In his previous blog post, Tom Stasi of Taft explained the importance of “unrelated business taxable income” (UBTI). To expand on this topic further, Stasi answers commonly asked questions related to UBTI and provides essential planning tips. Taft is a 2018 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.
As noted in our first blog post, 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. Thus, careful planning with respect to the fund’s structure is a necessary part of attracting tax-exempt investors. Below are commonly asked questions and key points to consider during that planning process.
1. Why do most investment funds require portfolio companies to be C-corporations?
While outside the norm for most funds, some venture capital or private equity funds may permit a target portfolio company to remain structured as a pass-through tax entity (such as an LLC taxed as a partnership). There may be plausible tax benefits for either the buyer or seller since a pass through entity avoids corporate level taxes upon an exit transaction. Regardless of these benefits, if a fund has tax-exempt investors, then an investment in a pass through entity will cause profits and income from the operating portfolio company to flow through to the tax-exempt investor. Because of the pass through nature of the entity, the tax-exempt investor is considered to engage in the activities of the pass through entity, and the portion of the income recognized by the pass through entity is thus considered derived from a trade or business that is unrelated to a tax-exempt investor’s charitable purpose, thereby triggering UBTI.
- One protection against this risk is to include language in the fund’s underlying legal governance documents that prohibits investments in pass through portfolio companies, unless otherwise approved by a fund’s investors. Portfolio companies taxed as C corporations do not allow for pass through taxation and dividend distributions are exempt from UBTI (unless the fund’s investment in the portfolio entity was, or is considered to be financed by debt as more fully discussed below). However, if investing in pass through portfolio companies remains an unavoidable matter, then a fund may consider creating a wholly owned subsidiary taxed as a C corporation (also known as a “blocker”) for purposes of holding the fund’s investment in the pass through portfolio company. Fund managers should take note that the income generated from the blocker will be subject to corporate tax rates which may exceed UBTI otherwise owed. It is important to have clear communications with tax-exempt investors around this issue so investors’ expectations are in line with fund management prior to any deployment of capital. Larger funds may also want to consider setting up separate parallel funds, one of which may invest in pass-through portfolio companies and the other of which will set up a blocker to invest in any pass-through portfolio company alongside the unblocked fund. Although this approach creates some additional accounting and logistical complexity, it can help address the interests of both taxable and tax-exempt investors.
2. If capital calls are slow, can a fund invest via bridge debt financings?
Although most income from investment funds is considered to be sources of passive income, UBTI can still be derived from assets subject to “acquisition indebtedness,” which certain funds may often use to finance investments. This occurs when (1) an acquisition or investment is financed by borrowed funds or (2) if debt is incurred after the acquisition or investment if (a) such debt would not have been incurred but for the acquisition or investment and (b) the issuance of indebtedness was reasonably foreseeable to occur at the time of the acquisition or investment.
Acquisition indebtedness may present issues for an investment fund that borrows capital for short-term capital needs, such as bridging capital for investment deployment in between capital calls. Since a fund is typically organized under a pass through tax structure (i.e., LP or LLC), a fund’s use of leverage to finance investments can be deemed to create indebtedness for its investors, including tax exempt investors. Income derived upon a disposition of a debt leveraged portfolio company will trigger UBTI on a pro rata basis with respect to the income attributable to the portion of the investment or acquisition that was debt financed. However, UBTI will not be triggered with respect to any gain from a disposition of partial or fully debt financed portfolio investments if the indebtedness is (1) repaid more than one year prior to the sale of the portfolio company and (2) no other income has been derived from the portfolio company prior to such date.
- One simple solution to help protect against UBTI risk in this instance is to include a blanket prohibition against debt borrowing in a fund’s legal governance documents. However, that may not be a practical solution for every fund’s financial or investment strategy. To the extent that short-term borrowings are a critical component of investments, some take the position that a short-term bridge borrowing that remains outstanding for less than a month can be disregarded in the UBTI analysis, but this position has not been expressly recognized by the Internal Revenue Service. At a minimum, fund sponsors should provide at least prior notice to its tax exempt investors from any anticipated borrowing at the fund level. The fund should then consider offering each investor the opportunity to fund its capital contribution in advance in order to avoid any borrowing being made on its behalf. Alternatively, a fund may also consider a “blocker” structure where tax exempt investors invest in a blocker entity which then acts either as (i) a limited partner or member of the investment fund or (ii) a “parallel fund” which invests side by side with the fund or via other blockers where appropriate.
3. Are there any risks with sharing management’s equity with investors?
A fund’s general partner or manager may offer a portion of its equity to an anchor investor as an inducement to invest in the fund or expedite an investment for a specific closing deadline. However, if this equity arrangement is offered to a tax exempt investor, then a number of issues may arise resulting in adverse tax consequences. For example, a venture capital or private equity fund’s general partner or manager may arrange to charge fees for certain transactions or services to the fund’s underlying portfolio companies, such as financing or consulting fees. In such instance, UBTI may be triggered if a tax exempt investor’s ownership stake in a fund’s general partner or management entity is deemed to be an ownership in a company conducting a trade or business. This would likely occur if such entity is deriving operating income as consideration for additional services to portfolio companies.
Fee arrangements between a fund’s general partner or management company and its portfolio companies can present issues for tax exempt investors even if such investors do not own any equity in the fund’s general partner or management entity. For example, sometimes a fund’s management entity will apply fees received by a portfolio company as a credit against fund management fees owed by a fund’s investors. It is unclear whether, for tax purposes, crediting this income against an investor’s management fees would constitute the fund itself receiving such fees rather than the general partner or management company. If so, then UBTI would likely be triggered for a tax exempt investor because the fund would be deemed to be receiving income from a trade or business that is unrelated to its charitable purpose.
- Fees received from a portfolio company should be explicitly credited to the general partner or manager of a fund rather than to the fund itself. However, it remains unclear whether this structure would serve as a guaranteed safeguard against triggering UBTI. At a minimum, a fund’s general partner or management company should be aware of the UBTI associated with such fee arrangements and communicate this to investors in the fund’s offering documents. If such fee arrangements are critical to the fund’s overall strategy or management’s compensation, then the underlying legal governance documents should also include a carve out in any UBTI prohibitions to allow for fee-crediting arrangements.
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.