Key US tax considerations when investing in or forming a fund
Authors
Investors and sponsors continue to pursue opportunities in the ever-growing private equity, venture capital, and hedge fund (each, a “Fund”) sectors. The complexity of the US federal income tax rules and regulations means that the tax treatment of these investments can significantly affect potential returns. This guide highlights several key US tax considerations that investors and sponsors should keep in mind when investing in or forming a Fund.
Types of investors and their sensitivities
The following are five general categories of investors that invest in Funds, each with distinct US tax sensitivities and structural preferences.
1. US taxable investors
These investors generally seek
- favourable tax characterization on Fund income (e.g., long-term capital gain rather than ordinary income);
- avoidance of adverse tax regimes that would not otherwise apply to them (e.g., controlled foreign corporation (CFC) or passive foreign investment company (PFIC) regimes); and
- minimization of corporate-level taxes and non-US taxes, and of resulting filing obligations.
2. Tax-exempt investors
Tax-exempt investors, such as certain pension funds and charitable organizations, are primarily focused on avoiding unrelated business taxable income (UBTI). UBTI can arise where
- income is attributable to a trade or business not substantially related to the tax-exempt entity’s charitable, educational, or other tax-exempt purpose, or
- the investment is in debt-financed property.
“Super” tax-exempt investors (e.g., state governmental agencies claiming an exemption under Section 115 of the Code) may be exempt from UBTI entirely.
3. Foreign investors
Foreign investors are generally focused on minimizing
- effectively connected income (ECI), which would require US tax filings and payment of US tax, and
- US withholding taxes on US-source payments that are not ECI.
These investors often rely on
- treaty benefits and
- statutory exemptions, such as
- the portfolio interest exemption and
- sourcing rules that treat capital gains from the sale of shares in entities treated as corporations that are not United States real property holding corporations (URPHCs) for US tax purposes as non-US source income, which is generally not subject to US tax.
4. Qualified foreign pension fund investors (QFPFs)
QFPFs have similar sensitivities to other foreign investors but are generally exempt from US tax on capital gains from investments in USRPHCs that would otherwise be taxable under FIRPTA.
5. Section 892 investors
Section 892 investors, such as sovereign wealth funds, are particularly sensitive to
- ECI and
- commercial activity income (CAI) that can jeopardize these investors’ ability to rely on the Section 892 exemption.
See our bulletins, IRS releases proposed and final regulations affecting foreign governments and IRS releases proposed regulations that provide clarification and transitional relief for proposed Section 892 regulations, for more discussion of the proposed and final regulations affecting foreign governments under Section 892 that were released in December 2025, with applicability date modifications released in June 2026.
Structural implications
Below are some structural considerations that Funds typically use to manage these differing investor sensitivities.
1. Use of blockers
Because investors have distinct sensitivities and preferences, sponsors often structure portfolio investments differently for each investor class. A common tool is to use a “Blocker” corporation (e.g., an entity treated as a corporation for US tax purposes) typically to shield Section 892, foreign and tax‑exempt investors from CAI, ECI and/or UBTI.
Example 1
A Canadian investor invests in a US Fund that makes minority equity investments in US operating companies that are structured as partnerships or LLCs treated as passthrough entities for US tax purposes.
To avoid potential CAI and ECI from the US portfolio investments flowing through to the Canadian investor, the Fund holds these equity investments through a corporate Blocker.
Results
- The Blocker pays US corporate tax on any ECI.
- The Canadian investor is “blocked” and therefore is not allocated CAI or ECI.
- The Canadian investor receives its share of dividend income from the Blocker and may qualify for reduced US withholding rates under the US–Canada treaty (or be eliminated under Section 892, if applicable).
If the Fund also intends to originate loans, which generally can give rise to CAI and ECI, the sponsor may use a separate corporate Blocker for the loan origination activity.
The formation of Blockers adds administrative and tax costs. As a result, US taxable investors—already subject to US tax—often prefer not to invest through Blockers to avoid the additional layer of corporate level income tax.
2. Master-feeder structures
In certain situations, sponsors may use a “master-feeder” structure. Under this structure,
- US taxable investors invest through a US partnership feeder,
- Section 892, foreign and tax-exempt investors invest through a Blocker (operating similarly to the Blocker described above), and
- both feeders invest into a single master fund that makes the portfolio investment.
This structure permits each investor to invest in a vehicle appropriate to its tax profile.
Example 2
A Canadian investor invests in a US Fund that plans to pursue an active lending strategy alongside its equity investments. Because Section 892, foreign and tax-exempt investors are sensitive to CAI, ECI, and UBTI that may arise from lending or other financing activity, the Fund forms a master-feeder structure rather than relying solely on deal-specific Blockers.
