Alternative Investments – Seeing the Forest through the … · Alternative Investments – Seeing the Forest through the Trees American Health Lawyers Association Tax Issues for

Alternative Investments – Seeing the Forest through the Trees American Health Lawyers Association Tax Issues for Health cCare Organizations – October 20/21, 2014 Presenters: Jim Lancaster, Texas Children’s Hospital Rick Sevcik, Perkin Coie LLP Jackie Coburn, Crowe Horwath LLP Contributors: John Woodhull and Jon Cesaretti of Crowe Horwath, LLP Contents:

I. Background and Definitions II. Types and Comparisons

III. Business Structures and Resulting Tax Consequences IV. Popularity V. Reporting Issues and Areas of Exposure

VI. Planning VII. Conclusion I. Background and Definitions Alternative investments have proven to be very popular with large tax exempt organizations wishing to diversify their portfolio while at the same time enhancing their rates of return. The primary tax exempt investors appear to be pension funds, colleges and universities, health systems and private foundations, but the investment opportunity is available to any tax exempt organization that wants to diversify its investment portfolio and hopefully earn higher returns than traditional investments such as stocks, bonds, mutual funds, etc. The term “alternative investments” includes a wide range of non-traditional investments, including investments in venture capital, private equity, hedge funds, and other derivatives as well as limited partnerships (“LPs”), limited liability partnerships (“LLPs”) and limited liability companies (“LLCs”). Each of these investment vehicles has its own unique reporting requirements that add a measure of tax complexity for all investors. The number of partnership investments held by tax exempt investors has grown exponentially in the last ten years, with some tax exempt organizations owning upwards of five hundred or more partnership interests. By investing in such a large number of partnerships (we will use the term partnership to include LPs, LLPs and LLCs types of investments), many tax exempt organizations have created a daunting task of identifying and reporting unrelated business taxable income (“UBTI”) at both the federal and state level. The time and effort required to review each Schedule K-1 to determine whether any of the income reported on the Schedule K-1 includes UBTI is substantial, and for many tax exempt investors, the UBTI analysis is just the beginning of the process.

Alternative Investments – Seeing the Forest through the Trees American Health Lawyers Association Tax Issues for Healthcare Organizations – October 20/21, 2014 2 | P a g e _____________________________________________________________________________ II. Types and Comparisons As noted above, an alternative investment refers to an investment product other than traditional investments such as stocks, bonds or cash. These non-traditional asset classes include hedge funds, private equity funds, venture capital funds, real estate partnerships and commodities. Hedge funds invest in stocks and bonds of public companies, commodities, and financial derivatives. Hedge funds are now tending to branch out into other investment types.

Private equity funds invest in “used companies.” These investments include management buyouts or operating companies that no long fit the business model of their historic owners. Venture capital funds: invest in “new” startup companies. Real estate funds invest in real property (fee interest or leasehold), REIT shares, mortgage loans, REMICs, and other real estate investment products. Oil and gas investments include limited partnerships and royalty interest trusts. Table 1 shows a summarized comparison of hedge funds vs. private equity.

Table 1: Comparison – Hedge Fund vs. Private Equity Features Hedge Fund Private Equity

General Entity Type Limited Partnership Limited Partnership

Investment Liquidity Marketable Illiquid

Types Investments Equity, fixed income, convertible debt, foreign contracts, futures, forwards, swaps, options and other derivatives

In private companies at different “life” stages

Structures Stand alone Master-Feeder - Tiered

pship structure: lower-tier Master which houses investment activity. Feeder partnership are partners of master accumulating individual partner investments

Fund of Funds (FOF) invests number of hedge funds

Generally limited partnership with fixed term of years run by specific private equity firm with investments at inception from large institutional investors.

May rely on debt for purchase underlying investments.

Funding and Redemptions

Allow regular redemptions Generally investor cannot redeem until unwinding of fund

Investment Term Perpetual investment vehicles that constantly acquire and dispose of assets based on their investment strategy

Redemption upon fund’s unwinding

1-2 year commitment required capital contributions

Investments mature during 3-8 year horizon

Alternative Investments – Seeing the Forest through the Trees American Health Lawyers Association Tax Issues for Healthcare Organizations – October 20/21, 2014 3 | P a g e _____________________________________________________________________________ III. Business Structures and Resulting Tax Consequences A large percentage of alternative investments are organized as limited partnerships or LLPs. A U.S. partnership form of business benefits the investment manager in that it provides a general partner or an investment firm with the most management flexibility. Limited partners are provided the legal benefit of limited liability. The partnership form of business is tax efficient to investors in that the LP is not subject to taxation on its earnings, the partners are subject to tax on their distributive shares of income. As such, no double taxation as with corporate form of business. The majority of alternative investments are structured as limited partnerships or limited liability partnerships. Organizations that are exempt from federal income tax under section 501(a) (including qualified pension trusts described in section 401(a) are nevertheless subject to tax on their unrelated business taxable income.1 The term “unrelated business taxable income” (“UBTI”) means the net income derived from an unrelated trade or business that is regularly carried on.2 Generally, an unrelated trade or business is any trade or business, the conduct of which is not substantially related to the organization’s exempt purposes (other than the organization’s need to produce income or the use to which the organization puts the income). For qualified pension trusts, the term “unrelated trade or business” includes any trade or business that is regularly carried on.3 Generally speaking, partnerships are accorded “look-through” treatment for UBTI purposes. That is, if an otherwise tax-exempt organization is a partner in a partnership that has income that would be UBTI if earned directly by the tax exempt partner, the tax exempt’s distributive share (whether actually distributed or not) of the partnership’s gross income and the deductions directly connected with such income is taken into account in computing the tax exempt partner’s UBTI.4 This rule applies regardless of how many tiers of partnerships are involved, and regardless of whether the partnerships are general partnerships or limited partnerships. If the taxable year of the tax exempt partner is different from that of the partnership, the tax exempt partner’s UBTI is computed based on the income and deductions of the LP or LLC for the taxable year of the partnership ending within the tax exempt partner’s taxable year.5 Certain types of income are statutorily excluded from UBTI, including dividends, interest, royalties and rents from real property.6 In addition, gains from the sale or other disposition of property that is not inventory or stock in trade or other property held primarily for sale to customers in the ordinary course of a trade or business ordinarily are excluded from UBTI.7 Notwithstanding these exceptions to UBTI, income is included in UBTI to the extent it is unrelated debt-financed income.8 However, an exception to the debt-financed property rules applies to certain investments in real property by certain

