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STATE TAXATION OF ALTERNATIVE INVESTMENTS IS A POORLY DEVELOPED AREA OF STATE TAX LAW, BUT THERE ARE APPROACHES TO MANAGING THE ISSUES INVOLVED.
lternative investments have proven very popular with certain types of large tax-exempt organizations. As noted in a recently published article that focused on federal aspects of Schedule Κ-1 reporting for tax-exempt investors,1 the primary taxexempt investors in alternative investments appear to be pension funds, colleges and universities, and private foundations. The term "alternative investments" includes a wide range of nontraditional investments, including investments in venture capital, private equity, hedge funds, and derivatives, as well as limited partnerships (LPs), limited liability partnerships (LLPs), limited liability companies (LLCs), and limited liability limited partnerships (LLLPs).
The discussion below focuses on the state unrelated business taxable income (UBTI) reporting issues contained in the footnotes of federal Schedules Κ-1 issued to tax-exempt investors by alternative investments. A review of state statutes, regulations, and tax filing instructions indicates that there are 40 state and two local (District of Columbia and New York City) jurisdictions that tax unrelated business income. Four states have no unrelated business income (UBI) taxes,2 and six states have no business or corporate income tax.3 As indicated above, many Schedules Κ-1 have state UBTI allocated or apportioned to these ten states,4 creating reporting information that is confusing at best, and may result in unnecessary tax filings or additional time spent in researching these issues.
When a tax-exempt investors partnership interests are small in number and the dollar amounts reported on the Schedules Κ-1, whether income or losses, are also small, there is a tendency on the part of tax-exempt investors to simply accept what is reported to them on the Schedules Κ-1 and not ask any questions of the partnership that provided the schedules. Many tax-exempt investors report the state UBTI information on either state unrelated business income tax returns or on corporation income tax returns even if there is not a UBTI filing requirement in that state. A not insignificant number of other tax -exempt investors simply do not file any state returns, given the small dollar amounts apportioned or allocated to the respective states.
As the number of Schedules Κ-1 increases and the state UBTI dollar amounts grow larger, and perhaps...