Investing in a Venture Capital Fund: Tax, Regulatory, and Finance Implications
September 01, 2021
Venture capital offers investors a myriad of opportunities from a finance and tax perspective. From a financial perspective, venture capital provides lower volatility, additional portfolio diversification and less correlation to the broader public trading markets. Another benefit includes sharing of risks and costs with the fund manager. Although investing in venture capital is somewhat riskier, the investment class comes with the potential of receiving a higher return on your investment. Most institutions and other investors investing in venture capital expect returns higher than one would expect while investing in hedge funds, mutual funds, ETFs, or any other alternative investment vehicle. Because venture capital funds pool capital together, they are able to obtain larger stakes in a company as opposed to an individual investor. Hence, they have greater influence over management and can assist in product development and other key areas of bringing a product to market.
Venture capital investing has become a major part of the alternative investment asset class. According to PitchBook Data Inc., the venture capital industry has steadily grown and in 2020 the industry raised $73.6 billion in the U.S. alone. The expectation is that the future of venture capital fund raising will continue to grow due in large part to some of the exploding industry trends such as gaming (which took off during the COVID-19 pandemic), crypto-currency (which is arguably still in its infancy), and life sciences which will continue to grow as the world tries to put an end to the COVID-19. Other areas expecting growth include artificial intelligence, and cannabis. Companies that are able to adopt a strong environmental, social, and governance (ESG) platform are those that are expected to do best and have a sustainable economic presence.
However, the disadvantages of investing in venture capital include liquidity constraint as an investment may be locked up for a period of three-to-ten years, and blind pool investing. In blind pool investing, investments usually begin in companies the investor is well aware of; however, at a later date once the investor has committed capital, the fund manager makes additional investments the investor may not be aware of or familiar with. One of the toughest decisions for an investor is choosing a fund manager they can trust and one that has a good track record. Other characteristics that represent a good fund manager include the following:
- Expertise in the industry which the investor has interest;
- Experience with portfolio construction;
- Ability to raise funds;
- Robust infrastructure;
- Great valuation experts or have close connections with professionals who are valuation experts;
- The ability to keep costs under control;
- One who has skin in the game;
- A team who has experience in different geographies; and
- Connections/relationships across the broader venture capital market
Along with the opportunity and benefits of investing in venture capital funds, the investor must be aware of the tax consequences as they relate to sourcing, timing, and character of income. These can be summarized in four main areas all of which should be part of any due diligence policy.
- The fund structure of the venture capital manager and the business entity of choice.
- The venture capital manager and its personnel, both internal and external, are aware of the regulatory, legal, and tax implications of the business.
- The investor or their team must have a working knowledge of the tax regime of its own tax jurisdiction including federal, state, and local levels.
- If the venture capital fund makes offshore investments, there needs to be an understanding of the jurisdictions in which the investments are being made, as well as the U.S. tax implications.
Structure and Business Entity
A. U.S. Taxable Investor
U.S. taxable investors typically choose to invest directly in pass-through entities. The pass-through entities typically then make investments into operating companies that elect to be taxed as a corporation. These corporations are typically in the early stages of their life cycle. Investments structured as corporations provide the following benefits.
- Corporations provide for long-term capital gains on exit as opposed to ordinary income from operating partnerships. There is essentially a 17% tax exposure that can be avoided if structured correctly. Today the top U.S. tax rate for an individual is 37% for ordinary income and currently 20% for long term-capital gains. Under the Biden Administration, the top individual rate is expected to climb back up to the 39.6%. Typically, VC funds’ exit strategies are to sell the stock and not receive dividends from earnings.
- Corporations (unlike partnerships) help the taxpayer avoid phantom income. Investors need to pick up their distributive share of income from an operating partnership via Schedule K-1. If the fund is invested in a corporation the investor will only be taxed when the corporation makes distributions, assuming that there are accumulated earnings, or when the investment is sold.
- A corporation is generally used as a blocker to avoid certain types of unwanted income and to avoid state and local filing obligations for certain investors such as U.S. tax-exempt investors and offshore investors. This will be discussed in more detail in the article.
