The US market offers a substantial source of investment capital, but PE teams need to structure their funds correctly to tap into it successfully.
There are two key types of US investor, US taxable investors and US tax-exempt investors. While a full analysis of all of the complexities of structuring for US investors is beyond the scope of this article, generally, the structuring needs of these two groups are nearly diametrically opposed.
For instance, US taxable investors generally prefer to invest in ‘tax transparent’ vehicles that allow for the investor to preserve the tax treatment of the item of income earned by the fund. This is achieved through the use of investment vehicles (such as partnerships) or by making various US tax only elections that treat certain entities as tax transparent (so called ‘entity classification elections’ or ‘check-the-box elections’).
In contrast, US tax-exempt investors generally prefer to invest in a ‘tax opaque’ structure with one or more entities in the structure act as ‘blockers’ to absorb any ‘bad’ income for US tax purposes. Common techniques are to use an entity within a portfolio company structure, create a feeder entity that acts as a blocker or to enable the fund itself to be treated as a blocker for US tax purposes.
For some fund structures where both US taxable and tax-exempt investors are of equal importance, this may lead to complex fund or investment structures to meet the needs of all parties. Alternatively, the fund manager may take a balanced view on what is best for most investors or the capital under management and seek to manage their affairs as a priority over smaller investors.
Understanding US investor tax requirements
While the tax profiles of US investors can generally be categorized as “taxable” or “tax- exempt”, these classifications can be overly simplistic in terms of designing an attractive fund structure for US investors. Acknowledging this simplified categorization, this can still be a convenient way to think about the populations of US investors.
1. Taxable Investor Profiles
From a US tax perspective, taxable investors can broadly be broken down into two sub-categories- corporates and individuals. Certain investors included in this profile will have a mixture of these two profiles.
a. Corporate Taxpayers
Of the US taxable investor profiles, corporate taxpayers tend to offer larger allocations of capital. This profile would generally include insurance companies or special purpose entities that are required to invest part of the corporation’s individual balance sheet as opposed to pension funds sponsored by the corporation. Corporate taxpayers are currently subject to a flat 21% federal rate of taxation while state and local taxes would apply based on the facts and circumstances of the corporation.
b. Individual Taxpayers
While individual taxpayers generally cannot allocate the largest sums under management to most professional fund managers, the US tax rules applying to this investor profile tend to be the most complicated. Currently, taxable income recognized by US high-rate taxpayers are subject to 37% federal income tax and applicable state and local taxes. However, preferential rates exist for income classified as ‘long-term’ capital gains (i.e. capital gains generated from a holding period of more than twelve months) and ‘qualified dividend income’. These types of income are currently taxed at 20%. Net investment income from all sources is subject to an additional 3.8% tax for certain individual taxpayers. Additional rules may apply to US individual taxpayers that received allocations attributable to a carried interest in the fund.
c. Family Offices
Of the taxable investor profiles, family offices tend to be the most difficult to cater for since the offices may be structured in a variety of different ways depending on the family and the family’s needs. While some take on a pure corporate form, others can represent a variety of legal entities and, therefore, may require a blended approach.
Fund-of-Funds (FOFs) are generally structured as tax transparent entities. However, due to the fact-specific requirements for the FOFs’ own investor bases, this means that there could be a mix of different US taxable investor profiles, US tax-exempt profiles and even non-US investor profiles to cater for. As with family offices, it can be hard to predict the specific needs of the FOF without entering a dialogue with them individually to understand their concerns and requirements.
2. Tax-Exempt Investor Profiles
While US taxable investors have a number of complex concerns around ensuring the timing and rate of taxation aligns with liquidity events in the fund, tax-exempt investors are generally more straight forward to deal with once you have allowed for some basic planning provisions to meet their needs. However, tax-exempt investors also have a range of profiles requiring slight nuances a fund manager will generally need to take account of.
It is also worth noting that the size of capital under management for this population of investors tends to be much larger than the taxable investor base and so it may be reasonable to assume that this will be the larger population of tax-exempt US investors in a fund’s investor base.
There are various US tax provisions that create the differing tax-exempt profiles, so each a specific set of laws will cause some differences to arise in comparing the exemptions. However, as a base, the exemptions available for particular tax-exempt investors generally provide that:
The investor is exempt from tax on passive types of income such as interest, dividends and capital gains
Trade or business income will only be tax-exempt if the trade or business is not directly related to their specific function or purpose of the tax-exempt investor. Therefore, most tax-exempt profiles would still be subject to tax on this ‘Unrelated Business Taxable Income’ (UBTI).
a. Pension Funds
Of the tax-exempt investor profiles, pension funds are one of the larger asset allocators. This category covers private as well as public pensions, however some public pensions claim to be ‘super’ tax-exempt as discussed below. These entities are generally exempt on income subject to the income not being of a trade or business nature, i.e. the income needs to be passive such as interest, dividends or capital gains. However, these investors are subject to tax on UBTI and certain types of debt-financed income.
Charities tend to invest to produce returns for their charitable endeavours. As a result, these institutions are also exempt from US tax subject to the returns being of a passive nature rather than from a trade or business. For organizations granted certain charitable status, a de minimus amount of ‘bad’ income may jeopardise their entire tax-exempt status and, as a result, preventing this arising tends to be a non-negotiable requirement for their investment. Charities are also generally subject to tax on UBTI.
c. ‘Super’ Tax-Exempt
While corporate and public pension funds generally face the same US tax issues, some public pension funds identify themselves as ‘super’ tax-exempt. These funds are able to claim tax-exempt status via a different set of tax legal provisions and generally maintain that they are not subject to tax on certain types of income that non-public pension funds are, in particular UBTI. They are also generally exempt from the reporting requirements that non-public pension funds are subject to.
Understanding US investor reporting requirements
US taxable investors will likely require a full service when it comes to US tax reporting on their investment. It is typical for an investor to either rely on provisions in the fund’s organizational documents or to separately agree expectations in the side letters related to their investment in the fund. Typical requests include specific types of US tax reporting to be issued by the fund and the timing of any draft or final reporting to be made in order to fit the investor’s timeframe to pay tax and file returns.
US tax-exempt investors are not completely immune to reporting requirements, however, it would be generally expected that the requirements are not as severe when compared to US taxable investors. As mentioned above, a number of US tax-exempt investors have a reduced amount of reporting and therefore may need even less than others.
Based on the sensitivity that tax-exempt investors have to UBTI, it is common for them to ask for either the fund to make a full restriction on the production of UBTI or for it to maintain a “reasonable endeavours” or “best efforts” approach to limiting this type of income in the investor’s returns. It is worthwhile noting that this often means that a fund manager will consent to restricting some forms of acquisition financing for portfolio investments. A further topic that generally arises is around the use of bridging financing for investor capital calls - this needs to be strictly monitored when dealing with tax-exempt investors.