Are Alternative Investments Worth Their SALT for Tax-Exempt Organizations?

By Marianne Evans, CPA, LL.M., and Caralee Hall, CPA, MST, Washington

Editor: Mary Van Leuven, J.D., LL.M.

State & Local Taxes

Many tax-exempt organizations have turned to alternative investments—such as limited partnerships, real estate funds, and private-equity funds—to generate returns higher than more traditional, direct investments in real estate, stocks, and bonds. These alternative investments are often in the form of passthrough entities whose items of income and loss are attributed to their respective owners.

Although, under Sec. 512(b), passive income from either alternative or direct investments generally does not constitute unrelated business taxable income (UBTI) to tax-exempt entities, this income, even if it is passive, may be classified as UBTI under Sec. 514 to the extent that (1) the tax-exempt organization's ownership interest in the alternative investment is purchased with debt financing, or (2) the activity conducted by—or any investment made by—the alternative investment generating the income is debt-financed.

In recent years, reportable UBTI of tax-exempt organizations with alternative investments has increased significantly, possibly because of an increase in debt-financed activity conducted by the alternative investments. (Most tax-exempt organizations are too tax-savvy to purchase an alternative investment using debt financing, which would make all income passed through to the tax-exempt owner UBTI.)

This item discusses some of the state and local tax (SALT) reporting challenges faced by tax-exempt organizations with passthrough (i.e., Schedule K-1) UBTI from alternative investments.

State Conformity to Federal Treatment of Tax-Exempt Organizations

Upon initial application for tax-exempt status, a qualified tax-exempt organization is issued a determination letter from the IRS certifying that the organization is exempt from federal income tax on income that is substantially related to the exercise of the organization's charitable, educational, or other tax-exempt function (i.e., on its non-UBTI). The tax-exempt organization remains subject to federal income tax on income from a trade or business that is unrelated to its exempt purpose (i.e., on its UBTI), as defined in Sec. 513. As noted above, passive income is generally treated as related to a tax-exempt organization's exempt purpose unless it is debt-financed. Imposing federal income tax on UBTI levels the playing field so that tax-exempt organizations are not using their tax-free profits or borrowing against their tax-free profits to expand operations into areas unrelated to their exempt purpose, in competition against for-profit corporations.

Certain states require tax-exempt organizations to apply for and obtain determination letters from the applicable state taxing authority to receive similar tax-exempt status for SALT purposes. For example, in California this is accomplished by filing Form 3500A, Submission of Exemption Request, and attaching a copy of the organization's federal determination letter; North Carolina requires a tax-exempt organization to send the Department of Revenue a copy of its articles of incorporation and bylaws to demonstrate its exempt purpose before it will grant an exemption from North Carolina income and franchise taxes.

When a tax-exempt organization's only connection to a state is that it derives state-sourced UBTI from alternative investments, how would it know whether a state-specific determination letter is required? For better or for worse, the onus is on the organization to determine where it is subject to tax and to comply with each state's requirements.

Nexus and State Tax Filing Obligations

As a general matter, investment in a passthrough entity doing business in a state creates income/franchise tax nexus—and therefore a state tax filing obligation—for nonresident owners, including tax-exempt organizations. A nonresident owner may be relieved of its state tax filing obligation if, for example, it is included on a composite return and the passthrough entity remits state income tax on its behalf. Barring that, however, the onus is (again) generally on the tax-exempt organization to file the required extensions, remit the estimated payments on UBTI, and file its state income/franchise tax returns.

Most states conform to the federal income tax definition of UBTI and impose corporate income tax or state unrelated business income tax on tax-exempt organizations with state-sourced UBTI from alternative investments. A few states, such as Delaware, Kentucky, New Jersey, Pennsylvania, and Texas, do not impose income/franchise tax on UBTI. Other jurisdictions, including the District of Columbia, New Hampshire, New York City, and Tennessee, impose income/franchise tax directly on the passthrough entity and not the owner. (Note that the rules relating to tax-exempt trusts often differ from those applicable to tax-exempt corporations, but the discussion in this item is limited to tax-exempt corporations.)

