Tax Strategies For Hedge Funds, Private Equity Funds

Hedge funds and private equity funds can be wise, lucrative investments for tax-exempt organizations. They are usually organized as limited partnerships or limited liability companies and are treated as limited partnerships for tax purposes, unless the funds elect to be taxed as a corporation. The default treatment as a limited partnership allows the fund to avoid taxation at the fund level and pass the income through to its investors or partners.

Before investing in these types of funds, you should understand the possible tax implications for your organization and consider some strategies for minimizing the tax burden and other unintended consequences of the investments.



Hedge funds typically hold a broad range of investments, including some investments that are not available to mutual funds, and can have an unlimited lifespan. Alternatively, private equity funds acquire and hold the stock of particular companies over a relatively long time and often take over the management of these companies. Private equity funds usually have a limited lifespan of about 10 to 12 years.

Both types of funds can yield high returns and have a small group of large institutional investors, often including tax-exempt organizations. What makes these types of funds even more attractive is that most income from these investments can be generated tax-free, since the income from many hedge fund and private equity fund investments is considered passive income, which is exempt from federal income tax for tax-exempt organizations.


Avoiding Unrelated Business Taxable Income

There is one caveat to be aware of in relation to hedge fund and private equity fund investments. They can produce unrelated business taxable income (UBTI), taxable under Internal Revenue Code (IRC) Section 511 for the otherwise tax-exempt organization. UBTI is income from a trade or business that is unrelated to the organization’s tax-exempt purpose and is regularly carried on for a profit, after deducting the related business expenses.

A tax-exempt investor will have UBTI from its investment in a fund when (1) the investment fund has an ordinary trade or business and generates business income that it passes along to its investors; or (2) the investment fund has debt-financed property.

Hedge funds and private equity funds generally meet the requirements for being characterized as investment partnerships, deemed not to be engaged in a trade or business. Therefore, tax-exempt investors in the investment partnership will not be considered to be engaged in a trade or business and would not have any UBTI from an investment partnership.

Passive income — such as dividends, interest, royalties and certain types of rental income — are excluded from tax on UBTI under IRC Section 512(b). However, the exclusion does not apply to passive income when debt financing is used on the property that generates the income. Therefore, when an investment partnership uses debt financing, income from the debt-financed property is taxable in proportion to the amount of debt that was used to purchase the property.


“Blocker” Corporation

To address the issue of receiving a substantial amount of UBTI from investment funds, which means jeopardizing your organization’s tax-exempt status, you can create a U.S. feeder corporation known as a “blocker” corporation. As a tax-exempt organization, you can invest through the blocker corporation, which then means you are no longer considered to be a partner in the fund. The U.S. blocker corporation is now the partner in the fund and, as a tax-exempt investor, your share of the income from the blocker corporation is considered passive dividend income and, thus, you are not subject to tax on the income.

However, the U.S. blocker corporation is subject to tax on its share of the partnership’s income. While the domestic blocker can help your organization avoid having UBTI, the U.S. blocker corporation will end up paying just as much tax on the income it receives from the fund as the organization would have paid if it were UBTI. The advantage of the U.S. blocker is that you will not jeopardize your tax-exempt status from having too much UBTI.

Also consider creating a foreign blocker corporation to minimize the tax burden from hedge fund and private equity fund investments. It is best to have the foreign blocker established as a tax resident in a country without a corporate-level tax on interest income received and without a withholding tax on distributions of earnings to nonresident shareholders, which would include U.S. tax-exempt organizations.

The foreign blocker will not be subject to U.S. tax on the distribution from the fund because its distribution to the foreign blocker is treated as nontaxable interest. When the foreign blocker corporation distributes income and can avoid the corporate-level tax, it increases the net after-tax cash flow to you as a tax-exempt investor. E

Karen Andersen, CPA, is a senior manager in the Cherry Hill, N.J., office of Baker Tilly Virchow Krause, LLP. She is a member of the New Jersey Society of Certified Public Accountants. Contact her at [email protected]