In this exclusive guest series, Tom Stasi of Taft Stettinius & Hollister LLP (Taft) explains why the “Golden Rule” to recruiting pension plans, foundations, endowments, and other tax-exempt investors to invest in your fund is to avoid “unrelated business taxable income” (UBTI). Taft is a 2017 Silver Service Provider member who represents both venture capital funds and venture-backed companies, providing award-winning legal counsel and cost-efficient, practical solutions that high-growth companies and their investors need.
Fundraising for a venture capital or private equity fund is never a dull moment. As many seasoned fund managers know, attracting and keeping anchor investors happy remains a constant priority. One common source for fund capital comes in the form of corporate pension plans, foundations, and endowments. These investors are also known as “tax-exempt investors” and adding them to a fund presents a unique set of regulatory and tax challenges. Careful planning with respect to the fund’s structure is a necessary part of attracting these tax-exempt investors. Here is the first post of our series, which briefly describes UBTI and why it’s important for investors to understand its implications. SPOILER ALERT: Not structuring to address UBTI is your kryptonite.
What is UBTI and why should a fund care?
A key part of attracting tax-exempt investors to a fund is taking care to shield such investors from certain types of income. Pension plans, foundations, and endowments are categorized as tax-exempt entities under the Internal Revenue Code which makes them subject to income tax on their “unrelated business taxable income.” UBTI generally includes any gross income derived by a tax-exempt entity that is (1) unrelated to its trade or business, (2) regularly carried on, and (3) not substantially related to furthering the exempt purpose of the respective organization. Needless to say, the unanticipated recognition of UBTI by a tax-exempt investor can cause financial complications (e.g., having to file U.S. federal income tax returns) and risks souring investor relations.
In general, a tax-exempt organization is exempt from U.S. federal income tax on its passive investment income, which is in part why venture capital and private equity funds serve as viable investments for tax-exempt investors. The majority of the income from a venture capital or private equity fund will likely consist of gains derived from the liquidation of its portfolio holdings through C corporations or any dividends and interest payments from such holdings. The Internal Revenue Code provides that these sources of income are considered to be “passive income” and generally will not result in UBTI. However, certain common activities of a fund manager may cause this fund income to be re-categorized as triggering UBTI, such as leveraged portfolio investments, sponsor fee arrangements, and investments in pass through portfolio companies.
Stay tuned for Taft’s next blog post in the series, which provides essential planning tips to protect against UBTI risk!
About Taft Stettinius & Hollister LLP (Taft)
Taft Stettinius & Hollister LLP (Taft) represents both venture capital funds and venture-backed companies, providing award-winning legal counsel and cost-efficient, practical solutions that high-growth companies and their investors need. Taft’s investment fund clients range from family offices and angel groups to institutional seed and late-stage venture funds; their team of corporate attorneys is engaged for the entire venture capital growth cycle, from fund formation to IPOs and strategic exit transactions. Typical services include deal negotiations; regulatory and tax planning and compliance; general partner entity and management company structuring and governance; compensation and incentives programs; and portfolio company due diligence, SEC filings and interaction, investment and ongoing oversight.