Thinking of targeting growth through retail alternatives investors? Be sure to consider these tax issues

  • Blog
  • November 20, 2024

Chad Bieber

AWM Tax partner, PwC US

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Matt Troia

RE Tax partner, PwC US

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Private market investment managers (including private equity and private credit) have ambitious growth goals, and many are targeting retail investors as an untapped source of capital for new offerings.

Attracted by the historic returns and diversification offered by alternative investments, retail investors may be poised to answer that call. However, private market investment managers should be aware that the standard retail investor has different expectations compared with institutional investors, which include simplified tax reporting.

While past performance does not guarantee future results, meeting retail investors' tax reporting expectations could lay the groundwork for ongoing relationships and, ultimately, an influx of investor capital. As such, private market investment managers can proactively simplify their tax reporting by revisiting their legal entity and investment structure.

3 key actions to stay ahead of the competition—will your firm thrive or struggle at capturing the retail alternatives market?

Simplifying tax reporting

Many retail investors are used to straightforward tax reporting resulting from traditional investments (e.g., mutual funds, ETFs), which often are structured as a corporate entity that generates a Form 1099. This reporting is simple, delivered shortly after year-end, and enables retail investors to file their own federal and state tax returns without paying a CPA.

The ease of a Form 1099 stands in stark contrast to a Schedule K-1 that is more often associated with a pass-through private market investment structure. It is possible the Schedule K-1 information can be greatly simplified, but this may come at the cost of tax efficiency. So, when seeking retail investor capital, private market investment managers should strike a balance between tax efficiency and tax reporting simplicity. Simplified tax reporting may require holding investments in corporate form as opposed to pass-through form.

Some key considerations when structuring corporate versus pass-through investments are listed below:

  • Corporate structures may:
    • Result in federal and state taxes that may reduce the investment return.
    • Provide easier investor tax reporting via Form 1099 or a Schedule K-1 with similar Form 1099 reporting.
    • Limit investors’ additional exposure to state and local tax filings.
    • Align taxable income events with the receipt of cash, limiting the potential of phantom income.
    • Allow for easier exit of the investment.
  • Pass-through structures may:
    • Enable investors to earn income that may be favorable in terms of timing and character (noting this also may increase the complexity of the reporting on Schedule K-1).
    • Increase investors’ exposure to state and local tax filings.
    • Require investors to extend their individual tax return filings deadlines.
    • Increase legal, administrative, and tax complexity.
    • Result in current taxable income without receiving cash from the investment, requiring an investor to make required individual income tax payments.

When structuring offerings, private market investment firms should consider the varied backgrounds and tax sophistication of retail investors, and how these factors can influence their tax reporting preferences. It is important to remember that the complexity of Schedule K-1 can depend on the tax structure implemented; and simplicity often comes at the cost of tax efficiency.

Earning trust should be a priority

No one likes a tax surprise (unless it's a refund). Investor education of tax considerations is a cornerstone to growing a trusted relationship. To reach this goal, private market investment firms should clearly articulate in overall investor-facing materials (typically an offering memorandum) the possible income tax compliance obligations and liquidity considerations in a manner that is clear and concise for the retail investor. Level-setting investor expectations is a critical first step. To maintain their trust, private market investment firms should have a back-office technology-driven reporting process and personnel to support retail investors’ expectations. Whether a private market investment firm decides to “buy, build or borrow,” it should have technology that can handle the intricacies of income tax reporting for a voluminous, diverse group of investors, as well as develop systems to quickly handle investor questions.

Looking ahead

The growth potential for private market investment firms in the retail investor market is substantial. To capitalize on this opportunity, private market investment firms should meet investors where they are, offering investment structures that align with their expectations for tax simplicity and liquidity. This requires a proactive approach in developing detailed processes for tax-simplified structures, clear communication strategies to convey the impact on investors, and a technology-driven system that can support these goals.

Learn more about PwC's Private Equity Tax Services

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