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by Peter Szostak, CPA, MBA - Audit Manager

and Robert Moreland, CPA - Tax Manager

  Print Version

Whether you are a newly formed organization looking to take your first step into the investing arena or your organization is a seasoned professional, there are certain items to take under consideration when a tax-exempt organization invests. These are items that can create unplanned expenses or even worst threaten the organization’s tax-exempt status. Items such as investment fees, taxes from unrelated business income, foreign income reporting and listed or reportable transactions can create some unpleasant results if they are not taken into consideration when an organization invests.

Investment Fees

Many not-for-profit organizations depend on investments and endowments and the income they provide to support their mission. According to Forbes, organizations may give up to 40% of their average annual investment return away in fees per year. The 40% annual cost can be calculated by taking the average expense ratio charged by mutual funds and add it to the average advisor fee, then divide this number by the expected portfolio return before fees. Many not-for-profit organizations do not even know they are paying some of these fees, due to fact that investment fees are many times netted from the investment returns, as well as a lack of transparency amongst some investment advisors and custodians.

Not-for-profit organizations can easily cut these costs. The first step in reducing these fees is to calculate the total fees that are being paid. Mutual fund fees are netted against investment returns, so one must calculate the annual fee amount by taking the expense ratio of the fund times the average balance of the fund during the year. These fees can be determined by looking up the fund on one of several investment websites, such as Morningstar. According to Morningstar, the average expense ratio for actively-managed equity mutual funds is 1.2% and the average expense ratio for investment grade bond funds is 0.9%. Taken together, a 60% global stock and 40% bond fund portfolio has an average combined expense ratio of 1.1% per year. The second expense that many organizations pay is advisor fees. The typical investment adviser charges about 1.0% per year on the first $1 million dollars of assets under management. This cost may be higher or lower depending on the amount being managed. Adding mutual fund expenses and adviser fees comes to 2.1% annually, assuming a 60% global stock and 40% bond portfolio.

Increased competition and technology has significantly reduced the fees that are available in the market today. Global and domestic index funds from companies such as Vanguard can have fees as low as .2%. Advisor fees ranging from .25% to .5% can be found in today’s market, especially for portfolios over $1 million. A good goal would be to reduce total fees to below .7% annually. This would lower the total expense to below 15% of the expected gross return for a global balanced portfolio. With reinvested dividends and profits, the reduction in fees can significantly increase investment returns for not-for-profit organization over the long run.

Unrelated Business Income

When a charity or other tax-exempt organization engages in activities that are not related to the purposes for which it receives tax exemption, and those activities generate income, that income may be taxable as unrelated business income (UBI).

Typically, investment income is excluded from UBI. Investing for the charity's own account is not considered as being engaged in a trade or business. Dividends, interest, annuities, certain rents from real property, and royalty income are specifically excluded from UBI. Furthermore, capital gains and losses, whether short-term or long-term, are generally excluded.

This exclusion does not apply if the income is derived from debt-financed property. “Debt-financed property” means property held for the production of income and acquired or improved by the use of a debt. The debt may be incurred before, during, or after acquisition or improvement of the income producing property, depending on whether the property would not have been acquired “but for” the debt. The exception to the exception is that property used for a charity's exempt purpose is not taxable under the debt-financing rules.

When property is acquired subject to a mortgage or other lien, it is considered debt-financed even though the charity does not agree to assume the debt or does not pay it. This rule has a ten-year grace period if the charity receives mortgaged property by bequest. A similar ten-year grace period exists for mortgaged property acquired by gift if the mortgage was placed on the property more than five years before the gift and has been held by the donor more than five years before the gift. The grace periods do not apply if the organization assumes and agrees to pay the debt or actually makes a payment for the equity.

Note that under a special provision in the tax code, there are certain “qualified organizations” where UBI does not result from indebtedness incurred by such qualified organizations in acquiring or improving any real property.

The consequence to a charity having UBI is that it must report the income and possibly pay tax at corporate rates. If a charity decides that it is appropriate to incur taxable, the organization's underlying tax exemption and the deductibility of its donors' contributions will not be affected, as long as the unrelated business activity is not substantial.

Foreign Investments

Exempt investors that invest in foreign partnerships and corporations either directly or indirectly are exposed to a myriad of additional filing requirements. The requirements associated with these filings can be bewildering at best. They require the investor to navigate a maze of forms and muddle through a mess of categories within those forms. Additionally, the forms require the investor, in certain circumstances, to report detailed information that it may only be able to obtain from the investment managers. Information about forms and filing requirements are so extensive that an adequate discussion is beyond the scope of this article. Therefore it is important that the investor work closely with investment managers and tax advisors to receive the information needed to ensure compliance.

Listed and Reportable Transactions

The penalty regime applicable to tax shelters is based on distinctions defined by the nature of the transaction and the responsibilities of defined parties. These transactions are known as listed or reportable transactions. Those involved in the transaction include participants, promoters, and material advisers. Tax exempt organizations can be participants or promoters and their professional advisers can be treated as material advisers.

Listed transactions are those transactions specifically identified by the Secretary of the Treasury as tax-avoidance transactions or transactions that are “substantially similar” to such transactions. Listed transactions are identified in notices issued periodically by the IRS; the most recent such notice identifies thirty transactions. Because each of the transactions is the subject of individual guidance from the Service, the record of the listed transactions should not be regarded as a self-explanatory checklist. These transactions are often complex and are generally designed imitate other transactions that are not regarded as abusive. Considerable judgment and experience may be required in determining whether a particular transaction presented to an exempt entity is in fact one of the listed transactions.

Reportable transactions are a much broader category that includes listed transactions. A reportable transaction is a transaction “having a potential for tax avoidance or evasion” and with respect to which certain information is required to be provided with a tax return or otherwise. The six categories of reportable transactions are:

  1. Listed transactions
  2. Transactions offered under conditions of confidentiality
  3. Transactions offered to the taxpayer with certain protections against risk of loss
  4. Transactions permitting a taxpayer to claim losses exceeding defined thresholds
  5. Transactions with a difference between book and tax treatment in excess of $10 million
  6. Transactions resulting in a tax credit exceeding defined thresholds

Participants, promoters and material advisors of listed and reportable transactions may be subject to sanctions and monetary penalties of up to 50% of the income derived from the activity as well as excise taxes levied against the tax exempt organization and individuals with authority positions within the organization.

If you are considering an investment and are unsure as to the effect that it may have on your organization or have concerns over an existing investment, our team of Blue non-profit specialists would be happy to meet with you to discuss these matters and provide possible solutions.


If you have any questions regarding the article above or any other issue affecting your not-for-profit organization please contact your Blue & Co. advisor or e-mail us at or call us at 800-717-BLUE


Please visit our website at for more information regarding the services we provide.

CIRCULAR 230 DISCLOSURE: To ensure compliance with recently-enacted U.S. Treasury Department Regulations, we are now required to advise you that, unless otherwise expressly indicated, any federal tax advice contained in this communication, including any attachments, is not intended or written by us to be used, and cannot be used, by anyone for the purpose of avoiding federal tax penalties that may be imposed by the federal government or for promoting, marketing or recommending to another party any tax-related matters addressed herein.


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