Autumn is ending, meaning private equity firms’ finance teams are aiming to finalize their tax planning strategies for the year ahead. Earlier this year, pfm gathered industry professionals in Boston to discuss these strategies and more at its inaugural Tax Forum.
For instance, delegates assured one another that if it was discovered initial portfolio company tax estimates used for K-1 reports sent to LPs turned out to be far off the mark, it didn’t necessarily make sense to recirculate updated reports. “Roll it forward, because it would be bad to put LPs in the same position of having to amend their own tax reporting,” one delegate put it plainly.
But one of the biggest insights shared at the forum was the realization that an increasing number of LPs are beginning to embrace flow-through acquisition structures. Historically, private equity investors sensitive to Unrelated Business Taxable Income (UBTI) or Effectively Connected Income (ECI) tax would review transactions on a deal-by-deal basis in order to determine when the use of a blocker or feeder fund was appropriate to protect their tax-exempt status. In a change from historical practice, an increasing number of LPs are realizing that the tax structures used in private equity investing do not necessarily trigger UBTI or ECI concerns, allowing them to avoid the tax leakage that comes with establishing intermediate entities offshore.
One CFO at the forum noted that roughly 35 percent of investor capital was routed through blocker entities when investing from a predecessor fund, a number that dropped to 14 percent when investments from the successor fund began in 2014. A second CFO remarked that “once an LP tastes the gains achieved through flow-through entities, they keep coming back for more.”
In fact, LPs’ comfort level with flow-throughs has reached a point where many no longer see the need to review transactions on a deal-by-deal basis for tax purposes, a green light is now the standard default position. Even better: by no longer reviewing each deal, LPs save on fees paid to tax lawyers and other consultants employed to spot UBTI or ECI triggers.
More tax and due diligence savings for LPs is good news from an investor relations standpoint, but, in this instance, difficult news for CFOs. Pass-through entities are resulting in an additional administrative burden for the firm’s finance team, delegates heard.
CFOs are only just coming to realize the additional administrative workload flow-through structures create as fund tax returns become dependent on K-1s generated by portfolio companies and the mountain of state tax return notices these flow-through investments are resulting in at the fund level.
Happily, delegates were able to share tips and strategies to work through the increased work demands – including the use of outside service providers – but the increasing popularity of flow-through structures will still be an interesting tax challenge for CFOs in the year ahead. Next autumn, we’ll be gathering again to take stock and advance best practice. Stay tuned.