Alternative Investments & Unrelated Business Income
By Ashley Cooper, CPA and HoganTaylor Tax Manager
In recent years, non-profit organizations have begun to more regularly participate in alternative investments. These alternative investments have the potential for higher returns than traditional investments such as stocks, bonds and property. Examples include private equity funds, real estate funds, venture capital funds, offshore fund vehicles, funds of funds, commodity funds, and hedge funds.
While generally non-profit organizations are permitted to invest in alternative investments. These investments also typically carry increased market risk, and the executives, boards of directors and management of organizations have an obligation to fully understand these risks before investing. A couple of the most important risks associated with this type of investment is the increased tax reporting requirements and the potential exposure to unrelated business income tax.
Typically alternative investments have two main practices that could generate unrelated business income (UBI) for the organization. The first practice deals with debt financed alternative investments. This could be from debt financing either inside or outside of the investment. If a loan is taken out to purchase an alternative investment, all of the income produced by the investment is considered UBI, regardless of its nature. In the same way, any capital gain produced by selling a debt-financed investment is also UBI. The fund could also be leveraged inside the investment. Meaning that the fund incurs debt and utilizes debt to purchase assets which would also create UBI. The second practice occurs when the fund operates a for-profit business. This is typically more common than UBI caused by debt financing and is subject to unrelated business income tax regardless if the non-profit organization directly participates in the for-profit business or not. The organization is typically exposed based on its proportional share of the earnings generated from the for-profit business inside of the fund.
Non-profits participating in alternative investments may receive a Form K-1 from any fund that is organized as a partnership. The Form K-1 will typically disclose amounts considered UBI and other important tax disclosure information. It is imperative for organizations to review the information carefully and it would be advised to discuss the K-1 with your tax advisors. In particular, the following information should be reviewed:
- Box 1 Ordinary Business Income (loss): The amount included in this box represents the organization’s share of the income generated from some type of for-profit business.
- Box 20V Unrelated Business Taxable Income: The amount in this box indicates the amount of taxable UBI for the organization. It can include several different types of income and expenses associated with UBI.
- Footnotes to the K-1: Typically this is the most informational place to look for tax disclosure information on Form K-1. The footnotes may include additional UBI information, state UBI allocations, and foreign disclosures.
Any amount of UBI exceeding $1,000 requires the organization to file a Form 990-T, which is filed separately from the organization’s Form 990, 990-EZ, or 990-PF. The 990-T must be filed if gross receipts are over $1,000 regardless if the net result is a loss. The loss can be used to establish a net operating loss that can either be carried forward to offset future income or carried back to refund any prior year taxes paid. Additionally, most states have a filing requirement for state income tax returns if any UBI is generated for that particular state.
Additionally, special consideration needs to be made for foreign investments. Any investments valued at $100,000 or more require the non-profit organization to complete Schedule F to be included with its Form 990. Tax-exempt organizations may also be required to file various other foreign forms including Form 926, Return by a U.S. Transferor of Property to a Foreign Corporation, Form 8865, Return of U.S. Persons with Respect to Certain Foreign Partnerships, or Form 5471, Information Return of U.S. Persons with Respect to Certain Foreign Corporations. Any investments that produce a Form K-1 should include information in the footnotes regarding required forms and information to complete those forms. These forms can also be required by alternative investments that do not produce K-1s such as blocker corporations or pooled investments that invest in foreign markets. It is important to be aware of any foreign investments your organization may have in order to complete the correct filing requirements and avoid extensive penalties.
Alternative investments are often an attractive investment strategy for non-profit organizations in order to increase investment return and diversify portfolios. As the discussion above indicates, it is important for organizations to understand and be familiar with their investments as they may involve exposure to tax liability and additional filing requirements.