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Know the Tax Consequences of Alternative Investments Before You Leap

04/05/2016

Charities that invest in alternative investments are not immune to the many income, excise, and foreign tax consequences related to the complex investments.  A tax-exempt status for U.S. federal tax purposes does not equate to exemption from all taxes.  For instance, if the alternative investment creates ordinary income that is unrelated to the charity’s exempt purpose, the income may be considered unrelated business income.  In addition, if the investment is operating in multiple states, the charity may have state filing obligations in those jurisdictions due to the ordinary income. 

What are alternative investments?

The following is a list of tax considerations for charities contemplating investing in alternative investments.  Please note this list is not all-inclusive and it is important for charities to discuss their investment decisions with their investment advisors and tax professionals.

Income and Excise Tax Impacts of Alternative Investments

  • Will any portion of the investment be debt-financed by the charity?  
  • If the answer is yes, any income or gains generated from the investment may be considered unrelated business income and taxed to the charity at corporate or trust income tax rates.  This would include interest, dividends, and capital gains that are normally excluded from income taxes.
  • How is the investment classified for tax purposes?
  • - Is the investment in a U.S. Corporation?  These investments are generally not considered alternative investments.  For charities, the only income typically generated in this case is dividends.  Additionally, capital gains or losses may occur when sold.  These items are statutorily excluded from income taxes unless the investment was purchased using debt.  For private foundations, this income may be subject to excise tax.
  • - If not a U.S. Corporation, what is the legal classification of the entity the charity is investing in?  Each classification has unique tax consequences.
    • U.S. Domestic Limited Partnership or Limited Liability Corporation?
    • U.S. Small Business Corporation (S Corporation)?
    • Foreign Corporation, Partnership or Trust?
  • What is the underlying activity of the investment (partnerships and limited liability companies only)? 
  • - Is there a trade or business involved?  If yes, is the trade or business the same as the charity’s exempt function?  For instance, if the investing charity has a tax-exempt status to provide housing to low-income individuals and the alternative investment (a limited partnership) does the same activity, any ordinary income earned in the LP would not be considered unrelated business income to that charity.
  • -Will the income be from passive sources such as interest, dividends, rents, royalties, and capital gains?  These sources of income are generally not subject to income tax for charities unless there is debt financing involved.  However, the income may be subject to excise tax for private foundations.
  • Will the LP/LLC have acquisition debt of its own?  If so, some of the passive income may be subject the unrelated business income tax rules.
  • What jurisdictions will the investment operate in?
  • - If the investment is operating a trade or business in multiple states, does the charity have an income tax obligation in those states?
  • If the investment has foreign corporation or partnership holdings, does the charity have any required foreign filings?  Forms 926, 5471, 8865, and 8621 are common foreign filings.
  • Will the fund provide the necessary unrelated business income tax disclosures needed to prepare the federal and state income tax returns? 
  • In addition, if there is unrelated business or net investment income excise tax, technically, the fund needs to provide the necessary tax information quarterly for the charity to properly annualize its quarterly tax payments.
  • For private foundations, who are the other owners of the investment?  If owned by disqualified persons, there may be excess business holding and/or self-dealing issues.
  • For private foundations, will there be any business transactions with the entity?  If so, consult your tax advisor to ensure no self-dealing occurs.