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Alternative Investments and UBIT: Weighing the Options


Keep calmPart two of a
two-part series on tax consequences of alternative investments. Part one can be found here.

Not-for-profits need to weigh their options carefully if they are thinking of adding alternative investments such as partnerships, private equity funds, real estate investment trusts and hedge funds to their portfolios.  As part of a well-designed investment strategy, alternative investment vehicles have the potential to provide greater returns than traditional stocks, bonds or money market funds, with the added benefit that they can counter risk exposure in volatile markets.

However, these investments can trigger tax liability under the unrelated business income tax (UBIT, pronounced “you-bit”) rules, and the resultant taxes (and accrued interest and penalties, if discovered subsequently) can take a bite out of an organization’s budget.

So what can be done to take the bite out of UBIT? 

There are basically three options:

  1. Just Say No

Some funds will permit tax-exempt investors to elect not to participate in investments that generate UBIT. Organizations may steer clear of alternative investments altogether to avoid tax compliance headaches. This may not be an ideal solution, as it generally leads to lower returns on the organization’s investments.

  1. Bob and Weave

Another strategy is to create special purpose entities to avoid or minimize UBIT exposure. Organizations taking this approach will incur costs and will need to engage the help of a CPA specializing in exempt organization taxes or an attorney. This tactic is usually accomplished through what are referred to as blocker corporations and feeder funds. These intermediate entities can be interposed between tax-exempt investors and the fund (referred to as feeders), or they may be interposed between the fund and a portfolio company LLC (referred to as blockers). Tax-exempt investors are able to avoid reporting UBIT on their own tax returns as, unlike partnerships, corporations do not pass through profits and losses to their shareholders.

  1. Keep Calm and Carry On

Many organizations manage their tax compliance issues and ongoing tax liabilities as part of a well-thought-out and vetted investment strategy. There is nothing inherently wrong with generating UBIT. Federal tax law permits a not-for-profit to engage in a limited amount of income-producing activity that is unrelated to its exempt purpose. Although there is no bright line test, as long as the unrelated income is not excessive, the organization’s tax-exempt status is not normally at risk.

Not-for-profits are encouraged to consult with an experienced tax specialist regarding the potential tax consequences.  In my practice, I don’t discourage clients from including alternative investments in their portfolios. With careful planning and foresight, the use of alternative investments can provide much needed capital and allow the organization to focus on what’s really important: advancing its mission.

You may be interested in signing up for a related webcast on Unrelated Business Income Tax: Tips, Tricks and Traps to Minimize Tax Liability, taking place October 24. Additional information is available from the AICPA’s Not-for-Profit Section, which offers exclusive, members-only news, resources and learning opportunities for not-for-profit professionals and their business advisers. Members can download dozens of resources, including a white paper on Unrelated Business Income Taxes, a Form 990-T preparation check list, and a guide for Auditing Alternative Investments.

Israel Tannenbaum, CPA, Senior Manager, WeiserMazars LLP. Israel has over a decade of experience serving not-for-profit clients in a range of subsectors. He specializes in delivering insightful, comprehensive consulting and compliance tax services to clients in the not-for-profit sector as well as Fortune 100 companies and pension trusts. He is one of the many speakers presenting at this year’s AICPA National Not-for-Profit Industry Conference, coming up June 27-29.

Keep calm image courtesy of Shutterstock

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