In the context of interval and tender-offer funds, tax blockers are tax-paying corporate entities used to transform “bad income” into “good income.” Interval and tender-offer funds are particularly attractive for investments in asset classes such as real estate, private equity, and debt instruments, where traditional liquidity mechanisms are not readily available. At the heart of managing these funds is the challenge of maintaining tax efficiency, a critical factor that can significantly impact the fund’s net return and its attractiveness to investors.
There’s a trade-off, though. A fund without a blocker generally won’t carry tax expense or taxes payable on its financial records—but a fund with one will, and those entries flow into net asset value (NAV). “Blocker” looks simple on a structure chart and gets complicated quickly in the books.
What is a tax blocker?
“Blocker” is a descriptive term, not a technical one. The blocker label just describes what the entity (a C-corporation) does inside the fund structure: it blocks income.
Unlike a partnership or other flow-through investment whose income passes through to the fund in its original character, a blocker is a separate taxable entity. It receives the income, pays corporate tax on it, files its own return, and remits taxes to the IRS and to state or local taxing authorities. What flows up to the fund from the blocker is a dividend.
That conversion is the whole point. Whatever the original character of the income — fee income from loan origination, rental income from real estate, gains on physical metals — the income coming out of the blocker is a dividend. And dividends are good income under the regulated investment company (RIC) rules.
Blockers have long been used in private funds in master/feeder structures, where they sit between a fund and tax-exempt or foreign investors to block UBTI, ECI, or FIRPTA‡-tainted income. The use described here — sitting between the fund and its investments to wash bad income for the 90% test — is a more recent adaptation of the same concept.
Figure: Diagram of typical RIC structure with tax blocker entity
Why an RIC needs a tax blocker: the 90% income test
The U.S. tax code mandates that RICs, including interval and tender-offer funds, must derive at least 90% of their income from specified sources of “good income” such as dividends, interest, and gains on the sale of securities to maintain their tax-advantaged status. “Bad income,” by contrast, isn’t a technical term — it’s anything not on the good-income list.
Failure to meet the annual 90% test could result in the loss of RIC status, subjecting the fund to corporate taxes and potentially diminishing the returns available for distribution to investors. In our experience, the below are common sources of “bad income” for interval and tender-offer funds:
- Commodity derivatives
- Physical metals
- Publicly traded partnerships (PTPs) other than qualified publicly traded partnerships (QPTPs)
- Real estate (rental or gain)
- Ordinary trade or business income, such as fee income from loan origination
- Virtual currency gains
Take loan origination as a concrete case, common in credit funds. If the fund earns the origination fee directly, that’s bad income. Put a blocker between the fund and the originating entity, and the blocker receives the fee, pays tax on it, and pays a dividend up to the fund. The fund now has a dividend instead of fee income, and its 90% test is intact. The cost of passing the test, of course, is the corporate tax paid at the blocker level.
Tax blockers: Domestic, offshore, or both
When implementing a tax blocker, fund managers must decide between a domestic entity and an offshore one, such as a Cayman Islands corporation. The general rule: a U.S.-based blocker is appropriate when the underlying activity is effectively connected to a U.S. trade or business, because that income is taxable here regardless. An offshore blocker is generally only worth using when the income isn’t effectively connected to a U.S. trade or business — in which case the U.S. has no taxing jurisdiction over it.
Some funds run both. That isn’t unusual for funds with mixed portfolios, but it adds legal, regulatory, administrative, and tax complexity in two jurisdictions instead of one.
A word of caution on offshore blockers: just because a blocker is in the Caymans doesn’t mean a tax accrual isn’t required. The same process used for a domestic blocker still applies — there’s just an added analysis step to determine how much, if any, of the income is effectively connected to a U.S. trade or business. That analysis can be hard to do in real time, since K-1s from underlying investments often don’t arrive until well after the period being closed. Interval funds — which strike NAV daily — feel that timing pressure acutely.
Current and deferred tax: what hits the balance sheet
Two kinds of tax entries occur:
- Current tax is what’s owed on the current period’s taxable income — the amount that will be due when the return is filed. It sits on the balance sheet as current tax payable until cash goes out the door to the government.
- Deferred tax captures what would be owed if unrealized gains inside the blocker were actually realized. It sits as a deferred tax liability (DTL) on the balance sheet until a realization event. No cash is moving today, but GAAP wants the future tax consequence reflected now.
When an investment is in an unrealized loss rather than a gain, the calculation flips and produces a deferred tax asset (DTA) rather than a liability. In most cases, that DTA must be offset by a full valuation allowance, on the theory that the asset is unlikely ever to be realized.
So, funds that simplify the deferred tax calculation as “tax rate times change in unrealized” need to stop the calculation at zero on the asset side—or be prepared to show the DTA and its offsetting valuation allowance on the balance sheet, because auditors will look for both.
Frequence of tax accruals
Tax expense isn’t a top-side adjustment that can wait until financial-statement preparation. Tax accruals are a component of the NAV and should be considered as frequently as the NAV is struck. If the tax liability is material to the fund, failing to record it can produce NAV errors. For many interval funds, daily tax accruals are required.
While many daily accruals are calculated simply as the daily performance on the blocked positions multiplied by the tax rate, it is also necessary to frequently consider, availability of tax estimates, changes in tax rates, valuation allowances, and changes to ECI percentages. These nuances make the daily accruals difficult to automate; it’s necessary to keep a close eye on the daily process.
An example of tax blocker use
Consider a domestic blocker holding a real estate investment that has appreciated by $100,000 over the period but hasn’t been sold. For tax purposes, the gain isn’t recognized until disposition—so no current tax is owed yet. But GAAP requires the future tax consequence to be in the books today. At a 21% federal rate, the blocker records a $21,000 deferred tax liability against the $100,000 unrealized gain. No cash moves; the DTL sits on the balance sheet, reduces NAV, and reverses when the asset is eventually sold and the actual tax is paid.
When that sale happens and proceeds are distributed, the RIC receives a dividend—qualifying income for the 90% test, even though the underlying gain came from real estate.
Bottom line for tax blocker use
By mitigating adverse tax implications, tax blockers allow tender-offer and interval funds to operate tax efficiently without significantly altering their intended investment strategy. Blockers reduce the risk of RIC qualification failure and let investment managers reach for a broad range of asset classes without subjecting the fund and its shareholders to double taxation.
The trade-off is the cost—both the direct corporate tax paid by the blocker, and the indirect cost of separate financial records, daily deferred tax accruals, and the legal, administrative, and audit attention that comes with running a separate taxable entity inside a fund structure. Whether that trade-off is worth it depends on how much bad income is at stake and how committed the fund is to the underlying strategy.
This communication should not be construed as tax advice. In the event any information contained herein is deemed to be tax advice, it was not intended or written to be used for the purpose of avoiding tax penalties.
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