By Michael A. Bloom and Sung H. Hwang – Venable LLP (New York)
Read Part One.
4 Legal Structure.
Most, if not all, of U.S. real estate funds are organized as partnerships and, to a lesser extent, as limited liability companies under the laws of a state of the United States. Delaware is the default state of choice in which to form a U.S. legal entity for transacting business and investments within the United States because Delaware has the most sophisticated corporate governance laws (e.g., laws relating to fiduciary duties of directors, officers, and general partners to shareholders and limited partners) and an efficient court system. Delaware is not selected for tax reasons.
The choice of partnership form is principally due to its “flow-through” nature for U.S. federal income tax purposes, which will be discussed later. While the limited liability companies have gained popularity in recent years, a limited partnership is still widely popular, because of many preferential tax and legal landscapes that have existed at the state and local levels governing real estate investments for many years.
A Delaware corporation (commonly known as a “C corp”) is not used as the legal entity of choice for a U.S. real estate fund (or any private equity or hedge fund) because investors in a C corp are subject to “double taxation” in the U.S. To avoid “double taxation,” most U.S. real estate funds are structured using a “flow-through” entity (e.g., a state law partnership or limited liability company, classified as a partnership for income tax purposes), including ones that invest through REITs.
This article discusses four commonly used structures: (A) a limited partnership, (B) a corporate blocker, (C) a corporate blocker with leverage, and (D) a REIT.
A. Delaware Limited Partnership.
In our example, Alejandro could structure the Coffee Fund as a Delaware limited partnership (“Coffee Fund LP”), since the fund’s investments will be made in the United States. Under this structure, Jay Gatsby, Silvio Bellini, and Maple Leaf Pensions would contribute capital to Coffee Fund LP in exchange for limited partnership interests in Coffee Fund LP. See Chart 1 below.
Chart 1: Delaware Limited Partnership Structure
As mentioned above, partnerships are “flow-through” entities for U.S. federal income tax purposes. Thus, unlike corporations, partnerships are not subject to income taxation at the federal level. Rather, each item of income, gain, loss, deduction, and credit (collectively, “Income Items”) of the partnership “flows through” to the partners and is reported on the partners’ individual tax returns for the year. For each of its taxable years, a partnership files an informational tax return: IRS Form 1065 (U.S. Return of Partnership Income). Attached to IRS Form 1065 are Schedule K-1s for partners allocating to the partners their distributive shares of the partnership’s Income Items for the taxable year.
The theory of “flow-through” taxation is that partnerships are conduits through which individual partners come together to perform an activity in the aggregate. As a result, the U.S. income tax rules governing partnerships (subchapter K of the Internal Revenue Code) require that the partnership’s Income Items be allocated among the partners consistent with how the partners have decided to share in the underlying partnership economics. The dense tax boilerplate found in the partnership and limited liability company agreement of a typical U.S. real estate fund is designed to ensure compliance with these complex tax rules.
Because of the “aggregate” theory of partnerships, foreign investors may be reluctant to invest directly in partnerships operating a U.S. trade or business, as explained below.
(i) U.S. Investors.
Turning the page back to the investors, we see that Jay Gatsby is likely content investing in a Delaware limited partnership. Jay Gatsby would receive a Schedule K-1 from Coffee Fund LP each year, allocating to him his share of Income Items (i.e., income, gains, losses, deductions, and credits). These Income Items would be reported on his IRS Form 1040 (U.S. Individual Income Tax Return) filed jointly with his wife, Daisy Fay Buchanan. Allocated ordinary income and short-term capital gain would be taxed at normal graduated rates up to 39.6%, at the federal level. Allocated long-term capital gains would be taxed at the current preferential rate of 20%, plus the 3.8% NII tax. As compared to a corporate structure, Jay Gatsby is likely content investing in a Delaware limited partnership.
(ii) Foreign Investors.
The tax treatment of Alejandro’s foreign investors, Maple Leaf Pensions and Silvio Bellini, is more complicated for three reasons:
- These investors generally will be taxed on a “net basis” (like Gatsby).
- If the foreign investor is a corporation, it will pay an additional 30% branch profits tax on its after-tax income.
- Foreign investors that are resident in jurisdictions with which the U.S. has entered into income tax treaties may be entitled to treaty benefits, which usually include exemption from the branch profits tax or reduction in the branch profits tax rate.
