MEMORANDUM
PRIVILEGED AND CONFIDENTIAL — ATTORNEY-CLIENT COMMUNICATION / ATTORNEY WORK PRODUCT
FROM: Sylvia Hartwell, Specialist Partner, Tax — Calderwood & Harkness LLP
TO: Harrowgate Capital Partners LLC
Attn: Catherine E. Loomis, General Counsel & Chief Compliance Officer
Jonathan P. Birch, Partner, Head of Operations & Chief Financial Officer
DATE: April 21, 2025
RE: Tax Structuring Analysis — Harrowgate Private Equity Fund V LP and Related Vehicles
MATTER NO.: 1003-00002
CC: Graham Sutherland, Responsible Partner, Calderwood & Harkness LLP Stephen Adler, Lead Associate, Calderwood & Harkness LLP
Right-click to update Table of Contents
I. EXECUTIVE SUMMARY AND PURPOSE
The purpose of this memorandum is to provide a comprehensive federal, state, and international tax analysis of the proposed multi-vehicle fund structure for Harrowgate Private Equity Fund V LP (the "Fund" or "Fund V") and to set forth our recommendations regarding tax-optimized structuring for the benefit of the Sponsor and its anticipated investor base. This memorandum has been prepared at the request of Harrowgate Capital Partners LLC (the "Sponsor") and is intended to serve as the foundational tax structuring document in connection with the formation and offering of Fund V.
This memorandum addresses the tax implications for each vehicle within the proposed fund structure, as well as the tax treatment applicable to each category of anticipated investor, including domestic taxable investors, U.S. tax-exempt organizations (including private endowments and governmental pension plans), non-U.S. corporate investors, and foreign sovereign wealth funds. Based on this analysis, we recommend structural approaches designed to optimize after-tax returns for the Fund's limited partners ("LPs") while ensuring full compliance with applicable federal, state, and international tax laws and regulations.
Fund V Key Parameters. Fund V has a target fundraise of $2,000,000,000 (the "Hard Cap"), with a minimum First Close target of $750,000,000. The general partner commitment (the "GP Commitment") will be $50,000,000, representing 2.5% of committed capital at the Hard Cap, to be made by Harrowgate Fund V GP LLC (the "Fund V GP"), whose sole member is Harrowgate Capital Partners LLC. Carried interest will be set at 20% of net profits above an 8% preferred return (compounded annually), distributed pursuant to a European-style (whole-fund) waterfall with an 80/20 GP catch-up provision.
Investment Strategy. Fund V will pursue North American mid-market and upper-mid-market buyouts in four primary sectors: industrials, business services, healthcare services, and technology-enabled services. Individual equity checks are expected to range from $75,000,000 to $250,000,000 per transaction. The investment strategy involves the acquisition of controlling interests in portfolio companies, typically utilizing significant leverage at the portfolio company level in combination with equity capital provided by the Fund.
Multi-Vehicle Structure. As described in greater detail in Section II below, the proposed fund structure consists of five entities: (i) the Main Fund (Harrowgate Private Equity Fund V LP, a Delaware limited partnership), (ii) the Parallel Fund (Harrowgate Fund V Parallel LP, a Delaware limited partnership), (iii) the Offshore Feeder (Harrowgate Fund V Offshore SLP, a Cayman Islands exempted limited partnership), (iv) the blocker (HGF V blocker Corp., a Delaware C corporation), and (v) the GP entity (Harrowgate Fund V GP LLC, a Delaware limited liability company). This multi-vehicle structure is designed to accommodate the distinct tax, regulatory, and structural requirements of the Fund's diverse anticipated investor base.
The balance of this memorandum is organized as follows: Section II provides an overview of the fund structure and investor classification; Section III analyzes partnership tax classification under IRC Subchapter K; Section IV addresses UBTI considerations for tax-exempt limited partners; Section V discusses ECI and FIRPTA considerations for non-U.S. investors; Section VI covers Section 1061 carried interest recharacterization issues; Section VII addresses Cayman Islands tax neutrality for the Offshore Feeder; Section VIII surveys applicable state and local tax considerations; Section IX outlines tax reporting and compliance obligations; and Section X sets forth our structural recommendations, open issues, and proposed timeline.
II. OVERVIEW OF FUND STRUCTURE
A. Description of Each Entity
The proposed Fund V structure comprises five distinct legal entities, each serving a specific function within the overall fund architecture. The relationship among these entities is designed to provide maximum flexibility in accommodating diverse investor types while maintaining operational efficiency and investment parity across all vehicles. Each entity is described below.
1. Harrowgate Private Equity Fund V LP (the "Main Fund"). The Main Fund is a Delaware limited partnership organized under the Delaware Revised Uniform Limited Partnership Act (6 Del. C. § 17-101 et seq.). It will serve as the primary investment vehicle for Fund V and will accept capital commitments from most domestic taxable limited partners. The Main Fund's general partner will be Harrowgate Fund V GP LLC, and the limited partners will consist of those investors for whom direct investment in a U.S. partnership is the most tax-efficient structure. The Main Fund will directly acquire and hold interests in portfolio companies, either through equity investments, debt instruments, or a combination thereof. All investment decisions will be made by the general partner, acting through the investment committee of Harrowgate Capital Partners LLC.
2. Harrowgate Fund V GP LLC (the "Fund V GP"). The Fund V GP is a Delaware limited liability company that will serve as the sole general partner of both the Main Fund and the Parallel Fund. The sole member of the Fund V GP is Harrowgate Capital Partners LLC. The Fund V GP will receive allocations of carried interest equal to 20% of the net profits of each fund vehicle (above the 8% preferred return), and will contribute the GP Commitment of $50,000,000 to the Fund. As a single-member LLC, the Fund V GP will be treated as a disregarded entity for federal income tax purposes, as discussed in Section III.B below.
3. Harrowgate Fund V Parallel LP (the "Parallel Fund"). The Parallel Fund is a Delaware limited partnership that will invest alongside the Main Fund on a pro rata basis in each portfolio investment. The Parallel Fund is designed principally for certain tax-exempt and non-U.S. limited partners that require structural separation from the Main Fund for tax, regulatory, or institutional reasons. The Parallel Fund will have the same general partner (Fund V GP) and will be subject to the same investment terms, fee structure, and waterfall provisions as the Main Fund. The Parallel Fund's limited partnership agreement will mirror the Main Fund's LPA in all material respects, subject to such modifications as are necessary to accommodate the specific needs of its investor base.
