Do Charities Actually Receive a K-1? – Avoid this Mistake + FAQs

Yes – charities can and do receive K-1s when they are involved as partners in partnerships, beneficiaries of trusts or estates, or members of LLCs taxed as pass-throughs.

In 2017, over 80,000 U.S. nonprofits reported taxable business income, illustrating that many charities indeed receive Schedule K-1 forms.

This means a 501(c)(3) charity (public charity or private foundation), a donor-advised fund, a religious organization, or even a fiscally sponsored project can end up with a Schedule K-1.

A K-1 form is a tax document that passes through a share of income (or loss) from another entity to the charity, potentially requiring the charity to report that income on its own tax filings.

Below, we break down how and why charities receive K-1s, the implications for their taxes (including Unrelated Business Income Tax (UBIT)), and what different types of nonprofits need to know.

(Spoiler: Receiving a K-1 is common for charities with certain investments or gifts, but it comes with important tax considerations!)

Why Would a Charity Get a Schedule K-1? 🤔

Charities receive Schedule K-1 forms when they have an ownership interest or beneficiary role in a “pass-through” entity. Unlike a regular corporation that pays its own taxes, pass-through entities pass income and tax attributes down to their owners or beneficiaries.

Here are the main scenarios in which a charity might get a K-1:

• Being a Partner in a Partnership or LLC – If a charity (like a university endowment, hospital, or foundation) invests in a partnership (including limited partnerships, LLCs taxed as partnerships, or joint ventures), that partnership will issue a Schedule K-1 (Form 1065) to the charity.

• The K-1 reports the charity’s share of income, deductions, and credits from the partnership. For example, a public charity might own a limited partnership interest in a real estate venture or private equity fund and receive a K-1 each year showing its portion of rental income, capital gains, etc.

• Beneficiary of a Trust or Estate – Charities can be beneficiaries of trusts or estates. In these cases, the trust or estate will issue a Schedule K-1 (Form 1041) to the charity, allocating any income distributed to the charity. For instance, if a donor’s will or trust directs annual income to a religious organization, that charity may receive a K-1 for its share of the trust’s income (like interest or dividends).

• This typically happens with charitable remainder trusts, testamentary trusts, or estate settlements that include charities as beneficiaries. The K-1 informs the charity of the income (which is often tax-free to the charity, but still reported for transparency).

• Member (Owner) of an S Corporation – It surprises many people, but charities can own stock in S corporations (a type of corporation that, like a partnership, passes through income to shareholders via Schedule K-1 (Form 1120S)). Congress allows 501(c)(3) organizations to be S-corp shareholders.

• If a charity or private foundation is given stock in a family S-corp or invests in a closely held business that elected S-corp status, it will receive a K-1 each year for its share of the corporate income. However, all income from an S-corp is generally treated as unrelated business income (UBI) for the charity (we’ll explain this below), so this scenario carries tax consequences.

• Donations of Partnership or LLC Interests – A donor might contribute a non-cash gift to a charity, such as an ownership interest in a partnership, LLC, or S-corporation. When a charity accepts such a gift, it effectively steps into the donor’s shoes as an owner.

• The charity will then receive any K-1s associated with that ownership stake. For example, if a donor gives a 10% interest in a rental property LLC to a wildlife conservation charity, that charity becomes a 10% member and will get a K-1 for 10% of the LLC’s income (rents, gains, etc.) until the charity sells or relinquishes the interest.

• Joint Ventures and Program-Related Investments – Sometimes charities form joint venture LLCs or partnerships with other organizations (for-profit or nonprofit) to carry out projects. A well-known example is a hospital (charity) partnering with physicians or investors in an LLC to build a new facility. In such cases, the charity will receive a K-1 as a co-owner.

• Similarly, a private foundation might make a program-related investment in a startup company or venture fund aligned with its mission, taking an ownership stake – again resulting in K-1s reporting any income or loss allocated to the foundation.

In all these scenarios, the K-1 is essentially an information slip. It tells the charity, “Here’s your share of what happened tax-wise in this entity this year.” But it’s not a tax bill on its own.

The charity uses the K-1 information to determine if it owes any tax (via UBIT) or reporting on its returns. Importantly, a charity does not receive K-1s for normal donations or grants – K-1s only come from ownership in taxable entities like partnerships, trusts, estates, or S-corps.

(If you donate cash or property to a charity, you do not get a K-1 from the charity; you’d simply get a receipt or acknowledgment letter. K-1s flow into charities from other entities, not out to donors.)

🔑 Key Terms Explained (K-1s, UBIT, and More)

To navigate this topic, it’s crucial to understand some key tax terms and entities involved. Here’s a quick glossary:

• Public Charity (501(c)(3)) – A nonprofit organization operated for charitable, religious, educational, or similar purposes that typically receives broad public support. Examples include charities like Red Cross, community foundations, universities, and churches. Public charities must spend the majority of their efforts on their tax-exempt mission. They file an annual Form 990 information return (except churches, which are generally exempt from filing). If a public charity receives a K-1 showing certain types of income (e.g. business income), it may have to file a Form 990-T as well (more on this soon).

• Private Foundation (501(c)(3)) – A charitable organization that usually has a single major funding source (like a family endowment or corporation) and typically makes grants to other charities rather than operating programs directly. Private foundations file an annual Form 990-PF return. They are subject to special rules, including an excise tax on net investment income (a small tax on interest, dividends, and capital gains) and limitations on business ownership (to prevent foundations from controlling for-profit businesses outright). Private foundations can receive K-1s if they invest in partnerships or are beneficiaries of trusts. They too use Form 990-T to report any unrelated business income from those K-1s.

• Donor-Advised Fund (DAF) – A donor-advised fund is not a separate legal entity, but rather an account held under the umbrella of a public charity (often a community foundation or a financial institution’s charitable arm). Donors contribute assets (which might include partnerships or LLC interests or stock) to the fund and then advise on grants to charities over time. The sponsoring public charity legally owns the assets once contributed. If a partnership interest or other pass-through asset is held in a DAF, the sponsoring charity will receive any K-1s related to that asset. (The donor who contributed it no longer receives the K-1, since they gave up ownership.) The sponsoring charity is responsible for handling any tax implications (like UBIT) on income from DAF assets.

• Religious Organization – In this context, typically houses of worship and their affiliated institutions (churches, mosques, synagogues, temples, etc.) that are recognized as 501(c)(3) charities. They are generally treated as public charities but are exempt from filing Form 990 due to special rules for church exemption. However, if a church or religious charity has unrelated business income (such as from a K-1), it must file Form 990-T to report and pay tax on that income, just like any other exempt organization would. So being a church doesn’t exempt one from UBIT if they engage in unrelated businesses or investments.

• Fiscal Sponsorship – A fiscal sponsor is a tax-exempt charity that agrees to partner with a group or project that does not have its own tax-exempt status, so that donations can be tax-deductible and funds managed under the sponsor’s 501(c)(3) umbrella. Essentially, the sponsor “lends” its charitable status to the project (with oversight). For our topic: if a fiscally sponsored project receives a complex asset like a partnership interest, the fiscal sponsor (the actual 501(c)(3)) is the entity that legally receives the asset. Thus, any K-1 from that asset will be issued to the fiscal sponsor. The sponsor then handles compliance (including UBIT or filing obligations) and typically uses the funds for the project’s benefit per the sponsorship agreement. Fiscal sponsorship doesn’t introduce new tax rules by itself – it just means the K-1 obligations fall on the sponsoring charity.

• Schedule K-1 – A tax form used to report an individual partner’s, member’s, shareholder’s, or beneficiary’s share of income, deductions, credits, etc., from a pass-through entity. There are three main types:

  • K-1 (Form 1065) for partners in a partnership (or members of an LLC taxed as a partnership).

  • K-1 (Form 1120S) for shareholders of an S corporation.

  • K-1 (Form 1041) for beneficiaries of estates and trusts.

  A charity receiving a K-1 will see various boxes and codes indicating the nature of income (for example, interest, dividends, rental income, charitable contributions made by the entity, etc.). This information is crucial to determine how that income is treated for tax purposes for the charity.

