The Operating Manual: Week 31
A more focused edition. Taxes, a swing, and a miss.
Housekeeping
Hey - Eli here.
Welcome to another edition of 2&20. We’re here to fill the void that exists between emerging fund managers and the information they need to excel. As always, I’m here to help you grow the two things that matter: AUM and Alpha.
So many changes since the last edition. I’d like to keep Two and Twenty going at a more regular cadence. To make that happen, my goal will be…
The Operating Manual: A longform newsletter every two weeks, on Thursday. This is the Main Idea section of past editions. Deep dives into topics you probably didn’t think you needed to know. Cool stuff on my radar. Interesting reads. Sans “Dank Tweets.”
The Feed: The tagline of Two and Twenty is “chronically on X so you don’t have to be.” I built this to be the highly curated news source I wish I had. Every Tuesday and Friday, I will share my favorite news highlights from the trailing days. Expect this to be super short.
A taste of the last few weeks:
As always, please hit me back with feedback and comments—I’m constantly seeking ways to make this newsletter a more valuable read.
Diving right in and keeping things brief:
On my radar:
I WANT to send you deals. No strings attached. Fill out our deal sharing form to have relevant deals sent to you!
I would love for you to introduce me to the 2 coolest people you know! My email is here :)
I would love to meet anyone in your network who is an expert at consumer product GTM. Someone who has blown up a brand, regardless of what category it was in.
Been starting to dabble in commercial & multifamily real estate… if you know anyone in the real estate world, would love to connect with them!
The Main Idea
Tax season is around the corner. There’s a good chance you’re about to get hit with a few surprises. Not because you did anything wrong, but because nobody sat you down and walked you through how venture fund taxation actually works.
Plus, a second, bonus topic, that’s a little sensitive for most.
This one’s going to be dense. Grab a coffee.
Part I: The Tax Stuff You Should Know (But Probably Don’t)
Your fund doesn’t pay taxes. You do.
Starting with the basics because I’ve seen this trip up more first-time GPs than I’d like to admit. Your fund is almost certainly structured as a limited partnership. LPs are pass-through entities for tax purposes - the fund itself doesn’t owe the IRS anything. Instead, all income, gains, losses, and deductions flow through to you and your LPs via Schedule K-1s.
Sounds simple until you realize what it actually means: your LPs are relying on you to get those K-1s out on time, and the information on them needs to be right. Late or inaccurate K-1s are one of the fastest ways to erode LP trust. If your fund admin is slow, that’s your problem to solve. Not theirs.
The deadline: Partnership returns (Form 1065) are due March 15 (or September 15 if extended). K-1s go out with the return. Most funds file extensions, which is totally fine and normal - but communicate that to your LPs proactively. Don’t make them chase you. Nothing makes an LP question their investment faster than radio silence during tax season.
Carried interest: the 3-year rule that catches people
Good news first: Congress didn’t kill carry in the One Big Beautiful Bill Act (signed July 4, 2025). We live to fight another day. The bad news is that the 3-year holding period rule under IRC Section 1061 is still very much alive, and it’s the thing most emerging managers misunderstand.
Here’s the deal: for your carried interest to qualify for long-term capital gains treatment (20% federal rate instead of 37% ordinary income), the underlying assets need to be held for more than 3 years - not the standard 1 year that applies to everyone else. This is specific to carried interest holders. Your LPs only need the normal 1-year holding period.
So if your fund exits a position at month 30, congrats on the return, but that carry is getting taxed at ordinary income rates. For a GP in California, that’s potentially 37% federal + 13.3% state. Over 50% of your carry, gone. On what you thought was going to be a capital gains event.
The play: When you’re thinking about exit timing, the 3-year mark matters more than you think. If you’re sitting on a secondary offer at month 28, do the math on whether waiting 8 more months saves you and your carry recipients a meaningful chunk of tax. Obviously don’t let the tax tail wag the investment dog, but be aware of it. I’ve seen GPs leave six figures on the table because they didn’t even know this rule existed.
