Happy Valentine’s Day, Funds Family!

In our prior series on 💰️ Investment Fund Tax Planning, we introduced foundational tax structuring considerations for investment funds.

This article will move from “tax 101” to “tax 102” and begin a new series of slightly more complex topics. Today we’ll discuss the intriguing underworld of unrelated business tax income (UBTI). Hold onto your assets!

📝 What are tax-exempt investors?

The U.S. tax code specially exempts certain entities from U.S. federal income tax (and for some, allows donors to deduct the value of their monetary contributions). These entities are broadly referred to as “U.S. tax-exempts” or “tax-exempts” and include charities, foundations, IRAs, private pension funds, and university endowments.

Investment funds often target tax-exempt LPs. Many tax-exempts supplement their donor contributions and grants with investment income. Some also like writing big checks to funds. 💵

💰 What is UBTI?

But tax-exempt LPs must be careful—not all passive investment income is exempt from taxation. While rules vary, most tax-exempt LPs are subject to U.S. federal income tax on “unrelated business taxable income,” or “UBTI” which they must report on their tax returns.

In extreme cases, too much UBTI can cause certain tax-exempts to lose their tax-exempt status, which would be disastrous for the tax-exempt LP (and not great for any donors planning to deduct charitable contributions). 🚨

🧐 Mom, where does UBTI come from?

On a high level, income or gain is UBTI if earned from:

1. a trade or business

2. regularly carried on

3. that is not substantially related to the tax-exempt’s purpose.

Example: If a tax-exempt hospital runs a bakery for the public, the income from that bakery is likely UBTI since it’s unrelated to the hospital's primary mission (taking care of patients). The hospital would have to pay taxes on this income, reducing its net proceeds.

There’s a laundry list of carve-outs to UBTI, such as certain rental income, royalties, dividends, and capital gains.

UBTI flows up to tax-exempt LPs from entities taxed as pass-throughs but is “blocked” by entities taxed as c corporations (see 💰️ this article for more detail on tax entity types).

The use of leverage (debt) to acquire an investment (or the use of leverage by a pass-through entity owned by a tax-exempt) can convert income or gain from non-UBTI to UBTI. 💰

⚒️ Generating UBTI in investment funds

For investment funds, UBTI issues arise in three common contexts:

1. Fund-level trade or business. The fund is directly engaged in a “trade or business,” such as loan origination in a private credit fund. This can be the case if the fund is originating loans and taking an origination fee.

2. Pass-through PortCo trade or business. The fund makes an equity investment in a pass-through entity (like an LLC taxed as a partnership) engaged in a trade or business. This is less common in venture capital (where companies are typically taxed as c-corporations) and more common in lower-middle-market private equity.

3. Leverage. The fund uses leverage, or a portfolio company taxed as a pass-through entity uses leverage.

Needless to say, the UBTI rules are complex, as are the range of structures and mechanisms to mitigate their impact. 🧩

💎 99 problems but UBTI doesn’t need to be one

Investment funds often try to solve UBTI problems for their investors. One common mechanism is to “block” UBTI 🛑 by creating an entity taxed as a c-corporation through which the tax-exempt LP invests in the fund. You can also put the blocker elsewhere in the fund structure, so long as it blocks the tax-exempt’s exposure to the UBTI.

⚠️ But beware – the blocker entity incurs U.S. corporate federal income tax (currently, a 21% rate) and care should be taken not to expose other investors (or the carried interest!) to this tax drag.  To accomplish this, your lawyer might set up parallel funds, feeder funds, or alternative investment vehicles (AIVs). The cost to set up the special structuring for the tax-exempt investors is often borne by the tax-exempt investors themselves, though some funds spread the expenses across the entire (taxable and tax-exempt) LP base.

Note that the usual UBTI regime does not apply to so-called “super tax-exempts” (U.S. governmental entities such as public pension funds) 🏦, which are subject to a different U.S. tax regime and are beyond the scope of this article.

Each investment fund should consult its tax advisor on whether the fund is expected to generate UBTI for tax-exempts and if so, tax planning options to address UBTI concerns.

🤝 How to handle UBTI conversations with LPs

In practice, GPs have three options to deal with UBTI situations.

1. Do nothing. Some managers – especially smaller funds and syndications – disclose the UBTI risks to investors and do not undertake special structuring to mitigate UBTI issues. In these cases, tax-exempt LPs can decide whether they’re willing to bear the tax drag UBTI creates or do their own structuring.

2. Special structuring. Some managers – larger funds with more tax-exempt investors – may choose to implement a blocker structure to accommodate tax-exempt investors or engage in other more exotic structuring beyond the scope of this article. This can benefit tax-exempt investors but requires more legal fees, entity formation, and complexity.

3. Avoid UBTI in the first place. Some funds, especially venture capital funds, will require that all companies convert to c-corporations before the fund will invest. Among other reasons, this helps eliminate the UBTI concerns for tax-exempt investors.

🧮 Sometimes, GPs and tax-exempt LPs do the math and conclude that generating some UBTI is preferable to the expense (e.g. U.S. corporate income tax in a blocker structure) and/or opportunity costs of special structuring or avoiding UBTI-producing investments.

In some cases, large LPs might ask for a UBTI covenant. This may require the GP to take “commercially reasonable efforts” (or some other level of efforts) to mitigate UBTI concerns for tax-exempt investors. If you’re a GP that agrees to a UBTI covenant, you’ll need to proactively limit UBTI for your investors. This is often a nice carrot to offer to tax-exempt LPs to entice them to invest. 🥕 

Thanks for reading! Next week, we’ll review UBTI’s exotic cousin – ECI (an important topic for funds and syndications targeting non-US investors).

⚠️ Note: This newsletter is for informational purposes only and nothing should be considered legal advice. For that, hire a lawyer! I am a lawyer, but not your lawyer (unless I actually am your lawyer because you’ve signed an engagement letter and we’re working together). This newsletter may be considered attorney advertising.