Tax and structure basics

Section 1061, blocker corporations, fee waivers, and the difference between a fee and a distribution - structurally, with the code sections named.

Fund tax structuring is jurisdiction-specific, investor-specific and changes with legislation, so what follows is structural only: what each mechanism is for, which code section governs it, and what arithmetic it changes. It states no conclusion about any particular fund, investor or transaction, and every point here requires tax counsel before it is acted on.

Section 1061 and the carried interest holding period

IRC section 1061, added by the Tax Cuts and Jobs Act of 2017, recharacterises long-term capital gain as short-term in respect of an applicable partnership interest held in connection with the performance of substantial services, unless a three-year holding period is met. It is a holding period rule, not a rate rule, and it applies on top of the ordinary section 1222 one-year test.

Holding period of the underlying asset	Treatment of gain allocated to the carried interest	Reference fund investments
One year or less	Short-term capital gain under the ordinary rules; section 1061 changes nothing	None. The shortest hold is four years
More than one year but not more than three years	Long-term under the ordinary rules, recharacterised as short-term by section 1061 for the applicable partnership interest	None
More than three years	Long-term capital gain; section 1061 does not apply	All six investments, held four to five years
Capital gain allocated to a capital interest	Excluded from section 1061 where the capital interest exception applies	The GP's 10.0 commitment, subject to the conditions in the regulations
Section 1231 gains and qualified dividend income	Outside the scope of section 1061 as drafted	Not applicable to the worked example

Blocker structures by investor type

A blocker is a corporation interposed between the fund and an investment, or between an investor and the fund, so that a character of income the investor cannot hold is converted into corporate income and then into a dividend or a share sale. The cost is corporate-level tax; the benefit is that the investor's own tax position is preserved.

Investor	Problem	Code sections engaged	Structural response
US tax-exempt investor - pension plan, endowment, foundation	Unrelated business taxable income arising from debt-financed income or from an operating business held in flow-through form	IRC sections 511 to 514, in particular 512(b) and the 514 debt-financed income rules	A blocker corporation holding the flow-through interest, so the tax-exempt investor receives dividends or share-sale proceeds rather than allocable UBTI
Non-US investor	Income effectively connected with a US trade or business, which creates a US filing obligation and withholding	IRC sections 864(c), 875, 1446, and 897 for US real property interests	A blocker corporation, so the non-US investor holds stock rather than a partnership interest carrying ECI
Non-US investor in US real property	Gain on a US real property interest taxed under FIRPTA	IRC section 897 and the section 1445 withholding rules	Structuring choices around the domestically controlled REIT rules and blocker use; highly fact-specific
Taxable US investor	Generally none from flow-through treatment; a blocker introduces a second layer of tax	Subchapter K generally	Usually holds directly, and objects to being placed behind a blocker put in for other investors
All investors	State and local filing obligations arising from the fund's activities	State law, varies	Composite returns, withholding, or a blocker depending on the states involved

Entries

Section 1061 and the three-year holding period

A rule recharacterising long-term capital gain allocated to an applicable partnership interest as short-term unless the relevant holding period exceeds three years. An applicable partnership interest is one transferred to or held by a taxpayer in connection with the performance of substantial services in an applicable trade or business - which is what a carried interest is.

Field	Value
Formula	`Recharacterised amount is computed under the section 1061(a) mechanics and the regulations thereunder. The test applies to the holding period of the asset disposed of, and in specified cases to the holding period of the partnership interest itself`
Worked, the reference fund	`All six investments are held four or five years, so no gain allocated to the carry fails the three-year test. The 87.0 of carry under the whole-fund waterfall is outside section 1061 on that basis`
Where it would bite	`An investment realised inside three years. A hypothetical exit of investment A in year 3 rather than year 5 would place the gain allocated to the carry inside the recharacterisation`
The capital interest exception	`Gain allocated in respect of the GP's own 10.0 of invested capital is capable of falling within the capital interest exception, subject to the conditions in the regulations`
What it does not change	`The LP's own treatment. Section 1061 addresses the character of gain allocated to the applicable partnership interest, not the fund's income or the LPs' allocations`

The practical effect is on holding period decisions at the margin, and it is one of the few tax rules that can align a GP with a longer hold. A sale at two years and eleven months and a sale at three years and one month can carry materially different after-tax outcomes for the carry recipients on the same price.
The rule is a recharacterisation, not a disallowance. It changes the rate applied to gain the GP receives and does not change how much the GP receives, so it has no effect on any figure in the waterfall on the economics page.
The mechanics, the treatment of tiered partnerships, and the scope of the capital interest exception are set out in regulations and are detailed. Nothing here is a substitute for reading them with counsel.

Source: IRC section 1061; Tax Cuts and Jobs Act of 2017; Treasury regulations under section 1061.

Blocker corporations and UBTI

A corporation interposed so that a US tax-exempt investor receives dividends or share-sale proceeds instead of an allocable share of unrelated business taxable income. The two usual sources of UBTI in a fund are income from an operating business held in flow-through form and debt-financed income under the section 514 rules.

