Considerations for Making Investments in Pass-Through Entities

Fund managers consider a variety of investment structures depending on the objectives of the fund they manage, the risk tolerance, investor sensitivities and the investment strategy. Though the types of investments and their structure seem ever evolving and almost infinite at times, each carries its own set of tax implications which can have a significant impact to both the fund and its investors. One in particular is investment in pass-through entities, such as partnerships and limited liability companies (LLCs) taxed as partnerships, which involves several tax considerations that fund managers should be aware of.

When a fund manager is evaluating a pass-through investment, there are a number of tax considerations that may be relevant to the fund and its investors. Though not exhaustive, below are a few:

• Will the underlying pass-through investment generate any Effectively Connected Income (ECI) or Fixed Determinable Annual Period (FDAP) Income?
• Will there be any Unrelated Business Taxable Income (UBTI) flowing-up from the investment?
• What states does the investment operate in and which states will it be filing in?
• When will the underlying pass-through investment issue its federal and state (if applicable) Schedule(s) K-1?

Will the underlying pass-through investment generate any Effectively Connected Income (ECI)?

Effectively connected income (ECI) refers to income earned from the conduct of a trade or business in the United States. This type of income is subject to U.S. income tax when it is allocated to non-U.S. investors. This could trigger withholding requirements for the fund manager and their fund, as well as U.S. tax filing requirements for the non-U.S. investor. Non-U.S. investors are generally averse to receiving an allocation of ECI. U.S. sourced interest and dividends are considered Fixed Determinable Annual Period (FDAP) income. When there is U.S.-sourced FDAP allocated to non-U.S. investors, it creates a withholding and reporting obligation for the fund.

Will there be any Unrelated Business Taxable Income (UBTI) flowing-up from the investment?

Unrelated Business Taxable Income (UBTI) refers to income earned by a tax-exempt organization from a trade or business that is not substantially related to its exempt purpose or function. Even though the organization is tax exempt, the IRS imposes a tax on this unrelated income. Many tax-exempt investors want to avoid receiving an allocation of UBTI.

What states does the investment operate in and which states will it be filing in?

State-sourced income refers to income that is attributable to a particular state due to the nature of the activities being conducted and giving rise to the income or the nexus which the business has with the state. The state where the income is sourced typically requires the owner to file a state tax return and potentially pay or withhold state income tax on behalf of the partners being allocated that state-sourced income. If the underlying investment has state-sourced income in multiple states, it could create additional state filing requirements for the fund, as well as some or all of its investors (depending on certain tax elections made). Understanding the underlying state activities is important for managing fund level state tax obligations and mitigating risk of state tax penalties and notices.

When will the underlying pass-through investment issue its federal and state (if applicable) Schedule(s) K-1?

Fund managers want the tax reporting for their fund to be accurate and complete, but they often also want to have the Schedules K-1 timely issued for their investors to incorporate the information into their tax returns. In order to finalize the tax reporting for the fund, it will need to receive the underlying Schedule(s) K-1 from the pass-through investment(s). This can create a domino effect on timing, so fund managers will need to manage their investors’ expectations as well as ensure they have clear communication from their pass-through investment(s) on when they will receive the underlying Schedule(s) K-1. It is also important that the fund manager communicates upfront what information it will require on its Schedule K-1 (including the items mentioned above), as the pass-through investment may not be aware of what information is required by indirect owners.

Investments in pass-through entities can provide opportunities for investors and present some unique tax benefits, while they may also pose some challenges depending on the investor demographics, many of which can be mitigated with proper planning and strategy. Weaver’s knowledgeable professionals can assist you in navigating these challenges to help maximize your opportunities as well as your results. Contact us today to get started.

©2024