In recent years, a growing number of our clients have taken advantage of international investment opportunities. From alternative investments that have holdings in foreign entities, to devoting part of a portfolio in a U.S. brokerage account to international equities, many of our clients find this type of diversification beneficial from an investment point of view. While we cannot comment on the benefits or drawbacks of holding these types of assets as investments from a financial perspective, there are an ever-increasing number of tax consequences of which our tax-exempt clients should be aware.
The IRS is becoming increasingly demanding in the type of disclosures required for organizations with these types of holdings. Over the past decade, the IRS has released several new forms and countless pages of guidance in an effort to gather information about the overseas activities of U.S. tax filers. Fortunately, at least for now, tax-exempt entities are not subject to nearly as many disclosure requirements as for-profit or individual taxpayers face. However, exempt organizations are not excused from all foreign disclosure filings. The most common forms that we run into with our tax-exempt clients are Forms 926, 8621, 8865, and FinCEN 114 (formerly TDF 90-22.1). Form 990 also contains a separate schedule, Schedule F, which tax-exempt entities that engage in foreign activities as part of their operations may have to file if certain thresholds are met.
The information provided to investors to comply with foreign reporting requirements is not standardized and often varies from source to source. Typically this information is provided in the footnotes or supporting statements of a Schedule K-1 issued by an investment partnership or limited liability company. However, no two K-1s tend to present that information in the same way.
One of the most common foreign forms that exempt organizations will come across is Form 926, Return by a U.S. Transferor of Property to a Foreign Corporation. Tax-exempt organizations must file this form if they contribute over $100,000 in cash or property during the year to a foreign corporation or if they own at least 10% of the voting power or total value of the corporation immediately after the transfer. The $100,000 or 10% threshold can be met if the tax-exempt organization directly contributes money to a foreign corporation, in which case requests must be made to its investment broker for the information necessary to prepare the form. The thresholds can also be met indirectly if the tax-exempt organization holds an interest in a flow-through entity that makes such transfers during the year. If this is the case, filing information will be contained in the supporting statements of the K-1 issued to the exempt organization. Some K-1s present this information specifically allocated to each shareholder. Others require the exempt organization to apply its ownership percentage in the partnership to the transfer amounts in the statements. Moreover, some K-1s may not contain all the necessary information asked for on Form 926, such as dates of transfers, consideration received, or the address of the foreign entity.
Form 8621, Information Return by a Shareholder of a Passive Foreign Investment Company or Qualified Election Fund, is one of the more complicated foreign disclosure forms. Under certain circumstances, this form must be completed by any U.S. person that is a direct or indirect shareholder in a passive foreign investment company (PFIC) or qualified electing fund (QEF). In a vast oversimplification, the purpose of Form 8621 is to track distributions and income from PFICs that otherwise may not be part of taxable income and assess a tax with interest on those amounts (referred to as excess distributions) from the current year. When there is an excess distribution the amount allocated to the current year is added to Line 12 of the organization’s 990-T, increasing gross unrelated business taxable income, with any additional tax and interest owed being added to Line 39. For a more in-depth discussion on Form 8621, PFICs, and excess distributions, refer to our article on Common Misconceptions Regarding Taxability of Foreign Investment Income.
In our experience, the information provided in the K-1 statements specific to this form is even less consistent than is the case for Form 926. Fortunately, tax-exempt organizations are not required to file Form 8621 unless their PFIC distributions stem from unrelated business income (UBI). However, most K-1 statements provide little or no information on what portion, if any, of the distributions relate to UBI. Because of this, a weighted average allocation is typically applied to the distributions. Because the distributions and applicable UBI allocation are to be tracked from the exempt organization’s inception into the PFIC, complicated and very detailed spreadsheets must be maintained. Depending on the exempt-organization’s ownership percentage in the partnership, and the amount of UBI reported on the K-1, these allocations tend to reduce taxable PFIC distributions to relatively small amounts. However, there is no de minimus threshold with Form 8621, making the entire process a lot of work for what typically amounts to relatively little in terms of significance.
Due to these issues, each page of the K-1 must be carefully examined in order to determine reporting requirements, if thresholds are met, or what other information may be needed. Moreover, a closer look at an exempt organization’s directly held investments is needed than otherwise would be required for 990 disclosure purposes. The result of these reporting requirements can be a significantly increased amount of professional time from both an analysis and form preparation standpoint. Organizations with a large number of K-1s or direct foreign activities often have the foreign tax compliance take longer than the preparation of any other part of the Form 990 or 990-PF.
Regrettably, the IRS does not appear to be inclined to back off their foreign information requests in the foreseeable future. Indeed, it is likely that tax-exempt organizations are going to face more reporting requirements down the line. So while owning foreign assets and equities may be an attractive investment opportunity, tax-exempt organizations should be aware that they are not always exempt from the tax compliance associated with these investments. For more information on foreign reporting requirements facing tax-exempt organizations or specific forms contact your BNN tax advisor.