Background
Many tax-exempt organizations and employee benefit plans, such as pensions, IRAs and retirement plans, are attracted to hedge or private equity funds (Funds) as a method of realizing above-average returns on investments. Since related function or passive income is exempt from federal income tax, and many hedge or private equity investments are passive to the tax-exempt, most income generated from these entities can be generated free of federal and state income tax.
However, these investments can produce unrelated business taxable income in two ways. First, where there are investments in partnerships that generate ordinary trade or business income, such income is likely to be taxable to the tax exempt partner/investor. Secondly, many of the Funds’ business models dictate that debt will be used to acquire its investments. The presence of that debt may serve to convert a nontaxable passive activity into a taxable activity to the tax-exempt, unless the tax-exempt structures its Fund investment properly.
This article provides an overview of the applicable rules, as well as some specific strategies used by Funds and their tax-exempt investors to mitigate or eliminate adverse tax consequences.
Applicable rules
Internal Revenue Code (IRC) Section 511 imposes a tax on unrelated business income (UBI) with respect to tax-exempt organizations. UBI is defined as the gross income derived from an unrelated trade or business regularly carried on, less deductions directly connected with the carrying on of such trade or business.
For federal income tax purposes, a partnership represents an aggregation of the activities of its partners, and the nature of its activities is imputed to its partners. Where a tax exempt investor is a partner in a fund or investment instrument that carries out activities considered an ordinary trade or business and that business generates ordinary income that is passed along to its investors, the tax exempt investor will have UBI from such activity.
Many tax exempt investors have investment activities in the form of an “investment partnership”. An investment partnership is not considered a trade or business if (i) it has never been engaged in a trade or business and (ii) substantially all of the assets (by value) have always consisted of items such as cash, stock, bonds, notes or interests in derivative financial instruments. Funds generally satisfy the requirements for being characterized as investment partnerships. Investment partnerships are deemed not to be engaged in a trade or business. Thus, none of a Fund’s partners, including tax-exempt investors, will be considered to be engaged in a trade or business, and thus no partner would generate UBI pursuant to the general unrelated trade or business rules.