Q&A with UMB: Exploring the Potential of Tax Blockers for Interval Funds
As managers seek to generate income across a broad spectrum of investment opportunities, many are turning to tax blockers in the tender and interval fund market to generate income more effectively.
Here, Spencer Erickson, Tax Managing Director at UMB Fund Services, speaks to With Intelligence about the strategy behind these tax blockers, and the critical role they can play in allowing fund managers to pass the ‘good income’ test and retain their Regulated Investment Company (RIC) status.
With Intelligence (WI): Why might an investment manager need to use a tax blocker, and what options do they have?
Spencer Erickson (SE): The use of a tax blocker may allow an investment manager with an alternative investment strategy in private equity, real estate, or private credit to create a fund that is accessible to a much broader investor base than previously thought possible.
Registered tender offer or interval funds can be distributed to investors much more broadly than private funds. With registration comes with the ability to qualify as a Regulated Investment Company (RIC) under the Internal Revenue Code.
One hurdle in qualifying is the 90% Good Income Test. 90% of a RICs gross income must come in the form of interest, dividends, gains on the sale of securities, etc. Often alternative investment strategies in private equity, real estate, or private credit produce ‘bad’ income in excess of 10%.
Bad income producing assets can be placed in a tax blocker to block that income from the fund; allowing it to pass the 90% income test, qualify as a RIC, reach the broad investor base, and distribute its income to be taxed at the investor level.
WI: How recent a development is the tax blocker, in both the tender and interval fund market, and within the private markets space? What is behind its growth in popularity?
SE: While tax blockers have been around for many years, the recent popularity of tax blockers in the tender and interval fund market is being driven by investment managers’ desire to reach broader distribution platforms.
There managers want to maintain investment strategies in private equity, real estate, private credit, and other alternative strategies that typically generate income that doesn’t qualify under the RIC tax rules.
WI: How does the tax blocker work as a tax mitigation tool?
SE: Although it may seem counter-intuitive on its face, adding a tax blocker to a tender or interval fund structure commits the blocker to corporate taxes, but could save the entire structure from paying corporate level tax.
By placing investments that produce bad income in the tax blocker and paying corporate level tax on income from those bad income producing investments, the fund is able to pass the 90% income test required of RICs and distribute its income to be taxable at the shareholder level.
WI: What hurdles (operational, financial, or corporate tax implications, for example) might fund managers need to be aware of, and how can they overcome these?
SE: Tax blockers should be organized as separate legal entities.
While management of the blocker is generally done in conjunction with the management of the fund, the blocker requires its own set of accounting books and records that are later consolidated into the fund for financial reporting.
Also, the blocker will require a separate tax return where it will pay corporate level tax on income earned in the blocker.
WI: Are there any investment strategies that are incompatible with this kind of tax blocker?
SE: The purpose of a tax blocker is to allow an investment manager to use investment strategies that are typically incompatible with a registered fund.
The bad income producing assets placed in the blocker can be aligned to any investment strategy. However, the tax blockers can only hold up to 25% of the fund’s gross assets. Investment strategies that require blocking of more than 25% of the investments may not be compatible with registered funds.
For more information, please visit https://www.umb.com/about-umb.
Spencer Erickson
Spencer Erickson is Vice President, Managing Director of Tax at UMB Fund Services. He leads the fund tax teams in support of federal and state tax compliance for mutual funds, real estate investment trusts, and private funds with hedge, private equity, venture, private debt, and real estate strategies.
Spencer started his career in the tax industry in 2004 and in fund administration in 2006 and has held a variety of technical and leadership roles since. Prior to UMB, Spencer served as a tax managing director for KPM, LLP.
Spencer obtained his bachelor’s and master’s degrees in accounting from Utah State University. He is a certified public accountant and a member of the Utah Association of CPAs.