It is a common misconception that “nonprofit” means “no profit.” However, not only is it acceptable for a nonprofit, tax-exempt organization to profit from their key activities (think: hospitals bills and university tuition), many have significant investment portfolios. In addition to traditional holdings of bonds and publicly traded stock, tax-exempt organizations increasingly seek and participate in private equity investments, opportunity funds, special purpose acquisition companies (SPACs), partnerships and joint venture deals. The managers and sponsors of those investment opportunities, as well as their accountants and attorneys, should have a basic understanding of the tax, governance and other issues facing their potential tax-exempt and nonprofit investors, including:

1. UBIT and the new “silo” rules — which bucket will your investment opportunity land in?
   
   
2. “Investment activities” and the benefits of qualification of an investment as a “qualified partnership interest” — QPI, your acronym of the day.
   
   
3. What is the “fractions rule” and when, actually, is it applicable? Learn just enough to spot the issue.
   
   
4. Private foundations as venture capitalists — can your investment opportunity qualify as a “program-related investment”? Create a “PRI” wrapper and a 5% head start on returns.
   
   

1.  UBIT Silos                                                                                                                   

Overview

Revenue generated by a tax-exempt organization may constitute unrelated business taxable income (UBTI) if the revenue is derived by an unrelated trade or business that is regularly carried on.[1] An activity is an unrelated trade or business if it “is not substantially related (aside from the need of such organization for income or funds)”[2] to the organization’s exempt purpose.[3] Generally, the following revenue sources are excluded from the definition of UBTI: dividends; interest and certain other investment income; royalties; rents from real property; and capital gains.[4] However, such revenue is generally still taxable to the extent that the underlying assets (e.g., stock, real property) are debt-financed. Also, it is critical to bear in mind that, under general partnership principles, if a tax-exempt organization is a partner (or a member in an LLC taxed as a partnership), it will be deemed to participate as such in the business operations of the partnership.               

UBTI may be reduced by any allowable deductions that are directly connected with the carrying on of that particular unrelated trade or business. Prior to the enactment of the Tax Cuts and Jobs Act of 2017 (TCJA),[5] a tax-exempt organization with multiple unrelated business activities was able to offset income from its profitable unrelated businesses/investments with losses from other unrelated businesses/investments.

However, the TCJA added Section 512(a)(6) to the Internal Revenue Code,[6] which now requires tax-exempt organizations to “silo” each activity within each particular unrelated trade or business. Taxable income from profitable (and taxable) lines of business or investments may no longer be offset with the net operating losses from other “silos.”                                                  

Determining Separate Trades or Businesses

In general, a tax-exempt organization will identify each of its separate unrelated trades or businesses using the first two digits of one of the 92 North American Industry Classification System (NAICS) codes that most accurately describes the trade or business.[7] The NAICS 2-digit code is the standard used by the Federal statistical agencies in classifying business establishments for the purpose of collecting, analyzing and publishing statistical data related to the United States business economy.

2.  Investment Activities

Investment activities through entities taxed as partnerships, with certain exceptions, are generally treated as participation in the underlying business — with each K-1, potentially, siloed alone. However, a few “activities in the nature of investments (investment activities) are treated collectively as a separate unrelated trade or business” [8] (i.e., they are siloed together, with losses from one available to offset taxable income from another). Those “investment activities” include:

• qualifying partnership interests (including limited liability companies classified as partnerships) (QPIs);
• qualifying S corporation interests; and
• unrelated debt-financed properties.[9]

Qualified Partnership Interests

A general partnership interest is not a QPI. QPIs include both directly held limited partnership interests and indirectly held limited partnership interests that satisfy either (i) the de minimis test or (ii) the participation test.

The de minimis test. A partnership interest satisfies the de minimis test if the organization holds directly or indirectly no more than 2% of the partnership’s profits interest and capital interest during the organization’s taxable year with which or in which the partnership’s taxable year ends.[10]           

The participation test. A partnership interest satisfies the participation test if the tax-exempt organization (i) holds directly or indirectly no more than 20% of the partnership’s capital interest during the organization’s taxable year with which or in which the partnership’s taxable year ends and (ii) does not “significantly participate” in the partnership.[11] 

An organization significantly participates in a partnership if:

• the organization, by itself, may require the partnership to perform, or may prevent the partnership from performing (other than through a unanimous voting requirement or through minority consent rights), any act that significantly affects the operations of the partnership;
• any of the organization’s officers, directors, trustees, or employees have rights to participate in the management of the partnership at any time or to conduct the partnership’s business at any time; or
• the organization, by itself, has the power to appoint or remove any of the partnership’s officers or employees or a majority of directors.[12]

There is no general facts and circumstances test for determining whether an organization significantly participates in a partnership — no other factors are considered.