- Investment in a C corporation allows IRC Sec. 1202 (Qualified Small Business Stock (“QSBS”)) to kick in. Remember, venture capital funds primarily invest in seed stage or start-up type C corporations and have a three-to-ten year investment horizon. IRC Sec. 1202 allows non-corporate taxpayers to potentially exclude up to 100% of the gain realized from the sale or exchange of QSBS. The lifetime limit on the amount of gain eligible for the exclusion is limited to the greater of 1) ten times the taxpayer's basis in the stock (annual limit) or 2) $10 million gain ($5 million, if married filing separately) from stock in that corporation. This is a per-issuer limitation on eligible gain. In order to qualify for the QSBS exclusion, the small business stock needs to be held for more than five years and must be acquired upon original issuance for cash, for property not including stock, for services, or in certain circumstances by inheritance. The other conditions that must be met include the following:
1. Stock is issued by a domestic C corporation after August 10, 1993.
2. Aggregate assets of the corporation do not exceed $50M before and immediately after the issuance.
3. There is an active business requirement (stock must be issued by a corporation that uses at least 80% of its assets (by value) in an active trade or business (other than personal services))
4. The stock is held by a non-corporate taxpayer (partnerships, LLCs, S corporations – underlying partners, individuals). Note QSBS does not apply to equity interest in partnerships and S corporations itself. However, these entities can pass these benefits through to their investors.
In addition to IRC Sec. 1202, IRC Sec. 1045 is an added benefit. IRC Sec. 1045 allows a taxpayer to potentially rollover gain from the sale of QSBS that has been held for more than six months. However, the fund must purchase new QSBS within 60 days of the sale.
If 100% exclusion of capital gains sounds too good to be true: “It is not!” Get more information and take a deeper dive on the qualified small business stock exemption and on IRC Secs.1202 and 1045.
Consideration with Investments Structured as Operating Partnerships
- Only one level of tax. Partnerships generally do not pay tax at the partnership level but rather only at the partner level whereas a corporation has the potential to be taxed twice.
- Operating partnerships pass tax attributes (such as net operating losses (NOLS)) through to their investors on Schedule K-1. This is not the case with investments in corporations.
- Upon sale, the operating partnership can permit the buyer to step up its tax basis in the acquired assets to their fair market values without the seller’s incurring corporate-level tax.
- With partnership investments, there are also state and local compliance considerations that may ultimately trickle up to each upper tier investor.
Another area that U.S. investors need to be concerned with is how the venture capital fund exits its investments and the tax consequences of doing so.
B. U.S. Tax-Exempt Investor
For U.S. tax-exempt investors, the major concern is unrelated business taxable income (UBTI). If the fund manager makes investments into operating partnerships, any distributive share of income allocated to its partners will be UBTI and may be subject to income tax. A special issue exists for a special type of tax-exempt investor called a charitable remainder trust (CRT) in which an allocation of UBTI may cause the CRT to have an excise tax imposed equal to the amount of such UBTI. If on the other hand, the fund manager makes investments structured as corporations, the venture capital fund will not create UBTI from any of its capital gains, dividends, or interest. However, if there is acquisition indebtedness, this can potentially cause unrelated debt financed income which will be subject to the UBTI rules. Acquisition indebtedness is when an investor borrows cash to fund its investments. Some fund managers may use a blocker type entity in order to block any UBTI allocated to its tax-exempt investors. The same blocker entity may also be used to block effectively connected income (ECI) allocated to offshore investors, which is discussed below. An investor may also create its own blocker to invest in the fund manager, but then the burden of additional administrative and compliance costs will fall on the investor directly. If the blocker entity is a U.S. corporation, it will be taxed on 100% of the operating income from the operating partnership. A foreign blocker will be taxed only to the extent of its ECI but may be subject to branch profits tax as well.
C. Offshore Investor
As suggested earlier, offshore investors are subject to a different tax regime than that of U.S. investors. For these particular investors, there are concerns in both their own jurisdiction and with the United States taxing authorities. Offshore investors tend to be invested in more opaque structures. Because of the offshore disclosure rules and efforts by the government to access revenue, offshore investors prefer to remain anonymous and wish not to file U.S. federal, state, and local tax returns. Offshore investors are not taxed on capital gains from portfolio investment activities derived from the United States as the gains are sourced to their resident country. However, dividends from U.S. companies are generally subject to a maximum 30% withholding tax under IRC Sec. 1441. This amount can be reduced depending on whether or not there is a treaty between the investor’s home jurisdiction and the United States. Portfolio interest is generally exempt from withholding as long as the offshore investor is not considered a 10% shareholder. According to IRC Sec. 871, a 10% shareholder means the following:
- In the case of an obligation issued by a corporation, any person who owns 10% or more of the total combined voting power of all classes of stock of such corporation entitled to vote; or
- In the case of an obligation issued by a partnership, any person who owns 10% or more of the capital or profits interest in such partnership.
If the fund manager invests into an operating partnership, then any of the income allocated from U.S. sources will be considered ECI, which is an undesirable type of income for these investors. ECI causes a federal, state, and local tax return filing obligation. A further complication exists for foreign blocker entities, in which the foreign corporation will not only be taxed on any ECI, but now may also have a branch profits tax issue to deal with.
