Not-for-profit organizations (NFPs), like most investors, have always sought the right balance between returns on funds invested and the risk that must be assumed to achieve higher returns. In recent years, NFPs have seen a significant increase in the types of investments available to them. One key to evaluating an alternative investment opportunity is understanding what new types of income it might generate and what taxes or filing obligations, if any, come with it.
Alternative investments include opportunities like commodities, hedge funds, private equity, and private real estate. However, these investment vehicles can also create headaches for NFPs, including increased tax complexity due to the structure of the investment, potential increases in unrelated business taxable income (UBTI) and state income taxes, and foreign investment reporting obligations.
Many alternative investment strategies involve interests in limited partnerships. Income generated through limited partnerships flows through to the partners in the same form it was received by the entity. The income received from the partnership is reported to the NFP and the IRS on Schedule K-1.
Depending on what type of income an alternative investment generates, the NFP may have to file additional information returns and could owe taxes on UBTI. If the NFP owes federal taxes on UBTI, there’s a good chance that it will also be liable for similar taxes at the state level.
Alternative investments that include foreign components may also generate additional reporting obligations on the NFP. Even though there may not be any tax owed on that income, there will still be a cost associated with pre-paring and submitting the information returns. If the NFP fails to file a required information return for a foreign investment, the penalties can be severe.
None of the issues described above should prevent an NFP from participating in an alternative investment opportunity if the risk and return are in line with the organization’s overall investment strategy. If your organization is considering investing in a limited partnership, hedge fund, or other alternative vehicle, make sure that the costs of any additional taxes and tax compliance are considered when calculating the return on investment. Moreover, be sure you understand the tax filing obligations that result from ownership of the investment. Unrelated business income isn’t necessarily a bad thing, but unexpected unrelated business income can cause significant problems.