The purpose of the branch profits tax is to prevent foreign corporations from avoiding “double taxation” by conducting business in the U.S., but not through a corporate subsidiary (i.e., through a branch), since dividends paid by a U.S. corporate subsidiary to a foreign parent are subject to a 30% federal withholding tax. Consequently, the branch profits tax rate matches the withholding tax rate on dividends of 30%, subject to treaty elimination or reduction. As Maple Leaf Pensions (but not Bellini) is a corporation for U.S. income tax purposes, Maple Leaf Pensions would owe an additional 30% branch profits tax on its after-tax income – essentially making Maple Leaf Pensions (unlike Gatsby) tax agnostic between investing in a U.S. corporation or U.S. partnership.
There is, however, another layer of complexity when dealing with foreign investors. Foreign investors resident in jurisdictions that have entered into income tax treaties with the U.S. may be eligible for elimination or reduction of the federal-level taxes under the treaty. Some old U.S. tax treaties provide for complete exemption from the branch profits tax, while many recent U.S. tax treaties extend to branch profits tax the same elimination or reduction in withholding tax on dividends.
Whether a foreign investor is eligible for treaty benefits generally depends on whether the U.S. has a tax treaty with the foreign investor’s tax residence under local law. In our example, Maple Leaf Pensions and Silvio Bellini are residents of Canada and Italy, respectively, and the United States has income tax treaties with these two countries. Both treaties significantly reduce the dividend withholding tax rate (and the branch profits tax rate) from 30% to 5%, because the Coffee Fund will invest in U.S. real estate. This rate reduction significantly mitigates the burden of “double taxation.” For example, because of these treaty benefits, if Silvio Bellini’s investment was made into a U.S. corporation, his combined effective tax rate would be only 38.25% (not 50.4%). Readers paying careful attention will have noticed that this rate does not include the 3.8% NII tax, as the NII tax generally does not apply to income earned by foreign investors.
Thus, there is no meaningful difference in effective U.S. federal tax rates between Bellini and Maple Leaf Pensions on rental and other ordinary income of the fund (39.6% vs. 38.25%), but there is still a pretty big difference on any long-term capital gains (i.e., gain from the sale of capital assets held for more than one year) generated by the fund (23.8% vs. 38.25%).
However, that is not the end of the story for Maple Leaf Pensions. Many income tax treaties provide for favorable treatment for pension arrangements that meet certain criteria. If Maple Leaf Pensions can demonstrate that it is a qualifying pension fund under the U.S.-Canada income tax treaty, it may escape the branch profits tax altogether and be subject only to the 35% federal corporate income tax.
(iii) U.S. Tax Compliance.
Putting aside the rate differences, foreign investors frequently are loath to invest in a U.S. flow-through entity operating a U.S. trade or business, because it requires them to a file U.S. income tax return: U.S. Internal Revenue Service (IRS) Form 1120-F (U.S. Income Tax Return of a Foreign Corporation) or Form 1040-NR (U.S. Nonresident Alien Income Tax Return). As noted above, partnerships are tax conduits such that their income and loss “flow through” to the partners, and the partners must file U.S. income tax returns reporting this income. If the foreign partner would not otherwise be required to file a U.S. income tax return, the receipt of such “flow-through” income triggers this new obligation.
A U.S. flow-through entity, such as Coffee Fund LP, will have an obligation to periodically withhold and remit to the IRS an estimated tax with respect to each foreign investor, based on the investor’s distributable share of the fund’s taxable income and gain. Such withholdings are treated as actually having been distributed to the investors for purposes of the distribution waterfall. A foreign investor will be required to file an income tax return after the close of each year, where it reconciles the tax withheld with the actual tax liability for the year. U.S. income tax return filers, therefore, become subject to the investigatory and subpoena powers of the IRS.
In contrast, U.S. corporations are not flow-through entities and are responsible for filing their own U.S. income tax returns (IRS Form 1120, U.S. Income tax Return) and paying their own taxes. Dividends paid by a U.S. corporation to foreign investors, while taxable in the U.S., are handled through withholding at the source, so foreign investors do not need to file a U.S. income tax return to report dividend income to the U.S. tax authorities.
(iv) Sponsor’s Share of Fund’s Profits.
Generally, the carry or promote paid to the sponsor will be structured so that it is taxed in a manner that is similar to the way in which the investors who actually put up the cash are taxed on the distributions from the same investment. Currently taxation of “carried interests” has received significant negative publicity because of the lower tax rates it tends to generate, and there are ongoing discussions about different ways to change the law, so that it is taxed more like service income at higher tax rates.
