Considerations for Tax-Exempt Organizations Investing in Pass-Through Entities

With assets totaling several trillion dollars, tax-exempt organizations in the United States are a significant segment of investors in financial markets.

Some tax-exempt organizations, such as university endowments, foundations, and qualified pension funds, have reported record donations and holdings during 2015. With the strong market performance of recent years and the low interest rate environment, many tax-exempt organizations have become incentivized to enter into alternative investments, such as hedge and private equity funds.

Lurking beneath the allure of higher investment returns, however, are special tax considerations of which tax-exempt organizations should be mindful when making those alternative investments. While the structure of these funds can take many forms, they are typically formed as limited partnerships or limited liability companies taxed as partnerships. For tax purposes, income from these funds is treated as passing through, and being taxed directly, to the investors in the fund. As a consequence of this attribute, tax-exempt organizations may unknowingly be subject to tax on certain investment returns and attendant filing requirements under federal and state law.

Aside from the excise tax on a private foundation’s net investment income, tax-exempt organizations are generally not subject to tax on income derived from activities that are related to their exempt purpose. Conversely, business income from activities that are unrelated to the organization’s exempt purpose may be taxable to the extent it exceeds allowable deductions from those unrelated business activities. This taxable amount is referred to as unrelated business taxable income (UBTI). Exempt organizations with UBTI are generally required to file Form 990-T, Exempt Organization Business Income Tax Return, with IRS. This is an additional requirement for organizations that already file returns with IRS (i.e., Form 990, Form 990-PF, or Form 5500, et al). The tax rate that applies to UBTI depends on the legal form of the tax-exempt organization under state law. Trusts are subject to the graduated rates for trusts, whereas corporations are subject to the corporate income tax rates. Tax-exempt entities with UBTI are also subject to the alternative minimum tax rules.

UBTI generally does not include investment income, such as interest, dividends, rents, royalties, and capital gains, but there are other factors to consider that may cause such types of income to fall under the UBTI designation. If, for example, a tax-exempt organization borrows money to acquire property, a proportional amount of the income from such property attributable to the debt-financing is includable in the definition of UBTI. To illustrate this concept, suppose a tax-exempt organization with $50 and no other assets borrows $50 to acquire an investment for $100. Under this fact pattern, 50% of the income from that investment, the debt-financed portion, will be subject to taxation despite the general exclusion of investment income from UBTI.

As a partner in a partnership, an exempt organization will include in UBTI its share of partnerships income that would be considered UBTI if it were earned directly by the exempt organization. To illustrate, suppose an exempt organization provides 50% of the capital requirement for a private equity venture taxed as a partnership for federal income tax purposes. The private equity fund invests in other partnerships engaged in trades or businesses that, if owned directly by the exempt organization, would be considered unrelated trades or businesses. If the private equity fund received $100 of business income from its underlying investments, the exempt organization would include $50 in UBTI with respect to that private equity investment. This result is the same whether the exempt organization is a general or limited partner in the venture.

Similar to individual taxpayers, certain tax-exempt organizations are subject to limitations on losses from passive activities. The loss limitations apply to items that may be included in UBTI. Generally, losses from passive activities may only be used to offset income from passive activities. Losses that exceed passive activity income are carried forward and can be utilized to offset passive activity income generated in future years or upon disposition of the activity generating the income or loss. As a result, an activity may appear to be generating losses but, when the limitations are properly applied, the activity is in fact generating income that is taxable as UBTI.

Publicly traded partnerships (PTPs), which include master limited partnerships, present a similar pitfall when they report losses to their investors. Income passed through from these investments will generally fall under the definition of UBTI. To the extent a PTP reports a loss to an investor in the current year, the loss is carried forward to future years. Although they generally follow the same rules as other partnership investments, net losses from PTPs can only offset future income from the same PTP. In contrast, other passive activities subject to the loss limitations described above can be aggregated or separated into groups of activities that are analyzed together to determine whether the limitation applies. Similar to other passive activities, losses from PTPs may be utilized in the year the partner disposes of its interest therein.

Pension trusts, public charities, and private foundations may also be S corporation shareholders. The major tax characteristic of an S corporation is that the income is treated as passing through, and is taxed annually, to its owners, similar to a partnership. As a general rule, all income from an S corporation is treated as UBTI to a tax-exempt shareholder, except for employee stock ownership plans (ESOPs).

The investment community is aware of UBTI and the effect it might have on returns for tax-exempt organizations or their willingness to participate in alternative investment funds. As a result, the use of blocker corporations has become common-place as a way to lessen the impact of UBTI. Since income does not pass through a corporation for tax purposes the way it does a partnership, the corporation blocks the tax-exempt investor from UBTI by participating in the venture and in-turn paying a dividend, which would not be considered UBTI. This structure is not without consequence, however, as corporations are separately subject to income tax on earnings, no matter the source.

State governments are also on the look-out for UBTI. Partners in a partnership will be subject to the tax laws and filing requirements of a particular state if the partnership holds underlying investments in that state. Currently, most states impose some form of tax on UBTI. The treatment of different tax-exempt organizations and the methods for calculating UBTI vary considerably from state to state.

In addition to potential UBTI exposure, tax-exempt organizations may be subject to a host of other filing requirements when investing in alternatives. The following are a few examples of such filings (not an all-inclusive list). Investing in a foreign partnership, or a domestic investment fund that holds an interest in a foreign partnership, may give rise to a requirement to file Form 8865, Return of U.S. Persons With Respect to Certain Foreign Partnerships. Similarly, investing in a foreign corporation or an investment fund that contributes capital to a foreign corporation could give rise to a requirement to file Form 926, Return by a U.S. Transferor of Property to a Foreign Corporation, or Form 5471, Information Return of U.S. Persons With Respect To Certain Foreign Corporations. Failure to file these forms could result in stiff penalties – in some cases up to $100,000 per form. Furthermore, tax-exempt organizations generally are not subject to the rules related to passive foreign investment companies (PFICs). Income from a PFIC investment, however, could be subject to UBTI under certain circumstances and therefore taxable. In this case, the organization must file Form 8621, Information Return by a Shareholder of a Passive Foreign Investment Company or Qualified Electing Fund, with respect to its direct or indirect investment in the taxable PFIC.

While the upside of alternative investment funds is attractive to tax-exempt organizations looking for a more competitive return, such organizations should be wary of potential tax consequences and filing requirements that may result when entering into such ventures. Certain types of investment returns that would not otherwise be subject to tax may become taxable. The organization may also face a substantial administrative burden with respect to its new tax filing requirements. Taxes, though, are not the only factor to consider when choosing investments. Alternative investment platforms may provide for greater diversity and be an integral part of an organization’s investment strategy. A tax professional with the right experience and expertise can help an organization identify and assist with structuring, avoiding pitfalls and, overall, keeping in compliance with applicable reporting requirements.