Charities that invest in alternative investments are not immune to the many income, excise and foreign tax consequences related to the complex investments. A tax-exempt status for U.S. federal tax purposes does not equate to exemption from all taxes. For instance, if the alternative investment creates ordinary income that is unrelated to the charity’s exempt purpose, the income may be considered unrelated business income. In addition, if the investment is operating in multiple states, the charity may have state filing obligations in those jurisdictions due to the ordinary income.
The following is a list of tax considerations for charities contemplating investing in alternative investments. Please note this list is not all-inclusive and it is important for charities to discuss their investment decisions with their investment advisors and tax professionals.
Income and Excise Tax Impacts:
- Will any portion of the investment be debt-financed by the charity? If the answer is yes, any income or gains generated from the investment may be considered unrelated business income and taxed to the charity at corporate or trust income tax rates. This would include interest, dividends and capital gains that are normally excluded from income taxes.
- How is the investment classified for tax purposes?
- Is the investment in a U.S. Corporation? These investments are generally not considered alternative investments. For charities, the only income typically generated in this case is dividends. Additionally, capital gains or losses may occur when sold. These items are statutorily excluded from income taxes unless the investment was purchased using debt. For private foundations, this income may be subject to excise tax.
- If not a U.S. Corporation, what is the legal classification of the entity the charity is investing in? Each classification has unique tax consequences.
- U.S. Domestic Limited Partnership or Limited Liability Corporation?
- U.S. Small Business Corporation (S Corporation)?
- Foreign Corporation, Partnership or Trust?
- What is the underlying activity of the investment (partnerships and limited liability companies only)?
- Is there a trade or business involved? If yes, is the trade or business the same as the charity’s exempt function? For instance, if the investing charity has a tax-exempt status to provide housing to low-income individuals and the alternative investment (a limited partnership) does the same activity, any ordinary income earned in the LP would not be considered unrelated business income to that charity.
- Will the income be from passive sources such as interest, dividends, rents, royalties and capital gains? These sources of income are generally not subject to income tax for charities unless there is debt financing involved. However, the income may be subject to excise tax for private foundations.
- Will the LP/LLC have acquisition debt of its own? If so, some of the passive income may be
subject the unrelated business income tax rules.
- What jurisdictions will the investment operate in?
- If the investment is operating a trade or business in multiple states, does the charity have an income tax obligation in those states?
- If the investment has foreign corporation or partnership holdings, does the charity have any required foreign filings? Forms 926, 5471, 8865 and 8621 are common foreign filings.
- Will the fund provide the necessary unrelated business income tax disclosures needed to prepare the federal and state income tax returns? In addition, if there is unrelated business or net investment income excise tax, technically, the fund needs to provide the necessary tax information quarterly for the charity to properly annualize its quarterly tax payments.
- For private foundations, will information be available from the investment to properly determine the income subject to the excise tax on net investment income?
- For private foundations, who are the other owners of the investment? If owned by disqualified persons, there may be excess business holding and/or self-dealing issues.
- For private foundations, will there be any business transactions with the entity? If so, consult your tax advisor to ensure no self-dealing occurs.
Considerations for Domestic Pass Through Entities:
A majority of alternative investments are in domestic partnerships or limited liability companies. The tax treatment for these entities is to pass on the investment’s underlying tax character to its partners or members and tax the income at the partner or member level. The charity will receive an annual Schedule K-1 from the investment and may have additional information to report on its Form 990/990-PF or 990-T.
If the alternative investment is an S Corporation, the charity will also receive a Schedule K-1 from the investment. S Corporations have a pass through nature similar to LPs and LLCs. However, there is one key difference: all income received from an S corporation is considered unrelated business income to a charity. Charities are rarely recommended to invest in S Corporations because of this reason.
- What is the year-end of the investment? If the year-end differs from the charity’s, the charity uses the Schedule K-1 with the year-end that falls within the charity’s reporting year.
- When will the annual Schedule K-1 be received?
- Will it be available when the charity has its financial statements audited?
- If not, will it be prior to September 15th for a calendar year-end investment? Most Schedule K-1s will come in late August or September. That may require the reporting charity to extend its Form 990/990-PF or Form 990-T filing in order to include the required information.
- How much ownership will the charity have?
- Will it be more than 50%? If so, then the entity may be related for financial reporting purposes and for reporting on Schedule R of the Form 990.
- For private foundations, will it be more than 2%? If so, consult your tax advisor to make sure the ownership doesn’t create an excess business holding.
- Have there been Reportable Transaction Disclosures reported to owners in the past? If the investment had previous transactions that may require a Form 8886 filing, the charity may want to inquire further of the nature of the disclosure.
Considerations for Direct Foreign Investments:
- What type of foreign entity is being purchased? For the U.S. federal tax treatment, consult your tax advisor to understand if the investment is a foreign partnership, foreign corporation or a passive foreign investment corporation. This categorization is important since it directly impacts how the income is reported and taxed.
- How much cash will be invested by the charity? Will it be more than $100,000? If so, Form 926 (for foreign corporations) or Form 8865 (for foreign partnerships) may be required.
- How much of the foreign entity will the charity own?
- Will it be greater than 10%?
- Will it be greater than 50%?
- If it is between 10% and 50% ownership, are there other U.S. owners that have a greater than 10% interest? If so, who are they and what are their ownership interests?
The above questions determine what potential foreign filings are required by the charity. If the charity owns more than a 10% interest, it needs access to the foreign entity’s financial records to be able to comply with the reporting requirements.
Clearly, careful consideration should be taken when deciding if the charity should invest in these types of investments. Often charities are surprised by the tax implications that may arise from alternative investments. The charity may not realize the impact until 12 to 18 months after the investment has been purchased when the tax return is being prepared or the K-1s are received. At that point, a charity may find the tax compliance costs dramatically increasing due to additional federal, foreign and state filings. When being mindful of financial reporting, economic and investment consequences, tax implications are just one of the factors to consider.