1 Section 511(a)(2)(A). 2 Section 512(a)(1). 3 Section 513(b). 4 Section 512(c)(1). 5 Section 512(c)(2). 6 Sections 512(b)(1), (2), and (3). 7 Section 512(b)(5). 8 Section 514(a).

Alternative Investments – Seeing the Forest through the Trees American Health Lawyers Association Tax Issues for Healthcare Organizations – October 20/21, 2014 4 | P a g e _____________________________________________________________________________ types of tax exempt organizations, including schools and universities, qualified pension trusts, and certain tax-exempt title-holding companies.9 The Schedule K-1 reporting of the real property rental exception of IRC section 514(c)(9) is generally fairly consistent, but it is especially important for educational institutions and pension funds to look closely at the rental income reporting of line 2 of the Schedule K-1. The most common debt financed UBTI situations arise when the underlying partnership assets are subject to debt. This will generally cause a portion of the partnership investment income as well as the sales proceeds to be UBTI. However, there is, often times, no clear indication from the liabilities section of the Schedule K-1 that a portion of the investment income could be UBTI without a determination made by the partnership and reported as such in the footnotes or on the Schedule K-1. In some situations, there is no evidence or indication of debt, and yet the partnership will report UBTI. In other instances, debt will be reported in Field K of Part II of the Schedule K-1, but no debt financed UBTI will be reported in Part III of the Schedule K-1. Although the focus and concern is typically on unrelated business income when discussing tax exempt organizations and partnership investments, an even bigger issue and one with potentially more monetary exposure may be the other tax and information reporting requirements that typically accompany partnership investments. For a tax exempt investor, there can be several levels of tax reporting, depending on the underlying partnership investments and activities. This can range from no additional tax reporting to federal UBTI reporting on the Form 990-T, to one or more state UBTI tax filings to multiple foreign information reporting. The number of tax and information filings can be in the hundreds, or it may be zero. A tax exempt organization (other than a private foundation) that has directly invested in a partnership that only generates investment income (dividends, interest, etc.) and with respect to which is no debt financing in the partnership, may have no additional tax IV. Popularity According to the January 28, 2014 NACUBO – Commonfund Study of Endowments ® (NCSE), College and Universities with endowment assets over $1 billion invested 59% of their portfolios in alternative investments. For the total 835 survey respondents, asset allocations are shown below.

9 Section 514(c)(9).

Alternative Investments – Seeing the Forest through the Trees American Health Lawyers Association Tax Issues for Healthcare Organizations – October 20/21, 2014 5 | P a g e _____________________________________________________________________________

Table 2: 2013 NACUBO – Commonfund Study of Endowments

The same study reported the alternative investment strategies as percentage of total alternative investments held by respondents as follows:

Table 3: Alternative Investment Types as % Alternative Investments Held

State defined benefit pension plans according to Cliffwater, LLC 2013 survey: “Trends in State Pension Allocation and Performance”, allocated 24% to alternative investments. The alternative investment composition included 42% Private equity, 17% Hedge funds, 32% Real estate and 9% real assets. U.S. Corporate defined benefit pension plans, as reported in Employee Benefit Security Administration Pension Plan Bulletin 2011 (Forms 5500), held assets of approximately $2.4 trillion of which $91.6 billion was invested in partnerships/joint ventures and $13.6 billion in real estate.

Alternative Investments – Seeing the Forest through the Trees American Health Lawyers Association Tax Issues for Healthcare Organizations – October 20/21, 2014 6 | P a g e _____________________________________________________________________________ V. Reporting Issues and Areas of Exposure Federal Reporting

