Passthrough investments by exempt organizations.

• Author: Dally, Curtis L.

Tax-exempt organizations must exercise care when investing in partnerships or S corporations. These investments can subject the organization to tax on its unrelated business taxable income (UBTI) on some or all of the passthrough income.

Sec. 512(c)(1) provides:

If a trade or business regularly carried on by a partnership of which an organization is a member is an unrelated trade or business with respect to such organization, such organization in computing its unrelated business taxable income shall, subject to the exceptions, additions, and limitations contained in subsection (b), include its share (whether or not distributed) of the gross income of the partnership from such unrelated trade or business and its share of the partnership deductions directly connected with such gross income.

However, the distributive share of a partnership's passive investment income is not UBTI. This is clarified by the following example in Regs. Sec. 1.512(c)-1:

[I]f an exempt educational institution is a partner in a partnership which operates a factory and if such partnership also holds stock in a corporation, the exempt organization shall include in computing its unrelated business taxable income its share of the gross income from the operation of the factory, but not its share of any dividends received by the partnership from the corporation. (Emphasis added.)

The amount of a partnership's income and deductions that are subject to UBTI must be provided to each tax-exempt partner pursuant to Sec. 6031 (d).

Before its repeal by the Revenue Reconciliation Act of 1993, Sec. 512(c)(2) provided an exception to Sec. 512(c)(1)'s general rule by requiring all income and deductions from publicly traded partnerships to be included in an exempt organization's UBTI. This repeal was effective for partnership years beginning after...