When a private equity fund invests in an operating LLC, the fund's otherwise tax-exempt investors will be subject to tax on their share of any operating income of the LLC that is allocated to the fund. This tax, known as the "unrelated business income tax," is imposed on the tax-exempt investor's "unrelated business taxable income" (UBTI) and is intended to ensure that businesses owned by tax-exempt entities do not have an unfair competitive advantage over businesses with taxable owners. Although tax-exempt investors are now more amenable to realizing small amounts of UBTI, they usually seek to minimize their exposure to it. Consequently, funds often undertake to avoid realizing UBTI, and funds increasingly are relying on creative investment structures and other techniques to ensure that UBTI is not a problem.
Electing Out of Investments
One possible approach to dealing with UBTI is for tax-exempt investors to "just say no." That is, a fund might permit tax-exempt investors to elect not to participate in investments that generate UBTI, or the tax-exempt investors might be segregated in a parallel fund that avoids these investments. This is not an ideal solution, since an increasing number of portfolio companies are organized as LLCs, and since tax-exempt investors make up a large source of capital for private equity funds. For these reasons, it is usually impractical for tax-exempts not to participate at all in a fund's LLC investments. Implementing the election-out procedures also introduces additional complexity into the fund's economic terms. Thus, fund sponsors are usually looking for approaches that allow tax-exempts to participate in all of a fund's investments, but in a way that avoids direct exposure to UBTI.
Use of Debt or Options
Some private equity funds have structured their investments in LLCs as convertible debt or options (or debt with warrants), rather than as a present equity interest. Until these investments are converted into true equity interests in the LLC, the fund will not be allocated any of the LLC's operating income, and the fund's tax-exempt investors will not realize any UBTI.
Convertible debt may be a practical alternative for investments in companies with relatively predictable cash flow. The fund may be allocated operating income after the debt is converted, however, unless the debt is converted (or disposed of) in connection with an exit event. Also, careful planning is needed to ensure that the debt investment is not recharacterized as equity for tax purposes, resulting in unanticipated exposure to UBTI.
Options to acquire equity interests in LLCs are a more recent phenomenon. As long as a private equity fund owns only options to acquire an equity interest in an LLC (and not an actual equity interest), it will not be allocated any of the LLC's operating income. As with convertible debt, some advance planning is needed to deal with the period after the option exercise when investors will be exposed to UBTI from operating income, unless the option can be disposed of (rather than exercised) in connection with the exit event. Although tax regulations now address the tax treatment of options to acquire interests in LLCs (and other tax partnerships), the accounting and special allocations that are required can be complex. For this and other reasons, portfolio companies organized as LLCs may be reluctant to issue options to investors.
Use of Blockers and Feeders
Since private equity funds and their investors often reject the above approaches as not sufficiently flexible, another approach has become more common: the use of special purpose entities in the investment structure. These intermediate entities may be interposed between tax-exempt investors and the fund (sometimes referred to as "feeders"), or they may be interposed between the fund and a portfolio company LLC (sometimes referred to as "blockers"). These entities involve additional costs and may involve additional taxes. If successful, however, they allow tax-exempt investors to avoid reporting UBTI on their own tax returns.
Feeder entities may be organized either in the U.S. or in a foreign jurisdiction. The advantage of using a foreign jurisdiction is that the same entity can accept both U.S. tax-exempt investors and foreign investors that wish to avoid directly incurring income that is "effectively connected" with a U.S. trade or business (ECI). Investors invest directly into the feeder entity, which is designed to be a corporation for U.S. tax purposes, and the feeder invests in the private equity fund, typically at the time of the fund's formation. Although it will usually incur no local corporate taxes, the feeder will be subject to corporate tax in the U.S. on its share of the private equity fund's ECI, including any operating income that is allocated to the fund from portfolio companies that are LLCs. In addition, an offshore feeder will be subject to a U.S. branch profits tax that can increase the effective rate of tax on ECI to over 50%. In fact, there may be no tax savings on LLC operating income that would be UBTI, just the convenience to tax-exempt and foreign investors of avoiding filing tax returns and reporting the income directly. If either the LLC or the fund's investment in the LLC will be leveraged, however, some tax savings may result.
Blocker entities allow the fund to invest in a corporate entity (the blocker) that, in turn, typically invests in a single operating LLC. As with the feeder, the blocker captures and pays U.S. corporate tax on any operating business income from the LLC. The blocker's after-tax income is then paid out to the fund. Unlike the feeder, the blocker can be set up at the time of a proposed investment in an LLC.
There are a number of structuring issues with blockers, and finding the optimal structure in a particular case will involve tradeoffs. For example, if the fund makes its entire investment in an LLC through a blocker entity, all of the fund's partners, including taxable partners, will bear a share of the tax paid by the blocker on the LLC's income. If, however, the LLC is unlikely to generate significant current income, the blocker's tax will be relevant only upon a disposition of the LLC. Accordingly, it is important to structure an LLC investment through a blocker so as to optimize after-tax returns from a future liquidity event. In a liquidity event, taxable individual investors, including the principals of the general partner, will prefer capital gain treatment (or even better, a tax-free exchange). It may be necessary to use another entity, in addition to the blocker, to avoid subjecting the general partner's carried interest in the investment to U.S. corporate tax.
None of the above structures are perfect solutions, and some of the structures are more appropriate where a fund expects only a limited exposure to income that would be UBTI. Nonetheless, more companies are now organized as LLCs, and funds are investigating ways to address the tax issues.
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