Private Foundations: Nontraditional Investments

September 20, 2016 | Article

By Kim Hunwardsen, CPA and Aaron Boyer, CPA

The following article is a review of tax consequences of nontraditional investments from a federal and foreign jurisdiction standpoint.  Specifically, the following topics are addressed:

  • Defining unrelated business income and identifying common sources
  • Identifying foreign reporting requirements triggered by investments in foreign countries
  • Identifying common tax concerns with making grants in foreign countries
  • Clarifying foreign reporting requirements related to payments to non-U.S. persons

Most of these topics are not regularly faced by private foundations simply making domestic grants or investing in basic investments such as publicly traded stocks or private bonds. However, as a private foundation begins to expand their activities or invest in more complex investments such as hedge funds, they need to become aware of the rules and restrictions that follow.

Unrelated Business Income
Unrelated business income (UBI) typically occurs when an exempt organization is conducting activities unrelated to its exempt purpose.  UBI is triggered when an exempt organization either directly or indirectly conducts an activity that is regularly carried on, has a profit motive and when the conduct is not substantially related to the exempt purpose. Most private foundations don’t engage in unrelated business activities as the excess business holding rules limit the ability to conduct such activities.  However, unrelated business income can also be generated by certain types of investment holdings the foundation may own. 

An analysis of income of a private foundation can identify many types of income streams that have the potential for UBI. 

  • Passive income including, interests, dividends, capital gains, annuity payments, royalties and real property rental income:  There are general exclusions to the UBI rules for these types of passive income.  However, if any of the passive income is generated from investments or property that are debt-financed the general exclusion does not apply.   
  • Sale of property held for investment:  The passive income exception will not apply to gains on property if the foundation is found to be an active dealer in property based on frequency of sales and taking a commercial approach to the sales.
  • Mineral interests:  Mineral interests measured by production or income are typically excluded as royalty income where mineral interests generated from a working interest is taxable.
  • Partnership and S-corporation interests:   Income that flows through a partnership retains its character and will be subject to tax based on the general UBI rules as discussed above. Typically the income will be excluded unless the partnership has ordinary income from a business activity.  All income generated through an investment in an S-corporation is treated as UBI regardless of the character of the income. 

Foreign Investment Reporting Requirements
In addition to federal tax considerations, nonprofits need to be aware of foreign filing obligations related to investments they may have outside of the United States. These foreign filings can be triggered by direct ownership of foreign investments, but more commonly come from investments in alternative investments which themselves may invest in foreign investments.  There are a number of IRS forms that are required to be filed to record ownership of foreign investments and transactions with foreign companies.  The filing thresholds for each form varies depending on the type of transaction. Therefore, even minor ownership in a foreign entity (via ownership in alternative investments) can potentially trigger filing requirements.   Potential foreign investment disclosures include Form 926 and related 6038B Statement (transfers to a foreign corporation), Form 5471(ownership of a foreign corporation), Form 8858 (ownership of a foreign disregarded entity), Form 8865 (transfers to a foreign partnership) and Form 114 (ownership of foreign financial accounts).  Penalties for failure to file these forms can be significant.  Oftentimes it can be difficult to determine which investments are foreign and therefore determining applicable U.S. filing requirements is challenging. In such cases nonprofits may be limited to a “best guess” approach to determine applicable tax filing requirements.

A tax exempt organization with alternative investments or foreign investments should implement steps to ensure compliance to avoid significant penalties. Such steps include maintaining communication among decision makers and the compliance/tax department; requesting information on foreign reporting before investments are entered into; requesting prospectus and quarterly or annual reports; understanding underlying investments and asking how the nonprofit will obtain required information to comply with U.S. foreign reporting disclosures.  Additionally, exempt organizations should annually review organization charts; track the organization’s alternative investments; review schedule K-1’s from partnerships for required foreign disclosures; and review foreign financial accounts (including foreign accounts of foreign affiliates) to determine whether the nonprofit or certain U.S. persons with signature authority have filing requirements.

Grants to Foreign Countries
If a private foundation decides to make grants to entities operating in a foreign county, they must have processes in place to ensure the grants are used for charitable purposes and they do not trigger penalties as taxable expenditures.  If a private foundation is making a grant to a foreign entity it needs to follow additional steps to avoid treatment as a taxable expenditure.  The two approaches for meeting these requirements are known as equivalency determination and expenditure responsibility.

An equivalency determination is a “good faith” determination that the foreign organization is the equivalent of a U.S. public charity. The primary method to conduct equivalency determination is to obtain a written determination from either legal counsel or a qualified tax practitioner concluding the foreign organization is the equivalent of a U.S. charity based on all relevant facts. In the past, a foreign charity could provide the foundation with an affidavit that indicated they had been determined by their home country to be a charitable organization.  However, this is no longer sufficient documentation.  These affidavits can be used to support an overall determination.  The equivalency determination is most applicable in a situation where the foundation will have a long term relationship with a foreign charity.  If a foundation is making a one-time grant to a foreign entity, conducting expenditure responsibility procedures, similar to the process for making grants to nonexempt organizations, would be most applicable.

There are some best practices that should be followed when making foreign grants, beyond the above procedures, to avoid taxable expenditure treatment. It is important to develop and standardize the process; know the grantee;  create a risk-based approach; obtain written and signed grant agreements; avoid disbursements of cash; obtain and review reports from each grantee; correct any misuse promptly; seek recourse and terminate the grant relationship if misuses continue; and stay informed of changes in the area.

U.S. Tax Withholding & Reporting
United States organizations that are making payments to foreign persons are required to comply with withholding and reporting requirements.  If a U.S. taxpayer remits a payment to a foreign payee and was required to withhold and report but failed to do so, the U.S. payor may be responsible for the amount that should have been withheld and may be subject to numerous penalties and interest. Therefore, when U.S. taxpayers remit payments to foreign payees they should generally determine whether the payee is foreign; whether the payment is of a specific type (interest, dividends, rents, royalties, compensation for services, etc.); and whether the payment is U.S. sourced. There are certain types of payments that are not subject to withholding, including payments for products; scholarships to foreign students and certain payments to teachers on special visas.  Generally a U.S. payor should request a W-8 Form from foreign payees to document the payee is foreign and to determine whether withholding is required.

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