Navigating uncharted not-for-profit tax territories
The not-for-profit industry experienced tremendous change as a result of the COVID-19 pandemic.
With this in mind, Baker Tilly’s Larry Mohr and Shelby Netz recently co-hosted a presentation, “Navigating uncharted tax territories,” as part of the 2021 CACUBO Annual Meeting. Baker Tilly’s presentation focused on the tax-related ramifications of the pandemic facing higher education institutions and other not-for-profit organizations.
In response to Baker Tilly’s question at the opening of the session, most of the participants acknowledged that the pandemic affected their tax compliance process to some degree. The most prevalent of their concerns included experiencing IRS delays (i.e., it has been quite difficult to contact the IRS during the pandemic) and receiving erroneous notices (i.e., this has been a headache for not-for-profit organizations).
Between these specific items, the general impact of the pandemic, recent and proposed tax legislation, and other recently issued guidance, there are quite a few layers of issues challenging not-for-profit organizations.
Key tax legislative changes
Several pieces of notable tax legislation passed over the last two years, and multiple tax legislation proposals may be passed in the near future. Here are some examples that fall into each category.
- Taxpayer First Act (2019) – mandatory electronic filing for Forms 990, 990-PF and 990-T
- Coronavirus Aid, Relief and Economic Security (CARES) Act (2020) – provided emergency relief to higher education institutions, the Paycheck Protection Program and employee retention credit (ERC)
- American Families Plan (changed and merged into the Build Back Better (BBB) Act) – the proposed BBB Act currently excludes the provision for two years of free community college, but increases the maximum Pell Grant available per year
- Accelerating Charitable Efforts Act (proposed) – would change distribution rules for private foundations and donor-advised funds to accelerate distributions from these entities to “working” not-for-profit organizations
- Infrastructure Investment and Jobs Act (2021) – terminates the ERC as of Sept. 30, 2021, and provides for new reporting requirements for digital assets (e.g., cryptocurrency)
Unrelated business income: separation of activities
During the 2020 fiscal year, the IRS collected almost $1 billion in unrelated business income (UBI) taxes. However, the recent changes to UBI could send even more money into the pockets of the IRS in the near future.
UBI is commonly defined as a trade or business that an organization regularly carries on, but is not substantially related to the organization’s tax-exempt purpose. Some common activities for not-for-profits include:
- Advertising
- Parking lot rental
- Rental of debt-financed real property
- Certain sales of goods or services
- Alternative investments
If any of these UBI activities generate more than $1,000 in gross income, the organization is required to file a federal Form 990-T, Exempt Organization Business Income Tax Return, and potentially a state-equivalent UBI tax return as well.
Organizations have been required to separately track these unrelated business activities since the Tax Cuts and Jobs Act was passed in late 2017. Before that, revenues and expenses from UBI activities could be aggregated on the Form 990-T. But now, organizations must file a separate schedule to report revenues and expenses for each of their UBI-producing activities.
It is important to note that losses from one activity incurred after the effective date of the legislation cannot be used to offset income from a separate activity. Losses from each activity must be carried forward and can only offset future income from the same activity.
Another key question is: How are activities classified and reported? There are two primary ways:
- Direct activity: an activity that an organization does directly through its operations
- Indirect activity: an activity conducted through an organization’s investment activity
Understanding the difference will help you separate your organization’s activities. Taking the time to do that correctly now will save time, energy and money in the future.
Alternative investment reporting issues
You may be wondering, what exactly is an alternative investment? Alternative investments are investments for which a readily determinable fair market value does not exist and can include hedge funds, private equity funds, real estate funds and offshore investment vehicles.
While alternative investments can provide substantial investment returns for a not-for-profit organization, there are some important considerations to note. Organizations should work with their investment managers to make sure they’re getting all the available information, not only with those funds treated as partnerships that issue a Schedule K-1, but any type of alternative investment the organization owns.
It is important to ask questions, such as:
- Is this investment domestic or foreign?
- If it’s foreign, were there capital transfers made to the fund?
- Is the investment taxed as a partnership, trust or corporation for U.S. or foreign tax purposes? Will there be a federal Schedule K-1 issued?
- Is there a Private Placement Memorandum or the equivalent?
- Was debt incurred to acquire the investment?
