The structuring of a partnership is a multifaceted process that requires careful consideration of investor profiles, investment strategies, regulatory requirements, and tax implications. A critical aspect of this process involves analyzing partnership structures to assist in optimizing tax efficiency and minimizing regulatory compliance for various investor types.
This guide provides an overview of blocker entities, explains when and why they are used, and outlines the most common blocker structures employed in private funds. By understanding the appropriate use cases and trade-offs associated with blockers, fund managers can design structures that enhance tax efficiency, reduce administrative friction, and support long-term fundraising and operational success.
What is a “Blocker” Entity
Contrary to the name, blocker entities do not “block taxes”. Rather, they are structured to redirect or minimize tax obligations by interrupting a taxable entity between the fund and the investor. These entities are often designed to simplify or minimize the investors regulatory obligations required from the U.S. In other words, the blocker entity typically bears the reporting requirements, often relieving the burden from the ultimate taxpayer.
Having this protection in place may be appealing when raising capital from tax-exempt or foreign investors. It is important to note that investors coming in through the blocker are treated as investing in a corporate entity instead of a flow through entity. This creates its own set of tax implications that need to be evaluated on a case-by-case basis to create the optimal outcome.
When to Use Blockers
Blockers are most relevant when considering the following:
Tax-Exempt Investors
Pension funds, endowments, and other tax-exempt entities may face Unrelated Business Taxable Income “UBTI” liabilities when investing in leveraged funds or partnerships structured as a fund of funds. Blockers prevent UBTI from flowing through to these investors.
Foreign Investors
Non-U.S. investors may incur Effectively Connected Income “ECI” or Fixed, Determinable, Annual, or Periodical income “FDAP” when investing directly in funds with U.S. sourced income. Intermediate blocker entities may help avoid direct U.S. tax liability and complex reporting.
Mixed Investor Base
Funds with both U.S. taxable, tax-exempt, and foreign investors often employ master-feeder structures, where feeders (onshore and offshore) invest in a master fund, with blockers positioned to optimize tax outcomes for each group.
Understanding Blockers: Types and Purposes
Generally, blockers fall under three categories. Onshore, offshore, and leveraged. They each have their benefits and consequences based on the needs of the structure.
Onshore Blockers
U.S. domiciled C-Corporations or LLC electing to be taxed as a corporation capitalized with equity. Often have lower startup costs. The entity will be subject to the federal and state corporate tax rates and filing obligations. It may be less tax-efficient for foreign investors as distributions may be subject to U.S. withholding on dividends; however, with the proper structuring and investment exit planning, it is often preferred for blocking income that is fully or primarily ECI.
Onshore Leveraged Blockers
U.S. Domiciled C-Corporations or an LLC electing to be taxed as a corporation capitalized with equity and debt. The “leveraged” aspect refers to the blocker being capitalized with both equity and debt, often at a high debt-to-equity ratio. Leverage blockers are considered when the goal is to minimize the tax liability of the U.S. corporate rate. The blocker deducts interest payments on the debt reducing the taxable income. The investor receives interest income in return for their share of the investment. Typically, leveraged blockers are more complex and come with additional administrative cost. Further considerations of compliance regarding IRS debt and equity rules need to be carefully analyzed to ensure unintended tax consequences are not triggered.
Offshore Blockers
C-Corporations or an LLC electing to be taxed as a corporation formed in non-US jurisdictions. Common locations include the Cayman Islands or British Virgin Islands. These jurisdictions offer favorable tax regimes, regulatory environments, and flexibility in fund formation. Offshore blockers are not subject to the U.S. corporate tax rate for non-ECI income but may be subject to withholding on U.S. sourced FDAP income and is generally subject to U.S. corporate tax rates, including branch profits tax, for ECI income. Generally favored when the fund has little-to-no ECI and a mixed investor base as offshore blockers are taxpayer friendly to both tax-exempt and non-US investors.
As with any structuring discussion, choice of entity depends on the needs of the manager, the investor base, and their type of investments. Factors can include the size of the investor base, the setup cost, and even treaty benefits.
Conclusion
The effective structuring of a partnership, with appropriate use of blockers, is essential for attracting a diverse investor base, optimizing tax outcomes, and ensuring regulatory compliance. Fund managers should consult with their tax and legal advisors to navigate the complexities of fund architecture, remain vigilant about evolving tax laws, and maintain transparent communication with investors. By adopting best practices in fund structuring and governance, managers can position their funds for sustainable growth and long-term success.
For specific guidance on your fund’s tax compliance, please reach out to your Richey May tax professional. To learn more about these best practices and how Richey May can help you navigate filing obligations, reach out to Steve Vlasak, Business Development Partner, Alternative Investments Practice.