A little caveat: Hopefully your profits interest in the GP is vesting… if you filed an 83(b) election within the window for your GP to vest (when it was worth close to zero), you locked in ordinary income tax on that near-zero value at the time of the election. The upside: any future appreciation on that carry is taxed at long-term capital gains rates after just 1 year of holding - not the 3-year rule under Section 1061 that normally applies to carried interest. The 83(b) effectively converts your carry from a profits interest subject to the 3-year holding period into a capital asset subject to the standard 1-year holding period. The downside is that if the fund never generates carry, you can’t recoup the tax you paid or claim a loss on the election. For most emerging managers, the tax at grant is negligible (you’re electing on something worth pennies), so the risk is minimal and the potential savings on a successful fund are massive. If you didn’t file one within 30 days of your carry grant, it’s too late - the IRS is strict on that window, no exceptions.
The management fee deduction trap
Here’s one that burns LPs and most GPs don’t even know about it.
Management fees paid to your fund are classified as investment expenses. Since the Tax Cuts and Jobs Act (2017, now made permanent by OBBBA in 2025), miscellaneous itemized deductions, including investment management fees, are permanently non-deductible for individual taxpayers.
In plain English: your LPs who are individuals (not institutions) are paying your management fee with after-tax dollars and getting zero deduction for it. On a $100K commitment with a 2% management fee, that’s $2K/year your LP can’t write off. Over a 10-year fund life, that’s $20K in non-deductible fees on a $100K commitment. Not great.
Why this matters to you: Sophisticated LPs know this already. It’s one of the reasons institutional LPs push so hard on fee reductions. If you’re raising from high-net-worth individuals, this is a quiet pain point worth acknowledging. Even if you don’t reduce fees, showing awareness of it builds credibility. It tells LPs you actually understand what it costs them to be in your fund.
Management fee waivers: the move most emerging managers don’t know about
This is one of the more powerful and underused structures in emerging fund land. I genuinely think more people should be doing this.
A management fee waiver lets the GP forgo some or all of their cash management fee in exchange for a profits interest in the fund. Instead of taking $200K in fees taxed as ordinary income, you convert that into a deemed capital contribution that participates in fund profits - potentially taxed at long-term capital gains rates.
Two big benefits:
You convert ordinary income (taxed at up to 37%) into potential capital gains (taxed at 20%). That’s a 17% spread on every dollar.
You increase your GP commitment without writing a check, which LPs love to see. Suddenly your alignment numbers look a lot better.
The catch: this needs to be structured properly from the start (ideally in your LPA), and the IRS has been paying closer attention. There’s an “entrepreneurial risk” requirement - the waived fee needs to be genuinely at risk of loss. If your fund tanks, you don’t get that fee back. It’s not free money, it’s a bet on your own fund.
But if you’re confident in your portfolio... it’s one of the smartest tax planning tools out there.
Talk to your fund counsel about this before your next fund. Not after. Before.
QSBS just got way better
If you’re not tracking QSBS for your portfolio, you’re leaving real money on the table. Full stop. We have discussed this in past editions, including the upgrade to QSBS, but worth mentioning it again because it’s freaking huge.
The One Big Beautiful Bill Act expanded Qualified Small Business Stock benefits significantly. For stock acquired after July 4, 2025:
Partial exclusions now available at 3 and 4 years (50% and 75% respectively), with full 100% exclusion still at 5 years
Gain exclusion cap increased from $10M to $15M, indexed for inflation
Gross asset threshold increased from $50M to $75M, also indexed for inflation
For venture funds, this is massive. More of your portfolio companies now qualify (the $75M gross asset threshold covers most Series A and B companies), and the benefits kick in earlier. You no longer have to hold for the full 5 years to get something.
