Private Equity – Tax Reporting Requirements and Considerations

When determining their tax reporting and compliance requirements, there are many factors that private equity firms must consider. Private equity firms are setup as tiered structures, generally with four levels: the portfolio investment level, the investor level, the fund level, and the fund manager level. At each of these levels, there are different concerns and needs of the stakeholders that will factor into the entity type and the jurisdiction the entity is established.  

As investors are the source of funding for private equity investments, investors’ concerns when setting up the structure of investments will often be the most important factor. 

Tax Reporting Requirements 

Private equity firms will use a variety of entities when structuring their investments to maximize their tax efficiency, limit liability and limit reporting requirements. These entities all serve different purposes in regards to structuring and all have different reporting requirements. 

Limited Partnership (L.P.) 

• Traditionally, the vehicle through which investors contribute their capital 
• The entity will file a form 1065 with the IRS, due on the 15th day of the third month following the end the entities tax year 
• Each investor in the entity will receive a Schedule K-1, which reports the income, gains, losses, deductions and credits attributable to the entity’s partners 
• The general partner of the fund, usually the fund manager will have unlimited liability for the entities debts 

Limited Liability Company (LLC) 

• Multipurpose entity, which by default will file tax returns as a partnership, so will file a form 1065 with the IRS, due on the 15th day of the third month following the end the entity’s tax year 
• Can file a form 8832 and elect to be taxed as a corporation. The entity would then file a form 1120 with the IRS, due on the 15th day of the four month following the end of the entity’s tax year 
• When filing as a corporation, each investor will only have to report income from the corporation if there is a taxable dividend paid to the investor from the entity 
• If the entity does not file an 8832 and there is only one owner of the LLC, the entity becomes disregarded for tax purposes or a “Disregarded Entity” (DRE), meaning the owner of the LLC will need to include the taxable income of the LLC in their own tax return. 
• Some states may require DRE’s to file separate returns. The deadlines for tax returns for DRE’s vary from state to state 

L.P.’s and LLC’s are generally the two main entity types that private equity firms will use when structuring their businesses. However, other entity types such as C-corporations and S-corporations may be utilized depending on the individual circumstances of the investment.  

There are also state filing obligations for all these entities. States filing deadlines for specific entities will generally be the same as the IRS deadlines, although some states may give additional time to file. Most states will also accept a federal extension to file their tax return as an extension to file their state return. It is important to note that extensions are always extensions to file a tax return, but never an extension to pay a tax liability.  

Private equity companies must also determine where they wish to domicile their entities. While the nature of the investment plays a role in where they will domicile the entity holding their investments, often the needs of their investors will be the determining factor in where they decide to setup their entities. 

Investor Issues 

While the structure the investors receive their income through will almost always be a pass through entity, the jurisdiction of the entity and how income and losses are passed to the investors will depend on the investors’ specific needs. 

US Investor Concerns – (Taxable entities, Individuals, Trusts, Estates) 

• The fund avoids double taxation;  
• Passthrough of items of income/losses separately, to take advantage of favorable tax rates and/or tax offsets (Qualified Dividends, Capital Gain/Losses, 1231 Gain/Losses) 
• The fund prevents passing income to investors where they did not receive cash or marketable securities along with the allocation of income 
• Minimizing or avoiding tax-reporting requirements in non-US Jurisdictions 
• Minimizing or avoiding tax in non-US jurisdictions 
• If there is tax in US Jurisdictions, ensure the tax paid can be passed as a tax credit to the investor to offset US tax 
• Minimizing or avoiding tax-reporting requirement in large numbers of states/localities 

UBTI Sensitive Investor Concerns 

There are additional US investors that may have additional needs when investing with a private equity company. Private equity companies have often attracted tax-exempt entities who have access to large pools of money. These could be pensions plans, private foundations, charitable trusts, etc. While investment income received by these entities are generally tax free, private equity investments often generate income that would be considered Unrelated Business Taxable Income (UBTI).

UBTI is taxable to all tax-exempt investors that derive their tax-exempt status from Code Section 501(c). Public Pension plans do not fall into this category, thus making them “super tax-exempt”. However, the rest of the tax-exempt investors often need the following to securely invest their funds with private Equity companies. 

• Minimizing or avoiding UBTI generating investments 
  
  • Income that comes from trade or business activities. This generally includes ordinary business income and real Eetate income 
• Income earned from investments financed from debt, also called Unrelated Debt Financed Income (UFDI) 
  • Income that comes from UFDI is generally all considered to UBTI, regardless of the nature of the income

Funds that want the option to make investments in UBTI generating deals can give UBTI-sensitive investors the right to opt out of certain deals in the partnership agreement, in hopes of still being able to attract UBTI-Sensitive Investors. If the UBTI-Sensitive Investor wants to make the investment but avoid receiving the income subject to UBTI, the investors can make the investment through a foreign feeder corporation. This will eliminate flow through income for the tax exempt investor and block the UBTI from passing through to the investor. 

Foreign Investor Concerns 

Foreign investors will generally have the following concerns and considerations when investing with private equity funds: 

• No US tax on capital gains 
• No difference in tax position in the investors home jurisdiction by investing through the fund than if the investment was made at the portfolio level 
• No requirement to disclose the identity of the investors to tax authorities. 
• No requirement to file US tax return 

Similar to their US equivalents, many foreign investors have specific concerns depending on what kind of investors they are. However, for investors such as Non-US pension funds, they do not receive the same exemptions that US pensions funds do under US tax law. This will in many cases lead to mandatory filings and withholdings. However, depending on the home jurisdiction of the investor, there may be treaties that eliminate withholding taxes. 

With all these concerns and considerations in mind, the structuring of the investments made by private equity funds becomes critical so that all investors have their needs satisfied. Once the structuring at the investor level is decided, it is then critical that the structure of the portfolio investment is optimized for the investor needs. 

Portfolio Investment Issues 

At the portfolio investment level, private equity companies must balance the needs of their investors with the needs of the business behind the investment. The goal of private equity firms, when investing in a business, is to work with management of the company to increase the profitability and eventually sell their stake in the company for a profit. One of the best ways of doing this is optimizing the tax structuring and reporting of the company, while also minimizing the taxes paid by the company. 

However, in many cases, the best structure for tax purposes at the portfolio investment level would lead to issues at the investor level. An example of this would be a retailer that has business activity and therefore nexus in multiple states. For the purposes of the business, the best way of reducing taxes owed at the investment level is to be setup as a pass-through entity, where they would not owe income tax at the business level for federal or state purposes. However, this leads to filing obligations at the investor level in multiple jurisdictions, which may be something that the funds investors wished to avoid. 

Therefore, it may be in the best interest of the private equity company to have the investment setup as a corporation. While they will have to pay tax at the investment level, they should receive the income as qualified dividends, which are subject to favorable tax rates.

Additionally, by the company filing as a corporation, there will be no filing obligation at the investor level beyond the investors personal home jurisdiction (foreign investors directly invested and not through a blocker may have additional requirements in this scenario). 

Conclusion 

Private equity firms have to take a variety of factors into account when they are structuring their investment for tax reporting purposes. Doing this strategically with tax structuring advisors is essential to properly accounting for the needs of all their stakeholders while still optimizing their tax efficiency. 

Evolved is a tax compliance and advisory firm with offices in New York City, Philadelphia and Stamford, serving clients nationally throughout the US.  We provide tax provision, private equity and venture capital services alongside advisory for high net-worth tax and family office tax.