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