Partnership Investments by Public Charities: Tax Reporting Complexities

Tax reporting for Sec. 501(c)(3) public charities’ investments in limited partnerships (LPs) (or limited liability companies treated as partnerships for Federal income tax purposes) has become increasingly risky and complex. In recent years, investment officers and committees, chief financial officers and treasurers of tax-exempt organizations have viewed alternative investments (including LP investments) as an attractive approach to diversifying their portfolios. However, new requirements have introduced added risks and burdens for exempt organizations involved in limited partnership investments.

UBTI

Failure to report unrelated business taxable income (UBTI) may result in the imposition of interest and penalties by the IRS and state authorities. Sec. 512(c)(1) dictates that when an exempt organization is a partner in an entity treated as a partnership for Federal income tax purposes, it must analyze the partnership’s activities to determine whether they would generate UBTI if the exempt organization conducted them directly. Frequently, partnership investments generate UBTI when the partnership conducts unrelated business activities (Sec. 512(a)(1)) or takes on certain debt (Sec. 514). An exempt organization reports UBTI on Form 990-T, Exempt Organization Business Income Tax Return. Further, a majority of states impose tax on unrelated business income (UBI); it is not uncommon for a partnership to generate UBTI in more than one state.

Reportable Transactions

The IRS has expressed concern that some exempt organizations participate in transactions that result in tax avoidance. When the reportable transaction final regulations were issued in February 2003 (TD 9046), exempt organizations were included, for the first time; see Regs. Sec. 1.6011-4. Such transactions are reported on Form 8886, Reportable Transaction Disclosure Statement. Similar to income reporting, information reporting requirements flow through to each limited partner; thus, if a partnership engages in a reportable transaction, each limited partner may also have a reporting requirement.

AJCA: The American Jobs Creation Act of 2004 (AJCA) enacted penalties (up to $200,000) for failure to disclose reportable transactions, for returns filed after Oct. 22, 2004; see Chassman and Brennan, Tax Practice & Procedures, “AJCA Penalties for Noncompliance with Reportable Transaction Regs.,” TTA, April 2005. A failure to file cannot be cured by re-filing the organization’s return with Form 8886 attached. This inability, plus the stiff penalties associated with a failure to file, put significant pressure on an organization to ensure it has exercised due diligence in identifying and reporting required transactions, including those arising through LP investments.

Foreign Reporting Requirements

Recent changes in the requirements for reporting transfers to foreign corporations have created additional burdens on exempt organizations. In 2002, the instructions to Form 926, Return by a U.S. Transferor of Property to a Foreign Corporation, were modified to include reporting of certain transfers to foreign corporations by exempt organizations. These filings are in addition to the reporting required on Form 8865, Return of U.S. Persons With Respect to Certain Foreign Partnerships (dating back to 1999), to disclose certain transfers to—and holdings in—foreign partnerships.

Failure to disclose these transactions may result in penalties. Some are based on a percentage of the value transferred (with a ceiling); some are fixed amounts. Generally, the failure to file can be cured by re-filing the organization’s return with the appropriate form attached.

From Gwen Spencer, CPA, J.D., LL.M., Boston, MA