4. Harrowgate Fund V Offshore SLP (the "Offshore Feeder"). The Offshore Feeder is a Cayman Islands exempted limited partnership organized under the Exempted Limited Partnership Act (as revised) of the Cayman Islands. It will serve as the offshore feeder vehicle for non-U.S. investors that prefer to invest through a Cayman-domiciled entity for regulatory, tax, or institutional reasons. The Offshore Feeder will be registered with the Cayman Islands Monetary Authority ("CIMA") as a regulated mutual fund under the Mutual Funds Act (as revised). The Offshore Feeder will invest alongside the Main Fund and the Parallel Fund on a pro rata basis, either by investing directly in portfolio companies or by acquiring a limited partnership interest in the Main Fund or the Parallel Fund, as the Sponsor determines to be most efficient from a structural and tax perspective.
5. HGF V blocker Corp. (the "Blocker"). The blocker is a Delaware C corporation that will serve as a single-purpose entity interposed between the Fund and certain tax-exempt investors to mitigate unrelated business taxable income ("UBTI") exposure. The blocker will hold a limited partnership interest in the Main Fund or the Parallel Fund (as determined by the Sponsor) and will be subject to federal corporate income tax on its allocable share of fund income. Distributions from the blocker to its tax-exempt shareholders will be treated as dividends, which are generally excluded from UBTI under IRC § 512(b)(1). The blocker structure is described in greater detail in Sections IV.D.1 and IV.E below.
B. Investor Classification and Vehicle Assignment
The following is a summary of the anticipated principal investors in Fund V and the recommended vehicle through which each investor should invest, based on the tax analysis set forth in this memorandum. This assignment is preliminary and subject to revision based on further diligence, investor preferences, and advice from each investor's independent tax counsel.
Domestic Taxable Investors — Main Fund. Domestic taxable investors, including high-net-worth individuals, family offices, and taxable funds of funds, will generally invest directly in the Main Fund. The pass-through partnership structure of the Main Fund is tax-efficient for these investors because it avoids entity-level taxation and permits the flow-through of capital gains, ordinary income, deductions, and credits to each LP's individual or entity-level tax return. Representative anticipated domestic taxable investors include:
• Velthorn Family Office LLC — anticipated commitment of $50,000,000. Velthorn is a single-family office organized as a Delaware LLC and taxed as a partnership. The flow-through of Fund V income and loss to Velthorn's principals is the most tax-efficient structure.
• Stonewall Partners Fund of Funds III LP — anticipated commitment of $75,000,000. Stonewall is a Delaware limited partnership that invests in private equity and venture capital funds on behalf of its own limited partners. As a pass-through entity, Stonewall benefits from the Main Fund's partnership classification and will issue its own Schedule K-1s to its underlying investors reflecting their allocable share of Fund V income.
U.S. Tax-Exempt Investors — Blocker or Parallel Fund. U.S. tax-exempt investors are subject to special considerations related to UBTI, as discussed in detail in Section IV. The recommended vehicle for each tax-exempt investor depends on the nature of the investor's tax-exempt status and the degree of UBTI exposure that the investor is willing to tolerate.
• The Kingsbridge Endowment Fund — anticipated commitment of $100,000,000. Kingsbridge is a 501(c)(3) university endowment with approximately $18.5 billion in assets under management. Given the potential for UBTI exposure from debt-financed income and pass-through operating income, we recommend that Kingsbridge invest through HGF V blocker Corp. or, alternatively, through the Parallel Fund with contractual excuse rights for UBTI-generating investments. The analysis of these alternatives is set forth in Section IV.D.1 below.
• Northmoor State Pension System — anticipated commitment of $200,000,000 (anchor LP). Northmoor is a state governmental pension plan with approximately $42 billion in assets under management. Governmental plans are subject to UBTI but may benefit from the exclusion for certain debt-financed income under IRC § 514(c)(9)(C). Depending on the results of the analysis set forth in Section IV.D.2, Northmoor may invest directly in the Main Fund or the Parallel Fund.
Non-U.S. Investors — Main Fund or Offshore Feeder. Non-U.S. investors are subject to U.S. taxation on effectively connected income ("ECI") and on gains from the disposition of U.S. real property interests under FIRPTA. The recommended vehicle for each non-U.S. investor depends on the investor's domicile, tax status, and the applicability of any income tax treaty or statutory exemption.
• Edgecombe Insurance Group Ltd. — anticipated commitment of $150,000,000. Edgecombe is a Bermuda-domiciled insurance holding company with approximately $27 billion in general account assets under management. Given the absence of a U.S.-Bermuda income tax treaty and the potential for ECI and FIRPTA exposure, Edgecombe is currently expected to invest via the Main Fund, with careful monitoring of ECI and FIRPTA risk on a deal-by-deal basis. The analysis of Edgecombe's specific situation is set forth in Section V.C.1 below.
• Tidewater Sovereign Investment Authority — anticipated commitment of $175,000,000. Tidewater is a foreign sovereign wealth fund with approximately $180 billion in assets under management. Tidewater will invest via the Offshore Feeder (Harrowgate Fund V Offshore SLP), and we will rely on the sovereign immunity provisions of IRC § 892 to exempt Tidewater's investment income from U.S. tax, subject to the limitations discussed in Section V.C.2 below.
Diagram Reference. An organizational chart depicting the flow of capital contributions and investment returns through each vehicle in the Fund V structure is being prepared by Stephen Adler and will be appended to this memorandum as Exhibit A upon completion. The chart will illustrate the relationships among the Main Fund, Parallel Fund, Offshore Feeder, blocker, and Fund V GP, as well as the flow of investments into portfolio companies and the return of proceeds to each category of investor.
C. Parallel Investment Mechanics
All investments will be allocated on a pro rata basis across the Main Fund, the Parallel Fund, and the Offshore Feeder based on each vehicle's share of the aggregate committed capital. Aggregate commitments across all vehicles will be treated as a single pool for purposes of the portfolio concentration limit, which is set at 20% of aggregate commitments (i.e., a maximum single-deal equity investment of $400,000,000 at the Hard Cap).
