Private Credit Blockers: Legitimate Structure or Substance-Free Tax Avoidance?

Medium

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🏢 Client

We're looking at committing $50 million to a private credit fund that will be doing some origination work and taking participation interests in loans. The fund manager is telling us we need a blocker structure because of UBTI concerns — apparently the fund will generate business income, not just passive investment income, and as a university endowment we can't have that hitting our 990-T. Their p…

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Case Summary ▾

Complexity ⓘ Medium

Fact Pattern University endowment investing $50M in private credit fund generating UBTI through loan origination activities, sourcing fees from borrowers, and active credit servicing. Endowment uses wholly-owned Cayman blocker corporation as LP to avoid direct UBTI exposure, accepting 21% corporate tax drag versus potential trust-rate UBTI taxation.

Position Taken Blocker structure necessary and appropriate. Fund's regular loan origination activities, receipt of sourcing fees paid by portfolio companies (80/20 split to fund), and ongoing borrower relationship management including amendments and waivers constitute trade or business under IRC § 513. These activities generate UBTI under IRC § 512(a)(1) that would be attributable to tax-exempt LP under § 512(c). Offshore corporate blocker converts business income to excluded dividend income under § 512(b)(1), with blocker paying corporate tax on effectively connected income. Position supported by Treas. Reg. § 1.513-1(d)(4)(ii) (regular lending activities constitute trade or business) and Rev. Rul. 78-51 (loan origination generates UBTI).

IRS Challenge IRS examiner would challenge whether Cayman blocker entity has sufficient economic substance beyond tax avoidance function under Gregory v. Helvering and Treas. Reg. § 1.701-2 anti-abuse rule. If blocker lacks independent directors, separate operations, real office, board meetings, and decision-making capacity beyond serving as signature entity, Service could disregard blocker under substance-over-form doctrine and attribute fund income directly to endowment as UBTI. This would result in trust-rate taxation under § 511(b) potentially exceeding $2M annually, plus accuracy-related penalties under § 6662(a) and compounded interest. Examiner notes taxpayer effectively conceded underlying fund generates business income by using blocker, shifting dispute to blocker substance requirements.

Authorities

IRC § 512(a)(1) IRC § 512(b)(1) IRC § 512(c) IRC § 513 IRC § 511(b) Treas. Reg. § 1.513-1(d)(4)(ii) Rev. Rul. 78-51 Gregory v. Helvering, 293 U.S. 465 (1935) Treas. Reg. § 1.701-2