Exploring Alternative Investments for Tax Exempt Organizations (article)

Exploring Alternative Investments for Tax Exempt Organizations (article)

The lingering effects of a recession are ever so concrete. Donors are not digging deep into their pockets and governments have cut spending to exempt organizations while concurrently increasing scrutiny of their activities. Exempt organizations are struggling as they strive to generate working capital and are seeking ways to remain self-sustaining. During these challenging times, many exempt organizations are exploring supplementary options for producing income in order to continue fulfilling their missions.

To produce additional income, alternative investments are one option exempt organizations may consider. These types of investments while effective, present specific challenges related to tax implications and reporting requirements on a federal and state level. Exempt organizations should be aware of the significant implications and requirements resulting from making alternative investments.

What is and is not exempt from tax?

Investment income, such as dividends, gains on the sale of securities, interest and annuities are all generally excluded in computing Unrelated Business Income Tax (UBIT). Although they are generally excluded from tax, these types of investments must be disclosed on IRS Form 990.

Alternative investments in pass-through entities such as partnerships could trigger UBIT and additional reporting requirements. There are three main considerations that need to be examined when considering the possibility of this type of investment. These considerations include:

  1. Potential Unrelated Business Income (UBI) from the partnership's regular trade or business,
  2. UBI from investments in debt-financed property, and
  3. Foreign investments and transactions of the partnership.

When a partnership engages in a trade or business, the exempt organization must act as if it conducted that activity itself. Thus, if the partnership generates income from an activity that is unrelated to the Exempt Organization's (EO) mission, the EO must treat its portion of that income and expense as UBIT. There is an important distinction to be made — as previously noted, an investment in a partnership is subject to UBIT to the extent that the partnership is engaged in unrelated trade or business with regard to the exempt organization. However, an investment in an S-corporation is always subject to UBIT, regardless of the nature or source of that income.

When UBI is involved, additional reporting requirements on both the federal (Form 990-T) and the state level surface. It is important to note that if a partnership has nexus in a state; the exempt organization is seen as having nexus in that state, and therefore must comply with those states' requirements. States have recently increased their scrutiny on these investments to ensure they are collecting their fair share of taxes.

Before investing in a partnership, an organization must disclose its tax-exempt status to the partnership. This is because a pass-through entity is required to disclose to its exempt organization partners which portion of the income derived is UBI. Furthermore, the K-1 footnotes should also apportion this income to different states to guide the organization with its state reporting requirements. This can be rather complex, and the partnership will almost always recommend that the organization consult their tax advisors to handle this compliance aspect.

Is debt-financed property of an exempt organization subject to tax?

Similar to income derived from an unrelated trade or business, income derived from debt-financed property by the partnership flows through to the partners as if they derived the income themselves. Since nonprofit laws state that income derived from debt-financed property is generally subject to tax, when a partnership generates this income and it is passed-through to the exempt organization, the income must be treated as UBIT and reported accordingly.

In addition, the organization must consider the external debt used in acquiring the partnership investment. Under these circumstances, both the indebtedness incurred by the organization in acquiring its partnership interest and the allocable portion of the partnership's indebtedness incurred with respect to acquiring the partnership's property, are considered to be incurred in acquiring income-producing property. The organization therefore has acquisition indebtedness attributable to both its own borrowing and the partnership's borrowing. Since income from debt-financed property is subject to UBIT, and the amount of income included is proportionate to the debt on the property, this would require debt to basis calculation at the partner level and exempt organization level.

What are the foreign investment implications?

The third aspect that must be considered when making the decision about these alternative investments is potential foreign investments and transactions of the partnership. Partnerships transferring assets to a foreign corporation, or to a foreign partnership, may trigger additional filing requirements. Specifically, one such additional requirement is Form 990, Schedule F. Other potential filling requirements include IRS Forms 926, 8865, etc. As previously discussed, an exempt organization who is a partner in a partnership which conducts this type of activity must treat these events as if they conducted it themselves and must report them accordingly.

There are other types of investments an exempt organization can make besides those in pass-through entities. An exempt organization with excess cash could consider loaning that money and collecting interest on it. This is generally permissible, even if the organization loans the money for an unrelated purpose. As long as the rate of interest is not excessive and there is no private inurnment, interest income is generally non-taxable and will not jeopardize an exempt organization's tax-exempt status.

It is important to weigh all options and to perform a cost/benefit analysis before making alternative investment decisions. The extra compliance costs could outweigh the potential benefits of the investment, or investments could be deemed as too risky and not worth jeopardizing an exempt organization's contributions. However, there are many great opportunities out there for alternative investments, and they should be analyzed with your tax consultants to identify the right decision for your organization. For more information, please contact your local CBIZ office.


Copyright © 2012, CBIZ, Inc. All rights reserved. Contents of this publication may not be reproduced without the express written consent of CBIZ. To ensure compliance with requirements imposed by the IRS, we inform you that-unless specifically indicated otherwise-any tax advice in this communication is not written with the intent that it be used, and in fact it cannot be used, to avoid penalties under the Internal Revenue Code, or to promote, market, or recommend to another person any tax related matter. This publication is distributed with the understanding that CBIZ is not rendering legal, accounting or other professional advice. The reader is advised to contact a tax professional prior to taking any action based upon this information. CBIZ assumes no liability whatsoever in connection with the use of this information and assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect the information contained herein.

CBIZ MHM is the brand name for CBIZ MHM, LLC, a national professional services company providing tax, financial advisory and consulting services to individuals, tax-exempt organizations and a wide range of publicly-traded and privately-held companies. CBIZ MHM, LLC is a fully owned subsidiary of CBIZ, Inc. (NYSE: CBZ).

Exploring Alternative Investments for Tax Exempt Organizations (article)The lingering effects of a recession are ever so concrete. Donors are not digging deep into their pockets and governments have cut spending to exempt organizations while concurrently increasing scrutiny of their activities. ...2012-03-22T18:21:00-05:00The lingering effects of a recession are ever so concrete. Donors are not digging deep into their pockets and governments have cut spending to exempt organizations while concurrently increasing scrutiny of their activities.