear its own set of tax requirements for the overall transaction to remain tax-free.

The division also determines whether the continuation fund is treated as a new partnership or a continuation of the existing fund — a distinction with significant downstream consequences. The continuation fund is treated as a continuation of the existing fund if partners who held more than 50% of the total interests in the existing fund’s capital and profits elect to roll their interests into the continuation fund.2 If that threshold is not met, the continuation fund is a new partnership.

This distinction matters for three reasons. First, a continuation fund that inherits the existing fund’s tax status also inherits its prior tax elections, including any IRC § 754 election, and its accounting methods. A new fund would start fresh, which can be either beneficial or burdensome depending on the circumstances. Second, under the centralized partnership audit rules enacted by the Bipartisan Budget Act of 2015, adjustments from IRS examinations of a partnership’s prior-year returns are assessed and collected at the partnership level under IRC § 6225. A continuation fund inherits not only the existing fund’s identity but also its exposure to audit adjustments arising from the existing fund’s pre-closing tax years, meaning that new investors in the continuation fund could indirectly bear the economic cost of tax deficiencies attributable to prior periods in which they held no interest. Third, the continuation vs. new partnership determination feeds directly into the nonrecognition analysis and the holding period analysis discussed below, making it the logical starting point for the full tax treatment framework.

The Deemed IRC § 721 Contribution and IRC § 731 Distribution

Under IRC § 721, a partner’s contribution of property to a partnership in exchange for a partnership interest is generally nonrecognition — no gain or loss is recognized by either the contributing partner or the partnership. However, this nonrecognition rule does not apply if the continuation fund would be treated as an investment company within the meaning of IRC § 351(e).3 A partnership is treated as an investment company for this purpose if it holds a diversified portfolio of readily marketable stocks, securities, or other specified assets such that a transfer to the fund would be a transfer to an investment company under the IRC § 351 rules. If the continuation fund holds a concentrated position in a single operating company or a small number of portfolio companies, which is the typical continuation fund profile, the investment company exception will usually not apply. But the composition of the continuation fund’s portfolio must be confirmed on the specific facts of each deal.

Under IRC § 731, a distribution of property from a partnership to a partner is generally a nonrecognition event. The distributing partner takes a substituted basis in the distributed property equal to the adjusted basis of the distributed asset in the partnership’s hands, subject to the limitation that the basis cannot exceed the partner’s outside basis in its partnership interest.

The key exception relevant to continuation fund transactions is the rule for distributions of “marketable securities” under IRC § 731(c). That provision treats a distribution of marketable securities as a distribution of cash equal to the fair market value of the distributed securities. Gain is recognized to the extent the deemed cash distribution exceeds the partner’s adjusted basis in its partnership interest.4

Whether the continuation fund interests constitute “marketable securities” for this purpose turns on whether those interests are traded on an established securities market or are readily tradable on a secondary market. In a private fund context, that result is unlikely; but it requires confirmation on the specific facts of each deal. As with the IRC § 721 step, a conclusion that the IRC § 731 step is tax-free requires a facts-specific analysis.

Disguised Sale Analysis Under IRC § 707(a)(2)(B)

The final mechanics of the continuation fund transaction — new investors contributing cash, the seller partnership receiving a redemption, and cash flowing out to selling investors — are analyzed under the disguised sale rules of IRC § 707(a)(2)(B) and the accompanying Treasury Regulations.5 These rules treat a contribution and a related distribution occurring within a two-year window as a sale of a partnership interest rather than a tax-free contribution and distribution.

A critical structural feature of the continuation fund format is that the seller for disguised sale purposes is the seller partnership (i.e., the existing fund as an entity), not the individual limited partners who hold interests in the existing fund. This entity-level analysis has two important downstream consequences. The first has to do with withholding tax simplification. Because the seller is the seller partnership, a domestic entity, the seller partnership can furnish a Form W-9 (certification of U.S. status) to the new investors. This eliminates the new investors’ obligation to withhold under both IRC § 1446(f) (which applies to transfers of interests in partnerships engaged in a U.S. trade or business) and IRC § 1445 (which applies to dispositions of U.S. real property interests by foreign persons).6 The withholding rules under IRC §§ 1446(f) and 1445 are among the most practically burdensome aspects of fund transactions involving non-U.S. investors, and the entity-level seller framework is a meaningful structural advantage of the continuation fund format. A second important consequence has to do with confidentiality. The entity-level seller structure means that the identities of individual selling investors are not disclosed to the new investors as part of the transaction mechanics. This preserves confidentiality within the fund’s limited partner base, which is a common concern in continuation fund negotiations.