B. Corporate Blocker.
Often U.S. tax-exempt investors or foreign investors (Maple Leaf and Bellini) will prefer to invest in a U.S. real estate fund through a “blocker” corporation, as shown below:
Chart 2: Delaware Limited Partnership Structure with a Corporate Blocker
The corporate blocker for a U.S. real estate fund typically is formed as a U.S. corporation, but there are many variations to this approach. A U.S. tax-exempt investor may use a corporate blocker if the investment strategy is likely to yield income and gain that is taxable as “unrelated business taxable income” (UBTI). UBTI is income that is generated in a manner and purpose inconsistent with the tax-exempt purpose of the investor, and is taxable at corporate tax rates. Generating UBTI can create perception issues and, in limited instances, result in tax penalties and/or the disqualification of tax-exempt status. For foreign investors, investing through a blocker also avoids their having to file a U.S. income tax return.
Thus, the foreign investors’ income from the Coffee Fund is “blocked” from direct U.S. income taxation and reported by the U.S. corporation (the “Coffee Fund Blocker”). Earnings distributed from Coffee Fund Blocker to Bellini and Maple Leaf are taxed again as a corporate dividend from a U.S. corporation to a foreign person. Interposing a corporate blocker may result in increased U.S. tax cost to foreign investors, depending on the facts and circumstances.
In our example, Bellini’s effective federal tax rate on ordinary income actually goes down slightly, from 39.6% to 38.25%, while his U.S. federal tax for long-term capital gain jumps from 23.8% to 38.25%. Since the Coffee Fund is counting on the economy of scale and better management fetching higher valuations (i.e., capital appreciation), Bellini’s U.S. federal tax cost could increase significantly if he invests through the Coffee Fund Blocker.
In addition, because of the compliance costs, such as annual separate accounting, tax, and registration costs, a corporate blocker is a high-maintenance proposition for some foreign investors. Bellini, being a man of numbers, decides that the Coffee Fund Blocker is not warranted, especially since Italy has a tax system comparable to that of the U.S., allowing a degree of tax credit for income tax paid overseas, defraying a significant portion of his U.S. tax cost.
Read Part Three on 3/28/2017.
 The term “C Corp” comes from the fact that, without a special entity tax classification election, it is taxed pursuant to Subchapter “C” of the Internal Revenue Code.
 Specifically, U.S. corporations are taxed at the entity level on their worldwide income, currently at rates as high as 35% at the federal level. After being taxed at the corporate level, corporate earnings are taxed again when distributed to shareholders as a dividend. Dividends from a C corp in the hands of an individual investor currently are taxed at rates as high as 20% at the federal level, and are subject to an additional 3.8% Medicare tax on net investment income (the NII tax) that exceeds an income threshold. This translates into a combined 50.47% effective tax rate at the federal level on the fund’s income.
 Forming a Delaware limited partnership requires filing a Certificate of Limited Partnership with the Delaware Division of Corporations in accordance with the Limited Partnership Act of the State of Delaware.
 In this hypothetical, Gatsby and Daisy are married.
 For a list of countries that have an income tax treaty with the U.S. see https://www.irs.gov/businesses/ international-businesses/united-states-income-tax-treaties-a-to-z.
 38.25% = 35% (corporate income tax) + (1-35%)*5% (branch profits tax)
Michael Bloom, email@example.com
Michael Bloom is counsel in Venable’s Tax and Wealth Planning Group, where he provides tax advice on all types of corporate transactions, such as mergers & acquisitions, restructurings, and venture capital investments. He is based in New York. In particular, Michael’s tax practice focuses on advising emerging fund managers on fund formation and portfolio acquisitions.
Sung H. Hwang firstname.lastname@example.org
Sung Hyun Hwang is a partner in Venable’s Tax and Wealth Planning practice, based in New York. He focuses on the full spectrum of business tax law, from complex structured financial products to multi-partner business joint ventures. Mr. Hwang has significant experience in domestic and cross-border transactions involving real estate partnerships and funds, private equity funds, hedge funds, asset managers, family offices, and financial institutions. Mr. Hwang also has significant experience in the tax credit space, including the energy-based tax credit area.
Venable (www.venable.com) has taken a two-pronged approach to building its global reach, one which delivers superior value, and maximizes the quality lawyering and client service that its clients expect. In many cases, it provides counsel directly to U.S. and foreign-based companies, institutions and individuals. Venable frequently deliver value to its clients in a number of very specialized areas where international recognition and scope are imperative. Examples include: FCPA; Tax; Privacy, Data Protection and Internet; International Trade; Intellectual Property; Advertising, Marketing and New Media.