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Alternative investments: High yield, but at what cost?

June 20, 2016


In recent years, many tax exempt, not-for-profit organizations have turned to alternative investment vehicles, seeking higher yielding returns for their charitable endowments and investment portfolios. Usually these non-traditional investments are organized as pass-through entities, such as limited partnerships, that may generate taxable, unrelated business income for a tax exempt investor. Before investing in these types of funds, though, it is important to understand the possible tax implications and filing requirements for your organization.

Unrelated business taxable income rules and exceptions
Unrelated business taxable income or UBTI, is income generated from a trade or business that is not substantially related to an organization’s tax exempt purpose.

One important exception to the UBTI rules is described in IRC Section 512; which excludes revenue from dividends, interest, royalties, rent, capital gains and other forms of investment income from unrelated business income tax. Therefore, the investment income generated by a traditional non-profit’s portfolio comprised of equities, bonds and CDs is essentially tax free to the exempt organization investor. There are, however, certain types of non-profits that do pay tax on investment earnings. These are typically social clubs and VEBAs.

But not all investment income is excluded from unrelated business income tax. In fact, investment income generated by property subject to debt is subject to UBTI despite originally being excluded from UBTI under Section 512 above. Thus, if an exempt organization purchases equities using margin, uses debt to acquire any income producing assets (including a limited partnership interest) or if that partnership itself uses debt to purchase income producing assets, the debt financed rule will apply, causing a portion of that investment income to be taxable under UBTI rules.

Furthermore, Section 512(c)(1) states that if an exempt organization is a member of a partnership regularly engaged in a trade or business that is unrelated to the exempt organization, the exempt entity must include in its UBTI calculation its share of the partnership income, and deductions derived from the unrelated trade or business. This rule is commonly referred to as the “look-through rule.” Additionally, income derived by an exempt limited partnership interest is subject to UBTI. Thus, it is important to understand the characteristics of the income generated from the alternative investment to determine if the tax exempt investor is subject to unrelated business income tax.

Additional obligations

In addition to Federal unrelated business income tax consequences, alternative investment partnerships often earn income in various states and countries, requiring additional state and foreign filing. Because numerous states impose a tax on UBI, it is important for the exempt, not-for-profit partner to understand their filing requirements in each state where the partnership operates a trade or business.

While alternative investments seem appealing on the surface due to their lucrative returns, the administrative burden of the additional tax filing requirements, as well as the tax cost itself, may outweigh the seemingly high rate of return. In other words, consider the after-tax ”costs” of these investments when comparing them to other, more traditional investment vehicles.

All content provided in this article is for informational purposes only. Matters discussed in this article are subject to change. For up-to-date information on this subject please contact a Clark Schaefer Hackett professional. Clark Schaefer Hackett will not be held responsible for any claim, loss, damage or inconvenience caused as a result of any information within these pages or any information accessed through this site.


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