Unrelated business taxable income (UBTI)

Tax-exempt organizations—such as universities, charities, and pension funds—normally don't pay taxes on their income. However, they can lose this tax-exempt status on certain income sources. UBTI represents income that comes from business activities unrelated to the organization's core charitable or exempt mission. This includes income from providing services for compensation and gains from activities that involve borrowing money.

The tax treatment becomes more complex when tax-exempt organizations invest in hedge funds. When a tax-exempt entity holds a partnership interest in a domestic hedge fund, tax law treats the entity as if it were directly running the fund's business activities. This means the tax-exempt investor can be taxed on their share of the fund's business income, even though they are normally exempt from taxes.

This situation differs significantly from investing in a corporation. When tax-exempt organizations buy corporate stock, the tax consequences typically stay at the corporate level and don't affect the shareholders. The , however, allows tax consequences to "flow through" to the individual partners.

The Internal Revenue Code defines UBTI broadly to include income and gains from any regularly conducted trade or business that has no meaningful connection to the organization's exempt purpose. This applies whether the organization conducts the business directly, through partnership investments, or sometimes through significant corporate ownership positions.

However, certain types of income are specifically excluded from UBTI treatment. These exclusions provide important safe harbors for tax-exempt investors. Key exclusions include dividends and interest from stocks and bonds, payments received from lending out securities, certain types of , rental income that meets specific requirements, and capital gains or losses from selling assets (except inventory or property held for sale to customers).

forms a distinct category of UBTI with specific rules. This category addresses situations where tax-exempt organizations use borrowed money to acquire income-producing property. The tax law aims to prevent tax-exempt entities from using leverage to unfairly compete with taxable businesses.

This category includes two main components. First, it covers income received by an exempt organization from property that was purchased with borrowed money, regardless of whether the organization holds the property directly or through a partnership. Second, it includes gains realized when selling property that had outstanding debt during the twelve months before the sale.

Starting September 14, 2021, the Treasury Department expanded the definition of . The updated guidance now includes implicit leverage created through and related financial instruments that hedge funds commonly use in their investment strategies. This change broadened the scope of what counts as debt-financed income for tax-exempt investors.

Tax-exempt entities face additional complexity when calculating UBTI from multiple business activities. The tax code requires these entities to calculate UBTI separately for each distinct business activity they conduct. Importantly, losses from one business cannot be used to offset income from a different business. This rule prevents tax-exempt organizations from using losses in one area to eliminate UBTI from profitable activities in other areas.

When a domestic hedge fund uses leverage (such as borrowing from banks) or makes investments that generate UBTI, the tax consequences flow through to the fund's tax-exempt investors. These investors must pay tax on their proportional share of the fund's UBTI, even though they would normally be exempt from taxation.

However, the UBTI only affects the specific income that triggers it. The tax-exempt investors' remaining distributions and allocations from the fund continue to receive tax-exempt treatment. Similarly, their other income sources outside the fund remain unaffected by the UBTI generated within the hedge fund.

For tax-exempt U.S. investors, investing through an offshore (foreign) hedge fund structured as a corporation offers significant tax advantages. Income that would create UBTI if earned directly—including income from leverage or operating business profits—passes through the foreign corporation as dividends or capital appreciation without creating UBTI for the tax-exempt investor.

This structural benefit occurs because the foreign corporation acts as a barrier, preventing the underlying business activities from flowing through to the tax-exempt investor. However, this advantage can be substantially reduced when U.S. federal apply to distributions or gains from the foreign entity. These withholding taxes can offset some of the benefits gained by avoiding UBTI.

Some types of tax-exempt organizations face particularly harsh consequences if they generate certain types of UBTI. The tax code imposes these severe penalties to ensure these specialized entities maintain their focus on their intended purposes.

For example, —specialized entities that provide income to beneficiaries before transferring remaining assets to charity—face an equal to 100% of any UBTI they generate. This penalty effectively eliminates any economic benefit from earning UBTI.

, which hold property for the benefit of their tax-exempt parent organizations, may lose their entire tax exemption if they generate certain types of UBTI that exceed specific thresholds. They lose exemption if the UBTI is not incidental to their primary business purpose, or if even incidental UBTI exceeds 10% of their total .