But here’s what most GPs miss: QSBS benefits flow through to your LPs on the K-1. If you’re not tracking which portfolio companies qualify and flagging it for your fund admin, your LPs might be missing significant tax savings. And for your own GP commitment and any co-invest you’ve done personally, you could be leaving hundreds of thousands of dollars on the table.
Action item: Ask your fund admin or tax advisor to specifically identify QSBS-eligible positions in your portfolio and ensure proper reporting on the K-1s. If they look at you like you’re speaking a different language, get a new fund admin. Seriously.
The multi-state filing nightmare nobody warns you about
You operate your fund in LA. Your portfolio company is in New York. Your LP is in Texas. Where do you file state taxes?
The answer, unfortunately, might be all three. Welcome to nexus.
States have been getting super aggressive about establishing nexus for fund management companies. California, for example, will assert income tax nexus over your management company if your total management fees from California-sourced clients exceed $500K - even if your management company has zero physical presence in the state.
And here’s the fun part: if your fund has portfolio companies in multiple states, the income from those companies could create filing obligations in those states too. Depends on how the income is characterized and whether the state treats the fund as having nexus through its portfolio investments.
Most emerging managers are either unaware of this or actively ignoring it. I get it - nobody wants to file in 7 states. But the penalties for non-filing are much worse than the cost of compliance. This is one of those “pay now or pay way more later” situations.
The SALT deduction and PTET workaround
Quick one but it’s basically free money if you’re not already doing it.
The SALT cap got bumped from $10K to $40K under the OBBBA (for tax years starting after December 31, 2024, through 2029). Better, but still a cap. The real move is the Pass-Through Entity Tax (PTET) workaround, which survived the OBBBA intact.
If your management company is structured as a partnership or S-corp, you can elect to pay state income taxes at the entity level in states that offer PTET regimes. This effectively converts a non-deductible individual SALT payment into a deductible business expense, bypassing the cap entirely.
California, New York, Connecticut, New Jersey, and many other states offer this. If your accountant hasn’t brought this up, bring it up yourself. Today. This week. I’m not exaggerating when I say this could save you tens of thousands of dollars annually depending on your income level and state.
Phantom income: the call from your LP you don’t want to get
This one’s a classic and it hits every fund eventually.
Your fund is doing great on paper. Markups across the portfolio, unrealized gains climbing. But you haven’t distributed a dime because you haven’t had any exits.
Your LPs still owe taxes on their share of the fund’s net taxable income, even if they haven’t received a dollar in distributions. This is phantom income. And it’s one of the most common sources of LP frustration. “You’re telling me I owe $15K in taxes on gains I haven’t seen a penny of?” Yes. That’s exactly what you’re telling them.
The worst version: your fund recognizes ordinary income from a portfolio company (interest payments on a convertible note, a short-term gain on a secondary) and allocates it to LPs on the K-1. Now your LP has a tax bill with zero cash to pay it.
Best practice: If your fund is generating meaningful taxable income without corresponding distributions, make tax distributions. These are distributions specifically sized to cover LPs’ estimated tax liability on fund income. Most well-drafted LPAs allow for this. If yours doesn’t, put it in the next one. Your LPs will thank you.
I felt like just talking about taxes would have been a little light, given I missed last week’s edition. A second topic, that I think might be pretty relevant for most, given the conversations I’ve been having over the last few weeks…
Part II: What to Do When Your Fund Dramatically Misses Its Target
First: can you even close below target?
Usually, yes. Most LPAs set a minimum fund size (often 25-50% of the target) below which the fund can’t operate. If you’ve hit that minimum, you can hold a final close and start investing. If you haven’t hit the minimum, you may need to either extend the fundraising period (with LP consent) or wind down and return capital.
The answer is in your LPA. Go read it. Like, actually read it. I know it’s 80 pages. Read it anyway. Or at the very least, throw it into Claude.
Do you have to return LP capital?