• Unrelated Business Income (UBI) – Also called Unrelated Business Taxable Income (UBTI) when calculated for tax. This is income from a trade or business activity that is not substantially related to the organization’s exempt purpose, and that is regularly carried on. In simpler terms, if a charity earns money in a way that doesn’t directly accomplish its charitable mission (and it does so repeatedly or continually), that income may be taxable. Common examples include operating a restaurant or gift shop by a charity (outside its mission), or income from debt-financed investments.

• Not all income is UBI: Donations, grants, most investment income (like interest, dividends), royalties, and rents from real property are generally excluded from UBI by law. However, income passed through on a K-1 can be UBI if it comes from an active business or from certain investments. UBI matters because if an organization has over $1,000 of gross unrelated business income in a year, it must file a Form 990-T and pay Unrelated Business Income Tax (UBIT) on that income.

• Unrelated Business Income Tax (UBIT) – The tax imposed on a charity’s UBI. Charities pay UBIT at corporate income tax rates (a flat 21% federal rate as of recent years) on their net UBI after allowed deductions. UBIT is meant to level the playing field, so nonprofits don’t get a tax-free advantage running regular businesses unrelated to their missions. A Schedule K-1 that reports business income to a charity often signifies the charity has UBI to report. (We’ll discuss later how K-1s specifically indicate UBI for exempt partners.)

• Form 990-T – The Exempt Organization Business Income Tax Return. This is separate from the normal Form 990. A charity (including churches or smaller orgs that might not file Form 990) must file Form 990-T if it has gross UBI of $1,000 or more in a year. The 990-T reports the details of unrelated business income and calculates the tax due. For example, if a charity gets a K-1 showing $5,000 of income from an LLC that runs a parking lot (unrelated to the charity’s mission), the charity would likely file a 990-T, report the $5,000 as UBI, possibly deduct any directly connected expenses or a $1,000 specific deduction, and then compute tax on the remainder.

• GP (General Partner) vs. LP (Limited Partner) – In partnerships (and by extension, LLCs), a general partner is an owner who typically has management power and personal liability for the partnership’s debts. A limited partner is an owner who invests money but does not actively manage; liability is limited to their investment. For charities, this distinction is important.

• If a charity is a general partner in a partnership, it means it’s actively involved in running a business – which could raise questions both about UBIT (likely generating UBI, since the activity is active and unrelated unless it furthers the mission) and even the charity’s continued exempt status if that business doesn’t further a charitable purpose. Most charities therefore participate as limited partners (or LLC members with limited roles) in for-profit ventures, to keep involvement passive.

• Charities often negotiate to be limited partners so that they provide funding but are not on the hook for managing day-to-day business. The K-1 form itself usually indicates the partner’s status (limited or general) and share percentage. Being a limited partner can sometimes help the charity argue that the income is more like passive investment income – though the IRS doesn’t let that alone shield the income from UBIT if the underlying activity is unrelated business.

• EIN (Employer Identification Number) – The tax ID number used by organizations (like charities) instead of a SSN. When a charity is a partner or shareholder, it gives the partnership its EIN, and that EIN is listed on the Schedule K-1. This identifies the charity in the IRS system. When the charity later files a 990-T, it uses the same EIN, so the IRS can match that the EIN reported K-1 income and the EIN reported UBI on the 990-T. Essentially, the EIN is how the IRS knows the K-1 belongs to an exempt organization and not an individual or corporation.

With these terms in mind, let’s delve deeper into how different types of charitable entities handle K-1s and what the tax implications are.

How Different Nonprofit Entities Handle K-1s

Not all charities are exactly alike under the hood. Public charities, private foundations, donor-advised funds, religious organizations, and fiscal sponsorship arrangements each have unique considerations when it comes to receiving K-1 income. Let’s break it down by entity type:

Public Charities and K-1 Forms

Public charities (typical 501(c)(3) nonprofits) can and do receive K-1s in various situations. For instance, universities, hospitals, and large nonprofits often invest part of their endowments in alternative investments like private equity funds or hedge funds – many of which are structured as partnerships that issue K-1s. Smaller public charities might receive a donated interest in an LLC or inherit a stake in an estate that leads to a K-1.

• Tax Filing: A public charity that gets a K-1 will report any income from it in its accounting records and on its Form 990 under the appropriate revenue categories (investment income, rental, etc., depending on the nature). But if any of that income is “unrelated business income,” the charity must also file Form 990-T. For example, suppose a community charity is a limited partner in a local bakery business (unrelated to its mission of, say, environmental conservation). The K-1 shows $10,000 of ordinary business income allocated to the charity. This $10,000 is UBI. The charity would file Form 990-T to report it and pay tax, even while also including the $10,000 in its overall financial statements.

• UBIT and Deductions: Public charities pay UBIT on net unrelated income. They can deduct expenses directly connected to earning that partnership income (the K-1 may report some of these, like their share of wages, rent, etc., which are already factored into the net income figure, but if the charity had additional expenses, those could offset UBI). Public charities also get a specific $1,000 deduction against UBI, effectively meaning the first $1,000 of UBI is not taxed (but they still have to file if gross UBI ≥ $1k). In practice, many K-1s might show small amounts of different types of income, and not all will be taxable – public charities must sift through the K-1 details to identify what counts as taxable UBI.

• Examples: A museum (public charity) invests in a partnership that owns a parking garage. The museum receives a K-1 showing $50,000 in parking service income (which is unrelated to its art mission – UBI) and $10,000 in interest income (which is excluded from UBI). The museum would likely file a 990-T, reporting the $50,000 minus any direct expenses as taxable, and pay tax on that. The $10,000 interest is reported on Form 990 as investment income but not taxed. The K-1’s data is essential to this split.

• Mission Alignment: If the partnership’s activity is related to the charity’s mission, then even though a K-1 is received, the income might not be UBI at all. For instance, if a conservation charity is a partner in a partnership that runs a wildlife sanctuary (consistent with the charity’s purpose), the income might be mission-related and non-taxable. Public charities have more leeway than private foundations to engage in business activities, but they must ensure their primary focus remains on charitable programs. The IRS has an “operational test” – if a charity’s activities veer too much into for-profit businesses beyond what’s needed for funding charity, its tax-exempt status could be in jeopardy. Receiving some K-1 investment income is usually fine; running a full-blown business that overshadows the charity work is not.

Private Foundations and K-1 Income

Private foundations often have substantial investment portfolios, which can include partnerships and alternative assets that issue K-1s. In fact, many family foundations park funds in venture capital or hedge fund partnerships.

• Tax Filing: Like public charities, private foundations will report income from K-1s on Form 990-PF (which has sections for various types of revenue). They also must file Form 990-T for any UBI. A key difference: Private foundations do not get the $1,000 specific deduction that public charities get for UBI – that deduction is specifically for organizations eligible to receive tax-deductible contributions (public charities, mainly). Foundations instead calculate UBIT on all net UBI (after any applicable expenses) without that extra cushion.

• Investment Income Tax: Private foundations are subject to an excise tax on net investment income (currently 1.39% of net investment income for most foundations). “Net investment income” includes interest, dividends, rents, and capital gains – regardless of whether related or not. So, if a K-1 reports interest or dividends, the foundation will include those amounts in its net investment income calculation and pay the small excise tax. This is separate from UBIT. It means that even income that is not taxed as UBI might still incur a tiny tax for foundations. For example, a foundation’s K-1 shows $100,000 of dividend income from a limited partnership fund; that’s not UBI, but the foundation will pay ~$1,390 in excise tax on it.

• Unrelated Business Rules: Private foundations face a stricter limitation called the “excess business holdings” rule. In general, a foundation and its insiders cannot jointly own more than 20% of a business enterprise (with some exceptions) without incurring penalties. If a foundation receives a large K-1-generating ownership (say a big chunk of an operating LLC) via donation or investment, it must be careful not to hold too large an interest in that active business. If the interest exceeds the allowed threshold, the foundation would need to dispose of the excess portion, usually within 5 years, to avoid taxes on excess holdings. This typically isn’t an issue when foundations invest in broad funds because their percentage is small, but it can arise if, for instance, a family donates their company to their foundation.

• Jeopardizing Investments: Another consideration for foundations is that they must invest prudently – extremely risky investments that threaten the foundation’s ability to carry out its charitable work can be considered “jeopardizing investments” and incur penalties. Most standard partnerships or funds are fine, but theoretically if a K-1 comes from, say, a very speculative venture that’s not a prudent investment, it could raise issues. This is just to say foundations must exercise due diligence when acquiring K-1 producing assets.