In the case of any partnership regularly carrying on a trade or business (within the meaning of section 512(c)(1)) the information required under subsection (b) to be furnished to its partners shall include such information as is necessary to enable each partner to compute its distributive share of partnership income or loss from such trade or business in accordance with section 512(a)(1) but without regard to the modifications described in paragraphs (8) through (15) of section 512(b).10 Although it is clear that partnerships are required by statute to provide partners with information necessary to compute their distributive share of partnership income and deductions from any unrelated trade or business, there are no real guidelines as to how that information should be reported to tax exempt investors. Box 20V of Schedule K-1 is supposed to be used by partnerships to report any information that the tax exempt investor needs to figure unrelated business income under section 512(a)(1), but again, there is no real guidance as to how the information should be presented. As a result, there is no consistency across investments in how UBTI is reported or even, for that matter, where in the Schedule K-1 the UBTI information is located. To a large extent, most of the information reported on the Schedule K-1s is geared to individual and corporate investors. This means that much of the information in the Schedule K-1 may not apply to the tax exempt investor leaving the UBTI information scattered throughout the Schedule K-1 or just simply hard to locate among pages and pages of information related to individual investors. As a result, tax exempt organizations must carefully review each page and each line of the information packet that accompanies the Schedule K-1 and its footnotes. To paraphrase an old saying, “if you have seen one Schedule K-1, then you have seen one Schedule K-1”. While it might be an exaggeration to say that no two Schedules K-1 are alike, the differences in Schedules K-1 is one of the more confusing and frustrating aspects for tax exempt organizations trying to identify not only federal UBTI, but state UBTI and foreign information filings. For example, some partnerships report the actual UBTI amount for each partner and for each line item on the Schedule K-1. Other partnerships report the full amount of UBTI earned by the partnership and direct the tax exempt partners to multiply the amount reported on the respective income and expense lines by the partners’ ending profit and loss percentage from Box J of Part II. Attempts to do these computations often times don’t quite match up with the amounts reported on page 1 of the Schedule K-1 and require additional time and effort to quantify. Still other partnerships list a percentage for each line item in the footnotes and direct the tax exempt partner to multiply that percentage by the line amounts reported on page one of the Schedule K-1. Other partnerships provide gross UBI receipts and gross UBI expenses. Some partnerships are actually reluctant to identify partnership income as unrelated business income believing they are not informed enough about UBTI to characterize the income one way or the other. Needless to say, the wide variety of reporting approaches to UBTI

10 Section 6033(d)

Alternative Investments – Seeing the Forest through the Trees American Health Lawyers Association Tax Issues for Healthcare Organizations – October 20/21, 2014 7 | P a g e _____________________________________________________________________________ makes it that much more difficult for tax exempt organizations and their tax preparers to efficiently review and process the Schedules K-1 they receive. Each extra calculation required to capture this information, although seemingly not much of an issue in the context of a single Schedule K-1, can begin to make a significant time difference if there are a hundred or more Schedules K-1 to review and categorize. More often than not, the information provided on the actual Schedule K-1 is not sufficient, in and of itself, to enable a tax exempt organization to properly identify and report UBTI on a Form 990-T. In some instances, there is no dollar amount reported for Line 20V on the first page of Schedule K-1, nor is it unusual to find no mention of Line 20V, not even a “see statement” on line 20. Thus, a quick review of a Schedule K-1 might lead an organization to initially assume that it has no UBTI to report when in fact the underlying footnotes may list thousands of dollars of UBTI. Tax exempt organizations have learned over the years that there is a good chance that they have earned UBTI if Line 1 of Schedule K-1 reports income or loss even when there is no information reported on Line 20V or in the footnotes. In either situation, the simple wording of line 1 (ordinary business income/loss) should be enough to put a tax exempt organization on notice that the “business income or loss” reported here may not be related to its exempt purpose and a further look at the footnotes is warranted. If the footnotes do not provide any guidance, it is generally a good idea for the tax exempt organization to contact the partnership directly and obtain an explanation of the tax reporting, especially if the partnership indicates that there is no UBTI on line 1 or is silent on the issue. It will be important not only to document the reasons for excluding this income or loss in the event that the organization is audited, but also for subsequent tax reporting by the same partnership in future years. As mentioned above, actually finding the footnotes to line 20V can be an arduous task in and of itself, especially when a schedule K-1 may have a 100 or more pages of footnotes. A recent search of an oil and gas Schedule K-1 found the detailed UBTI analysis on page 63 buried between an ECI analysis and various state Schedules K-1. There was no table of contents or a page reference on the Schedule K-1 itself to assist the organization in finding the UBTI page, nothing, except turning one page after another until it was located. It can take one to two hours for an experienced tax preparer to properly review and understand a Schedule K-1 package to determine whether there is any federal UBTI and state UBTI to be reported as well as to determine the appropriate foreign information filings and then input the relevant information into a spreadsheet or a work paper that can accommodate this “mass” of information. If a tax exempt organization receives one hundred or more Schedules K-1, it may take two to three weeks just to properly catalogue this information. Given the growing sophistication and complexity of Schedule K-1 reporting, tax exempt organizations face another problem. If the organization chooses to do the work internally, the organization must provide sufficient training to their own accounting or finance staff about the intricacies of the Schedule K-1 and how the information flows to the federal Form 990-T, the various state 990-Ts and corporate returns as well as the information reporting required for the foreign forms.

