Top 5 fundraising and initial investment questions for smart tax structuring

This article is part of a four-part series. In our first installment, Tax Structuring Checklist for Every Stage of the Investment Lifecycle, we outlined what fund managers should consider across fundraising, operations, and exit planning. In this piece, we take a closer look at the top five tax factors to consider during the initial stage of fundraising and investment.

From sourcing capital to deal structuring and entity classification, early tax decisions can directly impact investment outcomes and influence performance throughout the lifecycle. A clear investment strategy aligns decisions with investor goals, risk tolerance, and future capital needs.

Here are the foundational questions to consider:

1. Where are we sourcing funds for investments and what are investor expectations?

Investor expectations vary significantly depending on their classification, and understanding these differences is key to structuring a fund that works for all parties involved. The following investor types each carry unique tax considerations:

Foreign and Tax-Exempt Investors (e.g., pension plans, IRAs, endowments) are highly sensitive to taxable income generated by portfolio companies (PortCos). They are particularly impacted by unrelated business taxable income (UBTI) and foreign withholding taxes. Funds targeting these investors often need to establish blocker corporations to shield them from tax exposure.

Family Offices and High-Net-Worth Individuals tend to prioritize wealth preservation and simplicity. These investors often look for tax strategies that enhance after-tax returns, such as Qualified Small Business Stock (QSBS) gain exclusion, reducing state tax exposure through composite filings or pass-through entity (PTE) elections, and lowering administrative burdens.

Institutional Investors (e.g. other private equity funds, corporate partners, wealth managers) expect tax structures that integrate with their unique tax planning strategies. Close coordination with these partners is key.

2. What type of investment structure best aligns with our fund’s strategy and investor expectations?

A fund’s structure should match its reinvestment goals and investor mix. The choice between entity types directly impacts how income is taxed, distributed, and reinvested, which is why it’s important to evaluate these options carefully:

C Corporations are often a strong choice when the fund intends to reinvest earnings rather than make annual distributions. This structure may benefit from a lower effective tax rate (~28%) and QSBS eligibility. C corporations also reduce friction for foreign and tax-exempt investors. However, they come with the risk of double taxation at the corporate and shareholder levels.

Partnerships help avoid double taxation but increase complexity. They often require annual tax distributions at a high tax rate (~45%), blocker structures for sensitive investors, and careful attention to state tax compliance. Still, they allow for non-taxable distributions and the direct pass-through of losses and gains.

Note: A fund is not an eligible shareholder of an S corporation. If the target is an S corporation, a restructure will be necessary.

3. Do we understand how the target’s purchase price will impact the tax outcome?

The purchase price structure can impact everything from tax timing to allocation complexity. Funds should consider how components like equity, earnouts, and debt shape the overall tax picture.

Rollover Equity allows sellers to defer gains but introduces complex tax allocation issues (e.g., 704(c) built-in gain).

Earnouts align incentives post-close and are generally not taxable until paid, but they defer tax benefit for the fund.

Seller Notes may provide immediate benefit to the fund if they are not contingent and can signal confidence in the company’s growth.

Third-Party Debt, such as leveraged buyouts (LBOs), can be used to enhance the purchase price, particularly in partnership structures. This allows tax-free debt-financed distributions to sellers; however, this approach is generally not viable under a C corporation structure.

Debt as Equity, by using convertible debt instruments like Payment-in-Kind (PIK) notes, can help secure the fund’s investment, especially when structured to convert into equity at a future date. This approach can preserve cash flow while strengthening the fund’s position, but it introduces complexities around interest deductibility and fund-level income recognition.

4. How does purchase price allocation impact tax planning?

The purchase price allocation of an acquisition affects how quickly tax deductions can be realized and how much income is taxed as ordinary versus capital gain. It also plays a critical role in tax planning when buyer and seller priorities differ. Buyers want earlier depreciation benefits, while sellers prefer allocations that reduce ordinary income.

Tax Shields are created through depreciation and amortization of purchased assets. When negotiating purchase price allocations, the fund will want to increase the amount allocated to short-lived assets, such as Property, Plant, and Equipment (PP&E), to accelerate deductions. If purchasing C corporation stock, tax shields are generally lost unless a special tax election is made with seller consent and a purchase price gross-up to offset adverse impact on the seller.

Note: To decrease their ordinary gain upon sale to the fund, the seller typically seeks to allocate more of the purchase price to long-lived assets.

5. Is the tax structure flexible for future growth, acquisitions, and retention of key employees?

Private equity fund managers typically create a partnership to acquire a portfolio investment with a plan to add future bolt-on acquisitions. Designing a tax structure that supports expansion and team continuity positions your platform for sustainable growth while limiting tax complexity.

Bolt-on Acquisitions can increase company value and accelerate growth. Aligning the tax structures avoids integration hurdles. If the PortCo is taxed as a C corporation, bolt-ons can be the same or flow-through entities. However, if the PortCo is a partnership, bolt-ons should also be structured as flow-through entities to avoid tax complexity.

Management Aggregator and Intermediate Structures incentivize the retention of leadership to help drive portfolio growth by enabling equity participation. When a fund sells a PortCo, as equity owners, these employees receive capital gains as their bonus.

For more on this topic, see our article, Designing a Compensation Plan – What You Need to Know.

We Can Help

At Elliott Davis, we work with investors at every stage of the investment lifecycle, from deal structuring and due diligence to operational optimization and exit planning. Whether you’re raising capital, evaluating a target, or structuring a complex deal, our team helps design tax strategies that fit your needs and support growth.

Let’s talk about what comes next for your business. Reach out today to get started.

The information provided in this communication is of a general nature and should not be considered professional advice. You should not act upon the information provided without obtaining specific professional advice. The information above is subject to change.