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Investments and Tax Awareness: Tips for Trustees

Investments and Tax Awareness: Tips for Trustees

Unrelated Business Income (UBI) is an old tax concept that has gained renewed interest for the Internal Revenue Service (IRS) in the wake of the Great Recession.  Unrelated Business Income Tax (UBIT), a source of revenue for the IRS, applies to not-for-profit organizations when they regularly engage in revenue-generating activities that are not directly related to their exempt purpose (see “More About UBI” at right).  UBI rules apply to all tax-exempt organizations, including qualified pension trust funds.

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Many pension funds have begun investing in alternative investments, which could potentially trigger UBI.  As such, UBI is a mounting issue for trustees of pension funds and their advisors, because of the costs and reporting implications of UBIT. 

Following are considerations associated with UBI and alternative investments for pension fund trustees and their advisors.

Are you thinking of changing the trust’s investment strategy?

Guided by an investment policy, trustees (or other fiduciaries) are faced with challenging investment strategies to maximize returns, diversify investments and minimize risk.  Investment in partnerships or Limited Liability Companies (LLCs) is an alternative investment tactic used by many large defined benefit pension trusts to further diversify their investment portfolios.   Before investing in a partnership or LLC, trustees should ask:

·       Does the trust’s investment policy allow for these types of investments?

·       Will these investments trigger UBI?

Are there any reporting requirements?

Tax-exempt organizations (including pension trusts) must notify the partnership of its tax-exempt status.  The partnership is required to report the amount of UBI or sufficient information to the member investor in order to determine the UBI amount, if any.  The IRS does not assess tax on the partnership; investors are provided a Form K-1 that discloses the investor’s share of income, deductions, credits and taxable UBI for their income tax reporting purposes.  Tax-exempt organizations are required to report taxable UBI on federal Form 990-T and state returns, as applicable.  If a partnership has transactions with, or an interest in, a foreign organization, additional reporting requirements may apply. 

Is reporting required when a partnership reports a UBI loss?

No, a trust is not required to file Form 990-T to report a UBI loss.  However, the trust should consider reporting the loss because it can be carried forward to a subsequent year to offset taxable income and reduce the amount of UBI tax.

What is the UBI tax rate for trusts?

Exempt entities often assume that they are not subject to income taxes.  This is not the case and, in fact, the applicable tax rates can be significant.  For 2013, the federal tax rate ranges from 15% to 39.6%, with a rate of 39.6% for taxable UBI over $11,950. 

When are UBI taxes due?

An entity is required to deposit estimated tax if the UBI tax is expected to be $500 or more.   For a calendar or fiscal year organization, the payments are due by the 15th day of the 4th (the 5th month for private foundations), 6th, 9th and 12th months of the tax year. For example, for a calendar year organization, the payments are due by April 15, June 17, September 16, and December 16, 2013, except that for a calendar-year private foundation, the first payment is due on May 15. 

Look Before You Leap

Investing in alternative investments may be an appropriate investment strategy for a trust.  However, before venturing into a new business activity, trustees should start a conversation with their service providers regarding the above considerations, including identification of UBI-generating investments.  UBI requires implementation of tax planning and on-going monitoring procedures to ensure taxes are paid timely and reporting requirements are met.  If investing in partnerships or LLCs, it is important to arrange for a copy of the complete Form K-1 with all notes and attachments to be directed to the Form 990-T preparer.

Want more information and examples of UBI?  Visit IRS Publication 598, Tax on Unrelated Business Income of Exempt Organizations, at: http://www.irs.gov/publications/p598  

More About UBI

UBI applies to all tax-exempt organizations under Internal Revenue Code § 501(a), including all 501(c) organizations—charities, unions, apprenticeship training trusts, health and welfare trusts—and all 401(a) organizations, such as qualified pension trusts and Individual Retirement Accounts. The primary purpose of UBI tax is to put tax-exempt entities and for-profit organizations on equal footing with respect to their trade or business activities.

UBI is defined by three characteristics; all three must be met:

  1. Unrelated trade or business (activity has a profit motive),
  2. Regularly carried on (frequency of activity comparable to commercial businesses), and
  3. Not substantially related to exempt purpose (based on facts and circumstances).

Examples of UBI Activities
Although there are exceptions to the rules, some common UBI activities include the sale of advertising space in a trade periodical, rental income from debt-financed property (the organization has a mortgage secured by property and leases space or the organization invests in a partnership for this type of business activity) and operating income from a partnership or limited liability company.

Michelle L. McCann, CPA, is a partner in Lindquist LLP's San Ramon office. She is primarily responsible for overseeing quality control for preparation of exempt organization and employee benefit plan returns, including Forms 5500, 990, LM-2 and 199.  Michelle also provides QuickBooks training and support for the firm's clients.  Michelle can be contacted at (925) 277-9100 or mmccann@lindquistcpa.com

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