Selling a U.S. Fund Interest? Know the ECI Rules
When selling an interest in a U.S. private equity or venture fund, one of the first tax questions that comes up is: will the IRS want to take a cut of the sale proceeds? For many sellers who are not familiar with secondaries, the answer revolves around a concept called Effectively Connected Income (ECI).
What is ECI?
ECI is U.S.-sourced income that is considered connected with a U.S. trade or business. When a non-U.S. investor sells a fund interest, the IRS wants to ensure that any gain tied to U.S. activities is taxed. To enforce this, U.S. tax law (Section 1446(f)) requires the buyer of the LP interest to withhold 10% of the sale price if there’s a risk that ECI applies.
In short: even though the tax is aimed at the seller, the buyer is legally responsible for withholding. If they don’t, they could face penalties, and the fund itself may withhold against the buyer’s future distributions.
If the fund you are selling is a U.S. real estate fund, another rule comes into play: the Foreign Investment in Real Property Tax Act (FIRPTA). FIRPTA requires buyers to withhold 15% of the sale price if the fund is deemed to hold significant U.S. real property interests. This is designed to ensure that foreign investors in U.S. property pay tax when they sell. Just like with ECI, withholding can often be avoided if the fund or its manager provides a certificate confirming that its holdings don’t cross the relevant thresholds.
Here’s a flow chart showing when ECI or FIRPTA withholding applies (thanks to our friends at DMX Partners):
Why does this matter to sellers?
For sellers, the risk is straightforward: if you can’t prove that ECI or FIRPTA doesn’t apply, the buyer may hold back part of the purchase price and send it to the IRS. That means less cash to you at closing, even if, in reality, no U.S. tax is due. You might later reclaim the amount from the IRS, but that takes time, paperwork, and sometimes legal or accounting support.
How do sellers deal with this?
The good news is that there are clear ways to manage the risk:
Provide a Certificate: Typically, the seller provides a “no-ECI certificate.” This can be signed either by the fund’s manager (the GP) or, in some cases, by the seller itself if it has the right tax information. This certificate tells the buyer it doesn’t need to withhold.
Rely on the Fund: Many sellers ask the fund (through the GP) to confirm that its income isn’t ECI. If the GP provides such confirmation, buyers are usually comfortable.
Due Diligence on the Fund’s Assets: If no certificate is available, the parties may need to dig into the fund’s tax filings and portfolio. The key question: if the fund sold its assets today, would U.S. income be allocated to the selling LP? This is usually time-consuming, and sometimes not practical in a fast-moving deal.
What happens if withholding applies?
The buyer withholds 10% of the amount realised (not just the cash you receive, but also your share of fund liabilities being assumed). Then, the buyer files a form with the IRS and pays the withheld amount. You, as the seller, may later file for a refund if you believe too much was withheld.
Practical tips for sellers
Start early: Ask the GP upfront if they provide no-ECI certificates.
Expect negotiation: Buyers will want protection, and the purchase agreement usually spells out what evidence is required.
Be realistic: If no certificate is available, be prepared for withholding at closing.
Get advice: U.S. tax rules are complex. A consultation with a tax adviser can save time and money.
Closing Thoughts
ECI rules are designed to ensure that non-U.S. sellers pay U.S. tax if required. In practice, sellers can avoid withholding if the fund or the seller can provide the right paperwork. But if you’re new to secondaries, don’t be surprised when buyers bring it up: it’s a standard part of the process.
At Joran Partners, we help sellers navigate such questions and coordinate with buyers and fund managers to make sure surprises are minimised and transactions run smoothly.
Disclaimer: The information in this article is provided for informational purposes only and does not constitute legal, tax, or financial advice. It should not be relied upon as a basis for any investment or transaction. Readers should consult their own professional advisers for advice specific to their circumstances. Joran Partners assumes no responsibility for any actions taken based on this content.