• UBIT: Foundations, like others, pay UBIT on unrelated business income. For example, if a private foundation is a partner in an LLC that runs a chain of stores, its share of the store profits is taxable. The foundation would file 990-T and pay 21%. One quirk: if that foundation had multiple unrelated businesses (say multiple K-1s from different ventures), the Tax Cuts and Jobs Act now requires siloing of UBI by activity. The foundation can’t net a loss from one against income of another – each separate “trade or business” must be calculated independently on the 990-T. Partnerships issuing K-1s now often provide information by activity code to help charities comply with this rule.

• Example: A family private foundation holds a 5% limited partner interest in a private equity fund. The fund’s K-1 allocates $200,000 of long-term capital gain, $50,000 of dividend income, and $30,000 of operating business income (from a portfolio company that the fund owns which is considered active business). The foundation will:

  • Include the $200k gain and $50k dividends in its net investment income (for the 1.39% excise tax).

  • Treat the $30k operating income as UBI on a 990-T (assuming it’s unrelated to any charitable purpose) and pay ~21% tax on that $30k.

  • The capital gain and dividend are not UBI (passive income is excluded from UBI), so no 990-T tax on those, though they do owe the small excise tax on them.

  • The foundation ensures its ownership is not “excess” – at 5% in a widely held fund, it’s fine.

Donor-Advised Funds (DAFs) and K-1s

A donor-advised fund is managed by a public charity, so technically it falls under public charity rules. But it’s worth separate mention because of how the process works:

• Who Receives the K-1?: The sponsoring charity (like Fidelity Charitable, Schwab Charitable, or a community foundation) receives the K-1, not the individual donor who established the DAF. For example, if you donate your interest in a family LLC to your DAF account at a community foundation, the next K-1 will be issued to the foundation (often in the name “Community Foundation XYZ, as nominee for the [Your Name] DAF” or similar). The donor doesn’t get a K-1 anymore because the donor isn’t the owner post-donation.

• Tax Handling: The sponsoring charity will treat any income from that K-1 as part of its own books. Large national DAF sponsors often have many DAF accounts pooling investments. They will file a single Form 990 for the whole organization and one or more 990-Ts if there’s unrelated business income across their funds. If a DAF’s investment yields UBI, the charity will pay the tax out of the assets of that DAF (in practice, they reduce the balance of that donor’s fund by the tax amount or allocate the expense accordingly). This ensures that the tax liability doesn’t impact other unrestricted funds of the charity – it’s borne by the fund that generated it.

• Policy: Some DAF sponsors avoid or limit accepting assets that generate UBIT because it complicates administration. For instance, many will accept publicly traded stock (no K-1 issues), but if you offer a stake in a privately-held partnership, they will evaluate the likely UBIT. They might still accept it (especially if the gift is large), but they factor in that taxes will erode some of the contribution’s value. It’s not uncommon for DAF sponsors to use “blocker” corporations for certain investments – essentially setting up a taxable subsidiary that takes the K-1 income, pays corporate tax, and passes the remainder as a dividend to the DAF (dividends are tax-free to the charity). This way, the DAF avoids filing a 990-T directly. However, using blockers is a strategy mostly employed by sophisticated endowments and foundations; typical DAF providers might not go that far unless the sums are significant.

• Example: Jane donates her interest in a private real estate LP to her donor-advised fund. The LP throws off $20,000 of rental income and $5,000 of depreciation loss allocated. The community foundation (sponsor) receives a K-1 showing $15,000 net income (rental minus depreciation). Rental income from real estate can be an interesting case: if there is no mortgage debt on the property, rental income is typically excluded from UBI for charities. If there is debt (debt-financed income), a portion becomes taxable. Assuming this rental had debt, the foundation determines that, say, $10,000 of the $15,000 is taxable UBI after calculations. It files a 990-T and pays tax on that $10k (around $2,100). That tax is paid from Jane’s DAF account assets. The remaining income stays in the DAF, growing the fund to later grant to charities. Jane doesn’t have to handle any of this on her personal taxes – it’s all at the charity level now.

Churches and Religious Organizations

Religious organizations (especially churches) have some unique aspects but ultimately follow the same UBIT rules.

• Filing Exemption for 990: Churches do not file Form 990 annual returns. However, churches are not exempt from Form 990-T if they have unrelated business income. So a church could go years with no IRS filings (since donations and related income require no tax return), but if, for example, the church is given a 30% interest in a local business and starts receiving K-1 income from it, the church must start filing 990-T for those years where UBI exists.

• Examples of K-1 sources for churches: A common scenario might be a church that receives a bequest – perhaps a deceased member left the church a stake in a family limited partnership or LLC. Or the church invests some of its reserve funds in an income-generating partnership (though many are risk-averse to this, some larger churches or dioceses do invest in stock and alternatives). If a church gets a K-1 with unrelated business income (like business earnings, not passive), it will need to handle it just like any charity. It may come as a surprise to church treasurers who’ve never had to file a tax return before!

• UBI for Religious Orgs: If a church’s K-1 shows only interest, dividends, and gains, that’s not UBI (generally no tax, no 990-T required). But if it shows something like operating income from a partnership, that triggers UBIT. Churches would pay at the same 21% rate on that income. Paying taxes doesn’t jeopardize their exempt status by itself; it’s simply compliance with the law for their investment income. Churches, like other charities, should ensure that engaging in any business via partnerships doesn’t overtake their religious mission. In practice, it’s rare for a church to have so much business activity that its status is at risk – issues usually arise more with religious orgs running large side businesses themselves than passive investments.

• State considerations: Some states exempt churches from certain taxes, but most states that tax unrelated business income do include churches in that requirement. For example, if that church’s partnership operated in a state with income tax, the church might need to file a state equivalent of the 990-T. We’ll touch more on state nuances later.

Fiscal Sponsorship Arrangements

Under fiscal sponsorship, the fiscal sponsor (a public charity) is the entity recognized by the IRS. So from the IRS’s perspective, any K-1 belongs to the sponsor, not the sponsored project.

• Practical Handling: If a fiscally sponsored project is offered a partnership interest (say an environmental film project is offered a membership interest in a film production LLC as part of a grant deal), the sponsor would typically be the one to formally accept it. The sponsor’s EIN would be on the K-1, and the sponsor would include any income on its books. Usually, sponsors have multiple projects and maintain separate accounts internally for each. If K-1 income comes in attributable to Project X, the sponsor will credit that income to Project X’s account (after any taxes if applicable).

• UBIT and Strategy: Fiscal sponsors are often cautious about UBIT because it can impact all their sponsored funds if not handled properly. Typically, they will avoid investments that generate UBI unless it’s part of the project’s plan and the project has funds to cover the taxes. If UBIT arises, the fiscal sponsor files a single 990-T for itself (covering all projects’ UBI collectively, or siloed by activity as needed). The taxes paid would likely be allocated as an expense to the project that generated the income.

• Transparency: Sponsored projects’ donors and managers should be informed if a donation or activity will incur UBIT. For instance, if a philanthropist wants to donate an LLC interest to a small arts project under a fiscal sponsor, the sponsor might counsel on the ramifications: “We’ll have to file a 990-T and pay taxes on any income until we liquidate this interest, which will reduce the net funds available for the project.” Sometimes, the sponsor may even require the donor to also donate extra cash to offset the anticipated taxes, or they might quickly sell the interest to avoid ongoing K-1s.

• No Separate Identity: It’s key to remember the project itself isn’t a separate entity; it’s part of the sponsor. So it cannot separately receive or report a K-1. All flows through the sponsor. The sponsor might report, for internal purposes, a breakdown of the K-1 income to the project, but legally the sponsor is on the hook to the IRS.

The takeaway across all these entities: Regardless of type, if a charity has an ownership stake or beneficiary interest that issues a K-1, the charity must be attentive to what that K-1 implies for its tax reporting. Next, we’ll explore exactly what those implications are for tax filings and UBIT.

How Charities Report K-1 Income on Their Tax Returns

When a charity receives a K-1, it must integrate that information into its own reporting. Here’s how that typically works at the federal level:

• Form 990 (or 990-PF): The charity’s main informational return will include the income from the K-1 in the relevant sections. For example:

  • Interest, dividends from K-1 go into investment income lines.