State-Sourced UBTI Information on Schedule K-1 (or Lack Thereof)

Although reporting of UBTI on the federal Schedule K-1 by alternative investments has improved over the years, it often is not as complete as many tax-exempt investors may need, particularly for state taxable income/loss. Box 20, "Other Information," of Schedule K-1 (Form 1065), when code V is entered, tells what amount or proportion of each line on the Schedule K-1 constitutes UBTI or a deduction from UBTI for federal income tax purposes. Sometimes, however, an entry in box 20, code V, is the only information provided with respect to UBTI.

While a Schedule K-1 footnote often indicates the total amount of income/loss by state, there might not be a schedule listing the UBTI by state. As a result, the tax-exempt organization may need to reasonably approximate UBTI by state. A reasonable approximation may be made, for example, based on the proportion of regular (non-UBTI) taxable income by state to regular (non-UBTI) federal taxable income overall, multiplied by total UBTI.

A similar challenge can arise with state-specific Schedules K-1, which may be provided to the owners in addition to the federal Schedule K-1. If the alternative investment has not provided state-specific UBTI information, the tax-exempt organization might have to perform confirmatory calculations to determine whether the state-specific Schedule K-1 amounts relate to UBTI or to total (UBTI as well as non-UBTI) taxable income.


Not all states have a state-specific Schedule K-1 or other form (such as California's Form 592-B, Resident and Nonresident Withholding Tax Statement) on which to report state income tax withholding or estimated payments made by the passthrough entity on an owner's behalf. A federal Schedule K-1 footnote listing the amounts paid to a state might be the owner's only evidence of state income taxes paid on its behalf. If a state-specific Schedule K-1 or withholding form is not provided, a tax-exempt organization may find it challenging to receive credit for amounts paid on its behalf or obtain refunds of overwithheld amounts because state taxing authorities sometimes have difficulty matching the amounts paid to the correct owner (especially in a tiered passthrough entity structure).

Passthrough entities are generally relieved of the requirement to withhold state income tax on tax-exempt owners' behalf to the extent they obtain a withholding waiver from the owners. Some states provide a specific waiver form (e.g., Illinois Form IL-1000-E, Certificate of Exemption for Pass-Through Withholding Payments), while others might accept a generic signed declaration to this effect. Passthrough entities may also be relieved of state income tax withholding if the tax-exempt organization agrees in writing to take responsibility to remit all required state income taxes.

Apportionment vs. Allocation

A tax-exempt organization with UBTI arrives at state taxable income/loss by multiplying its overall federal UBTI amount by an apportionment percentage. The apportionment percentage is determined by a formula on a state-by-state basis. State apportionment formulas use one or more of the following ratios (in various weighted proportions): property, payroll, and/or sales in the state during the tax year (i.e., numerator), in relation to property, payroll, and/or sales everywhere during the tax year (i.e., denominator). If the tax-exempt organization is "unitary" with the alternative investment, the state may require UBTI to be apportioned using the sum of the UBTI-related property, payroll, and/or sales of the tax-exempt organization itself (if any), plus amounts passed through from alternative investments.

Determining whether two entities are unitary is a fact-based analysis. A tax-exempt organization may be considered unitary with the passthrough entity in which it invests if the tax-exempt organization is functionally integrated with the investment, has day-to-day operational oversight or control over the investment's activities, shares common management with the investment, and/or has a controlling ownership percentage in the investment.

Many state Schedules K-1 or similar schedules provide information regarding the owner's share of the passthrough entity's property, payroll, and sales apportionment data by state. Tax-exempt owners, however, usually receive no indication of whether the apportionment data relate specifically to items that gave rise to UBTI or to total taxable income. For tax-exempt organizations that are flowing through (and reporting on their state income/franchise tax returns) the apportionment factor information from the passthrough entities in which they invest, absent further inquiries to the alternative investment itself, the tax-exempt organization may report some apportionment information that does not relate to the actual generation of UBTI.

Another difficulty faced by tax-exempt organizations' flowing through the apportionment factors from alternative investments is that information received from the alternative investment might indicate only the percentage of apportionment attributable to each state, not the breakdown of actual property, payroll, and sales amounts.