Alternative Investments – Seeing the Forest through the Trees American Health Lawyers Association Tax Issues for Healthcare Organizations – October 20/21, 2014 8 | P a g e _____________________________________________________________________________ Tax exempt organizations looking for guidance on how to report the Schedule K-1 information will not find the Form 990-T instructions very helpful. Other than directing tax exempt organizations to combine all partnership income and losses on line 5, the rest of the instructions focus on the reporting of gross income and deductions of the partnership and direct organizations to figure their unrelated business income in the same manner they figure their unrelated trade or business income for activities they conduct directly.11 Since very few partnerships provide any gross income or deduction information on their Schedule K-1s, this is not particularly helpful. Almost all Schedule K-1s report “UBTI”, in other words, unrelated business taxable income. Even if partnerships did provide gross income and expense figures, there would still be a need for additional information on the underlying activities generating the income and expenses. Many tax exempt organizations have found that partnerships are not particularly helpful in explaining why income or expenses reported on the Schedule K-1 or in the footnotes is or is not UBTI. In many instances, the UBTI that is reported on the Schedule K-1 has been generated by a lower tiered partnership and the partnership completing the Schedule K-1 does not have any specific information regarding the underlying activities in the lower tiered partnerships to provide to the tax exempt partner. As mentioned above, the first sentence in the Form 990-T instructions seems to suggest that all income and expenses should be combined and netted to one number which should be reported on line 5 of the Form 990-T. The wording of the instructions does not seem to differentiate between ordinary income and capital gains and losses. The implication in the broad sweep of the instructions is that capital losses can be offset against any other UBTI reported. In fact, we have reviewed a number of partnership Schedule K-1 footnotes that have applied capital losses against not only ordinary income but also investment income.12 Interestingly, the instructions for S corporations in the same line 5 instructions, direct tax exempt organizations to report any capital gain or loss on line 4, thus, seemingly precluding S corporation investors from applying capital losses against ordinary income with respect to S corporation investments. State Reporting

A review of state statutes, regulations and tax filing instructions indicates that there are 40 states and two local (District of Columbia and New York City) jurisdictions that tax unrelated business income. Four states have no unrelated business income (UBI) taxes13, and six states have no business or corporate income tax.14 State and local taxing regimes are diverse. One of the main reasons why accurate state reporting of alternative investment tax obligations can be such a difficult task is that the forms and

11 Instructions for Form 990-T, Line 5. Income or (Loss) From Partnerships and S corporations: Combine all partnership income or loss (determined below) with all S corporation income or loss and enter it on line 5. Attach a statement to this return showing the organization’s share of the partnership’s gross income from the unrelated trade or business, and its share of the partnership deductions directly connected with the unrelated gross income. 12 Section 1211(a)(1) provides that in the case of a corporation, losses from sales or exchanges of capital assets shall be allowed only to the extent of gains from such sales or exchanges. 13 Delaware, Kentucky, New Jersey and Pennsylvania have no statutes that tax UBI 14 Nevada, Ohio, South Dakota, Texas, Washington, and Wyoming have no corporate business

income tax.

Alternative Investments – Seeing the Forest through the Trees American Health Lawyers Association Tax Issues for Healthcare Organizations – October 20/21, 2014 9 | P a g e _____________________________________________________________________________ regulatory rules in the area generally are not designed to address the ever-growing tiered flow-through structures utilized by alternative investments. State tax and jurisdictional concepts such as nexus, apportionment, allocation, and unitary business principles add a level of complexity and uncertainty not seen on the federal level. In addition to these issues, tax-exempt investors’ reporting obligations at both the federal and state levels are made more difficult by the fact that only a portion of the partnership’s “taxable income” reported on the Schedules K-1 is UBTI.15 In general, IRC Section 501(c)(3) organizations and pension trusts described in Section 401(a) are exempt from state income taxes. Nevertheless, as referred to above, both of these types of entities are subject to state income tax on their UBTI in 40 states, plus the District of Columbia and New York City. For purposes of this analysis, UBTI is described as follows:

Regular UBTI. This is the net income derived from a regularly carried on unrelated trade or business. A trade or business is considered to be unrelated if its conduct is not substantially related to the organization’s exempt purposes. Unrelated debt-financed income. The most common debt-financed income situations for tax-exempt investors occur when the underlying partnership assets are acquired with debt by the partnership. This generally will cause a portion of the partnership investment income, as well as the sales proceeds, to be UBTI.

Tax-exempt investors with ownership interests in partnerships are exposed to state tax on UBTI and, depending on the quality of state compliance, may be exposed also to a state’s withholding tax on their share of distributable income from their partnership investments, even if there is no UBTI sourced to that state. Nearly all states take the position that they have nexus with all partners of a business entity that is doing business in their state.16 While there was once some diversity of position among the states on this issue, little diversity remains.17 Over the past decade, states have revised their “doing business” statutes to include more subjective and broad statutory nexus standards, such as “deriving income” or even a standard based on the amount of gross receipts derived from the state.18 One of the most significant concerns of multistate tax law is how income is divided among the states. A fundamental principle that has its grounding both in constitutional

15 For the purposes of this discussion, partnership “taxable income” includes the income from Schedule K-

1, Part III, line 1-11, minus line 12 (IRC§179 deduction), 13 (other deductions), 16L (foreign taxes paid),

16M (foreign taxes accrued), and 20T (depletion). The net amount is reported in Part II, Item L. 16 See, e.g., Borden Chemicals and Plastics, L.P. v. Zehnder, 726 NE2d 7 17 See Fenwick, McLoughlin, Salmon, Smith, Tilley, and Wood, State Taxation of Pass-Through Entities