  • Rent from real property goes into rental income line (with detail if any expenses).

  • Income from partnerships might be specifically reported on a line for “income from investment in partnership” (public charities have a line for this on Form 990 Part VIII).

  • For a private foundation, the 990-PF has a section for income (divided by interest, dividends, etc., and “business income” if any).

  However, the Form 990/PF is just reporting income in a financial sense; it doesn’t calculate tax. So the presence of income there doesn’t automatically mean tax is due or not due – it’s more for transparency to the IRS and the public.

• Identifying UBI on the K-1: The charity needs to determine if any of the K-1 items are taxable as unrelated business income. This can be tricky:

  • Passive income (interest, dividends, capital gains, most royalties, certain rents) is generally excluded from UBI unless earned via debt-financed property or an S-corp (more on that in a second).

  • Active trade or business income (for instance, K-1 Box 1 “Ordinary Business Income” from a partnership engaged in business, or Box 3 “Other income” that is active) is usually UBI if the business is not substantially related to the charity’s mission.

  • Rental Income: If the partnership’s income is from rent of real property, it’s excluded from UBI if there is no debt on the property and no substantial services provided. But if the partnership has a mortgage (debt-financed), a portion of that rental income becomes taxable UBI (known as Unrelated Debt-Financed Income, UDFI). The K-1 might provide information to calculate this (some K-1 footnotes show the debt-financed percentage of income for exempt partners).

  • S-corp Income: For charities, all income from an S-corp K-1 is treated as UBI by law (IRC 512(e)). This is an important caveat: even if the S-corp’s income is just interest or rent, the charity can’t use the normal exclusions – Congress essentially said if you choose to invest via an S-corp, you must pay tax on whatever comes through. This rule was put in place to prevent tax-exempt entities from being used to shelter corporate income. So if a charity gets a K-1 from an S-corp, it will likely need to file a 990-T regardless of the character of income, provided the amounts are above the $1,000 gross threshold.

  • Trust/Estate Income: If a trust distributes income to a charity and issues a K-1, often that income falls under special rules. Many trusts get a charitable deduction for what they distribute to a charity (under Section 642(c)), meaning the trust, not the charity, effectively pays any tax (or rather, the income is offset by the deduction and the charity just receives the money tax-free). In those cases, the K-1 to the charity might just show information but not require the charity to act. However, if a trust or estate does not or cannot take a charitable deduction, and it passes taxable income to a charity, the charity might technically have to treat it as income (though it would be tax-exempt income in the charity’s hands unless it’s from an unrelated business operated by the trust). It’s a nuanced area, but generally distributions from a decedent’s estate or a simple trust to a charity are considered charitable gifts, not business income for the charity. So usually no UBIT there unless it’s an odd scenario where the trust is running a business and passing those earnings to the charity without taking a deduction.

• Filing Form 990-T: Once the charity identifies the portions of the K-1 that are UBI, it needs to file Form 990-T if gross UBI is $1,000 or more. “Gross” means before deducting expenses. So even if the partnership lost money but had $1,000 of gross receipts, technically a filing requirement could trigger (though practically, if a partnership K-1 shows a loss, many would say no filing needed since no tax due – but the safe harbor is $1k gross income threshold).

  On the 990-T, the charity will:

  • Report gross income from each unrelated trade or business activity. If it has multiple, it may use separate Schedule A forms (post-2018, the IRS requires separate reporting of each business).

  • Deduct any directly connected expenses. In the K-1 context, the partnership has effectively done this (the “ordinary business income” on a K-1 is net of expenses at the partnership level). But the charity might have additional expenses (like if it had to pay a lawyer to review the partnership agreement – whether that’s deductible against UBI is debatable, but generally any expense solely attributable to producing that UBI can be deducted).

  • Apply the $1,000 deduction (if a public charity).

  • Calculate the taxable amount and tax due at 21% (or trust rates if the charity is a trust; note: some charities are trusts, like certain private foundations or charitable trusts, which pay at slightly different graduated rates – but most big charities are corporations taxed at the flat rate).

  • If the charity had multiple K-1s from different businesses, it cannot net a loss from one against income of another (post-2018 rules) – each is siloed. It would carry forward a loss to use against future income from that same activity only.

  The charity then pays any tax due (sending payment with the 990-T or in estimated payments if the amounts are large enough to require quarterlies).

• Form 990-T is Public for 501(c)(3): An interesting note – since 2018, the IRS requires the 990-T of 501(c)(3) organizations to be made public (similar to Form 990). This was an odd result of the PATH Act. So, if a charity files a 990-T, that document can be requested by the public or found on databases, showing the amount of UBI and tax paid. This is relevant for transparency: outsiders can see if a charity is engaged in lots of business activities. (In contrast, 990-Ts of retirement accounts or other non-501c3 aren’t public.)

• Schedule K-1 Attachment: Charities usually do not submit the K-1 itself with their 990 or 990-T (unless there’s some special state requirement or if the IRS specifically asks). The K-1 is for their records and to pull data from. On the Form 990-T, there’s a place to indicate if any UBI came from partnerships or S-corps and whether the partnership provided information like qualified deductions, etc. Partnerships are supposed to identify UBI items for their tax-exempt partners via codes on the K-1 (for instance, Box 20, Code V on a partnership K-1 is often used to report “UBTI” information for an exempt partner). Charities should look for statements attached to the K-1 that break out the components of income and expense that make up the UBI. If those details are lacking, the charity might have to contact the partnership for more info, especially if depreciation or interest expense needs allocating.

• Example (Full Cycle): A humane society (public charity) invests in an LLC that operates a small business selling pet supplies (unrelated to its animal rescue mission). It gets a K-1 showing:

  • $50,000 ordinary business income

  • $2,000 interest income (from the LLC’s bank account)

  • $5,000 charitable contribution (the LLC donated inventory to a local shelter, which flows through as a deduction on K-1)

  The humane society will:

  • Recognize $50,000 as UBI (ordinary income from a pet supply business is not related to rescue mission).

  • Recognize $2,000 interest – not UBI (interest is excluded).

  • Possibly use the $5,000 charitable contribution as a deduction on the 990-T, but note: deductions on a K-1 like charitable contributions are tricky. For an individual, that would go on Schedule A of 1040 as an itemized deduction (subject to limits). For a charity, it doesn’t really need a charitable deduction (it is a charity!). In calculating UBI, only deductions “directly connected” with the business income are allowed. A charitable contribution made by the partnership is not directly connected to earning the business income – it’s more like an appropriation of profits. The IRS would likely not allow the charity to deduct that $5,000 against its UBI, since it’s not an expense to produce the $50k income. Instead, the $5k is just reported as a charitable expense on the partnership’s books. (So effectively that portion of income was given away before the distribution, but the K-1 shows it for info.)

  • The humane society files a Form 990-T showing $50,000 gross UBI, maybe zero direct expenses (unless they have some administrative costs to allocate), takes the $1,000 specific deduction (bringing it to $49,000 taxable), and computes tax ~$10,290. It pays that to the IRS.

  • On its Form 990, it will report the $52,000 total income in contributions and business revenue lines appropriately (the $5k contribution might not appear on 990 at all from the charity’s perspective, since it never actually received that – it was given away by the LLC).

  • The public (and IRS) now sees on its 990 that it had $50k from an unrelated business. On Schedule R of Form 990, it might also disclose that it owns part of an LLC, if significant (Schedule R is used to report related organizations and certain partnerships – if the charity owns a large enough stake or is general partner, it must list that partnership with some details).

  • The charity might decide this tax hit is too high and later withdraw or sell that LLC interest to avoid future UBIT, or it might accept it as the cost of a profitable investment.

• Recordkeeping: Charities should keep copies of all K-1s and workpapers of how they determined UBI vs non-UBI. The IRS can and does audit nonprofits on UBIT issues. If audited, the charity should be able to show, for instance, “This K-1 had $X interest (excluded), $Y dividends (excluded), $Z business income (taxable, which we reported on 990-T and paid tax).”

Now that we’ve covered the federal treatment, let’s consider state-level nuances, which add another layer of complexity when charities receive K-1 income.

Federal vs. State: How K-1 Income Is Treated at Different Levels

Federal law provides a uniform set of rules (UBI definition, 990-T filing, etc.) for all charities across states. However, each state may have its own approach to taxing (or not taxing) a charity’s income.