Because the transaction is characterized as a sale of partnership interests, rather than a direct asset-level sale, the continuation fund generally tacks the existing fund’s holding period in the underlying portfolio assets.7 This is a meaningful benefit in transactions where asset-level holding periods matter for purposes of long-term capital gain characterization or for IRC § 1061 analysis. A direct asset sale would restart the holding period clock; the interest-sale characterization under the disguised sale framework avoids that result.

Carried Interest and IRC § 1061

Under IRC § 1061, a sponsor’s share of net long-term capital gain attributable to an “applicable partnership interest” is recharacterized as short-term capital gain unless the gain arises from assets held by the partnership for more than three years.8 The three-year holding period requirement under IRC § 1061 is more stringent than the standard one-year threshold for long-term capital gain classification under IRC § 1222. The practical effect is that carried interest holders must ensure that the underlying portfolio assets have been held for more than three years before sale or disposition in order to preserve long-term capital gain treatment on their carried interest allocations.

In most continuation fund transactions structured as described above, the continuation fund tacks the existing fund’s holding period in the underlying assets, meaning that the clock does not restart when the assets are transferred from the existing fund to the continuation fund. This tacking result preserves the IRC § 1061 analysis that the carried interest holders would have had if the existing fund had simply held and sold the assets directly. Absent tacking, assets approaching the three-year threshold could fall short after the transfer, converting what would have been long-term capital gain into short-term gain for the carry-holders.

The holding period tacking analysis is logically dependent on the IRC § 721 contribution and IRC § 731 distribution steps being respected as nonrecognition events. If either step fails, because, for example, the continuation fund is treated as an investment company under IRC § 721 or because the distributed interests constitute marketable securities under IRC § 731, the tax-free continuity of the transaction is broken, and the holding period analysis becomes more complicated. This interdependency means that the IRC § 1061 analysis cannot be completed in isolation; it requires the practitioner to first confirm that the division steps satisfy the applicable nonrecognition requirements.

The Takeaway

Continuation funds sit at the intersection of M&A structuring, partnership tax, and fund formation — with withholding, audit exposure, carried interest, and basis issues all potentially live at the same time. The market for these transactions is large and still growing, and the tax issues can be complicated.

For sponsors and tax advisors working through a continuation fund transaction, the following diligence items should be on every tax advisor’s checklist:

  • Majority-interest test. Determine whether partners holding more than 50% of the existing fund’s capital and profits interests will roll into the continuation fund. The answer determines whether the continuation fund is a new partnership or a continuation of the existing fund, with significant downstream consequences for inherited elections and audit exposure.
  • Investment company exception. Confirm that the continuation fund’s portfolio composition does not trigger the investment company exception under IRC § 721(b), which would cause the deemed contribution step to be taxable.
  • Marketable securities analysis. Confirm that the continuation fund interests distributed in the deemed IRC § 731 step do not constitute marketable securities, which would cause gain recognition on the distribution.
  • Election and accounting methods. If the majority interest test mentioned above is met, determine what elections and accounting methods are in effect at the existing fund as they will carry forward.
  • Asset-level holding periods. Verify the holding period of each underlying portfolio asset for purposes of both long-term capital gain characterization under IRC § 1222 and the three-year threshold under IRC § 1061.
  • Withholding obligations. Confirm whether the fund’s investor base includes non-U.S. persons and evaluate § 1446(a), § 1446(f), and § 1445 obligations at the appropriate level.
  • State and local tax. Identify applicable state conformity rules and evaluate whether any state-level division, withholding, or apportionment issues require separate analysis.

For tax advisors who invest in understanding the full framework, there is a great deal of work to do here — and getting the analysis right at the outset is important.

Contact Lincoln PLLC to engage tax counsel on your next continuation fund transaction.

Footnotes

  1. Treas. Reg. § 1.708-1(d)(3)(i)(A) (assets-over form of partnership division).
  2. Treas. Reg. § 1.708-1(d)(1) (continuation of a divided partnership requires more than 50% of capital and profits interests).
  3. IRC § 721(b); Treas. Reg. § 1.721-1(a) (investment company exception to § 721 nonrecognition).
  4. IRC § 731(c) (marketable securities treated as money for purposes of gain recognition on partnership distributions).
  5. IRC § 707(a)(2)(B).
  6. IRC § 1446(f) (withholding on transfers of interests in partnerships with effectively connected income); IRC § 1445 (withholding on dispositions of U.S. real property interests by foreign persons).
  7. IRC § 1223(1) (tacking of holding periods in connection with exchanged basis property).
  8. IRC § 1061(a) (applicable partnership interests subject to three-year holding period for long-term capital gain treatment).

Erik Lincoln is a founding member of Lincoln. In addition to being an attorney he is also a CPA. Erik has consistently been recognized as one of the top attorneys in North Carolina, by Business North Carolina.