Sponsored: Tax Blockers – An Old Private-Fund Tool Finding a New Role In Registered Alts
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By Spencer Erickson, Vice President, Managing Director of Tax, UMB Fund Services
As investment managers seek to reach a broader investor base through tender-offer and interval funds, many are turning to tax blockers – historically common in private funds – to make alternative investment strategies work within a registered fund structure.
Registered tender-offer and interval funds can be distributed to investors much more broadly than private funds. For managers investing in private equity, real estate, private credit and other alternative strategies, the ability to qualify as a regulated investment company, or RIC, under the Internal Revenue Code can therefore be an important part of the structure. RIC tax treatment generally allows a fund to distribute its income to be taxed at the investor level rather than at the fund level.
The challenge is that some alternative investment strategies produce income that can make RIC qualification more difficult. Tax blockers can provide a way to address that challenge while maintaining the underlying investment strategy.
Here are four considerations for managers evaluating their use.
- Registered alternatives can create a tax-qualification challenge.
One hurdle in qualifying as a RIC is the 90% “good income” test. Ninety percent of a RIC’s gross income must come in the form of interest, dividends, gains on the sale of securities, and other qualifying income.
Alternative investment strategies in private equity, real estate or private credit, however, can produce “bad” income in excess of 10%. For managers seeking to maintain those strategies in a registered fund, that income can create a barrier to RIC qualification.
- A tax blocker can help preserve the investment strategy.
The use of a tax blocker may allow an investment manager with an alternative investment strategy in private equity, real estate or private credit to create a fund that is accessible to a much broader investor base than previously thought possible.
Bad-income-producing assets can be placed in a tax blocker, which pays corporate-level tax on income from those investments. Distributions of the blocker’s after-tax earnings to the fund generally constitute qualifying dividend income, helping the fund pass the 90% income test and maintain RIC qualification.
Although it may seem counterintuitive on its face, adding a tax blocker to a tender-offer or interval fund structure commits the blocker to corporate taxes but can help prevent the fund itself from becoming subject to corporate-level tax.
- The strategy still has to fit within the RIC structure.
The purpose of a tax blocker is to allow an investment manager to use investment strategies that are typically incompatible with a registered fund.
The bad-income-producing assets placed in the blocker can be aligned with a range of investment strategies. However, under the RIC asset-diversification rules, a fund generally cannot invest more than 25% of the value of its total assets in a single blocker.
Investment strategies that require more than 25% of the fund’s assets to be held through a blocker therefore may not be compatible with a registered fund structure.
For managers considering a blocker, the question is not only whether a particular investment produces bad income, but whether the amount of the strategy that requires blocking can fit within that limitation.
- Using a blocker adds operational requirements.
Tax blockers should be organized as separate legal entities.
While management of the blocker is generally done in conjunction with management of the fund, the blocker requires its own set of accounting books and records. Those records are later consolidated into the fund for financial reporting.
The blocker also requires a separate tax return and will pay corporate-level tax on income earned in the blocker.
Tax blockers have been around for many years, but their growing use in the tender-offer and interval fund market is being driven by investment managers’ desire to reach broader distribution platforms while maintaining investment strategies that may otherwise produce income that does not qualify under the RIC tax rules.
For more information, please visit https://www.umb.com/about-umb.
Spencer Erickson is vice president, managing director of tax at UMB Fund Services. He leads the fund tax teams in support of federal and state tax compliance for mutual funds, real estate investment trusts, and private funds with hedge, private equity, venture, private debt, and real estate strategies.
UMB is a nationally recognized and ranked provider of bond trustee and agency services to the corporate and municipal marketplaces. Our services reach beyond traditional offerings to service aviation, reinsurance and funeral trusts, and our agency business provides efficient escrow solutions. Our tenured and specialized teams understand the complexities of how you do business so we can provide tailored solutions to meet your needs.
UMB is a sponsor of AltsWire, and the article was published as part of its standard directory sponsorship package.
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