Alternative Investment Structures for Accommodating Unrelated Business Taxable Income (UBTI) Sensitive Investors

The alternative investment space, including hedge funds, private equity funds, venture funds, and funds of funds, has experienced a steady influx of capital from sources well beyond high net-worth individuals. Today, tax exempt organizations, pension funds, charities, retirement plans, and universities are commonly seen in the alternative landscape.  With tax-exempt entity investors becoming increasingly prevalent in the modern fund space, fund managers must be aware that some may be sensitive to Unrelated Business Taxable Income (UBTI) and the associated tax and compliance issues. As a result, fund managers should carefully evaluate their fund structures to ensure they can readily accommodate investors seeking to deploy capital in their fund.

UBTI is a tax concept that applies to entities, organizations, and account types that are exempt from federal income tax. It was enacted to prevent and discourage those with tax exempt status from competing unfairly with businesses that are subject to taxes. UBTI is typically derived from trade or businesses that sell products or services for profit and are not substantially related to the organization’s exempt purpose.

Notably, passive income, such as dividends, interest, and capital gains, is generally not subject to UBTI. For this reason, alternative investment funds attract tax exempt investors because they can generate returns that fund their purpose and mission without incurring tax. In practice, there are two common scenarios that often unexpectedly generate UBTI and create an issue for both tax-exempt investors and fund managers. Debt-financed income and flow-through investments (partnerships, LLCs taxed as partnerships, and S corporations) are often UBTI triggers that can catch funds and investors by surprise if not properly planned for.

Debt-financed income is an exception to the UBTI rules and applies in instances where a fund generates only passive income and does not engage in a trade or business. If a fund utilizes debt or leverage, or invests in a fund that utilizes leverage, a percentage of the income can be “tainted” and therefore subject to the UBTI tax. For this article, we will not dive into the complexities of calculating percentage of UBTI. However, any fund that employs leverage of any kind and has tax exempt investors needs to be aware of the debt-financed income exception.

As part of the due diligence process, tax-exempt investors must inquire about the fund manager’s use of leverage. Fund managers who utilize or plan to utilize leverage will are required to disclose this information or provide a structure that accommodates the UBTI sensitive investor, which will be discussed later in this article. While many hedge funds use leverage, private equity and venture funds should also be aware of these rules and how they utilize leverage. Often, a private equity or venture fund utilizes a loan or line of credit when it needs capital to make an investment but cannot call it from investors within the necessary timeframe. In this situation, it is critical to consult the fund’s legal and tax team to determine if this would trigger UBTI. Best practice is to use these loans or lines of credit sparingly and in a very short-term manner, paying them back as soon as feasible when capital is called from investors.

Fund of funds are a very popular investment vehicle, and it is not uncommon for funds themselves to have many pass-through investments. These are investment vehicles where a fund manager places investor capital with other fund managers. The investing entity will receive a Schedule K-1 from the fund(s) with which they place capital. The fund manager does not have complete control over the investments in the funds in which they are limited partners.

It is important for fund managers, particularly those with tax-exempt investors, to inquire before they place capital in another pass-through entity if it is expected to generate any UBTI through debt, leverage, or investment in operating businesses. Even if they do not expect to generate UBTI, in practice, a fund of funds with numerous partnership investments often unexpectedly leads to a UBTI allocation. For this reason, if there is a non-zero chance of UBTI being generated, it is essential to understand the structures and methodologies available to avoid this scenario.

When a fund manager expects significant foreign or tax-exempt interest, a master-feeder structure is often the first choice. A master fund, typically domiciled offshore in countries such as the Cayman Islands, Bermuda, or the British Virgin Islands, holds all the investments. An offshore feeder fund and an onshore feeder fund invest in the master. The offshore feeder is most often structured as a corporation, while the onshore feeder is typically structured as a U.S. domiciled partnership. UBTI sensitive investors, as well as foreign investors concerned with effectively connected income (ECI) or having a U.S. footprint, can join through the offshore fund. Investors subject to U.S. tax can join the onshore fund. The offshore fund serves as a “UBTI blocker” and prevents the tax-exempt investors from being allocated UBTI directly. When this structure is employed, the master fund, offshore feeder, and onshore feeder typically require audited financial statements and also necessitate robust administration to handle compliance needs and allocation amongst all entities.

An alternative to the master-feeder structure is organizing as a mini-master. In this structure, there is the main fund, which holds all investments, typically a U.S. partnership and an offshore vehicle, typically a corporation, which invests directly in the U.S. entity. This corporation would include the UBTI sensitive investors, as well as foreign partners who do not wish to join directly. In this scenario, only two audits would be required (main fund and offshore), and the administrative burden is significantly lighter as it is essentially one fund allocating income and expenses to multiple partners. This structure may make more sense when attempting to accommodate a handful of investors rather than an investor base that includes significant tax exempt and foreign partners.

Lastly, for investments that generate UBTI, a side pocket could be utilized. In this scenario, certain investments are segregated from the main portfolio, and investors can choose whether or not to participate. In a fund of funds context, a tax-exempt investor can choose not to participate in a particular investment that generates UBTI. Side pockets create unique administrative/compliance complexities and do not provide relief from the debt-financed income issue, addressed above, if the fund itself is utilizing leverage. Side pockets are typically reserved for private investments that are not publicly traded and lack significant liquidity. They are most often seen in private equity and venture funds, which contain more illiquid investments.

As always, both investors and investment managers should thoroughly discuss their structure with tax and legal professionals. Every fund has a unique investor base, and investments that may make one structure more advantageous than another. There are tax withholding requirements and legal requirements that need to be discussed in detail before a decision is made. Under the right circumstances, there are many viable options that can help both investors and managers efficiently employ their capital and achieve both their tax and investment goals.

For more information, please reach out to E. George Teixeira, Partner and Practice Leader of Anchin’s Financial Services Group, Matthew Talia, Senior Tax Manager, or your Anchin Relationship Partner.