Are alternative investments worth their SALT for tax-exempt organizations?

• Author: Evans, Marianne
• Position: State and local tax

Many tax-exempt organizations have turned to alternative investments--such as limited partnerships, real estate funds, and private-equity funds--to generate returns higher than more traditional, direct investments in real estate, stocks, and bonds. These alternative investments are often in the form of passthrough entities whose items of income and loss are attributed to their respective owners.

Although, under Sec. 512(b), passive income from either alternative or direct investments generally does not constitute unrelated business taxable income (UBTI) to tax-exempt entities, this income, even if it is passive, may be classified as UBTI under Sec. 514 to the extent that (1) the tax-exempt organization's ownership interest in the alternative investment is purchased with debt financing, or (2) the activity conducted by--or any investment made by--the alternative investment generating the income is debt-financed.

In recent years, reportable UBTI of tax-exempt organizations with alternative investments has increased significantly, possibly because of an increase in debt-financed activity conducted by the alternative investments. (Most tax-exempt organizations are too tax-savvy to purchase an alternative investment using debt financing, which would make all income passed through to the tax-exempt owner UBTI.)

This item discusses some of the state and local tax (SALT) reporting challenges faced by tax-exempt organizations with passthrough (i.e., Schedule K-l) UBTI from alternative investments.

State Conformity to Federal Treatment of Tax-Exempt Organizations

Upon initial application for tax-exempt status, a qualified tax-exempt organization is issued a determination letter from the IRS certifying that the organization is exempt from federal income tax on income that is substantially related to the exercise of the organization's charitable, educational, or other tax-exempt function (i.e., on its non-UBTI). The tax-exempt organization remains subject to federal income tax on income from a trade or business that is unrelated to its exempt purpose (i.e., on its UBTI), as defined in Sec. 513. As noted above, passive income is generally treated as related to a tax-exempt organization's exempt purpose unless it is debt-financed. Imposing federal income tax on UBTI levels the playing field so that tax-exempt organizations are not using their tax-free profits or borrowing against their tax-free profits to expand operations into areas unrelated to their exempt purpose, in competition against for-profit corporations.

Certain states require tax-exempt organizations to apply for and obtain determination letters from the applicable state taxing authority to receive similar tax-exempt status for SALT purposes. For example, in California this is accomplished by filing Form 3500A, Submission of Exemption Request, and attaching a copy of the organization's federal determination letter; North Carolina requires a tax-exempt organization to send the Department of Revenue a copy of its articles of incorporation and bylaws to demonstrate its exempt purpose before it will grant an exemption from North Carolina income and...