Alternative Investments: Understanding Tax Reporting Requirements for Tax-Exempt Investors

Alternative investments are a popular choice for tax-exempt investors seeking to diversify their investment portfolios. These private equity options offer potentially higher returns and longer investment periods, with exposure to unique assets not typically found in publicly traded securities.

However, they also have potential tax implications and reporting requirements. From unrelated business income tax obligations to triggering foreign reporting forms, here’s the latest you need to know.

Generating Unrelated Business Income (UBI)

Alternative investments can generate UBI for tax-exempt investors in two ways:

  • When the investment fund incurs debt to purchase assets (for example, rental income earned from debt-financed property)
  • When the fund operates a for-profit business that is unrelated to the organization’s exempt purpose (which is generally the case)

Tax-exempt investors are typically not directly involved in the operations of the for-profit business. However, they may have UBI on their share of earnings generated by the business. And while traditional investment income is generally exempt from tax under IRC Sec. 512-514, income from business activity may be subject to unrelated business income tax (UBIT).

Schedule K-1 Reporting

For alternative investment funds classified as a partnership (as most private equity funds are), a Schedule K-1 will be issued. A K-1 reports the investor’s share of the income broken down by the nature of the activity that produced it. It details traditional investment income, such as interest, dividends and capital gains, as well as income from any business activity.

As such, Schedule K-1 provides essential information for calculating taxable UBIT for the tax-exempt investor. So it’s important to review the Schedule K-1 to determine whether the alternative investment generates UBI. The relevant areas to focus on include Line J (Partner’s share of profit, loss, and capital), Line K (Partner’s share of liabilities) and Box 1 (Ordinary business income (loss)), among others.

State Reporting Requirements

When an alternative investment generates UBI, information on state UBI is often included in the footnotes of Schedule K-1. A tax-exempt investor may not have a presence in a state, but holding an alternative investment might create a corporate or trust income tax filing obligation in states with UBI. Additionally, sometimes the alternative investment will pay withholding tax to a state. This information is also listed in the K-1 footnotes.

As a tax-exempt investor, owning a partnership investment operating in a particular state creates nexus in that state—even if you never have any activities there. The fact that you’ve invested in a partnership with activity in that state could generate a filing requirement. According to the National Association of State Charity Officials (NASCO), 27 states tax UBI from investments for tax-exempt organizations.

Even if the partnership generates a loss, there’s usually a filing requirement if the organization has nexus in the state. Just because a tax return has little or no tax liability, it doesn’t mean the organization can choose not to file.

However, some organizations feel that the cost of compliance is too burdensome for a return with zero tax due. In such a case, they choose to set a threshold. For example, if the tax liability in a state is over a certain dollar threshold, then they will file, and if not, then they have made the determination that the cost of compliance outweighs the risk.

When making this decision, you should take the state’s aggressiveness about going after organizations into account. Considerations include:

  • Whether it is real estate or a different type of investment
  • Whether the state has a minimum tax liability
  • The reputational risk is to the organization if they do not meet all filing requirements

Foreign Reporting Requirements

An alternative investment may itself be a foreign entity, or it might invest in other foreign entities. In either case, foreign reporting requirements can be triggered depending on the ownership percentage in the investment or on transfers of cash or other property to a foreign entity.

Common foreign forms include Form 926, Form 5471, Form 8865, and FinCEN Form 114 (FBAR). And penalties for failing to file foreign forms are significant.

  • Failure to file Form 926 may result in a penalty of 10% of the amount transferred, capped at $100,000, unless the failure to comply is due to intentional disregard.
  • Penalties for failing to file Form 5471 can range from $10,000 to $100,000. The exact amount depends on the amount of income involved, with additional penalties if the failure to file is due to intentional disregard.
  • Similarly, failure to file Form 8865 may result in penalties ranging from $10,000 to $100,000, with additional penalties if the failure to file is due to intentional disregard.

Using UBI Blockers

Historically, many exempt organizations sought to invest in funds that allowed them to avoid UBI. Instead, they structured their investments in flow-through operating entities through blocker corporations. This structure prevents the fund (and its investors) from receiving UBI from the operating entity.

An investment in or held through a corporation generally does not generate UBI unless the shares themselves are debt-financed. This is because debt incurred by a corporation (or other entity treated one for federal income tax purposes) is not treated as debt of its shareholders. There’s also an exclusion from UBI for dividends received from a corporation.

However, while these structures prevent UBI from being generated, the income of the operating entity would be subject to tax in the hands of the blocker corporation at regular corporate income tax rates. A tax-exempt investor’s share of the corporate tax usually exceeds the UBIT that would be paid if the blocker were not used.

For this reason, most exempt organizations instead choose to accept some UBI rather than use blockers to avoid it. This has led to an increasing number of private equity funds limiting the percentage of capital commitments that can be invested in UBI-generating investments.

If your tax-exempt organization considers alternative investments, know these potential tax implications and reporting requirements and scrutinize Schedule K-1. And as always, seek the advice of your higher education CPA regarding compliance with state and foreign reporting requirements.


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