• State Income Tax on Nonprofits: Most states exempt nonprofits from state corporate income tax on their exempt function income, but many states tax a nonprofit’s unrelated business income similarly to the federal government. In other words, if your charity pays UBIT to the IRS, there’s a good chance the state also expects a cut of that income. Some states explicitly require filing a state version of the 990-T or attach the federal 990-T to a special form.

• Example – California: California requires tax-exempt organizations to file Form 199 (an annual information return) if gross receipts are above a certain amount, but more importantly, it requires Form 109 to report UBI (for California franchise tax purposes) if the organization has UBI in California. If a California charity (or an out-of-state charity earning income in CA) has over $1,000 in UBI, it generally must file Form 109 and pay the state’s corporate tax rate on that UBI. So if a charity in New York is a partner in a partnership that operates in California and generates taxable income there, California might want that New York charity to file and pay CA tax on its share. States can and do source partnership income to the states in which the partnership operates.

• State Filing Complexity: If a charity invests in a national or multi-state partnership (for instance, a big private equity fund that has operations or properties in many states), the charity could theoretically have filing obligations in multiple states for its share of income in those states. Often, partnerships help by doing something called “composite returns” or withholding tax on behalf of out-of-state partners. Sometimes partnerships will treat a tax-exempt partner as exempt and not withhold state tax on their share of income, if the income is of a type that’s exempt at the federal level. But if it’s UBI, they might be required to treat the nonprofit like any other partner and withhold state tax. For example, a partnership might send a charity a K-1 and a check for, say, “Oregon state tax withheld on your share of income.” The charity might then have to file an Oregon return to claim exemption or get a refund if that income was actually not taxable to the charity under Oregon law.

• Not All States Follow Federal Exactly: Some states do not recognize certain federal exemptions or have different thresholds. Most commonly follow the UBI definitions, but:

  • A few states might fully exempt charities from income tax (even on unrelated business income). For instance, some states with no corporate income tax (Texas, Washington, Florida (no corporate tax on individuals but has on entities?), etc.) naturally wouldn’t tax UBI because there’s no tax base for it, or they have a different type of business tax.

  • States like Texas have a franchise tax (margin tax) and generally exempt 501(c)(3) organizations from it entirely. So a Texas partnership K-1 might not cause any Texas tax to a charity partner at all.

  • New York taxes UBI similarly to federal, and requires nonprofits to file an Unrelated Business Income report if they have any.

  • Each state also might have different treatment of things like NOLs (net operating losses) for UBI or different apportionment rules.

• Property and Sales Taxes: While not directly linked to K-1, note that if a charity owns part of a partnership that operates in a state, it usually doesn’t impact property tax exemption or sales tax, because those are levied on the partnership or business itself, not the charity. But just being aware: a charity’s involvement doesn’t automatically make a business’s property tax-exempt or anything – the business is still taxable as a separate entity.

• Registrations: If a charity is a partner in a partnership doing business in a state, could that mean the charity is “doing business” in that state? Generally, passive investment alone doesn’t require a foreign business registration for the charity, but it might in some jurisdictions. This is more of a legal corporate question: e.g., if a non-California charity owns part of a California LLC, does it need to register in CA as a foreign nonprofit? Often not if that’s the only activity (just an investment), but if the charity gets more involved, maybe. These are rarely enforced issues, but something large nonprofits consider with counsel.

• State UBIT Rates: If a state taxes UBI, it will use its corporate tax rate (or trust rate if a charitable trust). These rates vary – could be anywhere from 4-10% typically. So add that on top of 21% federal, and a charity could be paying ~25-30% combined on its unrelated business earnings. This diminishes the net benefit of those earnings for the charity’s mission, which is why many charities are cautious about owning businesses directly.

• Example (Multi-State): A private foundation in Illinois invests in a nationwide LLC that owns billboards across various states. The LLC issues a K-1 showing $100,000 of business income to the foundation, and provides a statement that this income is apportioned as: $30k from Texas, $30k from New York, $40k from Illinois (just as an example).

  • Federal: the foundation files 990-T on $100k, pays 21% federal = $21k.

  • Texas: Texas doesn’t tax the charity’s share due to nonprofit exemption from franchise tax – no action needed there.

  • New York: New York expects a tax on that $30k at ~9% = $2.7k. The foundation files NY Form CT-13 (NY’s return for exempt org UBIT) and pays $2.7k.

  • Illinois: Illinois taxes UBI at 9.5%. As an Illinois entity, the foundation files IL-990-T and pays $3.8k on the $40k.

  • Total tax between federal and states: ~$27.5k. The net after taxes of roughly $72.5k goes back to the foundation’s coffers. While that’s still valuable money for charity, one can see a chunk (over 27%) went to taxes rather than charitable grants. This is one reason some foundations use intermediary blockers or prefer certain types of investments to mitigate multi-state UBIT.

• State Filing Thresholds: If a charity has a tiny amount of UBI in a state, often it won’t trigger filing due to economic nexus standards (especially for out-of-state charities). Many states have a “doing business” threshold, and a small limited partnership interest might not cross it. In practice, large partnerships often file a composite return paying state tax on behalf of all partners with small interests to simplify things. The charity might then get a credit on its K-1 for state tax paid on its behalf. The charity can’t use that credit on a 990-T (that’s federal), but it could potentially file in that state to claim a refund if it believes it was exempt. Whether they bother depends on the amount.

In summary, federal rules decide what is taxable (UBI) and states decide if they tax it at their level. Nonprofits have to be aware of both. For a charity receiving substantial K-1 income, consulting with a tax professional who understands multi-state issues is wise to ensure compliance everywhere.

Now, having navigated through the heavy tax implications, let’s step back and look at the big picture pros and cons for a charity dealing with K-1 income, as well as some real-world examples and guidance from IRS and courts that shape how charities approach these situations.

Pros and Cons of Charities Receiving K-1 Income

Should a charity even be involved in partnerships or other arrangements that produce K-1s? There are advantages and disadvantages to consider:

In essence, the decision to engage in K-1-producing activities is a strategic one for a charity. Many larger nonprofits deem it worthwhile to boost income or accept big gifts, while carefully managing the compliance. Others (especially smaller charities) might steer clear of anything that complicates their simple tax-exempt life. There’s no one-size-fits-all answer; it depends on the charity’s capacity, the opportunity at hand, and how it aligns with their goals.

Real-World Examples: How K-1 Income Plays Out in Charities

Let’s look at a few concrete examples to illustrate how charities deal with receiving K-1s:

• Example 1: University Endowment in a Private Equity Fund – A large university (a 501(c)(3) public charity) has an endowment that invests in a private equity limited partnership. Every year, the partnership sends a Schedule K-1 to the university’s endowment office showing the university’s share of income. One year, the K-1 shows $2 million of capital gains and $100,000 of operating income from a business the fund owns. The capital gains are not taxable to the university (investment income is excluded from UBI), but the $100k is UBI. The university files a Form 990-T and pays about $21k in tax. Importantly, that $100k came from an underlying company that might be completely unrelated to education (say the fund owned a chain of restaurants). The IRS doesn’t mind that the university invested in it; they just want the tax on the unrelated portion. The endowment still netted a huge benefit from the investment (the $2 million gain is tax-free, and even after tax the $100k leaves ~$79k). This extra money goes to fund scholarships and research. The university discloses in its financial statements that it had some unrelated business income tax that year – a common occurrence for big endowments. To manage risk, the university ensures it is always a limited partner in such funds (it exerts no control over businesses, so it’s clearly an investment activity). As long as the UBI remains a relatively small slice of its total income, the university’s primary educational purpose isn’t questioned.

