The uncertain economy and turbulent financial markets of recent years have led some not-for-profit organizations to turn to alternative investments. While these investments may hold the potential of higher returns, they also come with the risk of unrelated business income tax (UBIT). Even in the absence of tax liability, alternative investments can involve significant filing requirements.
In a Nutshell
Not-for-profit organizations have long put their money in traditional investments like stocks, bonds and real estate. But the recession and slow economic recovery have prompted some to consider investments in domestic or foreign hedge funds, private equity funds, commodity funds and private investment funds.
These entities typically are formed as partnerships or limited liability companies (LLCs), with the income and income tax liability passing through to investors.
The UBIT Issue
Revenue that a not-for-profit generates from a trade or business that is not substantially related to furthering the organization’s tax-exempt purpose may be subject to UBIT. Investment income — for example, interest, dividends, and gains on the sale of securities — is usually excluded from UBIT.
But when a partnership or LLC engages in a trade or business, its investors are treated for tax purposes as if they conducted that activity themselves. As a result, if a partnership or LLC generates income from an activity that is unrelated to a not-for-profit investor’s purpose, the not-for-profit must treat its share of the income as unrelated business income.
The risk of UBIT does not end there. Although interest, dividends and capital gains are generally exempt from UBIT as investment income, not-for-profits should bear in mind the exception for income from debt-financed property. If a not-for-profit took out a loan to make an alternative investment, all of the income produced by that investment is subject to UBIT, including any gain when the investment is sold. The debt-financed income exception also applies if the partnership or LLC used debt to finance the purchase of an income-producing asset, such as a rental property, that passes income through to the not-for-profit.
Role of Schedule K-1
Not-for-profit investors in alternative investments generally receive a Schedule K-1, which reports the investor’s income broken down by the nature of the activity that generated it. The form usually includes both income from unrelated business activity and traditional investment income. The Schedule K-1 should report income subject to UBIT on a separate line or in a footnote. However, the investment entity might not do so if it is unaccustomed to following applicable UBIT rules. Not-for-profit organizations, therefore, should closely scrutinize their Schedules K-1.
Alternative investments can also require the filing of additional tax forms. Failure to comply can result in costly penalties. For example, you may need to plan for:
- Form 990-T for unrelated business income;
- Form 926 for certain investments in foreign corporations;
- Form 8865 for investments in foreign partnerships;
- Form 8886 for transactions with the potential for tax evasion; and
- Estimated tax payments.
Remember, too, that you may have state filing obligations related to activities of the LLC or partnership, including in those states where your not-for-profit organization has no presence.
Look Before You Leap
Alternative investments can prove lucrative for not-for-profits, but it is critical to consider the implications of UBIT and filing rules. In the long run, tax and administrative burdens could outweigh the potential advantages.
If you have questions about alternative investments and the risk of unrelated business income tax (UBIT), please contact Jeff Chiles at [email protected] or call him at 312.670.7444.