A “blocker corporation” is an entity within a group structure treated as a corporation for federal tax purposes. As such, all income, expenses, gains, and losses are recognized and taxed at the corporate level, and they do not flow through to the shareholders like a partnership or S corporation.
A blocker corporation is typically used by a hedge fund, private equity fund, real estate investment entity, or other investment fund when its investors are non-U.S. persons or U.S. tax-exempt investors.
The blocker corporation can either be a U.S. or foreign entity. Deciding whether to utilize a U.S. or non-U.S. blocker corporation will depend upon the fund structure, the tax residency of the investors, and the type of income earned by the fund.
Example of a Blocker Corporation for Hedge Funds
Hedge fund managers will use blocker corporations in a master-feeder fund structure.
John is a hedge fund manager who wants to launch a fund investing mainly in U.S. equities and bonds. John will raise capital from both U.S. and non-U.S. investors. John sets up the master fund as a foreign corporation in the Cayman Islands and files an entity classification election to tax the entity as a partnership for federal tax purposes. John opens a Delaware limited partnership (LP) as the domestic feeder fund and a second Cayman Islands corporation as the offshore feeder fund.
The Delaware feeder fund accepts subscriptions from taxable U.S. investors, and the Cayman feeder fund accepts subscriptions from non-U.S. investors and U.S. tax-exempt entities.
In this structure, income flows from the master fund into the domestic and foreign feeder funds. The income flowing to the foreign feeder fund acts as the “blocker corporation” and is responsible for paying any income taxes on its allocable profits. The blocker corporation also protects the U.S. tax exempt shareholders from any Unrelated Business Taxable Income (UBTI) flowing from the master fund.
Once the foreign feeder fund pays any required taxes, the after-tax earnings and profits (E&P) are available for distribution to the shareholders, or can be reinvested back into the master fund. Since the foreign feeder fund is a Cayman Islands foreign corporation, dividend distributions from the Cayman corporation to shareholders are exempt from any withholding taxes.
The blocker corporation effectively shields non-U.S. investors from dealing with income tax filing and reporting requirements.