Each vehicle will participate in every portfolio investment on the same terms and at the same price, subject to such adjustments as may be necessary to accommodate the tax, regulatory, or structural requirements of specific investors (e.g., excuse rights granted in side letters). Co-investment opportunities, where additional capital is deployed alongside the Fund in specific transactions, will be coordinated at the Sponsor level by the investment committee of Harrowgate Capital Partners LLC, and co-investment allocations will be governed by the Sponsor's co-investment allocation policy, which is being developed separately.
The Parallel Fund and the Offshore Feeder will be managed by the same investment professionals and will be subject to the same investment strategy, risk parameters, and governance structure as the Main Fund. The parallel investment mechanic ensures that all investors across all vehicles receive substantially identical economic exposure to the Fund's portfolio, irrespective of the vehicle through which they invest.
III. PARTNERSHIP TAX CLASSIFICATION UNDER IRC SUBCHAPTER K
A. Check-the-box Classification — Main Fund and Parallel Fund
Under the Treasury Regulations governing entity classification (commonly referred to as the "check-the-box" regulations), an entity's classification for federal income tax purposes is determined based on the entity's organizational form and, in certain cases, an affirmative election by the entity. Treasury Regulation § 301.7701-3 provides that an eligible entity (i.e., an entity that is not a "per se" corporation listed in Treas. Reg. § 301.7701-2(b)) with two or more members is classified as a partnership by default, unless the entity elects to be treated as an association taxable as a corporation by filing IRS Form 8832.
Both the Main Fund (Harrowgate Private Equity Fund V LP) and the Parallel Fund (Harrowgate Fund V Parallel LP) are organized as Delaware limited partnerships. A Delaware limited partnership is not listed as a per se corporation under Treas. Reg. § 301.7701-2(b), and is therefore an "eligible entity" within the meaning of the check-the-box regulations. Each entity will have two or more members (a general partner and one or more limited partners), and therefore each is classified as a partnership for federal income tax purposes by default under Treas. Reg. § 301.7701-3(b)(1)(i).
No entity classification election on IRS Form 8832 is required or recommended for either the Main Fund or the Parallel Fund. The default classification as a partnership is appropriate and consistent with the intended tax treatment of these vehicles as transparent pass-through entities under IRC Subchapter K (IRC §§ 701–761). As partnerships, neither the Main Fund nor the Parallel Fund will be subject to entity-level federal income tax. Instead, each item of income, gain, loss, deduction, and credit will be allocated to the partners in accordance with the limited partnership agreement and the provisions of IRC § 704, and each partner will include its allocable share of such items on its own federal income tax return.
Conclusion. Both the Main Fund and the Parallel Fund will be treated as transparent pass-through entities under IRC Subchapter K for federal income tax purposes. No filing or election is necessary to achieve this classification.
B. Check-the-box Classification — Harrowgate Fund V GP LLC
Harrowgate Fund V GP LLC is organized as a Delaware limited liability company with a single member, Harrowgate Capital Partners LLC. Under Treas. Reg. § 301.7701-3(b)(1)(ii), a domestic eligible entity with a single owner is classified as a disregarded entity by default, unless the entity affirmatively elects to be treated as an association taxable as a corporation by filing Form 8832.
We do not recommend filing a Form 8832 election for the Fund V GP. As a disregarded entity, the Fund V GP's activities, assets, and liabilities will be treated as those of its sole member, Harrowgate Capital Partners LLC, for federal income tax purposes. This means that, for purposes of the GP's carried interest allocation, income attributable to the carried interest will flow through the Fund V GP to Harrowgate Capital Partners LLC, and ultimately to the individual principals of the Sponsor: Marcus J. Harrowgate (Founder, Managing Partner & Chief Investment Officer), Diana R. Castellano (Partner, Co-Head of Investments), and Jonathan P. Birch (Partner, Head of Operations & Chief Financial Officer). The specific allocation of carried interest among these individuals will be governed by the operating agreement of Harrowgate Capital Partners LLC and any applicable carried interest allocation agreements.
The disregarded entity treatment is consistent with standard practice for general partner entities in private equity fund structures and ensures a single layer of pass-through taxation on carried interest and GP capital interest returns.
C. Check-the-box Classification — Offshore Feeder
The Offshore Feeder, Harrowgate Fund V Offshore SLP, is organized as a Cayman Islands exempted limited partnership under the Exempted Limited Partnership Act (as revised) of the Cayman Islands. For purposes of U.S. federal income tax classification, the Offshore Feeder is a foreign eligible entity under the check-the-box regulations. Under Treas. Reg. § 301.7701-3(b)(2)(i), a foreign eligible entity with two or more members is classified as a partnership by default if at least one member has unlimited liability, or as an association (taxable as a corporation) if all members have limited liability. In a Cayman Islands exempted limited partnership, the general partner has unlimited liability, and therefore the default classification is partnership.
Recommendation. We recommend that the Offshore Feeder be classified as a partnership for U.S. tax purposes. The default classification should apply without the need for an affirmative Form 8832 election, provided that the entity has two or more members and a general partner with unlimited liability. However, we recommend confirming the Offshore Feeder's classification with Cayman counsel to ensure that the structure of the entity under Cayman law is consistent with the intended U.S. tax classification.
Alternatively, if the Offshore Feeder invests through the Main Fund or the Parallel Fund (i.e., the Offshore Feeder acquires a limited partnership interest in one of the domestic vehicles rather than investing directly in portfolio companies), it will function as a pass-through conduit between its non-U.S. investors and the domestic fund vehicle. In this scenario, the partnership classification of the Offshore Feeder ensures that U.S. tax obligations of the non-U.S. investors are determined at the investor level, based on the nature and source of the income flowing through the structure. Structural flexibility is preserved in either case.
D. Blocker Entity — Corporate Classification
HGF V blocker Corp. is organized as a Delaware C corporation. As a corporation organized under the laws of a U.S. state, it is classified as a per se corporation under Treas. Reg. § 301.7701-2(b)(1), and no entity classification election is available. The blocker will be subject to federal corporate income tax at the rate of 21% under IRC § 11, as enacted by the Tax Cuts and Jobs Act of 2017.
The use of a blocker corporation involves an inherent trade-off between corporate-level taxation and UBTI exposure for tax-exempt investors. On one hand, the blocker is subject to a 21% federal corporate income tax on its allocable share of Fund income, which reduces the after-tax return available for distribution to its shareholders. On the other hand, the blocker prevents UBTI from flowing through to tax-exempt shareholders, because distributions from the blocker to its shareholders are treated as dividends (to the extent of the blocker's earnings and profits), and dividends are generally excluded from UBTI under IRC § 512(b)(1).
