Considerations for Investment Fund Managers When Using Blocker Entities

Blocker entities are corporations that serve to block U.S. federal and state taxable income from being reported to certain investors on a pass-through basis. Domestic blockers can be formed as Delaware C corporations or Delaware LLCs that elect to be treated as corporations for U.S. federal tax purposes. It is important to note that offshore blockers can also be a useful option, and in some instances, may provide certain advantages over domestic blockers.

Blockers are desired by tax-exempt and non-U.S. investors who wish to avoid Unrelated Business Taxable Income (UBTI) and Effectively Connected Income (ECI), respectively. Allocations of UBTI and ECI to these investors can occur when the investment fund makes unblocked investments into pass-through portfolio companies. If unblocked, these investors can be subject to unwanted U.S. and state tax return filing requirements and certain U.S. and state excise and withholding taxes.

Why Should Fund Managers Care About Blockers?

Offering blocker structures to tax-exempt and non-U.S. investors can make a fund manager more attractive and improve fundraising. Blockers help certain investors preserve their tax profile and improve returns on investment. While blockers can add financial/tax reporting burdens and costs, these are typically outweighed by the increased access to investor capital.

What Should Fund Managers Consider When Contemplating the Use of Blockers?

Understanding the fund’s structuring options, limited partnership agreement and composition of the expected investment portfolio are important when determining the use of blockers.

• Fund structuring options: When initially marketing the fund and setting up the structure, fund managers should work with prospective investors to gauge blocker appetite. Proper planning is necessary to effectively implement and execute a fund structure that uses blockers. Some important questions to answer when setting up the fund’s initial structure include:
  • Where should the blocker(s) sit? Above, below or parallel to the fund?
  • Can a single fund blocker vehicle accommodate the needs of all tax-exempt and non-U.S. investors while also being tax efficient?
  • Will blockers be formed in the U.S. or offshore?
  • Should blockers be formed on a deal by deal basis or per strategic investor basis?
  • How can a potential fund structure with blockers increase or decrease flexibility on exits?
  • Will ECI/UBTI-sensitive investors use their own blockers?
• LPA considerations: If a fund manager determines blockers may be needed, it is important for LPAs or investor-side letter agreements to properly state the fund manager’s willingness to use blockers. For example, have you only agreed to use “reasonable efforts” to avoid ECI/UBTI? Are you mandated to use blockers? Have you agreed to offer the right to a blocker as requested? It is important for fund managers and investors to be aligned on this point so that unwanted ECI/UBTI surprises can be avoided down the road.
• Structure and activities of portfolio companies: Understanding expected tax entity classification and activities of future portfolio companies can help determine the need for blockers and optimal blocker structure. For example, it’s less common in the venture capital industry to require blockers since most investments are made into C corporations. Meanwhile in private equity, investments into partnerships are more common, so there is a greater need for blockers. Fund of fund managers may have the option to use the underlying fund manager’s blocker to achieve the desired result. Real estate fund managers must also account for the Foreign Investment in Real Property Tax Act (FIRPTA) tax rules which can have adverse effects on blockers and require additional tax structuring considerations for non-U.S. investors.

Operational and Tax Considerations:

As previously mentioned, using blockers can increase financial reporting/tax complexities and costs. Increased costs and administrative duties may include treasury management, accounting, regulatory filings, entity formations and tax return filings. Fund managers need to work with their various outsourced providers to manage these processes.

Blockers also come with the responsibility of making estimated and annual federal and state tax payments. Assessing the proper estimated tax payment amounts can be challenging since corporations are not eligible to apply a safe harbor method approach using prior year taxable income. To further complicate matters, blockers are generally dependent upon the underlying portfolio company to provide accurate estimated taxable income detail and tax distributions so the blocker has cash to pay its tax. To help mitigate underpayment tax penalties and excessive tax overpayments, it’s important to establish procedures with pass-through portfolio companies to receive timely tax info, understand if state tax withholdings will be performed on behalf of the blocker and if/when tax distributions will be received.

Achieving an optimal exit is also a critical component to using blockers in a tax-efficient manner. Structuring a sale below a domestic blocker results in corporate tax on the transaction gain. However, capital gain from the sale of corporate stock is generally not taxable to tax-exempt and non-U.S. investors. Within a private equity fund portfolio, it is common to set up blockers below the fund for each individual pass-through portfolio company. Upon exit, private equity fund managers will then seek to sell the blocker to avoid corporate tax. Proper structuring can result in significant tax savings.

Blockers are intended to provide tax benefits and efficiencies to tax-exempt and non-U.S. investors. Upfront planning can help fund managers create a blocker structure that fits their investor needs, while ongoing monitoring can help the structure smoothly operate. Contact Weaver for more information about using blockers. We are here to help.

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