Other areas that are of concern for offshore investors include the following:
- Foreign Investment in United States Real Property (FIRPTA);
- Fees from portfolio companies in which the fund manager provides services such as consulting or other services that are not ancillary. The fund manager would typically be involved in such an arrangement in order to generate fee income. In order to not create undesirable income for such investors, the fund manager could render such fee income services only on its own behalf and not the fund’s. Fee income could also be disadvantageous for tax-exempt investors that are discussed above; and
- Financing activities is an area that is worth mentioning. However, this area should not present much of a problem for venture capital funds as they are not in an active business in making loans to the companies in which they own equity. But to the extent that a venture capital fund starts making loans on a regular and continuous basis, then they would have to make sure this activity does not rise to or can be attributable to the active conduct of a U.S. banking, financing or similar business as the IRC Sec. 864(b) safe harbor would not apply and such an arrangement could be disastrous for offshore investors.
In general, in order to block undesirable income, branch profits tax, and the risk of losing anonymity for its offshore investors, the fund manager may put its offshore investors into a feeder entity that owns a U.S. corporation blocker. If the fund manager is confident that the investment will only produce capital gains, then the fund manager could consider investing either directly or through an offshore corporation.
If the venture capital fund makes foreign investments that are structured as corporations, then the U.S. investor needs to be aware of the U.S. tax laws that can apply to such investments. Under the U.S. tax laws applicable to foreign corporations, a foreign corporation can be subject to treatment as either a (1) passive foreign investment company (PFIC) or (2) controlled foreign corporation (CFC). These foreign corporations are subject to certain “anti-deferral” regimes (discussed below) that can require current income inclusions in the U.S., regardless of actual distributions from the foreign corporation. Theses tax regimes were implemented by Congress to prevent taxpayers from avoiding and or deferring U.S. federal income taxation on foreign investments. Furthermore, passive foreign investments will typically create phantom income. Several of these issues can be summarized as follows.
1. Passive Foreign Investment Company
U.S. investors in non-U.S. corporations that are classified as PFICs are subject to special anti-deferral rules under U.S. federal income tax law. A foreign corporation is treated as a PFIC if (i) at least 75% of the foreign corporation’s gross income for the taxable year is passive income (such as dividends, interest, and certain rents or royalties). or (ii) the average percentage of assets held by such a corporation during the taxable year that produce passive type income (such as cash, securities, or certain intangible assets) is at least 50%. Under the “excess distribution” rules, a U.S. investor in a PFIC is required to recognize ordinary income instead of capital gain as well as interest charges upon a distribution from the PFIC or a disposition of its stock.
These are harsh consequences that can significantly decrease an investor’s return on an eventual disposition. A U.S. investor can instead opt to make certain elections that would lessen the negative impact of the excess distribution rules by applying different current taxation. A qualifying electing fund (QEF) election allows the investor to be currently taxable on the net income of the PFIC whether or not cash is distributed. It also allows the U.S. investor the opportunity to pick up some part of income as long term capital gain as opposed to the ordinary treatment under the excess distribution regime and there are no interest charges. A mark-to- market (MTM) election allows the investor to be currently taxable on the annual unrealized gains in the value of the investment. It is less punitive than the excess distribution regime because under the MTM election, there are no interest charges upon exit, which essentially means that the investors’ income for books and tax should equal upon exit.
2. Controlled Foreign Corporations
U.S. investors invested in foreign corporations should consider whether those corporations are classified as CFCs. A foreign corporation is a CFC if U.S. shareholders each own at least 10% of the corporation’s voting power or value, and they collectively own over 50% of the total combined voting power or value of the corporation’s stock. This determination is made by applying a complex set of constructive ownership rules, pursuant to which shareholders can be attributed ownership via certain related parties.
If a foreign corporation is a CFC, its 10% U.S. shareholders will be taxed on their share of certain types of income of the CFC whether or not cash is distributed. For these purposes, a U.S. shareholder is defined as a United States person (as defined in IRC Sec. 957(c) ) who owns (within the meaning of IRC Sec. 958(a) ), or is considered as owning by applying the rules of ownership of IRC Sect. 958(b), 10% or more of the total combined voting power of all classes of stock entitled to vote of such foreign corporation, or 10% or more of the total value of shares of all classes of stock of such foreign corporation. The type of income generally subject to CFC reporting is what is known as Subpart F Income. Subpart F income includes dividends, interest, and certain income generated from related party sales and services.
Global intangible low-taxed income (GILTI) is yet another area of concern for U.S. investors. GILTI was created by the Tax Cuts and Jobs Act, which essentially expands the scope of the CFC regime and operates in addition to Subpart F. It’s important to note that there are current legislative proposals, which may enact significant changes to the GILTI rules, the effect of which would likely be increased GILTI exposure.
Due to the complexity of these reporting regimes and the ever-expanding set of compliance requirements in the U.S., additional compliance and due diligence is necessary when considering foreign investment.