Structure
- US taxable investors invest through a US partnership feeder.
- Section 892, foreign and tax‑exempt investors invest through a Blocker feeder.
- Both feeders invest into a single master fund, which conducts all lending and investment activity.
Results
- The Blocker feeder blocks any CAI, ECI, or UBTI from flowing through to Section 892, foreign and tax-exempt investors.
- US taxable investors receive passthrough treatment through the US partnership feeder.
The master-feeder may be more appropriate in this case because the CAI, ECI, and UBTI risk presents throughout the Fund life on an ongoing basis rather than as an isolated occurrence, making the constant formation of deal-specific Blockers impractical or inefficient.
In some cases, more than one Blocker and master fund may be set up to accommodate the differing sensitivities of Section 892, foreign and tax-exempt investors.
3. Exit considerations for investments made through a blocker entity
Any time a Blocker entity is used for an investment, the exit mechanics for the investment should be considered.
In particular, the Fund and its investors should consider the benefits and burdens of selling shares of the Blocker versus selling the Blocker’s underlying assets (i.e., the portfolio investment’s assets).
- Sale of Blocker shares. A sale of Blocker shares generally results in capital gain to the Blocker’s investors. Because Blockers are typically used by non‑US investors, gain from the sale of Blocker shares generally is treated as non‑US source income and therefore is not subject to US tax for those investors, provided the Blocker is not a USRPHC. In addition, a share sale generally avoids asset‑level dispositions that could otherwise give rise to US tax, withholding, or filing obligations.
- Asset-level sale. By contrast, a sale of the Blocker’s underlying assets may result in US federal income tax at the Blocker level, including with respect to ECI (and if the Blocker is a non-US entity engaged in a US trade or business, a “branch tax” may also apply), and may also trigger applicable US state income tax obligations.
- Buyer preferences. Potential buyers may prefer an asset-level acquisition for tax basis step-up or other commercial reasons, which can limit exit flexibility where a Blocker structure is used, or may cause a Buyer to offer a lower price if the transaction is structured as an asset-level tax (the lower price resulting in what economists call an “implicit” tax).
Common Categories of CAI, ECI, and UBTI
The following are common categories of CAI, ECI, and UBTI that are often found in Funds.
1. Businesses organized as passthroughs for US tax purposes (e.g., partnerships or LLCs that are treated as transparent entities for US tax purposes)
Whenever a Fund makes an investment in an entity that is treated as transparent for US tax purposes, the activity of the underlying investment flows through the Fund to the underlying investors. Therefore, if the Fund makes an investment in a US operating partnership, its business activities may constitute CAI, ECI, and/or UBTI to the investors.
2. Transaction fees and break-up fees
Fees paid by portfolio companies to the Manager or to the Fund potentially generally generate CAI, ECI, and UBTI. Fund management fee offsets can therefore create US tax risk for investors sensitive to CAI, ECI, and UBTI.
3. Debt investments
Engaging in loan origination may constitute a US trade or business and/or commercial activity.
Season-and-sell strategy
Some credit-focused Funds mitigate loan origination–related CAI and ECI risk by originating loans in a separate entity (e.g., an Onshore Fund) that earns and retains the income associated with originating loans, then holds or “seasons” the loans for a period of time, and then sells the loans to the master fund, typically set up outside the United States (the Offshore Fund), at the loan’s then-fair market value (typically referred to as a “season-and-sell” strategy). The specific mechanics of this strategy are beyond the scope of this guide, but the general goal is to prevent the Offshore Fund from being engaged in a loan origination business (which may constitute CAI and/or ECI).
4. FIRPTA
For foreign investors, gain from the disposition of a US real property interest (USRPI) is treated as ECI under FIRPTA, regardless of whether the investor otherwise conducts a US trade or business. As noted above, QFPFs generally are exempt from taxation under FIRPTA.
Common FIRPTA triggers include
- sale of US real estate, and
- sale of interests in entities that are USRPHCs—generally entities a majority of whose assets comprise US real estate.
5. Debt-financed property
Tax-exempt investors may receive UBTI from income attributable to debt-financed property, including
- real estate investments financed with debt,
- private credit or other investments financed through subscription lines or other leverage, and
- other forms of acquisition indebtedness.
As noted above, the US federal income tax rules governing cross-border and multi-investor structures are highly complex. This guide only touches the surface of some of the many issues that investors and sponsors should keep in mind when investing in or forming a Fund. We would be happy to discuss the above and other considerations in further detail.
To discuss these issues, please contact the author(s).
This publication is a general discussion of certain legal and related developments and should not be relied upon as legal advice. If you require legal advice, we would be pleased to discuss the issues in this publication with you, in the context of your particular circumstances.
For permission to republish this or any other publication, contact Bryn Turnbull.
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