In addition, there is a potential for double taxation on distributions: the blocker pays corporate-level tax on its income, and its shareholders may be subject to an additional layer of tax on dividends received. However, for tax-exempt shareholders, the dividends received are not subject to tax (because the shareholders are tax-exempt and the dividends are excluded from UBTI), so the double-taxation concern is limited to the single corporate-level tax.
Net Benefit Analysis. The net benefit of the blocker structure for a tax-exempt investor depends on the proportion of Fund income that would otherwise constitute UBTI. If a significant portion of Fund income is UBTI (e.g., because of debt-financed income or pass-through operating income from portfolio companies organized as partnerships), the 21% corporate tax rate may be more favorable than the UBTI tax rate, which for most tax-exempt organizations is the applicable rate for trusts (currently up to 37% for ordinary income, plus the 3.8% net investment income tax in certain circumstances). The specific analysis for each tax-exempt investor is set forth in Section IV below.
E. Anti-Abuse and Substantial Economic Effect
The limited partnership agreement ("LPA") for each of the Main Fund and the Parallel Fund must include allocation provisions that satisfy the substantial economic effect safe harbor under IRC § 704(b) and Treasury Regulation § 1.704-1(b)(2). Under these rules, allocations of income, gain, loss, and deduction among the partners will be respected for federal income tax purposes if the allocations have "substantial economic effect" or, alternatively, are "in accordance with the partners' interests in the partnership."
The substantial economic effect safe harbor under Treas. Reg. § 1.704-1(b)(2)(ii) requires that the partnership agreement provide for:
(a) the maintenance of capital accounts in accordance with the rules of Treas. Reg. § 1.704-1(b)(2)(iv);
(b) upon liquidation of the partnership (or a partner's interest in the partnership), liquidating distributions to be made in accordance with the partners' positive capital account balances; and
(c) a deficit restoration obligation for any partner with a deficit capital account balance after liquidation, or, alternatively, a "qualified income offset" provision as described in Treas. Reg. § 1.704-1(b)(2)(ii)(d).
We recommend that the LPA include each of these provisions to satisfy the safe harbor. Capital accounts should be maintained in strict accordance with the Treasury Regulations, reflecting capital contributions, allocations of income and loss, and distributions. Liquidating distributions should be made in accordance with positive capital account balances, and the LPA should include a qualified income offset provision (rather than a full deficit restoration obligation for limited partners, as limited partners customarily do not undertake unlimited deficit restoration obligations).
Special Allocations — Carried Interest. The allocation of carried interest to the Fund V GP (and, through it, to the principals of the Sponsor) constitutes a special allocation that must either have economic effect under the substantial economic effect safe harbor or be in accordance with the partners' interests in the partnership. The European-style whole-fund waterfall presents specific complexities in this regard, because carried interest allocations and distributions are deferred until all contributed capital and the preferred return have been returned to LPs across the entire fund. This deferral means that the timing of income allocations to the GP may differ from the timing of actual distributions, and the LPA must carefully coordinate the allocation provisions with the waterfall mechanics to ensure compliance with § 704(b).
Specifically, the LPA should provide for annual allocations of income and gain to the GP in a manner that is consistent with the economic arrangement reflected in the waterfall. This may require the use of "target allocation" provisions (sometimes referred to as "targeted capital account" or "layer cake" allocations), which allocate income in a manner designed to bring each partner's capital account balance into alignment with the amount that would be distributed to such partner if the Fund were liquidated at the end of each fiscal year at then-current values. This approach is widely used in private equity fund LPAs and, when properly drafted, satisfies the requirements of Treas. Reg. § 1.704-1(b)(2)(ii) or, alternatively, is respected as being in accordance with the partners' interests in the partnership under Treas. Reg. § 1.704-1(b)(3).
We will work with the LPA drafting team to ensure that the allocation provisions are structured to meet these requirements and will review the specific waterfall mechanics in the context of the § 704(b) analysis.
F. IRC § 704(c) — Contributed Property
IRC § 704(c) requires that, when a partner contributes property with a built-in gain or loss to a partnership, the partnership must allocate income, gain, loss, and deduction with respect to such property so as to take into account the variation between the property's adjusted tax basis and its fair market value at the time of contribution. The purpose of this rule is to prevent the shifting of pre-contribution gains or losses among partners.
At formation, the § 704(c) rules are of minimal concern for Fund V because all contributions by limited partners and the GP will be in cash, and there will be no disparity between the tax basis and fair market value of contributed assets. However, § 704(c) may become relevant in the following situations:
(a) If a portfolio company contributes appreciated property to the Fund or to an entity in which the Fund holds an interest, and the contribution is structured as a partnership transaction;
(b) If LP interests are transferred on the secondary market at a time when the Fund's assets have appreciated or depreciated relative to their tax basis, and the partnership makes an election under IRC § 754 to adjust the basis of partnership assets; or
(c) If the Fund receives in-kind distributions of appreciated or depreciated property from portfolio companies.
For any future in-kind contributions or § 754 adjustments, we recommend that the LPA specify the use of the traditional method or the remedial allocation method under Treas. Reg. § 1.704-3. The remedial allocation method provides greater flexibility and more accurately eliminates disparities between tax and book allocations, although it creates "phantom" income for certain partners. The choice between methods should be made in consultation with the Fund's tax return preparer and auditor.
IV. UBTI CONSIDERATIONS FOR TAX-EXEMPT LIMITED PARTNERS
A. Overview of UBTI Framework
IRC §§ 511–514 impose a tax on the unrelated business taxable income ("UBTI") of tax-exempt organizations described in IRC § 501(c), as well as certain other tax-exempt entities, including state and local governmental plans under IRC § 511(a)(2)(B). The purpose of the UBTI tax is to prevent tax-exempt organizations from using their tax-exempt status to gain an unfair competitive advantage over taxable entities in the conduct of commercial activities.
UBTI is defined generally as the gross income derived from any unrelated trade or business regularly carried on by the exempt organization, less allowable deductions directly connected with such trade or business. An "unrelated trade or business" is any trade or business the conduct of which is not substantially related (aside from the need for income) to the organization's exercise or performance of its tax-exempt purpose or function (IRC § 513(a)).
