Private credit’s tax hangover is giving investors buyer’s remorse

• Key insight: In addition to concerns like liquidity with private credit, there are tax complications that many clients and advisors don’t know about.
• Expert quote: “I think the alts mania is going to start playing out that people don’t want them anymore. The clients have no idea how these things work.” — Samuel Diarbakerly of Generation Capital Advisors

While private credit’s risks can lead to higher returns, several tax issues can increase the complication for clients and advisors.

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Being an investor in a partnership entity such as a private credit vehicle means getting a Schedule K-1 form, and these forms tend to arrive in August or September, forcing taxpayers to file for extensions rather than submitting their returns by the usual April deadline. 

“With the rise of alternative investments, it’s created a lot of tax complexity,” said Samuel Diarbakerly, the founder and CEO of Boston-based wealth management firm Generation Capital Advisors.

In addition to the Schedule K-1 issue, if wealthy individuals put enough into an alternative investment that does business in other states, they are required to file returns in all of those states, he said.

“I think a lot of wealthy people are kind of sick of alternatives because of that,” he added.

Not all financial advisors are familiar with these issues because few are tax professionals, so clients may fail to file extensions and then be required to file amended returns later, Diarbakerly added.

“One of our clients … inherited a hedge fund from their parents, and they’re like, ‘This makes paying our taxes impossible, and we can’t even get out of this thing because you can only get out once a year, and you can only get out 10% a year,'” he added.

The situation has some clients, Diarbakerly said, reconsidering whether the upside of private credit is worth the hassle and other inherent risks.

“I think the alts mania is going to start playing out that people don’t want them anymore. The clients have no idea how these things work,” Diarbakerly said.

Still, there are ways to avoid the tax complications, and alts can be useful in certain situations. Diarbakerly added that his firm uses alts when they’re appropriate for clients and for nontaxable accounts and entities, such as retirement accounts, family foundations or charitable lead annuity trusts.

Additional tax prep services needed

Another hurdle clients face is having to pay higher tax preparation fees depending on the number of Schedule K-1 forms, said David Askew, managing partner overseeing Mercer Advisors’ Southern California advisory teams.

Clients who are filing for extensions should take precautions to prevent fraudsters from filing in their names before they file and trying to claim their refunds, Askew said. Individuals can obtain passwords to submit their tax returns and can work with their tax preparers to set those up, he said.

Askew said he had clients who were required to file returns in three or four states because of the private equity fund’s domicile — further increasing complexity beyond what the client expected before investing.

“If someone is trying to do their own taxes, they may not recognize that they’re going to have to do multistate filings,” he added.

Reassessing tax projections midyear is a good idea, and so is partnering with a CPA. Also, clients should keep extra liquidity in case they end up owing tax on “phantom income” earned but not distributed, Askew said.

Because of this “potential tax trap,” clients are “second-guessing if it was the right investment choice after the fact,” he said.

On top of taxes and liquidity, another concern associated with private credit is credit quality, Askew noted.

While private credit still has a strong “allure,” Askew said clients have told him “they wish they would have known about some of the tax impact before they got into certain vehicles rather than after the fact.”