VWV charity investor services: schedules K-1 imminent: UK charities investing in U.S. private equity or property funds should scan them for UDFI

UK charities that are equivalent to U.S. section 501(c) organisations and invest in U.S. private equity or property funds (often formed as partnerships for U.S. tax purposes) will soon receive Schedules K-1 from these partnerships reporting their allocations of income, gains, and expense from operations for calendar year 2025. Most section 501(c)(3)-equivalent UK charities, other than private foundations, expect that their U.S.-source income and gains will be entirely exempt from U.S. tax.

But these charities sometimes have their expectations dashed by reason of a partnership's incurring "net asset value" borrowing or other financing secured by the acquired property. Thus, if the partnership has incurred debt to acquire the equity of a portfolio company or a U.S. property, secured by that asset, a portion of the U.S.-source gross income or gains arising from such "debt-financed property" will usually generate taxable "unrelated debt-financed income" ("UDFI") to UK charity investors. (Many U.S. venture capital funds sidestep this U.S. tax risk due to regulatory restrictions on their power to borrow.) Additional complications arise if, unusually, the charity itself has borrowed to acquire its limited partnership interest in the U.S. fund.

What is UDFI?

UDFI is a different type of taxable income from the more common category of "unrelated business taxable income" (UBTI) that arises from a partnership's investing in a fiscally transparent portfolio company, or operating a U.S. property, and which is similar to UK non-primary purpose trading income. This more common type of UBTI can be mitigated by electing to contribute capital for such a portfolio company or property via a "below-the-fund" blocker subsidiary, which election is almost always offered by fund managers at the time of commitment. Importantly, this election offers no protection from UDFI generated by the partnership itself incurring "acquisition indebtedness."

UDFI has no equivalent in the UK taxation of charities, and so is often missed; any U.S. tax paid on UDFI is unlikely to serve as a foreign tax credit on a UK self-assessment. UDFI is especially concerning because there is no easy mitigation offered by fund managers at subscription, and its amount in principle can equal the full amount of the income or gains arising from a "debt-financed property."

We have seen an increasing number of U.S. funds allocate UDFI from operations to UK charitable limited partners. Such allocations are usually not reduced by any U.S. taxes withheld, and a recipient must file a Form 990-T with the IRS if it has been allocated at least $1,000 of gross UDFI in a calendar year.

How would a UK charity know at subscription whether a fund will allocate any UDFI to it?

It will not know for certain. Many private equity funds retain the power to incur net asset value borrowing and may highlight a consequent U.S. tax risk in their PPMs. The PPM may contain disclosure of pre- and post-levered returns from prior vintages that may suggest a practice of incurring such borrowing. The decision as to whether UDFI has been generated is taken by the fund's U.S. tax return preparer only after the first year when "acquisition indebtedness" has been incurred, and these preparers appear to be taking a more conservative view recently.

How can a UK charity determine whether it has been allocated any UDFI for 2025?

The UK charity should check whether Box 20, Code V ("Unrelated Business Taxable Income") on Schedule K-1 has been ticked, in which case a statement should be included breaking down the total into the component items of income, gain, and expense. Then the charity needs to determine whether these amounts are the non-primary purpose trading type of UBTI, or UDFI.

Indicators of UDFI include: (1) a share of the partnership's liabilities has been apportioned to the UK charity at the end of the year at Part II, Item K1 of Schedule K-1; and (2) no allocation of "effectively connected income," overlapping almost entirely with the trading type of UBTI, has been made (and so no Form 8805 has been issued). But contacting the fund to confirm would be advisable.

What should a UK charity do next?

If the charity has indeed been allocated at least $1,000 of gross UDFI by a U.S. fund for the 2025 calendar year, it will need to file a U.S. self-assessment (Form 990-T) with the IRS and report the UDFI net of allowable deductions (such as interest expense). This is an item-by item calculation, using the components of the Box 20, Code V statement, and some income may benefit from relief available under the U.S.-UK double tax treaty or fall out of U.S. taxation completely due to U.S. sourcing rules. Schedule K-3's information about source will be helpful here. Specialist advice should be sought at this stage, and dialogue commenced with the reporting fund, because the UDFI statement on Schedule K-1 almost never contains the correct amounts for the U.S. tax return; and these amounts rarely match amounts set forth in other portions of Schedules K-1, K-3, or Form 1042-S.

A UK charity has a few self-help strategies that it can employ with the fund's cooperation to shelter it entirely from a future allocation of UDFI. A UK charity can undertake these at subscription if it fears being allocated a material amount of UDFI, or demand that the manager commit to collaborating with the charity's later self-help if there is a future allocation of UDFI.

Summary

UK charities generally are not familiar with UDFI. It is reported tersely on the Schedule K-1, and the ensuing U.S. tax liability must be paid in with a U.S. tax return. It is a niche U.S. tax risk because other types of borrowing in this sector generally do not generate UDFI (e.g., short term subscription line borrowing to finance late capital contributions, or borrowing by opaque portfolio companies).

A report of UDFI is easy to miss upon a quick review of Schedule K-1, as is "snail mail" correspondence from the IRS inquiring about an unfunded U.S. tax liability.

VWV has extensive experience in interpreting Schedules K-1/K-3 issued by U.S. private investment funds to UK charities, and in advising them how to present any debt-financed items of U.S.-source income or gains on their Forms 990-T. VWV represents UK charities of many kinds with respect to their global private fund investments.