and Their Owners 18 See, for example, UELCOM, Inc. v. Bridges, 77 SO 3rd

Alternative Investments – Seeing the Forest through the Trees American Health Lawyers Association Tax Issues for Healthcare Organizations – October 20/21, 2014 10 | P a g e _____________________________________________________________________________ law and in state statutes is the idea that taxable income should be divided into two categories for this purpose. The first and most common category includes operating or business income. The second category, which is commonly referred to as nonbusiness income, is typically defined in the negative as all income other than business income.19 It commonly includes proceeds from the sale of an asset held strictly for investment and proceeds from the liquidation of the business itself. Business income is apportioned among the various states that gave rise to the income. Nonbusiness income is generally allocated to a single state based on a generally agreed-upon set of rules and conventions. A taxpayer’s operating or business income must be apportioned, typically based on a formula consisting of the ratio of the taxpayer’s business activity in the taxing state compared with its business activity everywhere. Depending on the particular state’s laws, business activity is generally based on factors including the business’s property, payroll, and sales in the taxing state. Each of those state factors is then divided by the respective factor determined for the business everywhere, although there seems to be a trend among the states to give more weight to the sales factor, sometimes to the exclusion of the other two factors altogether. State tax practitioners spend a significant amount of time scrutinizing the numerators in these formulas as states’ statutes in this area are fairly complex and often provide opportunities to manage a taxpayers’ multistate liability. Also, a number of states provide special treatment for particular entities based on their activity. For example, New Jersey has a taxpayer-friendly provision for hedge funds. Illinois, California, and a number of other large states have taxpayer-friendly provisions for investment partnerships. New York has a taxpayer-friendly provision for taxpayers that trade on their own account. Each state’s laws should be analyzed on a stand-alone basis. States are increasingly concerned with their ability to collect tax from nonresident owners. The states have enacted an array of compliance mechanisms: information reporting (i.e., State K-1s), composite (or group) returns, mandatory withholding at the source and entity level taxes. A state composite filing is an aggregate of select investor’s share of the flow-through entity’s state taxable income. Tax paid by the flow-through entity on behalf of the investors does not represent an entity-level tax. Rather, this is a payment made by the entity on behalf of its investors. To the extent an investor’s income is reported on a composite return, the investor generally will not otherwise have a state filing obligation with respect to income from the flow-through entity. Composite inclusion is generally elective. Availability of composite filing exists in 38 states such that a group return can be filed on behalf of its investors, with a growing number mandating composite inclusion for eligible members. Fourteen states require elections/consents to be included in the composite return. What type of investors is includable in a group (composite) return? Generally, inclusion in a group (composite return) is for nonresident investors. Significant state-by- 19 It should be noted that not all state recognize this business vs. nonbusiness income distinction.

Alternative Investments – Seeing the Forest through the Trees American Health Lawyers Association Tax Issues for Healthcare Organizations – October 20/21, 2014 11 | P a g e _____________________________________________________________________________ state variances exits in entity type of the investor allowed. These include whether the investor is has other taxable activity in the state, operating or strictly investments from flow-through entities. Nonresident withholding is required in approximately 40 states. The flow-through entity withholds and remits tax to the state taxing authority based on the investor’s distributive share. This generally does not satisfy the investor’s tax filing obligation with the state. Rather, the investor must file its own return and may claim a credit for taxes deposited on its behalf by the flow-through entity. Withholding was traditionally required for distributive shares attributable to nonresident individuals. Distributive share may not equate to UBTI. In recent years, withholding has increasingly been extended to other types of investors (corporations, exempts, etc.) As a result, there is a heighted risk of over-withholding/opportunity for refunds. Twenty-seven states offer partners an opportunity to file a withholding exemption or adjustment certificate. States vary in terms of whether an opt-out is available, the type of investor it pertains to, and the process associated with the withholding exemption or adjustment. The primary emphasis of state Schedule K-1 information reporting appears to be directed at individual and corporate investors, presumably including tax-exempt investors. The information-gathering and analysis process becomes burdensome when tax-exempt investors to determine state UBI. For individuals and corporate investors, the methodology used by most partnerships incorporates most of the allocation concepts of “business” vs. “nonbusiness” and individual vs. corporate investors. For corporate investors, all of the partnership’s income and expenses are divided among the respective states based on long-standing apportionment factors and allocation rules. Unfortunately, tax-exempt investors, although treated as corporations, are not business corporations in the sense used in Schedule K-1 reporting. Thus, traditional apportionment rules and allocation processes do not work as smoothly or efficiently, if at all. One of the reasons for this situation appears to be the fact that only a portion of a partnership’s taxable income is usually characterized as UBTI. Some partnerships report very little UBTI as compared to the partnership’s overall taxable income, while others report significantly more. Nonetheless, there is almost never a situation where a partnership’s UBTI equals the partnership’s taxable income. But as best as can be surmised, much of the state sourcing of UBTI is based primarily on partnership apportionment factors that may not properly reflect unrelated business activities in the respective states.