In the context of private equity fund investments, the principal sources of UBTI are:
(i) Operating business income allocated from portfolio companies organized as pass-through entities (partnerships or LLCs taxed as partnerships), where the operating income of the portfolio company is treated as income from a trade or business regularly carried on by the tax-exempt partner;
(ii) Debt-financed income under IRC § 514, which treats a proportionate share of income from "debt-financed property" as UBTI, regardless of whether the underlying activity is related to the organization's exempt purpose; and
(iii) In limited circumstances, fees or other income that do not qualify for the exclusions from UBTI provided in IRC § 512(b) (e.g., interest, dividends, royalties, rents, and capital gains are generally excluded from UBTI, but only to the extent not derived from debt-financed property or an unrelated trade or business).
The following subsections address each of these sources of UBTI in the context of Fund V's investment strategy and structure.
B. Debt-Financed Income — IRC § 514
IRC § 514 provides that, to the extent a tax-exempt organization (or a partnership in which it is a partner) holds "debt-financed property," a proportionate share of the income from such property is treated as UBTI. "Debt-financed property" is any property held to produce income with respect to which there is "acquisition indebtedness" at any time during the taxable year (IRC § 514(b)(1)). "Acquisition indebtedness" is the unpaid amount of indebtedness incurred in acquiring or improving the property, or indebtedness that would not have been incurred but for the acquisition of the property (IRC § 514(c)(1)).
In the context of Fund V, debt-financed income may arise from two principal sources:
Portfolio Company Leverage. Fund V's buyout strategy involves the acquisition of portfolio companies using significant leverage at the portfolio company level. If a portfolio company is organized as a pass-through entity (a partnership or LLC taxed as a partnership), the debt incurred by the portfolio company to finance the acquisition constitutes acquisition indebtedness. A proportionate share of the income from the debt-financed property (i.e., the assets acquired with the debt proceeds) is treated as UBTI for any tax-exempt partner of the Fund. This is a well-recognized source of UBTI in leveraged buyout fund structures.
The principal mitigation for this risk is the organization of portfolio companies as C corporations (opaque for tax purposes), which prevents the pass-through of income and debt to the Fund level. As discussed in Section IV.C below, Fund V's investment strategy typically involves the acquisition of C corporations or the conversion of acquisition targets to corporate form, which substantially eliminates this source of UBTI.
Subscription Credit Facility. The Fund intends to establish a subscription credit facility with Ashford National Bank, N.A. (the "Subscription Facility"), with a maximum borrowing capacity of up to $500,000,000, subject to a fund-level leverage limit of 25% of uncalled commitments. The Subscription Facility will be used for bridge financing of capital calls and short-term working capital purposes, with bridge financing limited to 180 days under the terms of the credit agreement.
Short-term subscription line borrowings generally should not create acquisition indebtedness under IRC § 514 if the borrowings are used to bridge capital calls (i.e., to fund investments temporarily pending the receipt of capital contributions from LPs) and are repaid within a reasonable period. The IRS has not issued definitive guidance on the treatment of subscription credit facilities under the UBTI rules, but the prevailing view among tax practitioners is that borrowings used solely to bridge the timing gap between investment and capital call, and repaid promptly from capital contributions, do not constitute acquisition indebtedness because the property is not acquired "with" the borrowed funds in the relevant sense — the funds are a temporary bridge, and the property is ultimately acquired with contributed capital.
However, to minimize the risk of an adverse characterization, we recommend that the Fund establish a policy of repaying Subscription Facility borrowings within 90 days of drawdown. This 90-day target is more conservative than the 180-day contractual limit and provides a substantial margin of safety against the argument that the borrowings constitute acquisition indebtedness. The LPA should include provisions requiring the GP to use commercially reasonable efforts to repay Subscription Facility borrowings within this timeframe, subject to appropriate carve-outs for extenuating circumstances.
C. Operating Business Income
If portfolio companies are organized as partnerships or LLCs taxed as partnerships (pass-through entities), the operating income of those companies is allocated through the Fund to each limited partner, including tax-exempt LPs. Operating income from a trade or business regularly carried on by a portfolio company would constitute UBTI for a tax-exempt LP, regardless of whether the LP is involved in the management of the portfolio company.
The typical mitigation for this risk in private equity fund structures is the organization of portfolio companies as C corporations. When a portfolio company is organized as a C corporation, its operating income is taxed at the corporate level and is not passed through to the Fund or its limited partners. Distributions from the portfolio company to the Fund are treated as dividends (to the extent of earnings and profits) or as capital gains (upon disposition of the investment), and both dividends and capital gains are generally excluded from UBTI under IRC § 512(b)(1) and (5).
Fund V's investment strategy involves buyout transactions in industrials, business services, healthcare services, and technology-enabled services. These sectors typically involve the acquisition of established operating companies that are already organized as C corporations, or the conversion of acquisition targets to corporate form as part of the transaction structure. As a result, the risk of UBTI from operating business income should be limited in practice. Nevertheless, we recommend that the LPA include provisions requiring the GP to organize (or cause to be organized) all portfolio companies as C corporations to the greatest extent practicable, consistent with the investment strategy and operational requirements of each portfolio company. This recommendation is reflected in the action items set forth in Section X.A below.
D. Application to Specific Tax-Exempt Investors
1. The Kingsbridge Endowment Fund
The Kingsbridge Endowment Fund ("Kingsbridge") is a 501(c)(3) university endowment with approximately $18.5 billion in assets under management. Kingsbridge's anticipated commitment to Fund V is $100,000,000. As a 501(c)(3) organization, Kingsbridge is subject to the tax on UBTI under IRC § 511(a)(1).
UBTI Risk Assessment. Kingsbridge's UBTI exposure from Fund V arises principally from two sources: (i) debt-financed income under IRC § 514 (if any portfolio company is a pass-through entity or if the Subscription Facility creates acquisition indebtedness), and (ii) operating business income allocated from pass-through portfolio companies. Although the Fund's investment strategy mitigates these risks (as described in Sections IV.B and IV.C above), the potential for UBTI cannot be entirely eliminated. For example, the Fund may occasionally acquire a portfolio company organized as a pass-through entity if the operational or strategic circumstances warrant such a structure, or the Subscription Facility may be used in a manner that creates acquisition indebtedness.
