Part 3: Critical Tax Considerations for Private Asset Investing Through a RIC

Assessing the tax status of an underlying investment is the first and most critical step of any tax analysis. This determination is the key to understanding the impact on qualification requirements, tax reporting, level of transparency needed, and strategies to address potential bad assets or income.

What is a Security?

Historically, RICs were intended to invest in securities, and it is easier to meet qualification requirements with a portfolio comprised of securities only. Therefore, exploring the definition of “security” is the first step in understanding why private assets, which are generally not securities, present compliance challenges.

The term security is not defined in the tax code, and the relevant tax rule points the determination to the 1940 Act. This determination is difficult, as referring back and forth between the tax code and SEC guidance requires specialized knowledge. To add further complexity, depending on the tax status of the underlying asset, it might be subject to separate tax rules, regardless of the SEC definition. Pass-through assets, such as partnerships and grantor trusts, are subject to separate tax rules, likely regardless of the assets’ potential status as securities.

The key to the asset tests is, regardless of ownership percentage, if the investment is not a security, in practice it likely defaults to being a nonqualified asset, unless further investigation is performed to determine otherwise.

Corporate vs. Pass-Through Investment: The Look-Through Requirement

Pass-Throughs: RICs often invest in private asset classes via pass-through entities, such as partnerships and trusts. Many interval and tender offer funds have portfolios with high partnership concentration. These investments require careful consideration for RIC tax qualifications. A fund must look through the partnerships (LPs, LLCs, etc.) and trusts it holds. The income of such pass-through investments is treated as if earned by the fund itself. This approach may create qualification challenges because these investment vehicles themselves may hold assets such as commodities, real estate or active businesses that generate nonqualified RIC income. Understanding the structure of the equity for U.S. tax purposes and the expected underlying investments the partnership anticipates making is essential to the fund’s compliance status.

In Practice: This assessment may be difficult if these investments lack transparency regarding their own assets. In such cases, a RIC may not know on a real-time basis whether or not the investment vehicle holds assets that generate qualifying income. Instead, a RIC may learn about the type of income it has earned when it receives a Schedule K-1 or K-3 from the underlying partnership.

For example, the K-1 might list ordinary business income on line 1, which is generally nonqualified income for RICs. There may also be changes year-over-year during the life of the investment, where in initial years the underlying holdings are ramping up, so the first few years of K-1s may report losses or only show qualified income; later on, the RIC is faced with large operating income or other concerning items. Generally, waiting on the receipt of the K-1s is not the best way to manage this potential problem.

The transparency issue may go further if the underlying partnership is invested in other partnerships. The RIC, regardless of the relationship with the General Partner (GP) of its direct holding, could have even less insight or control over the income and activity flowing up through the structure. Tiered structures are difficult to work with when analyzing compliance. The fund must look through all layers of the pass-through structure.

Similarly, the asset diversification tests should be considered when analyzing pass-through holdings. The RIC is considered to own its share of the underlying asset(s) in the partnership or trust rather than a single investment in the partnership/trust. This could be beneficial or detrimental, depending on the type of assets held by the private investment.

For example, if the partnership or trust owns assets that are not securities — or cash, cash items, government securities or securities of other RICs — the RIC may risk disqualification because alternative investments, such as real estate and operating businesses, are not securities. A RIC may also own over 10% of the voting rights in an indirect position due to their pro-rata ownership share through the partnership, which disqualifies the position.

When it comes to closed-end funds with private assets, valuation and tax are the immediate accounting and financial reporting considerations. It is interesting to note that valuation complexities and tax challenges don’t always go hand-in-hand. For fund-of-funds structures, for example, valuation for an underlying private fund could be easier than a direct private holding. However, the look-through requirement tends to result in complex tax analysis to confirm all holdings and their qualification for an underlying private fund. This is a word of caution, as this situation could be quite deceiving for an asset manager unfamiliar with the look-through requirement.