Not if you’ve hit the minimum close and the fund is operational. The capital is committed and callable. The question isn’t whether you return it - it’s how you deploy it.
Where things get tricky: if your LPA has a concentration limit (say, no more than 10-15% of committed capital in a single deal) and your fund is much smaller than expected, your check sizes might be too small to be competitive. A $20M fund with a 10% concentration limit maxes out at $2M per deal. That might work for pre-seed, but good luck leading a seed round that’s now routinely $3-5M.
The portfolio construction problem
This is the real challenge. Your fund model was built for a $50M fund. You raised $15M. Everything breaks.
What needs to change:
Fewer bets. You can’t do 25 deals at $600K each and expect to matter. Better to do 8-10 deals where you have a meaningful position and the founder actually takes your call.
Lower reserves. Your original plan to reserve 50% for follow-ons? Probably needs to come down to 25-30%, or you won’t have enough for initial checks that move the needle. This hurts, but it’s the math.
Tighter thesis. A smaller fund forces focus. This is actually a feature, not a bug. Pick a lane and own it. “We invest in everything” doesn’t work when you can only write 10 checks.
More co-invest. Structure SPVs alongside your fund deals to give LPs additional exposure when you find winners. This also helps portfolio companies get bigger rounds filled without you needing more fund capital. Side benefit: your LPs appreciate the deal flow.
The messaging
This is where most GPs completely fumble it. They either pretend the miss didn’t happen (your LPs aren’t stupid, they can do division) or they over-explain and come off desperate.
The right frame: “We closed the fund at a size where we can execute our strategy with discipline. We’d rather be concentrated and high-conviction than over-diversified with a larger fund that doesn’t match the opportunity set.”
Short. Confident. Forward-looking. Don’t apologize. Don’t explain.
What you never, ever say:
“We struggled to raise”
“The market was tough” (everyone’s market was tough, you’re not special)
“We’re still hoping to add more LPs”
Anything that invites the listener to calculate how far you are from target
Timing the next fund
Conventional wisdom: raise your next fund after deploying 60-70% of the current one, typically 2-3 years in. But if you significantly missed your target, the calculus changes.
You need proof points before going back to market. That means:
At least 2-3 portfolio companies showing real traction (revenue growth, follow-on funding from name-brand investors)
A clear, data-backed narrative on why your smaller fund was actually a better setup
Ideally at least one marked-up position that demonstrates you can pick
If your fund is too small to generate a meaningful track record, consider whether an SPV strategy makes more sense for your next vehicle rather than a traditional blind pool. Some GPs have successfully used a series of SPVs to build a track record and LP relationships before coming back with a proper Fund II.
The honest timeline: If you missed your target badly, expect 3-4 years before raising again. Not 2. That’s okay. Deploying well and generating returns from a smaller fund is infinitely better for your long-term career than rushing back to market with nothing to show. The LPs can smell desperation. Don’t give them a reason.
The relationship game
Here’s the thing nobody says out loud: most of the LPs who passed on your fund are watching. They didn’t disappear. They’re waiting to see if you can actually invest.
Stay in touch. Send quarterly updates even if your fund is small. Share portfolio company wins. Be transparent about the losses too. The LPs who passed on Fund I and see you execute well from a smaller base? They’re your best prospects for Fund II. I’ve seen this play out over and over.
And the LPs who did commit at your lower raise? They took a bet on you when it was hardest. When everyone else was passing, they wired money. Never forget that. Over-communicate. Over-deliver. Make them look smart. Those relationships compound harder than any carry check ever will.
Closing
No cool stuff or interesting reads this week, I’ll have it back for you the next edition! Had to type this one out on the go :)
Thanks for taking time out of your Thursday to read. Since you made it this far, a little easter egg for you…
As always, you can find me on X and LinkedIn, and I’d love to hear from you via email. Whether it’s talking startups or just shooting the shit, I’m always happy to connect.
Onto the next!
//Eli