Determining Percentage Interests. An organization’s profits interest in a partnership is determined in the same manner as its distributive share of partnership income.[13] In the absence of a provision in the partnership agreement, an organization’s capital interest in a partnership is determined on the basis of its interest in the assets of the partnership which would be distributable to the organization upon its withdrawal from the partnership, or upon liquidation of the partnership, whichever is greater.[14] An organization determines such percentage interests by taking the average of the organization’s percentage interest in the partnership at the beginning and end of the partnership’s taxable year—provided, however, that in the case of a partnership interest held for less than a year, the organization uses the beginning and end of the period of ownership within the partnership’s taxable year.[15] When determining an organization’s percentage interest in a partnership, the interests of a supporting organization, other than a Type III supporting organization, in the same partnership must be taken into account.

An organization may rely on the Schedule K-1 (Form 1065) when determining its percentage interests only if the Schedule K-1 (Form 1065) provides specific information about the organization’s percentage interest.[16] For example, if the Schedule K-1 (Form 1065) lists an interest as “variable,” the organization may not rely on the form with respect to that interest.[17]

Qualifying S Corporation Interests

In the case of S corporations, each S corporation is treated as a separate unrelated trade or business.[18] The UBTI is the amount described in Section 512(e)(1)(B). However, if an organization’s interest in an S corporation satisfies either the de minimis or participation tests applicable to QPIs, the organization may aggregate the UBTI from such S corporation in its “investment activities” UBIT silo.[19]

Debt-financed Property

The “investment activities” UBIT silo includes unrelated business income characterized as such by reason of being “debt-financed property” described in Section 514. Generally, that includes property, other than property substantially all the use of which is substantially related to the organization’s exempt purposes, held to produce income and with respect to which there is an “acquisition indebtedness.” So, leveraged investments that might otherwise give rise to tax-exempt dividends or rents from real property, for example, could be eligible for inclusion in the investment activities UBIT silo.

A Silo Workaround — New Use for a Wholly Owned Taxable C Corporation

Tax-exempt organizations could consider placing multiple lines of unrelated businesses (e.g., non-QPI investment partnership interests) into a wholly owned taxable C corporation. C corporations are not required to silo their activities, so the net operating losses from one trade or business can be used to offset taxable income from other, separate lines of business, including pass-through income and losses from partnership investments. 

A “drop down” of assets into a taxable corporate subsidiary in exchange for 100% of its shares typically will not constitute a taxable event. Although the C corporation will be subject to corporate level tax, there typically is no “double taxation” as dividends generally are exempt from UBIT.[20]

3.  The Fractions Rule & UBIT

Hearing the word “fractions” may cause traumatic flashbacks to being called on in math class (or, the current equivalent, helping your kids with their math homework). Investment professionals should not feel such trepidation about the fractions rule — it rarely applies. When you have noted that it does — job well done —hand it over to the partnership tax lawyers. 

Generally, rents and capital gains from real property are excluded from UBIT, except that they are taxable to the extent debt-financed. This rule holds true when the real property is held as an investment through a partnership interest and there is acquisition indebtedness somewhere in the holding structure. However, for a certain subset of tax-exempt investors, that debt on real property is ignored for UBIT purposes, allowing for debt-financed rents and capital gains from real property to remain fully tax-exempt. In certain situations, for that exclusion from the usual debt-financed income rule to apply, a partnership must meet the (dreaded) fractions rule.  

The following chart[21] provides a useful visual aid when determining whether the fractions rule applies.

The purpose of the fractions rule is to preclude the improper allocation of gains to a tax-exempt partners and losses to taxable partners. In other words, it is designed to prevent improper tax avoidance.