Recommended Structure — Blocker. To provide comprehensive protection against UBTI, we recommend that Kingsbridge invest through HGF V blocker Corp. (the "Blocker"), the Delaware C corporation described in Section II.A.5 above. The blocker structure operates as follows:
(a) The blocker holds a limited partnership interest in the Main Fund or the Parallel Fund.
(b) The Fund's income (including any income that would constitute UBTI if received directly by Kingsbridge) is allocated to the blocker, which is subject to federal corporate income tax at 21% under IRC § 11.
(c) After payment of corporate-level tax, the blocker distributes its remaining income to its shareholders (including Kingsbridge) as dividends. Dividends are excluded from UBTI under IRC § 512(b)(1).
(d) The corporate-level tax effectively eliminates UBTI for Kingsbridge, but at the cost of a 21% tax on the blocker's allocable share of Fund income. This is a "tax leakage" that reduces Kingsbridge's after-tax return relative to a direct investment in a fund with no UBTI exposure.
Trade-Off Analysis. The trade-off between the 21% corporate tax imposed on the blocker and the potential UBTI tax that Kingsbridge would face on a direct investment depends on the proportion of Fund income that would otherwise constitute UBTI. If UBTI represents a significant portion of Kingsbridge's allocable share of Fund income, the 21% corporate rate may be more favorable than the applicable UBTI rate (which, for a trust-taxed tax-exempt organization, could be as high as 37% for ordinary income, plus the 3.8% net investment income tax under IRC § 1411). Conversely, if little or no Fund income would constitute UBTI, the corporate-level tax represents a pure cost with no offsetting benefit.
Based on our review of the Fund's investment strategy and the expectation that portfolio companies will generally be organized as C corporations, we believe that the UBTI risk is relatively low. However, the blocker provides a "belt and suspenders" approach that eliminates uncertainty and simplifies Kingsbridge's tax reporting. We recommend preparing an illustrative tax cost analysis for Kingsbridge's review, comparing the after-tax returns under the blocker structure with those under a direct investment, under various assumptions about the proportion of Fund income that constitutes UBTI. This analysis is identified as an open item in Section X.B below.
Alternative — Parallel Fund with Excuse Rights. As an alternative to the blocker, Kingsbridge could invest through the Parallel Fund with contractual excuse rights for UBTI-generating investments, to be negotiated in a side letter between Kingsbridge and the Fund. Under this approach, Kingsbridge would invest directly in the Parallel Fund (a partnership) and would receive pass-through treatment on its allocable share of Fund income. However, Kingsbridge would have the right to decline to participate in (or "excuse" itself from) specific investments that would generate UBTI. This approach avoids the 21% corporate-level tax but introduces operational complexity (selective participation) and may raise allocation issues under IRC § 704(b), as discussed further in Section X.B.
Kingsbridge's Outside Counsel. Kingsbridge is represented by Pelham Chambers LLP (Andrew K. Leverett, Partner). We will coordinate with Mr. Leverett regarding Kingsbridge's investment route and any additional tax analysis that Kingsbridge may require.
2. Northmoor State Pension System
The Northmoor State Pension System ("Northmoor") is a state governmental pension plan with approximately $42 billion in assets under management. Northmoor's anticipated commitment to Fund V is $200,000,000, making it the anchor LP. As a state governmental plan, Northmoor is subject to UBTI under IRC § 511(a)(2)(B), but the scope of its UBTI exposure is narrower than that of private foundations and university endowments in certain important respects.
Governmental Plan Exclusion — IRC § 514(c)(9). IRC § 514(c)(9) provides a qualified organization exception from the debt-financed income rules for certain types of tax-exempt organizations, including educational institutions described in IRC § 170(b)(1)(A)(ii) and their affiliated supporting organizations, and, importantly, certain qualified trusts under IRC § 401(a). The application of this exception to state governmental plans requires careful analysis.
Under IRC § 514(c)(9)(C), the exclusion from the debt-financed income rules for qualified organizations is subject to the "fractions rule," which limits the ability of the partnership to use debt to allocate disproportionate income to tax-exempt partners. However, the fractions rule does not apply to governmental plans in all circumstances, and the scope of the exemption depends on the specific type of plan and the structure of the partnership investment. The interaction of § 514(c)(9) with state governmental plans that are not described in § 401(a) (because they are not qualified trusts but rather governmental entities) introduces additional complexity.
Recommendation. Based on our preliminary analysis, Northmoor, as a governmental plan, may benefit from a broader exclusion from the debt-financed income rules than is available to private endowments such as Kingsbridge. Specifically, if Northmoor qualifies as a "qualified organization" under § 514(c)(9)(B), the debt-financed income rules may not apply to Northmoor's allocable share of income from the Fund, provided the fractions rule is satisfied (or the fractions rule is inapplicable to Northmoor's type of plan). This analysis is ongoing and requires further factual development regarding Northmoor's legal status under state law and its qualification under the applicable provisions of the Code.
Subject to confirmation of this analysis, we recommend that Northmoor invest directly in the Main Fund, which avoids the 21% corporate-level tax leakage associated with the blocker structure and provides Northmoor with full pass-through treatment on its allocable share of Fund income. If the § 514(c)(9) analysis does not support direct investment, or if Northmoor desires additional protection against UBTI, Northmoor may invest through the Parallel Fund or a partial blocker structure (in which a portion of Northmoor's commitment is invested through the blocker and the remainder is invested directly).
Northmoor's Outside Counsel. Northmoor is represented by Aldworth & McBride LLP (Margaret S. Quinlan, Partner). We will coordinate with Ms. Quinlan to confirm Northmoor's governmental plan status and to complete the § 514(c)(9) analysis.
E. Blocker Entity — Detailed Tax Analysis
The following is a more detailed analysis of the tax treatment of HGF V blocker Corp. for the benefit of the Sponsor and the tax-exempt investors who may utilize the blocker structure.
Corporate Income Tax. The blocker will hold a limited partnership interest in the Main Fund or the Parallel Fund. As a partner in the Fund, the blocker will be allocated its share of Fund income, gain, loss, deduction, and credit under the LPA and IRC § 704. The blocker will be subject to federal corporate income tax at the rate of 21% under IRC § 11 on its taxable income, computed after all allowable deductions (including its allocable share of Fund-level deductions for management fees, organizational expenses, and other fund-level costs).