• Example 2: Private Foundation with a Real Estate Partnership – The XYZ Family Foundation (private foundation) inherited a 25% limited partnership interest in a commercial real estate partnership when the donor-family’s patriarch passed away. The partnership owns office buildings with mortgages. Each year, the foundation gets a K-1 with, say, $300,000 of rental income, $150,000 of which is considered debt-financed income (taxable UBI) based on the ratio of mortgage to property value. The other $150k of rental income is excluded (the portion not debt-financed). The K-1 also shows $50,000 of capital gains from a building sale. The foundation files a 990-T for the $150k UBI, perhaps deducting $10k of depreciation or expenses allocated to that income, and pays tax on $140k ($29.4k tax). Separately, on its 990-PF, it counts the full $300k rent and $50k gain in its investment income and pays the 1.39% excise (~$4,862) on that. Over time, the foundation decides this partnership generates a lot of tax and might not be the best holding. However, it can’t easily sell the interest (maybe illiquid or other partners have right of first refusal). So instead, the foundation works with the partnership: it contributes its 25% interest to a charitable remainder trust (CRUT), which will eventually benefit the foundation further but provides some tax structuring (though CRUTs and UBIT have their own complications – notably if a CRUT earns UBI, it becomes taxable on all income as we mention below). This example highlights that foundations often become part-owners of businesses through inheritance or gift, and then have to navigate taxes and perhaps plan exits to reduce ongoing UBIT. In the meantime, they enjoy the income (post-tax) to fund grants.

• Example 3: Donor-Advised Fund Accepting an LLC Interest – A donor sets up a donor-advised fund at a community foundation and donates units of a family LLC that holds investments in several startups. The community foundation does its diligence and accepts the gift. For a couple of years, the foundation receives K-1s from that LLC. One K-1 shows a lot of losses (startups often lose money early on), which actually is interesting: the charity can’t use those losses to offset other income (because of the silo rules and also because an exempt org can’t benefit from losses beyond UBI context). They just carry forward within that activity. In year 3, one startup exits and the LLC allocates a big gain. Now the foundation’s K-1 shows $500,000 of capital gain and $50,000 of business loss from another startup – net $450k gain. The gain is excluded from UBI (capital gains are out of UBI, as it’s from sale of stock, not inventory). The $50k loss, since it’s from an unrelated business, can only offset future income from that same business activity, so for now it’s suspended. The community foundation thus owes no UBIT on the $450k gain. It adds that $450k to the donor-advised fund’s balance (the donor’s fund). This is a great outcome – essentially, by donating the LLC interest to the DAF before the big gain event, the donor avoided tax on the gain, and the full amount went to charity (well, minus any little UBIT which in this case was none). DAF sponsors regularly handle these scenarios, but they ensure to communicate: if instead there had been UBI, say the startups were operating businesses generating profit each year, the donor’s fund would be reduced by the amount of tax the sponsor had to pay.

• Example 4: Church Inherits a Local Business – A small church unexpectedly receives a gift: a long-time congregant passes and leaves the church a 10% interest in a limited partnership that owns a chain of convenience stores. The church trustees are initially unsure what a K-1 even is. At year-end, they receive a K-1 showing $20,000 of ordinary business income allocated to them. The church’s finance committee learns this is taxable income. They’ve never filed a tax return because churches usually don’t. Now they must file a 990-T. They do so, perhaps with help from a CPA, and pay ~$4,200 in tax. The next year, they decide to sell that 10% interest to someone else (perhaps to the remaining partners) because they’d rather have a one-time influx of cash than ongoing taxable income and complexity. When they sell, any gain on sale of that partnership interest itself is likely not taxed as UBI (sale of a capital asset by a church is not regularly carried on, and capital gains are excluded). They convert the asset to cash and use it to fund a new youth center – a much more straightforward use. This demonstrates that while a charity can receive K-1 income, it may choose not to hold onto that source if it’s more trouble than it’s worth.

• Example 5: Fiscal Sponsor Manages a Project’s Investment – A small arts project under fiscal sponsorship receives an unusual grant: an investor decides to support the arts by giving the project a 5% stake in a for-profit art gallery LLC (rather than cash). The fiscal sponsor (a larger arts charity) agrees to this arrangement. They receive K-1s from the gallery LLC. The gallery makes modest profits, and the K-1 shows $5,000 of income one year (which is UBI, as operating an art gallery selling art is not the same as the charitable purpose of supporting independent artists). The fiscal sponsor files a 990-T, pays maybe $1,000 in tax, and attributes that expense to the project’s fund balance. The sponsor also recognizes the remaining $4,000 as revenue available for the project (perhaps to help put on a free exhibition). Later, the gallery is sold, and the sponsor receives $50,000 as proceeds for that 5% stake. That $50k (likely mostly capital gain) comes free of UBIT and is now a large chunk of funding for the project’s activities. The sponsor and project conclude that the initial tax and hassle were worth it for the eventual payout. This example shows a fiscal sponsor’s balancing act: enabling a project to benefit from an unconventional donation while handling the interim compliance.

Each of these examples underscores a common theme: charities weigh the financial benefits of receiving K-1 income against the tax and administrative responsibilities that come with it. Many charities successfully incorporate such income into their funding mix, while others decide to liquidate or avoid these situations depending on their objectives.

IRS Oversight and Tax Court Rulings: The Official Perspective

The IRS is well aware that charities participate in partnerships and other ventures. Over the years, both IRS rulings and court cases have shaped how charities approach K-1 income and partnerships:

• Early IRS Position (General Partner Issue): Decades ago, the IRS took a hard line that a 501(c)(3) being a general partner in a partnership was problematic, fearing that fiduciary duties to profit-seeking partners could conflict with the charity’s duty to its mission. However, this stance evolved. A landmark case, Plumstead Theatre Society v. Commissioner (1980), involved a small nonprofit theater group that became the general partner in a limited partnership to produce a play (raising capital from investors). The Tax Court (upheld by the 9th Circuit) ruled that this did not jeopardize the theater’s tax-exempt status. Why? The arrangement was structured so the charity retained control over artistic decisions and the venture served its charitable purpose (promoting theater), even though investors got a return. This case signaled that charities can engage in partnership deals, even as general partners, if it’s in furtherance of their exempt purpose and carefully managed.

• Mission-Related vs. Wholly Unrelated Ventures: Following cases and IRS rulings built on Plumstead. If a partnership is directly advancing the charity’s mission, it’s much less likely to cause any issues beyond possibly needing to report revenue. If it’s purely an investment, that’s fine too (just UBIT might apply). The danger zone is if a charity’s partnership venture is unrelated and starts to dominate the charity’s focus or has private benefit concerns. For example, revenue rulings like Rev. Rul. 98-15 and a later modification Rev. Rul. 2004-51 provided guidelines for structuring joint ventures between nonprofits and for-profits (particularly in healthcare) to ensure the nonprofit’s exempt status is protected. The gist: the nonprofit should retain enough control over the venture to ensure charitable objectives are met and not just serve profit interests.

• Unrelated Business Income Enforcement: The IRS actively monitors UBIT. They periodically conduct compliance checks on organizations that might have UBI but aren’t reporting it. Because Schedule K-1 has an entry for tax-exempt partners, the IRS can match K-1 data with whether that nonprofit filed a 990-T. It’s worth noting a tax court case from 1987, Sierra Club, Inc. v. Commissioner, where the Sierra Club had substantial mailing list rental income it argued was not subject to UBIT; the court disagreed and classified it as UBI. While not a K-1 case, it shows the IRS and courts’ inclination to apply UBIT where activities are commercial in nature. For K-1 scenarios, if an exempt org doesn’t report UBI, it could face back taxes and penalties. Therefore, charities receiving K-1s generally err on the side of caution and file 990-T if there’s any doubt.

• Charitable Remainder Trust (CRT) Trap: A notable set of rulings involves Charitable Remainder Trusts (CRTs). A CRT is a split-interest trust (not exactly a charity, but a trust that eventually gives assets to charity and provides income to donors in the interim) that is generally exempt from tax unless it has UBI. In a prominent case (and an IRS position codified in law), if a CRT receives any UBI – say, from a partnership K-1 – the trust loses its tax-exempt status for that year and pays tax on all its income. This is extremely punitive. For example, CRUTs (Charitable Remainder Unitrusts) have been hit by this when they invested in limited partnerships that generated a small amount of UBI. The lesson for planners is to avoid putting CRTs in any investment that could produce UBI (like an operating business or leveraged real estate partnership). While this directly affects CRTs (which file 990-T as well when needed), it’s indirectly a cautionary tale for charities: UBI can carry consequences, and one must be mindful of the rules. Regular charities don’t lose exemption over UBI (they just pay tax), but special entities like CRTs do.

