Alternative Investments: 10 Forms That Question Their Worth
Many financial managers at exempt organizations are turning to alternative investments to chase higher rates of return and to diversify the portfolio beyond traditional stocks, bonds and mutual funds. Alternative investments are loosely defined as investments that do not trade publicly on an organized exchange. While they are attractive because of their higher rates of return, they might be subject to tax, as well as additional annual compliance burdens, including multi-state tax exposure and foreign filings.
While the economic benefits of investing in these non-traditional vehicles is undeniable, many tax-exempts managers fail to consider the non-economic costs associated with disclosing these asset classes on the Forms 990 and 990-T, as well as the significant administrative burden of preparing a variety of tax forms.
There are 10 forms associated with alternative investments.
1. Schedule K-1: Partner’s Share of Income, Deductions, Credits, etc.
Many alternative investments are structured as domestic limited partnerships that issue a Schedule K-1 to report the investor’s share of income, losses, deductions and credits. The Schedule K-1 is required to disclose to tax-exempt partners information identifying how much unrelated business income (UBI) the partnership is generating.
This amount often will appear on the face of the K-1 in Line 20V with no further explanation. However, if Line 20V is not completed, this does not necessarily mean that the partnership derives no UBI. In these instances, the partner must sift through the footnotes to determine if there is one that discloses UBI amounts or percentage allocations.
Tax-exempt partners frequently encounter incorrectly prepared Schedules K-1, either because the K-1 lacks sufficient detail to apprise the investor of its UBIT or the pass-through entity is unfamiliar with the UBI rules altogether. It is imperative that managers follow up with the K-1 issuer to ensure that the tax-exempt status is documented and UBI amounts are properly calculated and reported.
2. Form 990-T: Exempt Organization Business Income Tax Return
Most tax-exempts do not file income tax returns; they file a Form 990 Information Return. If a tax-exempt organization derives unrelated business income, it will be required to file a Form 990-T, Business Income Tax Return of Exempt Organizations.
A tax-exempt’s revenue stream will constitute taxable UBI if three factors are present:
It is income from a trade or business;
The trade or business is regularly carried on; or,
The conduct of the trade or business is not substantially related to the organization’s mission.
While investment income generally does not constitute UBI, an investment vehicle that is organized as a partnership might generate UBI. In a partnership, the tax-exempt partner is deemed to have undertaken the same activity as the partnership. If the partnership sells widgets, so too does the tax-exempt partner; if the partnership engages in a debt-financed transaction so, too, does the tax-exempt partner.
Investors in a partnership must look at the activity as if they conducted it themselves. If the underlying limited partnership is deemed to be engaging in an activity unrelated to the organization’s mission or in a transaction involving debt, a Form 990-T might be required. This even applies to organizations for which a Form 990 is not normally filed, such as public universities, churches or pension trusts.
3. State Income Tax Returns
While many tax-exempt investors are aware of the federal tax obligations, they need to be aware of the potential state ramifications. Along with the federal K-1, organizations might receive state K-1s or a state schedule (within the federal K-1) that reports UBI attributable to each state. Even though the organization might not have a physical presence in a particular state, (or conducts no business and has no employees), the alternative investment may nevertheless create a filing obligation.
Wherever that partnership engages in a trade or business, the tax-exempt partner will be conducting business there as well and might have to file a state tax return. If the tax-exempt partner’s investments generates losses in a jurisdiction, a business decision must be made whether to file in the state to preserve the loss and offset potential future gains. It should be noted that once a return is filed, the state will likely look for a return in subsequent years.
4. Form 5471: Information Return of U.S. Persons with Respect to Certain Foreign Corporations
The Form 5471 is an informational foreign filing (and not a tax form) that is used to disclose an ownership interest of greater than 10 percent in a foreign corporation. A tax-exempt might become responsible for filing a Form 5471 either through a direct investment to an offshore corporation or via its investment in a limited partnership. Failure to file the Form 5471 could result in substantial penalties and given the complexity of the form, it is advisable that the organization obtain further information from the investment to ensure accurate completion.
5. Form 926: Return by a U.S. Transferor of Property to a Foreign Corporation.
The IRS takes an interest whenever anyone transfers money outside the United States. A Form 926 must be filed when that transfer is made to an offshore corporation and that transfer exceeds $100,000. While the form is not overly complicated, a tax-exempt that either makes direct investments in offshore corporations or invests in a multitude of domestic limited partnerships that in turn transfer money offshore, could find it extremely time consuming to complete multiple Forms 926.
