A majority of alternative investments are in domestic partnerships or limited liability companies. The tax treatment for these entities is to pass on the investment’s underlying tax character to its partners or members and tax the income at the partner or member level. The charity will receive an annual Schedule K-1 from the investment and may have additional information to report on its Form 990/990-PF or 990-T.
If the alternative investment is an S Corporation, the charity will also receive a Schedule K-1 from the investment. S Corporations have a pass through nature similar to LPs and LLCs. However, there is one key difference: all income received from an S corporation is considered unrelated business income to a charity. Charities are rarely recommended to invest in S Corporations because of this reason.
- What is the year-end of the investment? If the year-end differs from the charity’s, the charity uses the Schedule K-1 with the year-end that falls within the charity’s reporting year.
- When will the annual Schedule K-1 be received?
- Will it be available when the charity has its financial statements audited?
- If not, will it be prior to September 15th for a calendar year-end investment? Most Schedule K-1s will come in late August or September. That may require the reporting charity to extend its Form 990/990-PF or Form 990-T filing in order to include the required information.
- How much ownership will the charity have?
- Will it be more than 50%? If so, then the entity may be related for financial reporting purposes and for reporting on Schedule R of the Form 990.
- For private foundations, will it be more than 2%? If so, consult your tax advisor to make sure the ownership doesn’t create an excess business holding.
- Have there been Reportable Transaction Disclosures reported to owners in the past? If the investment had previous transactions that may require a Form 8886 filing, the charity may want to inquire further of the nature of the disclosure.
Considerations for Direct Foreign Investments:
- What type of foreign entity is being purchased? For the U.S. federal tax treatment, consult your tax advisor to understand if the investment is a foreign partnership, foreign corporation or a passive foreign investment corporation. This categorization is important since it directly impacts how the income is reported and taxed.
- How much cash will be invested by the charity? Will it be over $100,000? If so, Form 926 (for foreign corporations) or Form 8865 (for foreign partnerships) may be required.
- How much of the foreign entity will the charity own?
- Will it be greater than 10%?
- Will it be greater than 50%?
- If it is between 10% and 50% ownership, are there other U.S. owners that have a greater than 10% interest? If so, who are they and what their ownership interests?
- The above questions determine what potential foreign filings are required by the charity. If the charity owns more than a 10% interest, it needs access to the foreign entity’s financial records to be able to comply with the reporting requirements.
Clearly, careful consideration should be taken when deciding if the charity should invest in these types of investments. Often charities are surprised by the tax implications that may arise from alternative investments. The charity may not realize the impact until 12 to 18 months after the investment has been purchased when the tax return is being prepared or the K-1s are received. At that point, a charity may find the tax compliance costs dramatically increasing due to additional federal, foreign and state filings. When being mindful of financial reporting, economic, and investment consequences, tax implications are just one of the factors to consider.