Unrelated Business Income from Alternative Investments: State Considerations

By Dori Eggett, CPA, Ehrhardt, Keefe, Steiner & Hottman PC, Denver, CO

Editor: Alan Wong, CPA

Exempt Organizations

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 investment 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-1 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-1 for exempt organizations. Because K-1 tax disclosure for alternative investments has improved in recent years, K-1 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

As part of their approach to determine if a state tax return is required to be filed, exempt organizations with potential state unrelated business income should consider a few of the reasons to file a return in a particular state. One consideration is whether the organization has nexus, which is usually determined by whether the organization has property, employees, and sales in a state. For alternative investments, some states will require that the organization “look through” to the activities of the partnership. States that follow this approach will conclude that if the partnership has activity in a particular state, the exempt organization partner does as well, thus giving the exempt organization state tax nexus and a filing requirement for state unrelated business income. Other states have declared that an interest in an alternative investment partnership is a passive investment and does not create nexus for the investor. The key is to become familiar with the rules on a state-by-state basis to properly assess potential filing requirements.

A second reason to consider filing in a particular state is to preserve net operating loss carryforwards that may be generated by poor investment performance. In many states, such losses may be used against future unrelated business income, so establishing their existence is important. However, not all states have provisions that allow the carryforward of net operating losses, so a careful review of such rules by the state is recommended.

Third, many states have specific disclosure requirements related to foreign filings and reportable transactions. Fines and penalties can be assessed for failure to make appropriate disclosures of foreign filings and reportable transactions at the state level.

Finally, organizations that are investing in alternative investment partnerships may be entitled to refunds of state taxes withheld by the partnership. The recovery of such refunds may be worth the time and resources to file even if no filing requirement exists.

Filing Options

Once an exempt organization has determined that it may have a filing requirement for state unrelated business income, it must assess its state filing compliance options. An organization may decide that the cost of additional compliance with reporting requirements of a particular state is significantly more than the risk of noncompliance, and do nothing. It may take a different approach with other states where the risk is greater and may decide to participate in an amnesty program, if available, or it may voluntarily disclose its past noncompliance and bring all filings current. For other states, the organization may decide that it will comply going forward and not worry about the past.

Organizations will need to carefully consider which approach they will take for each state and make a business decision about where to file. While the do-nothing approach is not generally recommended, there are situations where the compliance burden may exceed the risk of noncompliance. A potential benefit of the amnesty approach and the voluntary disclosure approach is that the state may waive or reduce penalties for past failures to comply and may limit the lookback period for compliance to the years where the statute is still open. The compliance going forward approach is likely to be the least expensive in terms of tax preparation fees, additional taxes, penalties, and interest. Regardless of whether an organization chooses amnesty, voluntary disclosure, or compliance going forward, it runs the risk that such communication with a state will generate further interest and inquiry, which may increase the compliance burden.

Determining Income

An exempt organization that makes a business decision to file in a particular state must then determine proper unrelated business income for that state. Most states require the use of the apportionment method for determining state taxable income. Although K-1 reporting of state activities has improved in recent years, it still provides only a portion of the information necessary to properly report unrelated business income by state.

Because an alternative investment may have partners that run the gamut of type of investor, the state K-1 information, if provided at all, may not apply to all types of investors. For example, some Schedules K-1 provide a list of states and the income apportioned to that state, which is appropriate information for individuals and other partnerships. However, the schedule may not provide sales, payroll, and property apportionment data by state, which is necessary for corporations and exempt organizations to determine state taxable income. In this situation, organizations should work closely with their investment advisers and tax preparers to request the missing apportionment data and create a reasonable state apportionment method using the best information available.


In summary, exempt organizations should be cognizant of the focus from state taxing jurisdictions on unrelated business income generated by alternative investments and should formulate a strategic approach to state tax compliance. While such analysis takes time and resources and may result in an additional compliance burden initially, it provides the benefit to the organization of reducing the risk of noncompliance and accompanying penalties and interest. In addition, as more organizations consider state unrelated business income and request the apportionment data necessary for filing complete and accurate state returns, the information provided will continue to improve.


Alan Wong is a senior manager at Holtz Rubenstein Reminick LLP, DFK International/USA, in New York, NY.

For additional information about these items, contact Mr. Wong at (212) 697-6900, ext. 986, or awong@hrrllp.com.

Unless otherwise noted, contributors are members of or associated with DFK International/USA.

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