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The uncertain economy and tempestuous financial markets of recent years have led some nonprofit 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
Nonprofits 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
As you probably know, revenue that a nonprofit generates from a trade or business that isn’t substantially related to furthering the organization’s tax-exempt purpose may be subject to the UBIT. Investment income — for example, dividends, gains on the sale of securities, and interest — 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’s unrelated to a nonprofit investor’s purpose, the nonprofit must treat its share of the income as unrelated business income.
The risk of UBIT doesn’t end there. Although interest, dividends and capital gains are generally exempt from the UBIT as investment income, nonprofits should bear in mind the exception for income from debt-financed property. If a nonprofit took out a loan to make an alternative investment, all of the income produced by that investment is subject to the 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 nonprofit.
Role of Schedule K-1
Nonprofit 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 the UBIT on a separate line or in a footnote. However, the investment entity might not do so if it’s unaccustomed to following applicable UBIT rules. Nonprofits, therefore, should closely scrutinize their Schedules K-1.
Alternative investments often require the filing of additional tax forms. And the 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 has no presence. As of this writing, 39 states tax unrelated business income and 13 require a distinct 990-T.
Look Before you Leap
Alternative investments can prove lucrative for nonprofits, but it’s critical to consider the implications of the UBIT and filing rules. In the long run, tax and administrative burdens could outweigh the potential advantages.