Table 4: States Taxing Unrelated Business Income

Alabama Idaho Minnesota Oklahoma

Alaska Illinois Mississippi Oregon

Arizona Indiana Missouri Rhode Island

Arkansas Iowa Montana South Carolina

California Kansas Nebraska Tennessee

Colorado Louisiana New Hampshire Utah

Connecticut Maine New Mexico Vermont

Florida Maryland New York Virginia

Georgia Massachusetts North Carolina West Virginia

Hawaii Michigan North Dakota Wisconsin

Legend: Yellow Highlight- specific state UBI Form remaining states use corporate form Foreign Information Reporting If organizations alternative investments include partnership that have invested in foreign corporations or foreign partnerships, there may be information reporting required to be attached to the Form 990 even though there is no taxable income or tax liability to report on the Form 990-T. Normally, foreign informational forms are attached to the Form 990-T and not the Form 990. It is not uncommon for tax exempt investors to overlook their foreign reporting requirements when there is no UBTI reported on a Schedule K-1 for tax exempt organizations. Of course, there is an even greater chance that a tax exempt organization will overlook its’ foreign information filing obligations if it makes a direct investment in a foreign corporation or a foreign partnership. In these situations, there is usually no specific footnote or other information to alert the tax exempt organization that there may be a filing obligation. In partnership settings, however, the instructions to the Form 926 state that if the transferor of tangible or intangible property in excess of $100,000 is a partnership, the domestic partners, not the partnership are required to file the Form 926.20 In recent years, the IRS has placed a special emphasis on the reporting of transfers from U.S. persons to foreign entities. In order to ensure compliance with what is essentially information reporting, the IRS has imposed significant penalties, (Table 6) on U.S. taxpayers that do not comply with these reporting requirements. These penalties and sanctions apply to tax exempt organizations as well. While some tax exempt organizations make sufficiently large direct investments in foreign corporations and foreign partnerships that create foreign information reporting obligations, it is unlikely that most tax exempt organizations, absent their partnership investments, would have significant enough investments requiring the preparation of a Form 8865 or a Form 926. 20 Section 6038B

Alternative Investments – Seeing the Forest through the Trees American Health Lawyers Association Tax Issues for Healthcare Organizations – October 20/21, 2014 13 | P a g e _____________________________________________________________________________ The Form 990, Schedule F, Part I requires the reporting of investments on a nine- region basis and the completion of columns (a) Region, Column (d) Activities, and column (f) Total Expenditures (Table 7). The Form 990 was further modified in 2010 to add a section in Schedule F requiring tax exempt organizations to indicate whether they had been investments in certain foreign entities.21 (Table 8) To make sure that the filing organizations are aware of their possible foreign information return filing obligations, each question provides a reminder that the organization may have a filing obligation by referencing the relevant foreign information return for the specific investment activity. Most foreign information reporting is triggered either by the size of the investment or the ownership interest acquired. Although there are a number of reporting thresholds, as displayed in (Table 5), the primary threshold that impacts tax exempt investors is the transfer or investment of cash or property in excess of $100,000. Domestic U.S. partnerships with investments in foreign corporations or foreign partnerships are required to provide sufficient information about their investments in the Schedule K-1 so that if tax exempt partner’s proportionate investment exceeds $100,000, a Form 8865 or a Form 926 must be attached to either the Forms 990-PF, 990 or 990-T. 22 The problem that tax exempt investors face is that their foreign reporting obligations are based on all of their proportionate shares of partnership investments computed on a cumulative basis. Thus, if a tax exempt investor has an ownership interest in 500 domestic partnerships and ten of these partnerships have invested in the same foreign partnership or corporation, the tax exempt investor’s combined investment may exceed $100,000 on a cumulative basis. However, to determine if the reporting threshold has been exceeded, every footnote reporting foreign corporate or partnership investments will have to be tabulated by the tax exempt investor. This will require tax exempt partners to identify and calculate the information they receive in the footnotes of their Schedules K-1 about the partnerships’ underlying investments in foreign corporations and foreign partnerships. A tax exempt investor that has hundreds of footnotes to review and categorize, may determine at the end of this exercise that there is no foreign filing obligation because the $100,000 reporting thresholds have not been reached. The penalty for failure to file Form 926 is levied at 10% of the transferred valued capped at $100,000. Form 8865 penalties are determined by the category of filer and offense. Failure to file or report all information requested is $10,000 for each year for each foreign partnership. If the IRS requests Form 8865 the penalty is an additional $10,000 for each month fail to provide the IRS, capped at $50,000 per each failure. Form 8865 Category 3 filers are subject to failure to file penalty of 10% the FMV of the property contributed, limited to $100,000.23 The penalty is unlimited if due to intentional disregard. If the undisclosed foreign financial assets results in an understatement of tax, the penalty is 40% of the tax understatement.24

21 Instruction to Form 990, Schedule F, Part IV, Foreign Forms 22 Section 6038B 23 IRC §6038B 24 IRC §662(j)

Alternative Investments – Seeing the Forest through the Trees American Health Lawyers Association Tax Issues for Healthcare Organizations – October 20/21, 2014 14 | P a g e _____________________________________________________________________________ Exempt organizations are excluded from Form 8621, Passive Foreign Investment Company filing requirements unless the exempt organization has received Subpart F income, in accordance with IRS Form 8621 instructions.

Table 5: Transfers to Foreign Partnerships and Corporations Reporting Requirements:

Form 8865 Category Filing Trigger- Citation- Conditions-

Category 1 50% partnership interest Reg § 1.6038-3(a)(1)

Category 2 10% partnership interest Reg § 1.6038B-2(a)(1)(i)

If Pship has Category 1 filer no Category 2 filer

Category 3 Either owned at least 10% or contributed >$100,000

Reg § 1.6038B-2(a)(1)(ii)

Measured as during 12-month period ending on date of transfer

Category 4 Reportable Event: Acquisition, disposition, or change in proportional interest

IRC §6046A(a)

Form 926 U.S. Transferor of Property to a Foreign Corporation

Form 926 Cash transfer > $100,000 or cash transfer resulting in either direct or indirect holding at least 10% voting control.

All property transfers must be reported unless transfer meets exceptions IRC §6038B

IRC §6038 and Reg. § 1.6038B-1.

Measured as during 12-month period ending on date of transfer

Form 5471 Category 1 Repealed Category 2 U.S. person is an officer or director

of a foreign corporation in which a U.S. person has acquired: 10% or more of the stock of the

foreign corporation An additional 10% or more of the

stock of the foreign corporation

Reg. §1.6046-1(a)(2)

Category 3 Includes the A U.S. Person who: Acquires stock in a foreign

corporation and their total stock ownership is 10% or more of the total stock

Increases stock ownership by 10%

A U.S. person who disposes of stock or formally owned own 10% or more of a foreign corporation and no longer does.

