This article provides an in-depth discussion about the use of blocker corporations in transactions involving private equity (PE) buyers who include rollovers of target owner equity in leveraged buyout (LBO) transactions. Below are the key points discussed:
What Are Blocker Corporations?
- Blocker corporations are entities that “block” taxable income at the corporate level for federal, state, and local income tax purposes in the U.S.
- Typically, tax-exempt and foreign investors in PE firms invest through Delaware C corporations known as blocker corporations during LBO transactions.
Purpose of Blocker Corporations:
- These corporations prevent foreign and tax-exempt investors from being allocated income categorized as “effectively connected with a U.S. trade or business” or unrelated business taxable income (UBTI), shielding them from U.S. taxes and filing requirements.
- The use of blocker corporations allows tax-exempt and foreign investors to avoid U.S. income taxes on capital gains when the blocker corporation’s stock is sold.
Disadvantages and Considerations:
- The use of blocker corporations may create misalignment between the economic interests of blocker corporation stockholders and other PE investors.
- There might be a potential adjustment to the purchase price due to the loss of future tax benefits, impacting non-blocker corporation investors and rollover participants adversely.
Why Are Blocker Corporations Used?
- PE firms use blocker corporations to attract and retain foreign and tax-exempt investors by offering them favorable tax treatment.
- Despite potential disadvantages for other investors, the use of blocker corporations is typically a non-negotiable aspect of purchase transactions for many PE firms.
Questions Raised:
- There are questions the necessity of selling blocker corporation stock instead of the blocker corporation selling its equity interest in a portfolio company. It suggests that most blocker corporation stockholders might not face double taxation in the event of a sale followed by liquidation.
- PE firms, while acknowledging the necessity of blocking certain types of income, might not fully communicate the benefits foreign and tax-exempt investors enjoy through blocker corporations.
Conclusion and Recommendations:
- The special treatment afforded to blocker corporation investors may seem unfair to others but is a result of U.S. tax laws.
- For rollover participants, the implications of blocker corporations are important to note but are usually not deal-breakers.
- The tax treatment for foreign investors in their home jurisdictions should also be considered.
- It suggests that potential tax benefits might warrant the use of blocker corporations in specific scenarios, such as when their stock could qualify as qualified small business stock (QSBS) under Section 1202.
