Hidden consequences of alternative investments for not-for-profits

The search for higher returns has made the investment landscape significantly more complex in recent years. Fund managers have created increasingly specialized entities and instruments in order to help investors maximize returns while targeting and managing risk more effectively. Not-for-profits (NFPs) looking to improve investment returns face some extra challenges. Because of their tax-exempt status, many fail to realize that ownership of certain investments can trigger a reporting and/or tax payment obligation where one might not otherwise exist. Failure to meet these obligations can result in significant penalties and interest charges for unwary NFPs.

One of the most frequent causes of unexpected tax filing obligations is investment outside of the United States. In order to avoid being surprised by these requirements, exempt organizations need to ask one key question before committing funds: Will the activity involve investment outside of the United States or investment in a partnership that will place investments outside of the United States? If the answer is “yes,” the organization needs to understand any additional filing requirements up front in order to factor the costs of compliance into the rate of return.

Commonly missed forms and related penalties

The following forms provide an example of the typical filings that tax-exempt organizations often miss and the resulting penalties that can be assessed:

• Form 926 — Return by a U.S. transferor of property to a foreign corporation
  The federal government uses this form to track tax-free transfers of cash or property, typically capital contributions, to foreign corporations. It’s generally required when a U.S. investor transfers more than $100,000 cash in a 12-month period property of any amount, or any other contribution when the investor owns more than 10 percent of the foreign corporation. The obligation to file this form can arise from direct investment in the foreign corporation, or it can flow through to partners if the transfer is made by a partnership. The penalty for failing to file a Form 926 when required is 10 percent of the amount transferred, up to $100,000 per transfer.
• Form 8865 — Return of U.S. persons with respect to certain foreign partnerships
  The government uses this form to track ownership of and property transfers by U.S. entities in foreign partnerships. Generally, a U.S. taxpayer must file this form if they transfer cash or property totaling more than $100,000 in a year, or if they own 10 percent or more of the entity. As with the Form 926, the obligation to file this form can be triggered by direct investment in the foreign partnership or by investment in a partnership that crosses the $100,000 in a year or 10percent ownership thresholds. The penalty for not filing this form when required is generally $10,000 per failure to file.
• FinCEN Form 114 — Report of foreign bank and financial accounts
  This form tracks assets that U.S. taxpayers hold in offshore accounts—foreign bank accounts, brokerage accounts, and mutual funds. Any individual or entity that owns more than 50 percent of the account, directly or indirectly, must file the form. Also, individuals who have signature authority over the accounts have a filing obligation. The penalty for failing to file this form can be as high as 50 percent of the account’s value.

Depending on the form that was overlooked and the size of the accounts, an organization could face a sizable tax bill before it even realizes it has a problem.\

Best practices for managing the impact of foreign investments
Perhaps the best defense against finding out too late that an investment requires extra tax compliance from an organization is open and frequent communication between the people who manage investments and the finance/accounting department. Those who manage the entity’s investments should also stay in contact with the fund managers who can help inform them when assets are invested in a way that might trigger an obligation.

In addition, these tips can help an organization avoid surprises and comply with reporting rules:

Never assume that an investment won’t have a tax consequence just because a nonprofit is doing the investing.

Share all documentation on the initial investment and subsequent information with the finance/accounting department. All relevant parties should review the prospectus and other offering materials for potential tax impact before investing.

Never assume that an investment won’t have a tax consequence just because a nonprofit is doing the investing.

Consider additional tax compliance costs when calculating the rate of return on an investment that triggers a new obligation.

The organization’s finance professionals are uniquely positioned to support the investment team in analyzing new opportunities in order to determine if they will trigger additional reports and possible taxes or penalties. The key is to have the finance and investment teams consulting closely before an investment is made in order to understand the additional costs that a new investment might trigger.