Publicly Traded Partnerships (PTPs): The above considerations are for private partnerships. PTPs and master limited partnerships (MLPs) are subject to special tax rules. A regular PTP taxed as a partnership also follows the above look-through guidance. However, if the PTP’s income does not meet the RIC income test, it is considered a Qualified Publicly Traded Partnership (QPTP) for purposes of RIC qualification. A QPTP does not require a look-through for asset diversification tests purposes nor gross income test purposes; all income from QPTPs is qualified. The trade-off is that QPTPs cannot make up, in aggregate, over 25% of the fund’s portfolio at any quarter-end. The 25% limitation makes compliance a bit easier, as compared to compliance for private partnerships and other (nonqualified) PTPs, as it skips the detailed analysis associated with performing look-through testing.

In Practice: To simplify the tax entity assessment, during the due diligence process consider asking the simple question: Does this investment produce Form 1099s or Schedule K-1s? This is a simple way to determine and potentially avoid complex technical discussions around entity structuring. Entity structuring and organizational charts might still be needed, but they don’t need to be the first step in the assessment.

Timing and Transparency: Tax Due Diligence Before Purchase

Tax pre-purchase due diligence is necessary when considering acquiring private assets. Understanding an underlying partnership’s holdings and sources of income is essential. Having that knowledge timely is even more important. Negotiating estimates, transparency and timing of K-1s during the due diligence process of a deal could minimize compliance concerns and potentially tax dollars. Similar considerations apply to controlled foreign corporations (CFCs) and PFICs.

In Practice: Unfortunately, negotiating reporting transparency may not be an option, particularly with secondary transactions. If timing and transparency are an issue, advisers should consider alternative tax planning strategies, such as blockers. Using a checklist that outlines the main tax considerations can assist with tax determinations. While achieving full transparency is difficult, any insight prior to making the investment is vital to understanding the potential future implications on the fund. Making the GP aware of the level of insight a RIC requires is helpful with requesting estimates and notification of further investments or sales. This upfront arrangement will benefit the fund significantly.

If it’s an option, negotiating certain covenants could be a good solution to address problematic assets and income:

• Limit partnership holdings to corporate entities only.
• Request a limit on investments with effectively connected income (ECI), unrelated business taxable income (UBTI), commodities and others.
• Ask for advance notice of restructuring and the right to transfer an interest to a blocker.

Once an investment is made, there should be ongoing monitoring of estimates, K-1s or other reports to ensure the fact pattern understood at the time of investment is still correct and no mitigation is necessary.

Tax Planning Tool: Use of Blockers

Blockers provide great opportunities for safe investing. They are a tax planning tool that can provide enhanced benefits to shareholders. Blockers allow access to any investment that generates nonqualifying income while maintaining a level of control that might not be possible without the blocker between the fund and the asset.

GP Blocker: If all other options in assessing bad income ahead of investing are limited, or it is known the potential investment would produce significant amounts of bad income, the use of an existing private investment sponsored blocker sleeve (GP-sponsored blocker) could be a great option to avoid undesirable exposure at the RIC level.

Wholly Owned Subsidiary: A fund may also avoid potential disqualification by investing in alternative asset classes through subsidiary “blocker” corporation(s), since the fund does not have to look through a corporation in applying the gross income test. Any bad income from the underlying investments moved to or housed in the blocker is earned by the subsidiary, and the fund only includes any dividends (good income) the blocker distributes to the fund in its income test. Such an approach may create tax liability at the blocker level, if the subsidiary is a domestic blocker or if the wrong investments are held in a foreign blocker. There is a potential to minimize this tax liability by using a specialty structure that is a combination of a subsidiary partnership and corporation. These complex structures require the assistance of legal and tax teams to assess and set up, and need significantly enhanced recordkeeping.

A fund using blockers must be cautious with investing too heavily in them because of the asset diversification tests limitations. Wholly owned blockers are inherently nonqualified assets for the 50% test due to the RIC holding over 10% ownership. Usually, the more relevant limitation is the 25% test. If multiple blockers are held, they might need to be aggregated and, when combined, must be below 25% at each quarter-end. There should be consideration for having a cushion and not pushing against the 25% test, especially if there are investments in the blocker where valuation might not be known for weeks after quarter-end, which is typical for private assets. This timing is relevant for the ability to cure any failures discussed in Part 4.