Tax Return Filing. The blocker will file IRS Form 1120 (U.S. Corporation Income Tax Return) annually, reporting its taxable income and computing its federal income tax liability. The blocker's taxable year will be the calendar year, consistent with the Fund's taxable year.
Distributions to Tax-Exempt Shareholders. Distributions from the blocker to its shareholders will be treated as follows:
(a) To the extent the blocker has current or accumulated earnings and profits ("E&P"), distributions to shareholders are treated as dividends under IRC § 301(c)(1). For tax-exempt shareholders, dividends are generally excluded from UBTI under IRC § 512(b)(1), which provides that dividends are not included in UBTI (with certain exceptions for debt-financed income and controlled entity payments, which are not applicable here).
(b) To the extent distributions exceed E&P, they are treated as a return of capital under IRC § 301(c)(2), reducing the shareholder's basis in its blocker stock. Return-of-capital distributions are not taxable (and not UBTI) to the extent of the shareholder's basis.
(c) To the extent distributions exceed both E&P and basis, they are treated as gain from the sale or exchange of the blocker stock under IRC § 301(c)(3). For tax-exempt shareholders, capital gains from the sale of stock are generally excluded from UBTI under IRC § 512(b)(5).
Liquidation. Upon the termination and winding up of the Fund, the blocker will be liquidated. The blocker will recognize gain or loss on the deemed or actual sale of its assets (including its partnership interest in the Fund) in connection with the liquidation. Any gain will be subject to corporate-level income tax at 21%. After payment of corporate-level tax, the remaining proceeds will be distributed to the blocker's shareholders. Distributions in complete liquidation are treated as amounts received in exchange for the shareholder's stock under IRC § 331, and gain or loss is computed with reference to the shareholder's basis in its blocker stock. For tax-exempt shareholders, gain on the liquidation of the blocker stock is generally excluded from UBTI.
State Tax Considerations. The blocker is organized in Delaware. Delaware does not impose a corporate income tax on entities that do not have Delaware-source income (i.e., income derived from activities conducted in Delaware or from property located in Delaware). However, Delaware does impose an annual franchise tax on corporations based on authorized shares or assumed par value capital. The blocker should be structured with a minimal number of authorized shares and a low par value to minimize Delaware franchise tax. In addition, the blocker may have state income tax filing obligations in New York and other states where the Fund's portfolio companies are located or conduct business, depending on the nexus analysis in each jurisdiction.
Administrative Burden. The blocker structure imposes additional administrative costs, including the preparation and filing of a separate corporate income tax return (Form 1120), Delaware franchise tax filings, and ongoing corporate maintenance (e.g., annual reports, registered agent fees). These costs should be borne by the investors utilizing the blocker, either through direct charges to the blocker or through allocation of such costs among blocker investors. The LPA and blocker corporate documents should specify the cost allocation methodology.
F. UBTI Silo Rule — IRC § 512(a)(6)
IRC § 512(a)(6), enacted by the Tax Cuts and Jobs Act of 2017, requires tax-exempt organizations to compute UBTI separately for each unrelated trade or business (the "silo rule"). Under this provision, losses from one unrelated trade or business cannot be used to offset income from another unrelated trade or business. Each unrelated trade or business is treated as a separate "silo," and UBTI is computed independently for each silo.
The silo rule has significant implications for tax-exempt LPs that invest in multiple private equity funds. If a tax-exempt investor has UBTI from Fund V and also has losses from a separate unrelated trade or business (e.g., a different fund investment), the losses cannot be offset against the Fund V UBTI. This may increase the investor's overall UBTI liability relative to the pre-2017 regime, under which all unrelated trade or business activities were aggregated.
Implications for Fund V Structure. For tax-exempt LPs investing directly in the Fund (without the blocker), each separate unrelated trade or business conducted through the Fund is a separate silo. If the Fund has multiple portfolio companies organized as pass-through entities (which, as noted above, should be uncommon given the Fund's investment strategy), each such portfolio company may constitute a separate silo.
For tax-exempt LPs investing through the blocker, the silo rule is generally not applicable at the investor level, because the blocker (as a C corporation) is the taxpayer, and the blocker's income is not UBTI to the tax-exempt investor. However, the silo rule may affect the tax-exempt investor's computation of UBTI from other investments made outside the blocker structure.
Recommendation. We recommend investor-specific analysis of the silo rule's implications for each tax-exempt LP, particularly for those investors considering direct investment in the Fund (without the blocker). If a tax-exempt investor invests through multiple blocker entities (one for each fund), the silo rule generally does not apply, but if the investor invests directly in some funds and through blockers in others, the interaction of the silo rule with the blocker structure requires careful planning.
V. ECI AND FIRPTA CONSIDERATIONS FOR NON-U.S. INVESTORS
A. Effectively Connected Income (ECI) — IRC § 864(c)
A non-U.S. investor that is a partner in a U.S. partnership is treated as engaged in a U.S. trade or business to the extent the partnership is engaged in a U.S. trade or business. Under IRC § 875(1), a non-resident alien individual or foreign corporation is considered to be engaged in a trade or business within the United States if the partnership of which such person is a member is so engaged. Income that is effectively connected with the conduct of a trade or business within the United States ("ECI") is subject to U.S. federal income tax on a net basis at the applicable graduated rates (up to 37% for individuals, 21% for corporations).
In the context of Fund V, ECI may arise if portfolio companies are organized as pass-through entities (partnerships or LLCs taxed as partnerships) that conduct a trade or business in the United States. In that case, the operating income of the portfolio company flows through the Fund to each partner, and the non-U.S. partner's allocable share of such income is treated as ECI, triggering U.S. tax filing obligations and withholding.
IRC § 1446 Withholding. IRC § 1446 requires a partnership engaged in a trade or business in the United States to withhold tax on the allocable share of ECI attributable to its foreign partners. The withholding rate is the highest applicable rate: currently 37% for foreign individual partners and 21% for foreign corporate partners. The withholding is remitted to the IRS on a quarterly basis using Form 8813, and an annual return (Form 8804) is filed with accompanying Form 8805 for each foreign partner. The withholding is creditable against the foreign partner's U.S. income tax liability on its ECI.
