Industry Insights

The potential high rate of return that makes alternative investments so attractive also comes with certain risks and additional tax filing requirements for investors, including tax-exempt organizations. While tax-exempt organizations often hold alternative investments, choosing to do so requires careful monitoring to avoid risking the organization’s tax-exempt status. Potential issues for tax-exempt organizations include:

• Unrelated business income (UBI) and related federal tax liabilities
• Potential state income tax liabilities
• Reportable transaction reporting
• Foreign activity reporting

Tax-exempt organizations generally are exempt from federal income tax. However, there are exceptions. Certain activities are considered unrelated business activities, and possibly subject to tax, if the three following conditions are met:

• The organization conducts a trade or business for the production of income from selling goods or performing services.
• The trade or business is regularly carried on.
• The activity is not substantially related to the organization’s exempt purpose.

While the alternative’s activities might trigger UBI, alternative investments often trigger UBI reporting through the alternative’s investment in operating businesses taxed as partnerships and S corporations. If gross UBI exceeds $1,000, Form 990-T must be filed to report the UBI, and the federal tax is assessed on the net UBI.

In addition to federal UBI tax, an exempt organization also may be subject to state tax in its resident state or other states. When evaluating alternative investments, an organization should consider the potential federal and state tax liabilities of a particular investment, along with costs to prepare and file additional state returns.

Certain types of alternative investments may trigger reportable transaction reporting. The IRS continues to focus on potentially abusive transactions, and disclosure of these items has become increasingly important. Reportable transactions require investors to attach Form 8886, Reportable Transaction Disclosure Statement, to their tax return for each year they participate in the transaction. Reportable transactions include listed transactions, confidential reportable transactions, transactions with contractual protection, loss transactions and transactions of interest. Failure to disclose these transactions may result in harsh penalties.

Alternatives may invest in foreign entities, creating various disclosure requirements for investors. In some cases, an organization may invest directly in a foreign alternative investment, creating additional disclosure reporting. Along with additional reporting on Schedule F of Form 990, foreign reporting for investments in foreign alternatives also may include the following:

• Form 8865, Return of U.S. Persons With Respect to Certain Foreign Partnerships
• Form 5471, Information Return of U.S. Persons With Respect To Certain Foreign Corporations
• Form 8621, Return by a Shareholder of a Passive Foreign Investment Company or Qualified Electing Fund
• Form 926, Return by a U.S. Transferor of Property to a Foreign Corporation
• TD F 90-22.1, Report of Foreign Bank and Financial Accounts

Holding alternative investments often creates additional filing burdens for tax-exempt organizations. Due to the complexity of these investments and potential for significant penalties, exempt organizations should develop a close working relationship with the fund’s investment manager to obtain all necessary information regarding the investment to remain compliant with IRS standards. Reporting UBI, all required forms related to reportable transactions and all forms related to foreign activities appropriately will help an investor reap the financial benefits while mitigating risks associated with alternative investments.

For more information on alternative investments and their potential implications, contact your BKD advisor or Paige Gerich at pgerich@bkd.com.