Not-for-Profit Alternative Investments: The Good, the Bad and it Could Get Ugly

Unrelated Business Income and Reporting Considerations for Alternative Investments

For many years, not-for-profits organizations, including foundations and endowment funds, have used traditional investments, such as stock, bonds, mutual funds, and real estate to generate investment income. However, with the current slow economic recovery, market volatility and rising inflation, exempt organizations are turning to alternative investments to generate cash flow.

Alternative investments include domestic or foreign hedge funds, private equity funds, commodity funds, offshore fund vehicles and private investment funds.  These investments are commonly formed as a partnership or limited liability company (LLC) with income passing through to the investor. While alternative investments have the potential for high return, they can also expose exempt organizations to unrelated business income (UBI) as well as other tax reporting requirements.

Usually, unrelated business income is generated through an alternative investment fund in two ways. The first instance occurs when the fund incurs debt and uses the debt proceeds to purchase assets. The more common instance occurs when the fund operates a for-profit business. Although the exempt organization is not directly involved in the operations of the for-profit business, as an investor in the fund they may have UBI on their share of the earnings generated by the business.

If the alternative investment fund is classified as a partnership, a schedule K-1 will be issued by the fund reporting the investor’s share of the income broken out by the nature of the activity that produced it. The K-1 will report traditional investment income, such as interest, dividends, and capital gains as well as income from any business activity. In most cases, traditional investment income will be exempt from tax under IRC Sec. 512-514, while income from the business activity may subject to unrelated business income tax (UBIT). Income subject to UBIT will either be reported on a separate line of the K-1, box 20V, or disclosed in a footnote specifically identifying it as unrelated business income.

In addition to the federal filing requirements, there may also be state filing requirements. Exempt organizations may receive, along with the federal K-1, various state K-1s, allocating a portion of unrelated business income to the state. While the organization may not have a presence in those states, their interest in the alternative investment may create a corporate filing requirement.

Alternative investments often have foreign reporting requirements. If the exempt organization invests in a foreign fund whose value is $100,000 or more, they may need to include Schedule F with their Form 990 to report activities outside of the U.S. Other foreign disclosures, such as Form 926 (foreign corporation investments), and Form 8865 (investments in foreign partnerships) may need to be filed as well.

Many exempt organizations use alternative investments to diversify their investment portfolios and increase their investment returns. However, exempt organizations should be aware of the tax implications and additional filing requirements involved with each of their alternative investment funds as the tax and administrative burdens could outweigh the potential advantages.

Questions on proper reporting of alternative investments for your not-for-profit? Contact your Keiter Opportunity Advisor or Email | Call: 804.747.0000