Tax-exempt organizations need a steady, reliable revenue stream to survive and thrive. But as traditional revenue sources and donations dry up, and competition for scarce resources heats up, more and more organizations are turning to “alternative investments” to generate much-needed cash.
So-called “alternative investments” have the potential for higher returns than traditional investments such as stocks, bonds and property. However, they also carry greater market risk, and the executives, boards of directors and management of organizations have an obligation to fully understand these risks before investing.
In addition to the inherent market risks of hedge funds, private investment funds, commodity funds and private equity funds, tax-exempt organizations run the risk of losing their exempt status if they do not adequately account for alternative investment income and comply with very strict government disclosure requirements.
Alternative Does Not Mean New
First of all, there is a common belief that alternative investments such as hedge funds and private equity funds are something new. This misperception is largely due to their recent unflattering exposure in the popular media. In fact, the first hedge fund was created in 1949. Today, about 12,000 different hedge funds are available to investors in an industry worth more than $1 trillion.
So non-traditional investments are not the new kid on the block, but they are growing, and that’s why tax-exempt organizations need to understand what they are getting into.
Alternative investments are often used as a tool to reduce overall investment risk. They are commonly organized as partnerships or limited liability corporations (LLCs), with income passing through to investors. Taxes are levied at the partner level. While there is potential for high returns from alternative investments, an exempt organization must be aware of the tax implications. One of the most critical is the potential for unrelated business income.
Unrelated Business Income
Typically, income from activities related to an exempt organization’s charitable purposes is not subject to federal income tax. This includes day-to-day operations conducted while carrying out its charitable purpose, certain special fundraising events and income derived from traditional investments (interest, dividends and capital gains).
However, revenue generated from unrelated trade or business may be defined as unrelated business income (UBI). That income may be subject to federal and state taxes. Generally, UBI is income that is not substantially related to the mission on which the organization’s exempt status is based.
Examples may include the sale of advertising space in an organization’s newsletter or magazine, certain services to members, affinity marketing programs (such as branded credit cards) and some joint ventures. IRS Publication 598, Tax on Unrelated Business Income of Exempt Organizations, has additional information and examples.
Section 512(a) of the Internal Revenue Code offers a three-prong test for UBI. The code says that an activity is unrelated if:
- It is a trade or business that is engaged in for profit
- It is regularly carried on by the organization
- It is not substantially related to the organization’s exempt purpose.
UBI can be generated by the organization itself, or indirectly through the activities of an alternative investment. In its current form, the tax code provides that net profits from activities that do not further a tax-exempt organization’s exempt purposes are subject to taxation at normal corporate rates. This is known as the Unrelated Business Income Tax (UBIT).
Know Your Schedule K-1
Be forewarned that UBI generated from alternative investments can be slightly more complicated due to the fact that there is usually a mix of unrelated business income and exempt purpose income. In the most common scenarios, the income from an alternative investment is reported to the investor (in this case, the exempt organization) on Schedule K-1. Income is broken out by the nature of the activity that produced it. The Schedule K-1 for a typical investment reports income from a business activity (most often unrelated to an organization’s exempt purpose) along with traditional investment income such as interest, dividends and capital gains.
In most cases, traditional investment income will continue to be exempt from income tax, while a portion of the remaining income will be subject to UBIT. The Schedule K-1 should report, either on a separate line or in a footnote, the amount of the income that is subject to UBIT.
The one major exception to the tax treatment of this income is on debt-financed property. If a loan is taken out to purchase an alternative investment, all of the income produced by the investment is subject to UBIT, regardless of its nature. Similarly, any capital gain produced by selling a debt-financed investment is also subject
If an exempt organization has gross UBI of $1,000 or more during its fiscal year, it must file IRS Form 990-T at the same time as Form 990, to report the income and pay any tax due. However, if the organization expects its annual UBIT (after certain adjustments) to exceed $500, it must make estimated tax payments throughout the year.
States Want Their Share, Too
Along with the federal Schedule K-1, organizations may receive K-1s from various states. These state K-1s will report the amount of total income and unrelated business income that is attributable to their state. Even though the organization may not have a presence in a particular state, an interest in an alternative investment may create a corporate income tax filing obligation.
Prepare First, Invest Second
Even as alternative investments have grown in the portfolios of exempt organizations, the IRS has increased its scrutiny of unrelated business income. It’s more important than ever to understand the pros and cons of all revenue sources and their contribution to fulfilling the organization’s mission. iBi
Jim Gibson is a partner in Clifton Gunderson’s Peoria office. He has
more than 25 years of experience in accounting and audit services for