• Blocker Corporations: The IRS acknowledges (implicitly, through practice) that many nonprofits use “blocker” C-corporations to avoid UBIT from K-1s. For instance, a university might invest in a partnership through an offshore corporation; the partnership’s K-1 goes to that corporation, which pays U.S. tax on effectively connected income, but then distributes dividends out to the university. Those dividends are tax-free to the university (since dividends are excluded from UBI if from a regular corporation). The IRS hasn’t challenged this structure; it’s an accepted tax planning strategy. This shows that the government is primarily interested in collecting some tax on unrelated business activities (whether at the corporate blocker or at the charity via UBIT) and isn’t aiming to penalize charities beyond that.

• Disclosure and Transparency: IRS rules require charities to disclose certain partnership investments in their Form 990 schedules. Schedule R of the Form 990 asks for information on partnerships where the charity has a significant ownership (generally over 10%, or any general partnership interest, or control). The charity must list the partnership’s name, EIN, type of entity, and indicate if it’s a related organization or not. Most K-1 situations, the partnership is not related (meaning not controlled by the charity), but if it were, it might even be considered a taxable subsidiary. The IRS uses this info to keep an eye on complex structures. There’s also Schedule K (not to be confused with K-1) on the 990, but that deals with tax-exempt bonds, unrelated here.

• Case Law on UBIT from Investments: There have been cases about whether certain income is truly passive or actually a disguised business. One example: a case involving the Los Angeles Central YMCA (1971) where the Y’s partnership owned a department store building and rented to commercial tenants – the IRS tried to say it was UBI (as rental from debt-financed property), and indeed debt-financed rent is taxable. The Y argued it was substantially related because it helped revitalize a blighted area, etc. That argument failed; the court held it was taxable. This underscores that claiming an unrelated income is related is tough unless it clearly furthers the charitable mission in a direct way.

• “Substantiality” of UBI: There’s an overarching rule (not clearly numerical) that if a charity has too much activity that is unrelated to its purpose, it could lose exemption (the organization is supposed to be operated “exclusively” for exempt purposes, which the IRS interprets as primarily for exempt purposes). Courts have generally given leeway as long as the unrelated stuff is not dominant. For instance, if 80% of a charity’s work is programs and 20% is running a taxable business (with taxes paid on it), that’s usually fine. But if it flips such that the charity looks like a business with a side charity program, the IRS may step in (there was a case, United Missionary Aviation, where a nonprofit’s supposedly charitable plane service was mostly doing commercial cargo – they lost exemption). So, related to K-1s: if a charity’s only real activity is holding a partnership interest in a money-making venture and then donating those profits out, one might question if it’s a charity or an investment conduit. Usually though, the presence of meaningful charitable programs saves them.

• Private Letter Rulings (PLRs): While not law for anyone except the requester, PLRs give insight. There have been PLRs where the IRS allowed creative solutions, like a charity that wanted to accept S-corp stock and immediately sell it to avoid UBIT – generally allowed, and the IRS didn’t impose UBIT on the immediate sale (since selling a donated S-corp stock for cash can be treated as not producing UBI if done promptly – it’s akin to selling donated property, which is not an ongoing business activity). The IRS basically said if the charity is just liquidating a gift, that’s not an unrelated business activity “regularly carried on.” So a charity could plan to accept an S-corp or partnership interest and have a pre-arranged sale to eliminate ongoing K-1 issues. This kind of ruling guides practitioners in advising charities: yes, you can take it and sell quick without tax on the gain, as long as you didn’t agree to do so before donation in a way that would attribute the gain to the donor (a separate issue known as the assignment of income doctrine).

In summary, IRS guidance and court cases have generally supported charities engaging with K-1 generating entities as long as they follow the rules:

• Pay UBIT on unrelated income.

• Don’t let the tail (profit) wag the dog (charitable mission).

• Structure joint ventures carefully to preserve charitable control if the venture is directly part of carrying out programs.

• Use legal strategies (like blockers or quick sales) when appropriate to minimize tax while staying compliant.

Charities today operate in a complex financial world, and the law has evolved to accommodate that – you’ll find charities investing in everything from start-ups to real estate, armed with accountants and lawyers ensuring that the K-1s are handled correctly. The IRS expects compliance but doesn’t forbid these activities.

Pitfalls to Avoid When Dealing with K-1s (What Charities Should Watch Out For) ⚠️

For a charity receiving (or considering receiving) K-1 income, there are some key “don’ts” and cautionary points to keep in mind:

• Don’t Ignore a K-1 or Fail to File Required Taxes: A K-1 is not just an FYI; it often requires action. Avoid the mistake of sticking it in a drawer because “charities don’t pay taxes.” If the K-1 shows income that’s unrelated business income, you must file a Form 990-T (and state equivalents where applicable). Penalties for not filing 990-T can accrue, and the IRS could assess back taxes and interest if they catch unreported UBI. Staying on top of filings each year is critical.

• Avoid Excessive Unrelated Business Activity: While earning some unrelated income is fine (and common), a charity should avoid letting that become its primary focus. If a charity’s leadership starts spending most of their time managing business investments, or if the majority of revenue each year is from a business rather than donations or mission-related program revenue, it’s a red flag. The IRS could potentially question whether the organization is operating for exempt purposes. Maintain the primacy of the charitable mission. For private foundations, avoid violating the excess business holdings rule by holding onto a large chunk of a business beyond the allowed period – otherwise the foundation could face hefty excise taxes.

• Don’t Neglect Estimated Tax Payments (if Needed): If the charity anticipates owing a significant amount of UBIT (for instance, it consistently earns large UBI from partnerships), it may need to pay quarterly estimated taxes to the IRS and states, just like a regular corporation would. Failure to do so can lead to interest penalties. Many smaller orgs don’t cross the threshold (the IRS has safe harbors for small amounts), but large ones might. It’s better to avoid an unpleasant surprise tax bill by budgeting and paying throughout the year.

• Be Cautious with S Corporation Gifts: If someone wants to donate S corporation stock to a charity, know that it will trigger UBIT on all income and possibly gain. A charity might want to liquidate S-corp stock immediately. But one pitfall: If the sale is prearranged before the donation, the IRS can argue the donor (not the charity) realized the gain (which messes up the donation benefit). So coordinate carefully – ideally, the charity should take the stock and not be legally obligated to a sale until after it’s received (to avoid donor tax issues), but then sell as soon as reasonably possible. Holding S-corp stock long-term is usually to be avoided due to perennial UBIT. In short, don’t hold S-corp interests longer than necessary, unless the charity is prepared for ongoing UBIT.

• Understand UBIT Silos: After the 2017 tax law changes, you can’t use a loss from one unrelated business to offset income from another. So avoid a false sense of security that a “portfolio” of businesses will balance out. If you have one K-1 with a loss and another with profit, you’ll pay tax on the profit and carry the loss forward separately. This means multiple UBI activities can each generate tax even if overall you’re break-even. Charities should avoid chasing too many different business ventures thinking they can cancel each other out – that strategy no longer works under current law.

• Avoid Private Benefit/Conflict of Interest: If a charity enters a partnership, ensure the terms are fair and further the charity’s interests. A pitfall to avoid is entering deals where a charity’s presence is used just as a “tax-exempt shield” for others’ benefit without the charity getting adequate benefit. For instance, a charity should not be lending its exemption to a partnership in exchange for negligible returns while the lion’s share goes to private investors – that could be seen as impermissible private benefit. Always make sure any joint venture is structured so the charity’s share of profits is proportional to what it brings to the table, and the arrangement helps achieve something aligned with its mission or investment goals.

• For Foundations and DAFs: Don’t Overlook Special Rules: Private foundations should steer clear of owning too much of any active business (beyond 20%, roughly, combined with insiders – the excess business holdings rule as mentioned). If a family wants to donate a whole company to a foundation, plan an immediate sale or split it among multiple charities to avoid this issue. Donor-advised funds, on the other hand, should avoid letting donors use them to circumvent private foundation rules (there are proposed rules about DAFs holding business interests – as of now, a DAF can hold such interests, but Congress has considered limiting it if it’s an attempt to avoid those foundation rules). In any case, foundations and DAF sponsors must follow their internal policies – e.g., many DAFs won’t allow a donor to have their fund invest in a business the donor or related persons control, to avoid conflicts and self-dealing.

