Tax-exempt and non-profit entities represent a significant source of capital in private equity investments. In November 2024, the NYS Common Retirement Fund (NYSCRF) committed nearly $3 billion to private equity investments and, as of June 2024, Yale allocated an estimated $18.6 billion of its $41.4 billion endowment to private equity and venture capital. Private equity investments can be beneficial for nonprofits, but they come with specific concerns and risks, one of which is that they can inadvertently generate Unrelated Business Taxable Income (UBTI).
A commonly used approach that often triggers UBTI exposure is the use of ‘management fee offset structures,’ a mechanism used to reduce investor fees. If not designed carefully, fee offset arrangements can result in substantial tax liabilities.
Despite this challenge, with strategic planning and precise structuring, fund managers can implement fee offset mechanisms and still mitigate the tax burden for their exempt investors.
UBTI in Private Equity
The IRS grants tax exemption to a variety of organizations, including charities and foundations, private pension funds, college and university endowments, individual retirement accounts (IRAs), and state and municipal institutions. However, these organizations remain liable for taxes on UBTI.
UBTI is defined as any gross income derived by a tax-exempt entity “from an unrelated trade or business that it regularly carries on,” less the deductions directly connected with that trade or business. Essentially, it is income that does not align with an organization’s tax-exempt purpose. Only passive income, including dividends, interest, capital gains, and certain real property rents are excluded and generally not defined as UBTI.
A real-world example of UBTI would be a tax-exempt hospital that runs a gift shop open to the public. The income derived from sales would likely be considered UBTI because selling gifts is not related to patient healthcare. By contrast, if a university owns stock in a manufacturing company and earns dividends, that income is not UBTI. It is deemed passive investment income; it is not sourced from active income that is unrelated to the university’s mission. The proceeds would be exempt from taxes.
Private equity and UBTI risk factors
Several common private equity activities can create UBTI for non-profit organizations. These include using leverage to make investments, investing in operating businesses structured as partnerships or LLCs, and implementing certain fee offset arrangements.
UBTI offsets work by finding permissible deductions or losses that can be applied against this taxable income.
Private equity firms typically charge investors two main fees:
- Monitoring fees are charged to portfolio companies for oversight.
- Management fees are charged to investors for fund management.
To avoid “double-dipping,” many private equity firms offer management fee offsets. They reduce management fees charged to investors based on a percentage of the monitoring fees collected from portfolio companies. Fee offsets appear deceptively simple, but in fact, require careful structuring to avoid UBTI implications.
UBTI is largely determined by how income is characterized. If monitoring fees are recognized as compensation for services rendered and they flow back to tax-exempt investors through offsets, they might be reclassified as UBTI.
Structuring solutions
Tax-exempt investors are well advised to work with fund managers to structure offset arrangements that avoid UBTI implications. The following strategies can achieve this:
- Ensure that offsets are characterized as adjustments to management fees rather than distributions of monitoring fee income.
- Use “blocker” entities: specialized legal structures that shield problematic income and the tax-exempt organization to absorb monitoring fees before they reach tax-exempt investors.
- Carefully word partnership agreements to clarify that tax-exempt investors are not participating in service businesses.
- Use completely different fee structures, like reduced management fees, from the start of the business relationship.
The Bottom line
UBTI for tax-exempt organizations is generally taxed at the corporate income tax rate (presently 21%), so the stakes can be high. Based on our experience with a wide range of tax-exempt clients, we’ve learned that, with careful structuring, it is possible to avoid initiating UBTI.
A tiered partnership structure that clearly separates income streams offers an elegant and effective solution to UBTI challenges. When the management company receives monitoring fees directly and the fund applies corresponding reductions to its management fees, services and proceeds remain separate and defined. In this way, tax-exempt investors enjoy fee reductions without directly participating in or receiving income from service activities that would trigger tax liability.
Maintaining this crucial distinction between service income and investment activity allows nonprofits a dual benefit: participation in private equity investment and protection from tax exposure.
This material has been prepared for informational purposes only, and is not intended to provide or be relied upon for legal or tax advice. If you have any specific legal or tax questions regarding this content or related issues, please consult with your professional legal or tax advisor.