Now that you know when the fractions rule actually comes up, and its purpose, the next step is to understand what the fractions rule actually requires of a partnership agreement. At the 30,000-foot level: a partnership complies with the fractions rule if (1) the allocation of items to any “qualified organization” (e.g., universities, pension funds) does not result in the qualified organization having a share of the overall partnership income for any taxable year greater than its overall share of partnership loss for the year for which such loss share will be the smallest; and (2) except for partnership items allocated pursuant to Section 704(c), all allocations have “substantial economic effect” within the meaning of Section 704(b)(2).[22] Let’s leave it at that…

4.  Program-Related Investments

Program-related investments (PRIs) are an important tool for private foundations (a subset of section 501(c)(3) tax-exempt organizations). Among other things, the acquisition of a partnership interest or other private, for-profit equity investment can constitute a PRI. 

There are four requirements for an investment to qualify as a PRI.[23] First, the primary purpose of making the investment is to accomplish one or more of the private foundation’s exempt purposes, including charitable, educational, scientific and literary purposes. Second, there is no significant purpose to generate income or appreciate property. Third, the investment would not have been made but for the relationship between the investment and the accomplishment of the foundation’s exempt purpose. Fourth, no purpose of the investment is an attempt to influence legislation or participate or intervene in a political campaign. 

Since the PRI regulations were first written in 1972, private foundations have utilized PRIs to support economic development, scientific and technological advancement, educational and artistic programs, and the environment. A private foundation may make PRIs into for-profits, nonprofits, or individuals so long as the investment furthers the private foundation’s exempt purpose and a significant purpose for making the investment is not to make a profit.

The PRI regulations contain several examples of investments that qualify as PRIs, which reflect the following principles: “(1) an activity conducted in a foreign country furthers an exempt purpose if the same activity would further an exempt purpose if conducted in the United States; (2) the exempt purposes served by a PRI are not limited to situations involving economically disadvantaged individuals and deteriorated urban areas; (3) the recipients of PRIs are not required to be within a charitable class so long as they are the instruments for furthering an exempt purpose; (4) a potentially high rate of return does not automatically prevent an investment from qualifying as a PRI; (5) PRIs can be achieved through a variety of investments, including loans to individuals, tax-exempt organizations, and for profit-organizations, and equity investments in for-profit organizations; (6) a credit enhancement arrangement may qualify as a PRI; and (7) a private foundation’s acceptance of an equity position in conjunction with making a loan does not necessarily prevent the investment from qualifying as a PRI.”[24] 

A private foundation may structure its PRIs as straight debt, convertible debt, debt with an “equity kicker,” common or preferred equity interests, stock, limited liability company or partnership interests, warrants, loan participations, funded or unfunded loan guarantees, royalty interests, or otherwise. Importantly, a PRI will not cease to be considered a PRI merely because of income production or property appreciation, or because the investment has the potential for a high rate of return. 

Although the PRI regulations do not require that private foundations have an exit strategy for their PRIs structured as equity investments, private foundations may nevertheless negotiate for various exit rights and other appropriate provisions — for example, a “put,” “call,” forced liquidation, demand or piggy-back registration right, or similar provisions.

PRIs can often provide early stage financing (including convertible debt) or early investment dollars to allow a startup to reach the threshold necessary to tap commercial debt and capital markets. In order to attract investments from private foundations, sponsors of private equity offerings may want to include with their offering memorandums or other pitch materials a “PRI wrapper”— information that lays out how an investment in the entity serves charitable, environmental, educational or scientific purposes, and as such may qualify as a PRI.

5.  The End

As tax-exempt organizations increasingly seek out and participate in private equity investments, the managers and sponsors of those investment opportunities, as well as their accountants and attorneys, should have a basic understanding of the tax, governance and other issues facing their potential tax-exempt and nonprofit investors. Doing so may well allow those opportunities to find a while new class of investors. Good luck with the next pitch!

Ofer Lion is the head of the tax-exempt organizations practice group and a partner in the Los Angeles office of Seyfarth Shaw LLP. He is a Fellow of the American College of Tax Counsel and Co-Chair of the American Bar Association’s Subcommittee on UBIT.

Dustin W. Lauermann is an associate in the Los Angeles office of Seyfarth Shaw LLP.

This article represents the views of the authors only, and does not necessarily represent the views of Seyfarth Shaw LLP.