Mitigation Strategies. The most effective mitigation strategy for ECI exposure is the organization of portfolio companies as C corporations. When a portfolio company is a C corporation, it is a separate taxpayer, and its operating income is not passed through to the Fund or its partners. The Fund's income from the portfolio company (dividends and capital gains) is not ECI unless the Fund itself is engaged in a U.S. trade or business (which, as discussed in Section VIII.B below, is unlikely under the investment management safe harbor). Accordingly, we strongly recommend that all portfolio companies acquired by the Fund be organized as, or converted to, C corporations to minimize ECI exposure for non-U.S. investors.
The Offshore Feeder structure (investing through a Cayman Islands exempted limited partnership) does not, by itself, eliminate ECI exposure. If the Offshore Feeder invests in U.S. partnerships or directly in portfolio companies that constitute pass-through entities conducting a U.S. trade or business, ECI flows through the Offshore Feeder to its non-U.S. investors, because the Offshore Feeder (classified as a partnership for U.S. tax purposes) is transparent. The Cayman interposition does not create a taxable entity that would absorb the ECI at the fund level.
B. FIRPTA — IRC §§ 897 and 1445
The Foreign Investment in Real Property Tax Act ("FIRPTA"), codified at IRC § 897, provides that gain or loss of a non-U.S. person from the disposition of a "United States real property interest" ("USRPI") is treated as ECI, and is therefore subject to U.S. federal income tax on a net basis. A USRPI includes (i) an interest in real property located in the United States and (ii) an interest in a domestic corporation that is (or was within the preceding five years) a "United States real property holding corporation" ("USRPHC"). A USRPHC is a domestic corporation in which the fair market value of U.S. real property interests equals or exceeds 50% of the aggregate fair market value of all real property interests (domestic and foreign) plus all other assets used or held for use in a trade or business (IRC § 897(c)(2)).
Fund V FIRPTA Risk Assessment. Fund V's investment strategy focuses on buyouts in industrials, business services, healthcare services, and technology-enabled services. These sectors are generally not real property-intensive, and the risk that a portfolio company will be classified as a USRPHC is lower than for funds that invest in real estate, natural resources, or real property-heavy industries. However, the risk is not zero. Certain portfolio companies may hold significant real property (e.g., manufacturing facilities, distribution centers, healthcare facilities), and the USRPHC analysis must be performed for each portfolio company on an ongoing basis.
Relevant Exceptions. Several exceptions may limit FIRPTA exposure in specific circumstances:
(a) Domestically Controlled REIT Exception (IRC § 897(h)(2)): This exception is not directly applicable because Fund V is not a real estate investment trust ("REIT"). However, the analogous principle — that a domestically controlled entity may not trigger FIRPTA for foreign investors — is relevant to the extent that a portfolio company could be restructured as a REIT in certain circumstances.
(b) Publicly Traded Exception (IRC § 897(c)(3)): Gain from the disposition of stock in a publicly traded domestic corporation is not subject to FIRPTA if the foreign investor held 5% or less of the regularly traded class of stock at all times during the shorter of (i) the five-year period ending on the date of disposition or (ii) the period the investor held the stock. This exception may apply upon the exit of a portfolio company through an initial public offering, if the Fund's stake is reduced to 5% or less of the publicly traded class of stock.
(c) Cleansing Disposition: A corporation ceases to be a USRPHC if it disposes of all of its U.S. real property interests in taxable transactions, and all gain is recognized. This "cleansing" may be relevant in exit planning.
FIRPTA Withholding. IRC § 1445 requires withholding of 15% of the amount realized on the disposition of a USRPI by a non-U.S. person. In addition, IRC § 1446(f), discussed in Section V.D below, requires 10% withholding on the transfer of a partnership interest if the partnership has ECI (which includes FIRPTA gain treated as ECI). The Fund's LPA should include provisions for FIRPTA withholding and related tax indemnification, ensuring that the Fund and the GP are authorized to withhold and remit the applicable taxes on behalf of non-U.S. LPs.
Recommendation. We recommend that the Fund implement a USRPI tracking protocol for each portfolio company, requiring the GP to monitor the composition of each portfolio company's assets on a periodic basis and to determine whether any portfolio company is or may become a USRPHC. If significant real property exposure is identified in a particular investment, the Sponsor should consider structuring the investment through a blocker-like vehicle for non-U.S. investors, or otherwise structuring the transaction to minimize FIRPTA exposure. The LPA should include provisions authorizing the GP to take such structuring actions.
C. Application to Specific Non-U.S. Investors
1. Edgecombe Insurance Group Ltd.
Edgecombe Insurance Group Ltd. ("Edgecombe") is a Bermuda-domiciled insurance holding company with approximately $27 billion in general account assets under management. Edgecombe's anticipated commitment to Fund V is $150,000,000, and Edgecombe is currently expected to invest through the Main Fund (a Delaware limited partnership).
ECI Analysis. As a non-U.S. corporate investor in a U.S. partnership, Edgecombe is treated as engaged in a U.S. trade or business to the extent the Main Fund is so engaged. If any portfolio company is organized as a pass-through entity conducting a U.S. trade or business, Edgecombe's allocable share of such income would constitute ECI, subject to U.S. income tax at the 21% corporate rate. In addition, IRC § 1446 requires the Fund to withhold 21% (the applicable corporate rate) on ECI allocable to Edgecombe. Given that Bermuda imposes no income tax, there is no foreign tax credit available to Edgecombe to offset U.S. tax on ECI, and the U.S. tax represents a net cost to the investor.
FIRPTA Exposure. Edgecombe is subject to FIRPTA withholding on dispositions of USRPIs at the 15% rate under IRC § 1445, plus potential withholding under IRC § 1446(f) on any transfer or deemed transfer of its partnership interest. As discussed above, the risk that a Fund V portfolio company will be classified as a USRPHC is relatively low given the Fund's sector focus, but must be monitored on a deal-by-deal basis.
Branch Profits Tax — IRC § 884. A particularly significant consideration for Edgecombe is the potential applicability of the branch profits tax under IRC § 884. The branch profits tax imposes an additional 30% tax on the "dividend equivalent amount" of a foreign corporation's effectively connected earnings and profits. The dividend equivalent amount is, in general, the foreign corporation's ECI (after regular income tax) less net increases in its U.S. net equity, plus net decreases in U.S. net equity. The branch profits tax is intended to approximate the additional layer of tax that would be imposed on dividends if the foreign corporation operated its U.S. business through a U.S. subsidiary (which would be subject to dividend withholding on distributions to its foreign parent).
The