Foreign Subsidiary: Typically, foreign subsidiaries are used to shield the RIC from nonqualifying income derived from commodity-based strategies (for example, managed futures) and non-U.S. business income. Foreign subsidiaries are usually Cayman entities that elect to be taxed as a corporation, and they are CFCs for U.S. tax purposes.

The most obvious benefit of a CFC, as compared to a domestic blocker, is the CFC may not generate a U.S. tax liability. However, avoiding corporate tax is dependent on the CFC’s investments. Generally, the foreign blocker is only used when U.S. trade or business income (effectively connected income or ECI) will not be generated by the CFC’s investments. If there is ECI in the CFC, it would be subject to corporate tax, additional withholding requirements and branch profits tax, thus defeating the purpose of the CFC and better suited for a domestic blocker.

There are special rules governing the timing of CFC income recognition from the perspective of a RIC. Net gain from a CFC is recognized to a RIC as ordinary income, regardless of whether a distribution is made from the blocker entity to the RIC. The fund sponsor, therefore, has limited ability to time the income inclusion at the RIC level. Additionally, net losses occurring within a CFC for a taxable year are not carried forward to future periods. As a result, the tax consequences from a shareholder’s perspective may be unfavorable in a series of years where there is material movement in the price of an underlying asset. For example, any mark-to-market or realized losses on a commodity futures contract may be lost in a year in which a CFC finds itself with a net loss. The following year, a rebound in the price of the hypothetical commodity futures contract may create a distribution requirement for the RIC.

Domestic Subsidiary: RICs may choose to block bad income via a domestic blocker entity. Domestic blockers are subject to federal, state and local taxes on taxable income. Additionally, the subsidiary must consider deferred taxes against net unrealized gains and losses. Accrual of deferred taxes needs to happen at the pricing intervals of the fund and thus adds operational complexities. Generally, a domestic blocker will have lower tax drag than a CFC for investments that generate ECI (think U.S. operating businesses). The domestic corporation can also carry forward net operating losses and carry forward (and back) capital losses, offsetting future (or past) taxable income. Some of these tax benefits are not available in the foreign blocker.

Domestic blockers have certain financial statement considerations and enhanced reporting, such as consolidation consideration and ASC 740 Accounting for Income Taxes disclosures, as well as separate federal and state tax filings. Current taxes require quarterly analysis for tax payments and operational considerations for making cash available for these payments. Advisers should consider the cost-benefit analysis of these enhanced operational, compliance and reporting items.

Unlike CFCs, income from domestic blockers is taxable to the RIC as dividend income when distributed by the blocker, subject to limitations. Generally, management controls when this distribution occurs, so can plan to mitigate adverse tax consequences at the RIC level or deliver good income to the RIC.

Subsidiary blockers can provide a viable path for RICs to access alternative investments that would otherwise not fit within the RIC investment universe due to potential bad income. Both domestic and foreign blockers offer benefits and potential drawbacks depending on underlying investments and management priorities. Asset managers considering a subsidiary blocker should carefully analyze which option makes the most sense based on the fund’s fact pattern and goals. In most cases, the benefits outweigh the drawbacks discussed above. A wholly owned subsidiary blocker is likely to be the primary tool through which an adviser can achieve its private asset strategy.

Practical Tax Planning Considerations

While these tax concepts are complex and there are different areas to consider for different investment options, the following summary of practical considerations is a good starting point for advisers exploring private assets. To get to scale, the focus should be on building policies and procedures, as opposed to using highly skilled personnel to solve problems.

• Track entity tax classification for all investments (corporation/blocker versus pass-through)
• Perform detailed review of the pass-through entity’s assets and income; look through to the types of assets and income
• Ask about future business plans; assess impact on assets and income
• Avoid bad income or consider blocking it
• Monitor asset and income tests at least quarterly and when changes in underlying assets occur (allows for timely action to correct course)
• Evaluate foreign investments for PFIC exposure (early identification can help with compliance challenges)

Overview: RIC Tax Rules Relevant to Private Asset Closed-End Funds