Regulatory Environment for Venture Capital
A. Exempt Reporting Advisers
Fortunately, for venture capital funds with less than $150 million in assets under management, Congress specifically allows venture capital fund managers to register as exempt reporting advisers (ERAs) if they meet certain conditions. ERAs need to register with the (SEC) under a more limited compliance and reporting regime, which simplifies and reduces the costs of running a venture capital fund. Such limited registration obligations are less onerous than the rigorous registered investment advisor obligations imposed on an investment adviser which advises funds other than venture capital funds or which advises separate accounts.
In order to oversee compliance, the SEC created a multi-factor test to define whether a fund is pursuing a VC strategy, pursuant to Rule 203(l)-1 of the Investment Advisers Act. In order to register as an ERA, a fund must satisfy each factor of the definition:
- Representation: Must represent itself as pursuing a venture capital strategy, including in investor and marketing materials;
- Leverage limitations: Strict limitations on the use of leverage at the portfolio company and fund levels;
- Redemptions: Prohibition on annual redemptions of investors; and
- Qualifying investments: At least 80% of a fund’s activity must be direct investments into private companies, or “qualifying” investments.
Violation of any of these parameters by one fund can trigger an RIA regime for every fund managed by that VC firm.
Another area of regulatory concern for venture capital managers is the Employee Retirement Income Security Act of 1974, as amended (ERISA). ERISA is a significant concern for any venture capital fund, whether or not established in the United States, that wishes to raise capital from U.S. pension plans or other U.S. employee benefit plans. In order to protect participants in employee benefit plans, ERISA imposes strict fiduciary standards on the management of plan assets. In the case of a venture capital fund with an ERISA plan as an equity investor, these may include all of the fund's assets. The ERISA restrictions are regarded as too onerous by venture capital fund managers to merit being subject to those restrictions. Therefore, in order to access ERISA plan funds, a venture capital fund will generally structure itself so as to be able to rely one of the following ERISA exemptions:
- The insignificant interest exemption, which applies where benefit plan investors subject to ERISA own less than 25% of the value of each class of the equity interests of a fund, disregarding equity interests that the general partner and its affiliates hold.
- The venture capital operating company (VCOC) exemption, which applies if at least 50% of the investments of a venture capital fund, valued by cost, are in qualified venture capital investments which are investments in operating entities engaged in the production or sale of a product or service (other than the investment of capital) with which the fund has specific contractual rights substantially to participate in or influence the conduct of management of the entity.
In addition, ERISA also has strict reporting and disclosure requirements where its participants must receive certain reports and the fund must make certain disclosures to plan participants in order to comply.
Venture capital funds that allow foreign investors such as foreign nationals and foreign governmental entities among their investor base may have yet another regulatory issue to consider. On August 13, 2018, the former President Trump signed into law the Foreign Investment Risk Review Modernization Act of 2018 (FIRRMA). FIRRMA strengthens and modernizes the Committee on Foreign Investment in the United States (CFIUS), a multi-agency government body chaired by the Secretary of the Treasury that reviews foreign investment for national security considerations. Like prior CFIUS legislation, FIRRMA does not single out any specific country. CFIUS’s authority may be applied to address the national security risks posed by foreign investment in the United States, regardless of where the investment originates. Businesses to which CFIUS jurisdiction generally kicks in include companies involved in the following areas: critical technology, critical infrastructure, sensitive personal data of U.S. Citizens, and other areas that Treasury feels could threaten the security of the United States. The acquisition of a TID business could be considered a covered transaction. TID is an acronym for technology, infrastructure, and data.
Having competent internal and external teams is important because being able to understand a company’s capital and tax structure will provide insight into the best methods and locations for tax compliance and the best capital structure to implement so that the company may maximize its net profit and minimize its tax liabilities. Furthermore, in a complex regulatory environment, failure to follow any of the Treasury, IRS, SEC or state regulatory requirements can have harsh consequences including huge penalties, severe damage of the fund’s reputation, and blowing up the fund’s intended structure and certain elections made by the fund manager.
As discussed throughout this article, the importance of the tax consequences from investing in venture capital cannot be overlooked. As part of the planning and due diligence phase in making the investment decision, investors should have their own set of questions for the fund manager and its service providers including internal personnel. A clear reading and understanding of fund documents are necessary in order to alleviate any surprises. Investors along with fund managers need to balance between an acceptable rate of return and the tax implications for both its investors along with the tax implications in its investment decisions. Equally important in light of regulatory and the evolution of more complex tax regimes throughout the world is the importance of understanding the legal, regulatory, and tax aspects for both the investors and investments home jurisdictions. Much success can be gained while investing in venture capital however careful financial and tax planning is crucial.