Continuation vehicles: Tax considerations to drive private equity fund value

Private equity sponsors are searching for new methods to increase distributions to paid-in capital for investors amid headwinds in the private deal and initial public offering markets. As liquidity has tightened, the alternative investment industry has increasingly turned to the use of continuation vehicles, or CVs. These vehicles facilitate the sale of partnership interests in existing funds rather than in the assets themselves, providing returns to limited partners (LPs) and potentially unlocking investor liquidity to drive fundraising.

This CV growth brings opportunities for sponsors and investors alike. However, CV transactions can also create complexities, including income allocations and gain exclusion benefits.

The prevalence of CVs, as a fraction of all private equity exits, leaped dramatically in the first half of 2025 compared to recent years. Due to the success of CVs in the private equity space, other players in the alternative investment industry have turned to the secondary market for liquidity. Per PitchBook data, private credit CV volume is estimated to have tripled from 2023 to 2025, and the market size of venture capital CVs is projected to grow by $1.5 billion over the next two years.

Understanding the tax-deferred nature of CV transactions: Crystallized unrealized gains

As the use of CVs grows, sponsors and investors should be aware of their potential tax implications. A common misunderstanding is that the issuance of CV partnership interests to “rollover partners” is “tax-free.” In reality, it is more akin to “tax-deferred,” in that the exchange of historic fund interests for CV interests can drive a future taxable gain. Because this gain may arise without a corresponding cash distribution, proactive planning and communication are critical.

Rollover partners are investors from the historic fund who choose to participate in the CV. Each rollover partner’s pro rata interest is determined by the fair market value of their roll from the historic fund. This is known as crystallizing unrealized gain, as the roll’s fair market value includes any historic unrealized gain.

The crystallization of unrealized gains can be material to the general partner (GP) of the historic fund, as the earned unrealized carried interest can be crystallized into its committed capital of the CV. While the GP’s roll of carried interest into the CV may vary, LPs generally expect a meaningful amount, as it represents a vote of confidence in the new product.

This roll, however, generally locks in a tax-deferred gain. Because the purpose of a CV is to provide additional runway for high-performing assets, the fair market value in the CV received by each rollover partner is generally higher than the tax basis of the historic assets contributed. While the gain is nontaxable at the time of the transaction under the property contribution rules in section 721(a), the roll is essentially a tax-deferred event in which the taxable gain will be captured later.

The tax mechanism for capturing each partner’s tax-deferred gain involves tracking the “704(c) layer,” also known as built-in gain. A correlating delta between tax basis and fair market value exists for the assets as well and is tracked back to the 704(c) layer for each partner. When a portfolio asset is sold, each historic partner is first allocated their respective share of built-in gain related to that asset, after which any residual gain is run through the tax waterfall. In a single-asset CV, the 704(c) tracking to the asset is relatively straightforward. In a multi-asset CV, the 704(c) layer is tracked separately for each asset, with the gain independently allocated as each asset is sold.

Because the 704(c) layer essentially captures the deferred gain on a cashless exchange of partnership interests, the gain allocation is not necessarily accompanied by a corresponding cash distribution. This cash-to-tax disparity can be even greater if the historic GP rolled a significant amount of unrealized carried interest that later drives a large 704(c) allocation.

Note that if the GP rolled crystallized unrealized carried interest into the CV, that portion of the 704(c) layer is treated as an applicable partnership interest under section 1061 of the 2017 Tax Cuts and Jobs Act. Therefore, if long-term capital gains subject to a holding period of less than three years are used to fill the 704(c) layer, some of the gain allocation could be subject to short-term capital gains rates at the individual taxpayer level. While mature assets with a holding period of more than three years are generally rolled into a CV transaction, add-on acquisitions may be held for less than three years.

Qualified small business stock planning and considerations in CVs

Another area for careful consideration while structuring a CV is the impact on qualified small business stock (QSBS) gain exclusion eligibility. QSBS has served as a meaningful source of tax efficiency for many funds, with up to 100% gain exclusion available for eligible investments. The focus on QSBS benefits has heightened since passage of the One Big Beautiful Bill Act in July 2025, which expanded the gain exclusion, introduced additional tiers of benefits, and broadened eligibility to include larger companies.

As noted earlier, during a CV transaction, assets are generally contributed from the historic fund into the new CV partnership. It is important to understand whether the transfer renders an asset ineligible for QSBS treatment—a frequent occurrence.

Under the original issuance test, certain investors in CVs may not qualify for the QSBS gain exemption. This requirement states that the stock must be acquired directly from the company (primary issuance) and cannot be bought from another shareholder (secondary market). 

Additional planning considerations

• Waterfall provisions: Because CVs generally hold higher-performing assets that have already been subject to a significant holding period, waterfall provisions often do not follow the classic 20% carried interest structure and are frequently tiered based on fund performance. This tiering helps drive alignment for the LPs investing in an asset held for an extended period and incentivizes the sponsor to maximize value within a shorter time frame.
• Section 754 elections and 743(b) basis adjustment: For the new investors, a 754 election and a resulting 743(b) basis adjustment can equalize the inside and outside basis. The 743(b) basis adjustment can smooth out the realized gains or losses over time rather than leaving a large outside capital loss at the end of the CV life, which may be subject to loss limitations at the individual level.
• Transferring assets of operating U.S. partnerships: The seller of an operating U.S. partnership may need to consider the realization of effectively connected income (ECI), which can be subject to withholding when allocated to foreign investors. If the historic fund sells an ECI asset to the CV, and the selling LPs are foreign investors, the asset sale may generate withholding tax on behalf of the foreign investor.

Working with tax and legal advisors on these issues can help stakeholders avoid unexpected surprises, understand the tax implications associated with each asset and optimize the CV transaction overall.