Unrelated business income from alternative investments: state considerations.

• Author: Wong, Alan

The economic roller coaster over the past few years has been especially trying for exempt organizations. Donations and investment income are two traditional revenue streams that nonprofit organizations rely on to stay afloat and further their exempt purposes. As donors have trimmed donation dollars and investment returns have been squeezed by market swings, nonprofit organizations have turned to alternative investments to improve returns. Alternative investments can include hedge funds, private equity offerings, real estate investment trusts, currency funds, oil and gas and real estate limited partnerships, and limited liability companies (LLCs), to name a few.

With the increase in risk, and hopefully in return, come additional tax compliance considerations.

Alternative investments held in passthrough entities (partnerships, LLCs) can generate unrelated business income. This can come from trade or business income earned in the underlying activities of the passthrough, or from in-vestment earnings (interest, dividends, rents, gains/losses) that are debt financed. The unrelated business income generated from alternative investments is taxable at the federal level, pursuant to Sec. 512. Given the recent economic climate, many states have stepped up inquiry and enforcement so they can have their piece of the unrelated business income tax pie.

Alternative investments structured as partnerships or LLCs provide tax compliance information to investors in an annual Schedule K-l statement. Tax preparers of these types of investment partnerships are required to make certain disclosures of components of unrelated business income in the Schedule K-l for exempt organizations. Because K-l tax disclosure for alternative investments has improved in recent years, K-l reporting has been enhanced to include better unrelated business income information for federal filing purposes and information about activities and income sourced to different states. The additional state disclosures have given state taxing jurisdictions information that some states are now using to require exempt organizations to comply with state unrelated business income reporting rules, and they are hoping to increase state revenues in the process. This heightened scrutiny requires nonprofit organizations to take a thoughtful approach to state unrelated business income reporting compliance to minimize risk and improve compliance objectives.

Reasons to File

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