If a tax-exempt organization is not unitary with the underlying investment (which is often the case), it may be required to allocate, rather than apportion, its Schedule K-1 UBTI. In the context of alternative investments, "allocation" generally means that a nonresident owner takes its state-sourced UBTI amounts from Schedule K-1 and reports them directly on its state income/franchise tax return as state taxable income/loss, without applying an apportionment percentage. On some state returns, this is accomplished on the line(s) for nonapportionable income, for example, lines 4 and 8 on Wisconsin's 2014 Form 4T, Wisconsin Exempt Organization Business Franchise or Income Tax Return. Some states have forms specific to passthrough entity income/loss; for example, line 35 of the Michigan Form 4891, Corporate Income Tax Annual Return, is used to report income allocated from nonunitary passthrough entities, in conjunction with a separate Form 4898, Non-Unitary Relationships With Flow-Through Entities.

Do Federal Unrelated Losses Mean Zero State Income Tax Liability?

To the extent that a tax-exempt organization is in an overall unrelated business loss position for federal income tax purposes, it might assume that it does not have a state income/franchise tax liability. However, a taxpayer with negative overall federal taxable income could still have positive state taxable income in one or more states.

Example: A tax-exempt organization has alternative investments with oil and gas activity in North Dakota that generate positive UBTI. It also owns alternative investments with real estate activities in Arizona—a state hard hit by the housing collapse—that are generating unrelated business losses. In the aggregate, the tax-exempt organization's alternative investment Schedules K-1 total a net unrelated business loss for federal income tax purposes.

In this scenario, the tax-exempt organization owes state income tax in North Dakota on its positive UBTI, but it does not owe state income tax in Arizona because of negative allocated unrelated business losses. Despite being in a loss position, the tax-exempt organization should consider filing state income/franchise tax returns in Arizona to perfect its loss carryforwards for use against possible future UBTI in Arizona. Most states will not permit a taxpayer to use prior-year losses against positive current-year state taxable income unless the taxpayer filed state income/franchise tax returns in the year(s) the losses were incurred.

Franchise Tax

Several states impose a capital-based franchise tax in addition to a corporate income tax. Because—unlike a for-profit C corporation—a tax-exempt organization does not have stock, additional paid-in capital, etc., on which a franchise tax is typically based, states that do not otherwise exempt tax-exempt organizations from franchise tax generally impose only the minimum tax. State exemptions from franchise tax are not always easy for tax-exempt organizations to identify (i.e., usually not listed in the filing instructions), and some states have prequalification requirements for a franchise tax exemption (e.g., obtaining a state-specific determination letter).


In an ideal world, alternative investments would meticulously cater to each of their tax-exempt organization investors by providing Schedule K-1 footnotes and state-specific Schedules K-1 with UBTI information. However, in the annual rush to get thousands of Schedules K-1 out the door in a limited time, steps to tailor footnotes or other information to tax-exempt organization investors may not be at the top of compliance priority lists. As the overall contingent of tax-exempt owners becomes larger, though, alternative investments may in the future provide more and better state-sourced UBTI information.

In the meantime, tax-exempt organizations with a large volume of alternative investments should expect to spend a significant amount of time analyzing Schedules K-1 and complying with state income/franchise tax reporting requirements each year. Tax-exempt organizations should be aware that even if they are in an overall loss position for UBTI purposes, state-level allocated UBTI may be positive in certain states, and therefore state income/franchise tax liabilities can still exist even when the federal unrelated business income tax liability is zero.

To safeguard against penalties for underpayment of estimated tax, tax-exempt organizations may consider paying 100% of their prior-year state income/franchise tax liability at extension. In addition, tax-exempt organizations may need to increase their communications with the investment offices of their various alternative investments and request notification if a transaction during the year is expected to generate significant UBTI.


Mary Van Leuven is director, Washington National Tax, at KPMG LLP in Washington.

For additional information about these items, contact Ms. Van Leuven at 202-533-4750 or

Unless otherwise noted, contributors are members of or associated with KPMG LLP.

This column represents the views of the authors only and does not necessarily represent the views or professional advice of KPMG LLP. The information contained herein is of a general nature and based on authorities that are subject to change. Applicability of the information to specific situations should be determined through consultation with your tax adviser. ©2015 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative (“KPMG International”), a Swiss entity. All rights reserved.

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