Transfers are aggregated over a 12-month period. If financial managers invest in several limited partnerships that all transfer money to the same offshore corporation, the tax-exempt organization will be required to aggregate those transfers and complete a Form 926.
While the 926 is most commonly filed when a transfer exceeding $100,000 is made, it also must be filed by those tax-exempt entities that own at least 10 percent of the voting power or 10 percent of the value of existing stock. Similar to the Form 5471, the penalties for failing to file this form are very severe.
6. Form 8865: Return by a U.S. Transferor of Property to a Foreign Partnership
The Form 8865 is a corollary to the Form 926. Individuals or organizations transferring $100,000 or more to a foreign partnership are required to file it. Most tax-exempts will encounter these type investments via a domestic limited partnership. From a tax perspective, it makes much more sense to invest in an offshore corporation than an offshore partnership because the corporate entity blocks UBI from flowing back to the tax-exempt investor. A foreign partnership does not afford that same tax advantage. The tax-exempt investor will usually only become involved in a foreign limited partnership via the domestic limited partnership which is disclosed on a Schedule K-1 that provides the information necessary to complete the Form 8865. Like the 5471 and 926, the penalties for failing to file the 8865 are very severe.
7. Form 8621: Information Return by a Shareholder of a Passive Foreign Investment Company
The Form 8621 is required to be filed by a shareholder of U.S. Passive Foreign Investment Companies (PFIC) to report distributions from PFICs, disposition of PFIC stock and to make certain elections. The PFIC rules make it clear that exempt organizations are not required to file this form unless the PFIC stock is debt-financed, either at the organization level or at the partnership level.
8. Form 8886: Reportable Transaction Disclosure Statement
While tax-exempt organizations are exempt from income tax on revenues related to the exempt mission, they may get involved (via a limited partnership investment) in listed transactions that the IRS has identified could represent a tax shelter transaction (i.e. a tax avoidance transaction). The IRS Form 8886 is intended to capture these type transactions.
A typical example is loss transactions from sale of stock, property or interest or loss from foreign currency transactions.
The taxpayer must attach a Form 8886 disclosure statement to its tax return reflecting participation in the reportable transaction. For most tax-exempt investors, the limited partnership in which it invests will often file the Form 8886 on behalf of its partners as a protective measure. Nevertheless, since the potential penalties for failing to disclose such transactions are very severe, a financial manager would be well-advised to consider filing a Form 8886 with the nonprofit’s Form 990-T filing.
9. FinCEN 114: Report of Foreign Banks and Financial Accounts
The FinCEN 114 (formerly known as the FBAR) is an annual filing completed by those individuals or organizations with a financial interest in, or signature authority over, a financial account located outside of the United States exceeding $10,000 at any time during the calendar year. Hedge funds and other similar investment vehicles are not currently deemed to be bank accounts for purposes of the FinCEN 114 filing.
10. Form 8582: Passive Activity Loss Limitations
The Form 8582 is the least common of these forms. It is only required to be filed by exempt trust organizations. The Form 8582 is filed by trusts with passive activity losses (PAL). A PAL is derived from a non-business activity, such as rental activities. Compounding the complexity of the PAL rules are the publicly traded partnerships (PTP) rules. Section 469(k) provides that passive activity limitations must be applied separately to each PTP reported within the K-1. This means that passive activity losses from one PTP may only be used to offset the income from passive activities of the same PTP. As a result, exempt trust organizations should maintain an internal roll-forward of PTP suspensions and may be required to file Form 8582 to track passive activity loss carryovers for future years.
Are they worth it?
While alternative investments can provide portfolio diversification and higher investment returns, managers at tax-exempt organizations should factor in the additional costs to manage the fund, the cost to prepare additional tax and disclosure filings, as well as the risks associated with a failure to file a required form. These “unexpected” costs will reduce the return on investment and the increase in administrative burden may overshadow the economic benefits.
Rebecca Zecha is a manager at Grant Thornton LLP. Her email is Rebecca.firstname.lastname@example.org; Daniel Romano is National Partner-in-Charge,
Not-for-Profit Tax Services at Grant Thornton LLP. His email is Daniel.Romano@us.gt.com; Scott Thompsett, is a managing director at Grant Thornton. His email is email@example.com