Tax Considerations for Funds with Tax-Exempt and Foreign Investors
Articles by: Richey May, Dec 20, 2022
When creating and structuring a prospective alternative investment vehicle or family of entities, it is important to consider the tax impact that both tax-exempt and foreign investors may have on your fund. At Richey May, we provide resources to help determine the impact of these investors, as there are certain tax rules to navigate to provide the most tax efficient result for all investors. Unrelated business taxable income, effectively connected income, withholding agent responsibilities, and proper U.S. tax classification are important items you should take into consideration when forming a fund structure.
Unrelated Business Taxable Income (UBTI)
Unrelated Business Taxable Income (“UBTI”) is income that is taxable to IRC 501(c) tax-exempt entities. These entities are typically individual retirement accounts or foundations that qualify under IRC 501(c). The term unrelated trade or business is generally defined as any trade or business which is not substantially related to the purpose of such organization. Income from investment activities within an alternative investment fund (interest, dividends and capital gains) is generally not taxable to tax-exempt entities. However, there are instances in which UBTI is generated by investing in an alternative investment fund.
There are various circumstances that can trigger UBTI. However, there are two common activities that typically generate UBTI in a fund.
- The most notable is trading on a margin account (or the use of other debt/leverage to purchase portfolio assets). Funds may from time to time strategically use leverage in their trading strategy.
- The other main way UBTI can be produced is by investing in underlying partnerships (or any other “U.S. Trade or Business”). If lower tier partnerships incur UBTI or generate income that would be considered UBTI to an upper tier partnership, it will ultimately be passed through to the fund.
There are ways to mitigate UBTI from within certain fund structures. Various offshore blockers can be employed in certain cases to block the UBTI from flowing to tax-exempt investors. Alternatively, tax-exempt investors could be placed into a side pocket within the existing fund (away from the UBTI generating investments).
UBTI is often a concern of tax-exempt entities before considering investing into a fund. Fund managers should consult with their legal consul and/or their tax advisors beforehand to ensure a plan is in place and the fund documents allow for tax-exempt investors in the fund.
Effectively Connected Income (ECI)
While UBTI relates to tax-exempt investors, Effectively Connected Income (“ECI”) is income that is “effectively connected” to, or generated from, a U.S. Trade or Business and is taxable to foreign investors in U.S. alternative investment funds.
Like UBTI, portfolio income (interest, dividends, capital gains, etc.) is generally not subject to ECI rules, but some of the same triggers of UBTI can also trigger ECI for foreign investors in U.S. funds. Generally, ordinary income from operating entities, as well as real estate income are subject to ECI when passed through to the fund. Underlying partnership investments (private partnerships, publicly traded partnerships, and master limited partnerships) have the potential to pass through ECI.
For cryptocurrency fund managers, ECI has been a recent concern when there is reward or staking income distributed to foreign investor(s). If you expect reward or staking income in the fund, consult your tax advisor on potential ECI implications.
To help mitigate the burden of ECI, an offshore blocker entity can be structured, and the foreign investors can be invested into that offshore entity rather than the main fund. This can be accomplished in both a master-feeder fund and a mini-master fund, among other strategies, but these two are most common within the industry.
Unlike UBTI, if foreign investors are not protected from U.S. trade or business income, it can cause a host of burdensome filing requirements for the foreign investors. Protecting foreign investors from U.S. filing requirements can make the fund more desirable. However, it is important to make sure the cost of setting up the structure is beneficial for the overall health and longevity of the fund.
If ECI is applicable, the fund is responsible for withholding on behalf of their investors and filing forms 8804 and 8805 with the IRS timely.
Fixed, Determinable, Annual or Periodic (“FDAP”) Income
Similar to ECI, withholding also applies to foreign investors in U.S. funds who are allocated FDAP income. The most common sources of FDAP income are interest, dividends, rents, and royalties. The standard withholding rate on FDAP income is 30%. However, for countries that have tax treaties with the United States, there may be a lower withholding rate that would be applied if foreign investors were domiciled in such countries.
There are exceptions to the required 30% (or lower) withholding rate for certain income activities or foreign entities. The income earned must be U.S. source in nature; for example, foreign interest, dividends, rents, royalties, etc. do not fall under the U.S. taxing regime. There are also exception codes on form 1042 and 1042-S that reduce or remove withholding obligations entirely.
FDAP income withholding is reported on Forms 1042 and 1042-S. Under the recently enacted Tax Cuts and Jobs Act (“TCJA”), there have been changes to the rules and deadlines for filing form 1042, which the fund, as a withholding agent, must comply with.
Foreign Fund Structures and the “Check the Box” election
Form 8832 is a multi-purpose form that allows domestic and foreign entities to change their entity classification for U.S. tax purposes, but without changing the entity type for legal purposes. It can also allow a foreign fund that is registered offshore (Cayman Islands, British Virgin Islands, etc.) to elect to be treated as a U.S. Taxpayer. This can be desirable for master-feeder fund structures who want to open the offshore funds to U.S. investors. If an offshore fund elects to be treated as a partnership for U.S. tax purposes, that entity will file a U.S. partnership return (Form 1065) and will issue a K-1 to the domestic feeder fund, as well as any U.S. investors within the offshore master fund.
The main benefit of treating an offshore entity making the check-the-box election as a U.S. entity for tax purposes is for the flow through of income generating activities to reach their investors via Schedule K-1. Alternatively, without making the check-the-box election, U.S. investors may be subject to Passive Foreign Investment Company (PFIC) or Controlled Foreign Corporation (CFC) rules, which are more disadvantageous to U.S. investors.
The check-the-box election is a powerful election that allows flexibility to taxpayers to attain their desired outcome. However, when setting up these structures it is imperative that fund managers communicate with their legal counsel and/or their tax advisors to ensure the election is completed in a timely manner and properly to avoid unnecessary tax consequences.
If you have any questions about forming a fund structure, determining the impact of these investors, or minimize the tax impact for investors, please contact Stephen Vlasak.