Reg. §1.6046-1(c)


Form 8865 Category Filing Trigger- Citation- Conditions-

Category 4 Significant acquisition or disposition of stock of foreign corporation

Reg. §1.6038-2

Category 5 Ownership of >50% of foreign corporation in an uninterrupted period of at least 30 days

IRC §6038(a)(4)

Form 8621, Passive Foreign Investment Company

Form 8621- Not required of exempt organizations unless Subpart F income from PFIC

IRS Form 8621 Instructions


Table 6: Reporting Penalties – Foreign Transfers Reporting Requirements:

Form 8865 Category Offense Penalty Citation

Categories 1,2,3 and 4

Failure to file or report all required info

$10,000 for each partnership, reduction 10% Foreign tax credit available. Continued failure may result penalty increasing to $50,000

Category 3 Failure to file or report all required info

10% FMV transferred property, not in excess $100,000

Reg § 1.6038B-1(f)(4)

Other considerations-

Criminal penalties Statute limitations does not begin until Transfer forms are filed

Form 926 Failure to file 10% value transferred limited to $100,000

Reg § 1.6038B-1(f)

Section 6662(j) If underpayment tax as result undisclosed foreign financial asset

40% penalty on underpayment

IRC §6662(j)

Form 5471 Failure to file $10,000 for each tax period

IRC§6038(b)(1)

Form 8621 Failure to file No penalty, taxation of distributions or dispositions is less favorable

IRC §1291

Table 7: Form 990, Schedule F, Part I – Reporting for International Investments

List investments in each region separate from other activities in those regions. Complete columns (a), (d) and (f)

Region should be identified based on the legal domicile of the foreign investment Columns (b), (c), and (e) can be left blank


Table 8: Form 990, Schedule F, Part IV, Foreign Forms

Other Considerations Sale of Partnership Interest Many organizations are surprised when they sell their partnership investment and are advised that the sale may produce significant tax liabilities on what they assumed would be a nontaxable capital gains transaction. Depending on the type of assets owned by the partnership and whether debt was incurred by either the tax exempt partner or the partnership itself, a portion of the gain may be treated as ordinary income and/or debt financed unrelated business taxable income. Gains from the sale or other disposition of property that is not inventory or stock in trade or other property held primarily for sale to customers in the ordinary course of a trade or business ordinarily are excluded from UBTI.25 Thus, capital gains are generally excluded from UBTI, subject to a number of exceptions discussed in more detail below. Depreciation recapture is taken into account as UBTI only to the extent the depreciation was allowed or allowable in computing UBTI or in computing taxable income for a period in which the organization was not exempt.26 When there are tiered partnerships or LLCs, a partnership is treated as owning its proportionate share of any section 751 assets owned by a partnership in which it is a partner.27

25 IRC §512(b)(5) 26 Regs. §1.1245-2(a)(8); Regs. §1.1245-6(b); Regs. §1.1250-1(c)(2) 27 IRC §751(f)

Alternative Investments – Seeing the Forest through the Trees American Health Lawyers Association Tax Issues for Healthcare Organizations – October 20/21, 2014 18 | P a g e _____________________________________________________________________________ Notwithstanding the portfolio income exceptions to UBTI described above, income is included in UBTI to the extent it is unrelated debt-financed income.28 Thus, if a partnership interest or the underlying partnership assets are subject to debt, a portion of the partnership income as well as the sales proceeds may be UBTI. However, an exception to the debt-financed property rules applies to certain investments in real property by certain types of tax exempt organizations, including schools and universities, qualified pension trusts, and certain tax-exempt title-holding companies.29 Partners generally realize gain or loss on the sale of a partnership interest to the extent of the difference between the amount realized on the sale and the partners’ adjusted basis in the partnership interest immediately prior to the sale.30 A partner’s original basis in the partnership interest generally is the amount of cash and/or the fair market value of property transferred in return for the partnership interest.31 To determine a partner’s adjusted basis on the date of the sale, adjustments should be made on a cumulative basis from the date the interest was acquired through the actual date of the sale The transferor partner’s original basis is generally increased by the following:

1. The amount of cash, and the adjusted basis of any property contributed to the capital of the partnership, in addition to the partner’s original capital contribution;

2. The partner’s share of partnership taxable income and tax-exempt income (determined as of the date of transfer, under one of the methods described below);

3. The partner’s share of percentage depletion that exceeds the basis of partnership depletable property; and

4. Any increase in the partner’s share of partnership liabilities (which is treated as a deemed cash contribution by the partner to the partnership).32

The transferor partner’s basis generally must be decreased by the following:33

1. The amount of cash and the adjusted basis of property (generally, the partnership’s adjusted basis in the property) distributed in kind to the partner;

2. The partner’s share of partnership losses and non-capital expenditures that are not deductible for tax purposes;

3. The partner’s share of depletion deductions (to the extent the depletion deductions do not exceed the partnership’s basis in the depletable property); and

4. Any reduction in the partner’s share of partnership liabilities (which is treated as a deemed cash distribution from the partnership to the partner).34

28 IRC §514(a) 29 IRC §514(c)(9) 30 IRC §742: Regs. §1.741-1(a) 31 IRC §722, 742, 1012 32 IRC §705(a)(1) 33 IRC §705(a)(2) 34 IRC §705(a)(2)

