Income tax consequences of hedge or private equity fund investments


Many tax-exempt organizations and employee benefit plans, such as pensions, IRAs and retirement plans, are attracted to hedge or private equity funds (Funds) as a method of realizing above-average returns on investments. Since related function or passive income is exempt from federal income tax, and many hedge or private equity investments are passive to the tax-exempt, most income generated from these entities can be generated free of federal and state income tax.

However, these investments can produce unrelated business taxable income in two ways. First, where there are investments in partnerships that generate ordinary trade or business income, such income is likely to be taxable to the tax exempt partner/investor. Secondly, many of the Funds’ business models dictate that debt will be used to acquire its investments. The presence of that debt may serve to convert a nontaxable passive activity into a taxable activity to the tax-exempt, unless the tax-exempt structures its Fund investment properly.

This article provides an overview of the applicable rules, as well as some specific strategies used by Funds and their tax-exempt investors to mitigate or eliminate adverse tax consequences.

Applicable rules

Internal Revenue Code (IRC) Section 511 imposes a tax on unrelated business income (UBI) with respect to tax-exempt organizations. UBI is defined as the gross income derived from an unrelated trade or business regularly carried on, less deductions directly connected with the carrying on of such trade or business.

For federal income tax purposes, a partnership represents an aggregation of the activities of its partners, and the nature of its activities is imputed to its partners. Where a tax exempt investor is a partner in a fund or investment instrument that carries out activities considered an ordinary trade or business and that business generates ordinary income that is passed along to its investors, the tax exempt investor will have UBI from such activity.

Many tax exempt investors have investment activities in the form of an “investment partnership”. An investment partnership is not considered a trade or business if (i) it has never been engaged in a trade or business and (ii) substantially all of the assets (by value) have always consisted of items such as cash, stock, bonds, notes or interests in derivative financial instruments. Funds generally satisfy the requirements for being characterized as investment partnerships. Investment partnerships are deemed not to be engaged in a trade or business. Thus, none of a Fund’s partners, including tax-exempt investors, will be considered to be engaged in a trade or business, and thus no partner would generate UBI pursuant to the general unrelated trade or business rules.

The nontaxable results of investment partnership income are a result of IRC Section 512(b) which provides certain exclusions to the tax on UBI which generally include income from passive activities. Among those passive activities excluded from UBI are dividend, interest, royalties and (some) rental income. Exclusion from these passive income sources does not apply where debt is used to generate the passive source of income. That is, where either the tax exempt investor uses debt to purchase its interest in the investment or where debt is used within the partnership to purchase property, generally any income received on account of such property, is taxable in proportion to the amount of leverage used for the purchase.

IRC § 514(b)(1) defines ‘debt-financed property’ as any property that is held to produce income, and with acquisition indebtedness at any time during the tax year or, if the property was disposed of during the tax year, at any time during the 12 months before the disposition.

Whether the investment produces taxable trade or business income or debt financed income, the filing threshold is very low with regard to reporting the activity. Qualified plans with investments producing gross UBI in excess of $1,000 will be subject to tax on the net income at corporate rates and triggers a Form 990-T filing requirement. A substantial amount of taxable UBI could threaten the tax exempt status of the exempt investors.

Potential investment structures

There are a number of strategies employed to mitigate the tax consequences of these alternative investment instruments to the tax exempt investor.

Domestic blocker

Some tax-exempts create a domestic “blocker” corporation as a way to mitigate taxable debt-financed income. In this type of scenario, the tax-exempt is the sole shareholder of the blocker corporation; the blocker, in turn, invests in a Fund. When the Fund distributes income to the blocker, the blocker receives taxable income. However, when the blocker then distributes income to the tax-exempt, such distribution is a passive dividend in the hands of the tax-exempt. This is because, unlike the way in which partnerships and their partners are viewed for federal tax purposes, corporations are viewed as entirely separate entities from their shareholders1 (the “corporate veil”). This dividend characterization holds true regardless of the nature of the activities or ownership interests of the corporation.

While this structure does mitigate the imposition of tax on UBI, the domestic blocker will have an almost equivalent tax liability that will be imposed on the blocker’s receipt of Fund income. However, the tax-exempt status will not be jeopardized by reason of too much UBI.

Foreign blocker

Some tax-exempts favor the creation of a foreign blocker to mitigate the imposition of taxes on Fund investments. Unlike the case with domestic blockers, the foreign blocker will not be subject to U.S. tax on the distribution from the Fund, due to the application of “portfolio debt exception,” which would treat the Fund’s distribution to the foreign blocker as nontaxable interest. Additionally, the distribution of earnings by the foreign blocker may result in foreign withholding tax of $02. Thus, under this type of arrangement, there is also the potential avoidance of the intermediary corporate level tax, which enhances the net after-tax cash flow to the tax-exempt investor.

In opting to structure an investment through a foreign blocker under this scenario, it is preferable to have the foreign blocker resident in a country which neither imposes corporate level taxation on interest received, nor imposes withholding tax on a distribution of earnings to nonresident shareholders (such as a U.S. tax-exempt organization in the instant case) under its domestic statute.


The issues involved with investment in alternative arrangements can be complex particularly when the investments are through pension plans and other investment instruments. This alert is intended only as an overview of the general rules and their applicability under certain assumed facts. Every tax-exempt organization seeking alternative investments will be subject to the particular model of the Fund, as well as non-tax objectives. Moreover, there are various tax regimes to consider, such as U.S. taxation on foreign investments; partnership taxation and withholding rules. Thus, although alternative investments may generate attractive investment returns, properly structuring them is a complex undertaking that should be done only in connection with advice from competent and experienced tax practitioners.

As a practical matter, many of the K-1s that tax exempt investors receive from their fund investments do not properly record the UBI activity either from unrelated trade or business or debt financed investments. That is generally because either the return preparer is unaware that a tax exempt entity is a partner and/or the preparer is generally unaware of these rules. Tax exempt investors should begin to ask questions about the nature of the investments in their portfolio to be sure they understand the tax implications to their organizations.

For more information on this topic, or to learn how Baker Tilly tax specialists can help, contact our team.

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