Field	Value
Formula	`Cost of the blocker = corporate-level tax on the income earned inside it. Benefit = the tax-exempt investor avoids the UBTI allocation and the associated Form 990-T filing`
Where UBTI arises	An investment held as a partnership or LLC conducting an active trade or business, and debt-financed income under IRC section 514
Where it generally does not	Gain on the sale of stock of a corporation, and most dividends and interest, under the section 512(b) modifications
Who bears the cost	Usually the investors who needed the blocker, through a separate feeder or an allocation of the blocker's tax cost - which is a term in the LPA rather than a tax rule
Worked, the cost of the blocker	`100.0 of income earned inside a blocker at the 21.00 percent statutory federal corporate rate under IRC section 11 leaves 79.0 available to distribute, before any state or local tax and before withholding. The tax-exempt investor has paid 21.0 to avoid a UBTI allocation on the 100.0`

The structuring question is almost never whether a blocker works but who pays for it. An LPA that spreads blocker tax costs across all LPs transfers value from taxable US investors to tax-exempt ones, and the allocation provision is the term to read.
Most buyout investments are held through corporations for exactly this reason, which is why UBTI is more often a private credit and real assets problem than a buyout one. A fund that acquires a flow-through target is making a structuring decision with consequences for a subset of its LPs.
The section 514 debt-financed income rules are the reason fund-level leverage is a tax question and not only an economic one. A NAV facility or a subscription line secured at the fund level can have consequences for a tax-exempt investor that the economic analysis does not surface.

Source: IRC sections 511 to 514, in particular 512(b) and 514; IRC section 11 for the corporate rate.

Blockers and effectively connected income

A corporation interposed so that a non-US investor holds stock rather than a partnership interest that would allocate income effectively connected with a US trade or business. Without it, the non-US investor acquires a US filing obligation and is subject to withholding under section 1446.

Field	Value
The problem	A non-US partner in a partnership engaged in a US trade or business is treated as so engaged, is taxed on the effectively connected income, and must file
Code sections	IRC section 864(c) for the ECI definition, section 875 for the attribution to partners, section 1446 for withholding, and section 897 for US real property interests
The trade-off	The blocker pays US corporate tax and the investor receives dividends subject to withholding at the treaty rate, in exchange for no US filing obligation and no ECI allocation

Whether a buyout fund is engaged in a US trade or business at all is a fact question about its activities, and the answer differs between a fund holding corporate stock and one holding flow-through interests or originating loans. The structuring follows the answer rather than the strategy label.
Section 1446 withholding is the operational consequence non-US LPs feel most, because it takes cash out of a distribution regardless of the eventual tax outcome. The refund mechanism works and it takes time.
Treaty position, not just blocker presence, determines the after-tax result for a non-US investor. Two investors behind the same blocker in different jurisdictions receive different net amounts from the same distribution.

Source: IRC sections 864(c), 875, 897, 1445 and 1446.

Management fee waivers

An arrangement under which the GP waives management fee otherwise payable and receives instead a priority allocation of future fund profit of a broadly corresponding amount, frequently used to fund all or part of the GP commitment.

Field	Value
Formula	`Fee waived reduces the LP's fee-funded capital calls. The GP receives a priority profit allocation instead, so the amount moves from a fee to a share of profit`
Worked, mechanics	`Waiving the year-1 fee of 10.00 reduces the year-1 call from 119.30 to 109.30 and funds 10.00 of the GP's 10.0 commitment`
What changes for the LP	`Paid-in capital falls by 10.00 and the same 10.00 comes off the top of future profit as a priority allocation to the GP. The LP's total economics are close to unchanged; the timing and the character are not`
The risk that has to be real	`For the arrangement to be respected, the priority allocation must be genuinely contingent on there being profit to allocate. A waiver whose recovery is effectively assured is the case that has attracted scrutiny`
Proposed regulations	`Proposed regulations issued in 2015 under IRC section 707(a)(2)(A) address disguised payments for services and set out factors bearing on whether an allocation lacks significant entrepreneurial risk`

From the LP's side the question is not the tax treatment, which is the GP's problem, but whether the waiver is being used to fund a GP commitment that the LP believed was cash from the principals. Those are different alignment facts and the LPA disclosure is where to look.
A waiver also changes the reported fee. A fund that waives fee and takes a priority profit allocation reports a lower management fee and a higher profit allocation to the GP, on identical economics. Comparing fee levels across managers without checking for waivers compares nothing.
The 2015 proposals under section 707(a)(2)(A) remain proposed. Anything built on the current treatment should be revisited with counsel rather than assumed stable.

Source: IRC section 707(a)(2)(A); proposed Treasury regulations on disguised payments for services, 2015.

A fee and a distribution are not the same thing

A management fee is a payment for services, deductible or capitalisable at the fund level depending on the facts, and ordinary income to the recipient. A distribution of profit is a share of the partnership's income, taking the character of the underlying income. The same amount of money produces different results depending on which it is.

Field	Value
Formula	`Fee: an expense of the fund and ordinary income to the manager. Profit allocation: no fund-level expense, and the character of the underlying income flows through to the recipient`
Worked, the same amount both ways	`10.00 taken as management fee is called from LPs, reduces the LPs' capital accounts, and is ordinary income to the manager. 10.00 taken as a priority profit allocation is not called, and takes the character of the fund's gain`
Effect on reported figures	`As a fee, it raises paid-in capital by 10.00 and lowers DPI. As a profit allocation, it lowers distributions by 10.00 and lowers DPI. The direction is the same and the arithmetic is not`
Effect on the waterfall	`A fee increases contributed capital and therefore the return-of-capital hurdle and the preferred return base. A profit allocation does neither`

This distinction is why a fee waiver is attractive and why it is scrutinised: it converts ordinary income into a share of capital gain without changing the amount. The economics are close to identical and the tax outcome is not.
The same distinction runs through the whole of the waterfall arithmetic on the economics page. Fees enter paid-in capital and therefore raise the amount that must be returned before carry; carry does not. That is why the reference fund's 66.2 of fees increases the return-of-capital tier and the 87.0 of carry does not.
Characterisation is a question of substance and it is not for the parties to elect by labelling. Nothing here is advice on where any particular arrangement falls; the point is only that the label changes the arithmetic as well as the tax.

Source: IRC section 707; Subchapter K.