Alternative Investments – Seeing the Forest through the Trees American Health Lawyers Association Tax Issues for Healthcare Organizations – October 20/21, 2014 19 | P a g e _____________________________________________________________________________ The amount realized by a partner on the transfer of a partnership interest is increased by the partner’s share of partnership debt, but only if the liability has been included in the partner’s basis in the partnership interest.35 If none of the partnership’s liability is included in the partner’s basis, the partner is not required to include any portion of the partnership debt in the amount realized.36 A partner’s share of partnership liabilities may vary depending on whether the liabilities are recourse or nonrecourse liabilities.37 Passive Activity Losses Exempt organizations formed as a trust are subject to the Passive Activity Loss rules (PAL) of IRC §469. Covered tax exempt entities include Pension Trusts under Section 401a, Private Foundations formed as trust, and Voluntary Employee Benefit Associations 501(c)(9). L.P. and LLP partners and members LLC considered passive because of their limited liability. The purpose of PAL is to prevent sheltering by certain taxpayers of passive activity losses (PAL) and tax credits against non-passive income. A passive activity is a trade or business the in which the taxpayer does not materially participate. If there is insufficient passive activity income to offset the passive activity loss, the passive activity loss is carried forward indefinitely. Suspended passive activity losses of the activity can only be utilized against current passive activity income, and when there is a disposition of the entire passive activity in a taxable transaction. Upon disposition, the suspended loss can be offset against ordinary income. Listed Transitions and Prohibited Tax Shelters Reportable Transaction- is a transaction with respect to which information is required to be included with a return or a statement as prescribed under IRC §6011 which IRS deems has potential for tax avoidance or evasion. There are five categories reportable transactions:

1. Listed transactions 2. Confidential transactions 3. Transactions with contractual protections 4. Loss transactions 5. Transactions of interest

Classification as prohibited tax shelter transaction requires satisfying two criteria: (1) the item meets the definition of a listed transaction IRC §4965(e)(1)(A) and §6707A(c)(2) and (2) IRC§6011 and IRS notices.

35 IRC §752(d); Regs. §1.752-0 36 Regs. §1.752-0 37 Regs. §1.752-0

Alternative Investments – Seeing the Forest through the Trees American Health Lawyers Association Tax Issues for Healthcare Organizations – October 20/21, 2014 20 | P a g e _____________________________________________________________________________ VI. Planning Alternative investment tax planning should be undertaken throughout the year not merely as a tax filing season exercise. Organizations should manage risk through quantifying alternative investment universe, developing a compliance approach, building and maintaining relationships with investment managers and if possible structuring of investment agreements. Alternative investments can be identified by reviewing audited financial statements and looking to see if the investment footnote indicates any alternative investments. Reporting under Generally Accepted Accounting Principles uses Level 3 and occasionally level 2 investments to report alternative investments. Prior tax returns. Investment prospectus, agreements and periodic financial reports are all helpful sources in identifying alternative investments. Maintaining an on-going relationship with investment managers, both internal and external, is essential. This type of relationship helps to develop and maintain the flow of information and expectation for questions. Organizations should regularly receive and review information from investment managers such as prospectuses and periodic financial reports. Make the investment manager aware of the organization’s intent as to unrelated business income, frequency of desired tax data, and other reporting requirements and risks.

Table 9 -: Annual Best Practices to Determine Appropriate Filing Responsibilities

Task Reason

Compile a complete listing by legal entity of alternative investments

Tracking appropriate info received, i.e. Schedule K-1 or other info

Compare listing to Audited Financial Statement’s Investment Footnote

To ensure all investments are accounted for

Determine entity type:

Partnership

Corporation

Determine appropriate filing responsibilities

Determine entity domicile:

Domestic

Foreign

Determine appropriate filing responsibilities

Check investor information:

Entity type-tax exempt

Residency or commercial domicile

Foreign or state withholding

Determine appropriate tax info and treatment

Track Foreign contributions or distributions:

Date

Amounts

Resulting ownership %

Determine appropriate tax info and treatment


Task Reason

Maintain documentation:

Schedules K-1

Investments’ Audited Financial Statements

Offering memorandum

Subscription documents

Investment manager communications

Includes legal classification, tax domicile and other tax specific info

On-going relationship with investment managers- internal and external to obtain:

Information reporting and updating

UBI and regulatory reporting

Review business structure pre-investment

Obtain best possible data in timely manner

Structure agreements with investment managers as to:

“Best efforts” clause avoid or minimize UBI and limit borrowings

Quarterly investor notifications clause for transactions causing significant tax liabilities

Liquidity clause, i.e. pay anticipated taxes, etc.

Indemnification clause for investor penalties and interest caused by investment manager failure to disclose

Minimize UBIT surprises

VII. Conclusion The ability of tax exempt investors to properly gather and report the information they receive in their Schedules K-1 is at a breaking point. Given the huge growth in partnership investments by tax exempt organizations coupled with the explosion of information reporting required of domestic partnerships and the complexity of the tax information that must be reported to investors, it is highly likely that some of the information provided to tax exempt investors is either not sufficient for proper federal and state UBTI determinations or is simply not correct. Added to this concern is the fact that the sheer volume of reporting forms that must be filed or attached to a Form 990, Form 990-PF or Form 990-T whether paper or electronic, create significant logistical problems for tax exempt investors.

Documents

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