ABA Health eSource
 February 2006 Volume 2 Number 6

Public Charities with Partnership Investments – Tax and Reporting Obligations
by Gwen Spencer, PricewaterhouseCoopers LLP, Boston, MA

Gwen SpencerSection 501(c)(3) public charities, including healthcare organizations, continue to view alternative investments, often limited partnerships, as a viable approach to diversifying their investment portfolios. Although organizations often report federal unrelated business income (“UBI”) 1 that arises from limited partnership investments, they may not be aware of obligations associated with state UBI tax, reportable transactions disclosure, and foreign reporting. In the past, organizations may have weighed the federal tax costs, and possibly the state tax costs, against investment returns. Even more importantly now, however, organizations need to manage the risks associated with the failure to make appropriate disclosures of reportable transactions and certain investments in foreign organizations. The failure to meet these filing requirements, particularly the failure to disclose reportable transactions, may result in the imposition of steep penalties.

Unrelated Business Income – Federal and State

The failure to report UBI may result in the imposition of interest and penalties by the IRS and state taxing authorities. In general, tax-exempt organizations are subject to a tax on UBI at the federal level. Tax-exempt organizations may also be subject to a tax on UBI at the state level. A majority of states impose a tax on UBI. 2 It is not uncommon for a partnership to be engaged in activities in various states.

Tax-exempt organizations as partners must "look through" the partnership and analyze the activities conducted by the partnership. If the activities conducted by the partnership would result in UBI when conducted directly by the tax-exempt partner then the income generated from the activities conducted by the partnership is subject to UBI. 3 The most common sources of UBI include income generated from activities that are unrelated to the tax-exempt partners' exempt purpose and income from transactions where there is debt.

Reportable Transactions

The Treasury and the Internal Revenue Service (“IRS”) are concerned that taxpayers, including tax-exempt organizations, are engaged in transactions that result in tax avoidance. Since February of 2003 4 when final regulations were issued in this area, tax-exempt organizations have been subject to the reporting requirements associated with reportable transactions. 5 Reportable transactions are reported to the IRS on Form 8886 (Reportable Transaction Disclosure Statement).

Similar to the reporting of UBI, the requirement for information reporting flows through to each partner. Therefore, if a partnership has engaged in a reportable transaction, each of the partners may also have a reporting obligation.

Penalties for failure to report were added with the American Jobs Creation Act of 2004. 6 These penalties are stiff -- up to $200,000. In addition, the failure to file cannot be cured by re-filing an amended return with the Form 8886 attached. These penalties, along with the inability to cure a failure to file, place considerable pressure on tax-exempt organizations to identify and provide timely reporting of these transactions.

Foreign Reporting Requirements

Tax-exempt organizations are also subject to the information return requirements associated with certain holdings in, and certain direct and indirect transfers to, foreign corporations (filed on Form 926 - Return by a U.S. Transferor of Property to a Foreign Corporation 7 ) and foreign partnerships (filed on Form 8865 - Return of U.S. Persons with Respect to Certain Foreign Partnerships 8 ). In addition, a partner may be required to report a tax shelter entered into by the partnership (Form 8271 - Investor Reporting of Tax Shelter Registration Number). In certain circumstances Form 5471 (Information Return of U.S. Person With Respect to Certain Foreign Corporations) and Form 8621 (Return by a Shareholder of a Passive Foreign Investment Company or Qualified Electing Fund) may be required.

Again, the "flow through" concept applies here. If the partnership has a filing obligation, then the partner may also be required to file. In addition, a filing requirement may arise for tax-exempt partners as a result of their direct investment in a foreign partnership or a foreign corporation.

The failure to disclose these transactions may result in the imposition of penalties. Generally, the failure to file can be cured by re-filing the organization’s tax return with the appropriate form attached.


Often those making the investment decisions for the organization, as well as those responsible for tax reporting, are unaware of the risks and burdens associated with partnership investments. Clearly it may be costly if an organization fails to manage both the UBI tax liabilities (federal and state) and the reporting requirements resulting from reportable transactions and foreign activities. However, once the range of tax compliance issues is understood, these obligations can be managed with up-front planning and the implementation of appropriate policies and procedures.

1 Note that a full discussion of UBI is beyond the scope of this article. In general, UBI is generated from activities that are unrelated to the organization's exempt purpose, engaged in for-profit, and regularly carried on. There are a number of exceptions to UBI including income generated from passive activities. IRC §§ 512, 513. UBI may be generated, however, from passive investments where debt is utilized. IRC § 514.
2 States continue to add UBI statutes. Massachusetts recently added a tax on UBI for tax years beginning after January 1, 2006 (approved December 8, 2005). Chapter 163 of the Acts of 2005, Section 28.
3 IRC § 512(c). Clearly the intention of this rule is to prevent tax-exempt organizations from avoiding taxable income by operating taxable activities through the use of a partnership structure.
4 TD 9046. See Treas. Reg. §1.6011-4.
5 Note that an in-depth discussion of reportable transactions is beyond the scope of this article. Additional information on reportable transactions can be found at http://www.irs.gov/businesses/corporations/article/0,,id=97384,00.html.
6 Pub. Law. No. 108-357(2004).
7 In 2002 the rules were broadened to include additional reporting for tax-exempt organizations.
8 Reporting has been required since 1999.