• Watch Out for Debt-Financed Income: If a charity invests in a partnership or trust that uses debt (like leveraged real estate or buying stocks on margin), a portion of otherwise excluded income (rent, interest, dividends) becomes taxable UBI. This is a pitfall because it’s not obvious – e.g., the charity might think “rent is normally not UBI,” but if there’s a mortgage, it is partially UBI. Partnerships should report the ratio of debt-financing, but not all do clearly. Charities should inquire or review the K-1 footnotes. The way to avoid surprise UBIT here is either invest in funds that don’t use leverage (if possible) or be prepared for the calculation. Some charities even invest in such things via a blocker corp to avoid this whole issue.

• Don’t Assume State Exemption: As we discussed, not all states spare you from tax. So avoid assuming that because you’re a charity, you have no state obligations. Always check state-by-state. Ignoring state filings can lead to accumulative penalties or the state potentially coming after the charity’s other assets in the state. If the amounts are material, register and file in that state for UBI. Some states might require an initial registration for the organization if it’s conducting business there (even via partnership). This might involve a simple form to declare your exemption. It’s wise to consult local state tax advisors especially if the K-1 shows significant multi-state operations.

• Self-Dealing and Other Penalties (for Foundations): Private foundations have a strict self-dealing prohibition. If a partnership involves disqualified persons (like foundation insiders), be cautious. For example, if a foundation and the donor’s son are partners in a business, any transactions between the foundation and that business could inadvertently become self-dealing if not handled properly. Also, if the partnership distributes property or loans to the foundation or vice versa, check the self-dealing rules. It’s a nuanced area, but the pitfall is a foundation could incur excise taxes for acts that are fine for public charities but not for foundations. So foundations receiving K-1s where insiders are also involved in the venture must navigate carefully to avoid any dealings that benefit those insiders.

• Lack of Exit Strategy: A charity should avoid getting stuck in an illiquid, ongoing K-1 situation without an exit plan or review. Accepting a partnership interest that the charity cannot eventually sell or redeem can lock the charity into annual tax and reporting forever. It’s best practice to evaluate: Can we sell this interest in the near future? Is there a market, or a clause to get bought out? If not, perhaps negotiate such terms before accepting (if a donation) or think twice about investing in that fund. An open-ended commitment might still be fine if the net returns are worth it, but always assess periodically. Charities often decide to pull back from investments that are generating small net returns but huge paperwork headaches.

By being aware of these pitfalls, charities can enjoy the benefits of receiving K-1 income (where it makes sense) while minimizing the downsides. When in doubt, consulting with nonprofit tax counsel or experienced accountants can help navigate complex situations—better to get it right upfront than to clean up a tax mess later.

Comparison of K-1 Treatment by Charity Type

To recap how different types of charitable entities deal with K-1 income, here’s a quick comparison:

As you can see, the mechanics of handling K-1 income are largely similar across entity types – the main differences lie in additional rules (like foundation-specific ones) or whether they have to file a base Form 990 at all. But the core concept – report unrelated income and pay any due tax – is universal.

Finally, let’s address some frequently asked questions to crystalize the key points in a straightforward Q&A format.

FAQ: Reddit-Style Q&A on Charities Receiving K-1s

Q: Do charities get Schedule K-1 forms if they invest in businesses?
A: Yes. If a charity is a partner in a partnership (or member of an LLC taxed as a partnership) or a shareholder of an S-corp, it will receive a K-1 reporting its share of income.

Q: Will a charity issue me a K-1 for my donation?
A: No. Donations to a charity do not generate K-1s. K-1s come from partnerships or trusts to owners/beneficiaries. Donors to charity get a receipt or acknowledgment, not a K-1.

Q: Can a nonprofit be a partner in an LLC or partnership?
A: Yes. Nonprofits can and often do become partners or LLC members. It’s legal for them to share in profits; they just must pay tax on any unrelated business profit via UBIT rules.

Q: Does receiving a K-1 endanger a charity’s tax-exempt status?
A: No. Simply receiving a K-1 doesn’t harm tax-exemption. However, if the underlying activity is substantial and unrelated to the mission, the charity must manage it carefully (and pay taxes on it) to stay in compliance.

Q: Do charities have to pay taxes on K-1 income?
A: Sometimes. If the K-1 income is from an unrelated business (UBI), the charity pays taxes on that via Form 990-T. If the K-1 income is from passive sources (interest, dividends, etc., with no debt or special rules), it’s generally tax-free to the charity.

Q: Would a church ever file a tax return because of a K-1?
A: Yes. Churches don’t file the annual 990, but if a church has $1,000+ of unrelated business income (perhaps from a K-1 partnership investment), it must file Form 990-T and pay UBIT.

Q: Are donor-advised funds subject to UBIT on K-1 income?
A: Yes. The sponsoring charity of a DAF pays UBIT on any unrelated business income generated by assets in the DAF. The tax is usually taken out of the donor-advised fund’s balance.

Q: Do private foundations pay tax on partnership income?
A: Yes. Private foundations pay the corporate tax rate on any unrelated business income from a K-1. They also include all partnership income (even interest/dividends) in calculating their 1.39% net investment income excise tax.

Q: Is all K-1 income considered unrelated business income for a charity?
A: No. Only income from an unrelated trade or business is UBI. Many items on a K-1 (interest, dividends, royalties, capital gains) are excluded from UBI, unless there’s debt-financing or it’s from an S-corp. Each line of the K-1 must be evaluated.

Q: Can a charity use losses from one K-1 to offset gains from another?
A: Not usually. Under current law, an exempt organization must silo each unrelated business. Losses from one partnership’s activity can’t offset income from a different, unrelated activity. Losses can carry forward for that same activity.

Q: If a partnership donates to a charity, does the charity still pay UBIT on that partnership income?
A: Generally, yes. A partnership might make a charitable contribution (reducing its taxable income); the charity’s K-1 may show that contribution. But the portion of income given away doesn’t magically become related – the charity still pays tax on any UBI it was allocated. The charitable deduction on the K-1 doesn’t directly benefit the charity (it’s meant for taxable partners).

Q: Do charities need an EIN to receive a K-1?
A: Yes. A charity will use its EIN as its taxpayer ID on the K-1. Partnerships issue the K-1 to “[Charity Name] EIN 12-3456789” (for example). The EIN is how the IRS tracks the income to the organization.

Q: Can a charity avoid UBIT by creating a subsidiary corporation for the partnership investment?
A: Yes. This is a common strategy. The charity can form a taxable C-corporation (sometimes offshore) to hold the partnership interest. The corp gets the K-1 and pays corporate tax on any income, then can dividend the rest to the charity. Those dividends are tax-free to the charity. It’s basically paying the tax through a subsidiary (“blocking” the UBIT).

Q: If a charity sells a partnership interest, is that sale income taxed?
A: Usually no. Selling a partnership interest typically yields capital gain. Capital gains are excluded from UBI for charities (unless the asset was inventory or held primarily for sale, which investment interests are not). If the partnership had debt, a portion of the gain might be taxable as UDFI, but generally a one-time sale of a donated interest is not taxed as UBI.

Q: Do states tax a charity’s K-1 income?
A: Often, yes. Many states impose tax on unrelated business income just like the IRS. A charity may need to file state returns for its K-1 income if that partnership did business in certain states. However, some states or scenarios may not require it (especially if the income is low or the state has exemptions).

Q: Should charities avoid partnerships to avoid the hassle?
A: It depends. Small charities might choose to avoid complex investments. Larger ones often find the extra income outweighs the hassle and tax. It’s a case-by-case decision, balancing mission, capacity, and financial benefit.

Q: Can a 501(c)(3) own 100% of an LLC and still get a K-1?
A: If it’s a single-member LLC, there’s no K-1 (it’s disregarded). The LLC’s activity is treated as the charity’s directly. K-1s are issued only to partners/members in a partnership (which requires 2 or more owners). If a charity is the sole owner, tax-wise it’s not a partnership. If the LLC elects to be taxed as a corporation, then no K-1 either (it would issue dividends possibly). K-1 comes into play when the LLC has multiple members or is explicitly structured as a partnership for tax.

Q: Does unrelated business income from a K-1 affect how much a charity can spend on programs?
A: Only to the extent of taxes owed. The gross income can be used for the charity’s work, but the charity will have to divert some of it to pay UBIT. Also, managing UBI might incur accounting costs. But the presence of UBI doesn’t restrict spending (beyond paying tax) – in fact, it’s extra income they wouldn’t have otherwise, so after taxes, they still have more funds to deploy for programs.