Alternative investments continue to be attractive to nonprofit organizations. They can reduce volatility in an investment portfolio and potentially result in greater investment earnings. However, these investment earnings also come with potential tax issues such as unrelated business income and additional filing requirements. Alternative investments may include partnerships, limited liability companies, hedge funds, other funds, or direct investments in foreign companies. If you are currently participating in in alternative investments, or if you are considering them, you may be impacted by the following tax liability and compliance issues.
Unrelated Business Income
Income from alternative investments may be passed through to a nonprofit organization via a Form K-1. This income must be reviewed at the nonprofit organization level to determine whether it is subject to unrelated business income tax (UBIT). Form K-1s should have proper disclosures for UBIT when there are tax-exempt partners; however, this information is often missing or incomplete. It is the nonprofit organization’s responsibility to ask additional questions to determine if there is UBIT. UBIT is taxed at the federal corporate tax rate of 21 percent for tax years after December 31, 2017. In addition to federal UBIT, alternative investments may also have state-sourced UBIT that would require state income tax returns and payment of state income tax at the respective tax rates.
Investments that have been purchased with borrowed funds may subject income that would otherwise be exempt from tax (e.g. interest, dividends, royalties and rents) to federal and state income tax. Nonprofit organizations should be aware of the debt-financed income rules and analyze whether there is potential for UBIT.
If a nonprofit organization has gross unrelated business income of $1,000 or more, it must file Form 990-T to report the income and related expenses. An organization that fails to timely file its return is subject to a penalty of 5 percent of the unpaid tax for each month or part of a month the return is late, up to a maximum of 25 percent of the unpaid tax. The penalty for late payment of taxes is usually one half of 1 percent of the unpaid tax for each month or part of a month the tax is unpaid. The penalty can’t exceed 25 percent of the unpaid tax.
Alternative investments must also be analyzed for foreign filings. A nonprofit organization may have an alternative investment that generates no UBIT, but still triggers foreign filing requirements. Forms that may be required include:
Failure to file required forms may result in penalties ranging from $10,000 to $100,000 per form. In addition, failure to file also leaves the statute of limitations period open, meaning the IRS has no time constraints for assessing the penalties.
Alternative investments present the opportunity to make tax compliance complex. Nonprofit organizations should analyze their portfolio holdings to gain a better understanding of what risks they may have. Contact your Eide Bailly professional or our Tax Exempt team for more information on investment reporting.