- What is the organization’s ownership percentage of the alternative investment?
If an alternative investment is taxed as a domestic partnership, your organization will receive a Schedule K-1 reporting your organization’s proportionate share of the income generated by the alternative investment. The next question is whether any of the income reported on the Schedule K-1 needs to be included as income on the Form 990-T. The answer really depends on the investment activities of the partnership and will need to be determined on a case-by-case basis.
Meanwhile, three boxes on the Schedule K-1 are particularly important:
- Box 1: Ordinary income: This box reports income from an operating trade or business, which may constitute UBI for your organization.
- Box 2: Net rental real estate income: This box reports rental income from real estate activity. This may result in UBI if the property has acquisition indebtedness.
- Box 20 Code V unrelated business income: This box reports the amount of UBI the partnership generated during the year. Sometimes it will simply indicate whether there’s additional UBI information in the Schedule K-1 attachments.
- Footnotes: This is where most of the information is located and, yes, the devil is in the details. There can be many pages of footnotes, including critical details surrounding UBI and other tax items, that you may need to disclose with your Form 990-T. It is important to note that if debt is incurred to purchase the investment, the investment is considered debt-financed property; any income generated from the investment may be taxed as UBI, regardless of the UBI footnotes on the Schedule K-1.
Leading practices and common questions
In continuing to address the needs and concerns of not-for-profit organizations, Larry and Shelby examined four common questions surrounding the filing of alternative investments.
First and foremost, it is important to establish a tracking system for all new and existing K-1 and capital transfers. You should keep an organized, written list of all investments that you own, both foreign and domestic. As part of this list, track the name, how much ownership you have and any capital transfers. Due to various funds’ different year-ends (and, thus, different deadlines), it is important to be organized and consistent.
Additionally, you should sum or monitor the following information as part of your K-1 tracking system on an annual basis: federal UBI, state UBI, capital transfers made to foreign entities (see Question No. 3 below), and ownership in each direct or indirect investment. Last, but not least, make sure to always read the footnotes (or engage an accounting or law firm to assist).
If an organization has a tax return filing requirement in a state due to income generated via alternative investments, the technical answer is yes, the organization should file the state equivalent of the Form 990-T or income tax return in those states. Of course, every organization is free to make its own “business decision” whether or not to file a return in a state after weighing the risk (penalties, etc.) and benefits of filing or not filing in each state.
With this in mind, it is important to know that:
- Domestic partnerships generally provide either state K-1s or a summary of state-sourced UBI along with the federal K-1
- Each state has its own requirements and nexus thresholds for income tax filing
- There are some states where UBI is not taxed, e.g., Delaware, Kentucky, New Jersey, Nevada, Pennsylvania and Texas
When organizations invest in foreign entities either directly or indirectly through a domestic investment such as a partnership, there are certain international forms that may be required depending on the amount of cash or other property transferred in exchange for ownership or the amount of ownership maintained as a result of the transfer(s). Common forms include, but are not limited to:
- Form 926, Return by a U.S. Transferor of Property to a Foreign Corporation
- Form 8865, Return of U.S. Persons with Respect to Certain Foreign Partnerships
- Form 8621, Information Return by a Shareholder of a Passive Foreign Investment Company or Qualified Electing Fund
- Form 5471, Information Return of U.S. Persons with Respect to Certain Foreign Corporations
- Form 8858, Information Return of U.S. Persons with Respect to Foreign Disregarded Entities and Foreign Branches
- Form FinCEN 114, Report of Foreign Bank and Financial Accounts
While these forms are informational in nature, the penalties for nonfiling or late filing can be significant. For example, failure to file a Form 5471 or Form 8865 on time can result in a $10,000 penalty per information form, up to a maximum of $60,000 per return. Separately, the omission of certain international informational forms could potentially implicate an open statute of limitations for the filer’s broader tax return filing (not just for the missed form itself) for the affected period(s).
The primary reasons for failing to file the forms are due to the disclosures being buried in the Schedule K-1 footnotes or the complex filing requirements not properly understood by the recipient of the K-1. To add to that complexity, there are new Schedules K-2 (extension of Schedule K used to report items of international tax relevance from the operation of a partnership) and K-3 (extension of Schedule K-1 used to report to partners their share of the items reported on Schedule K-2) to be completed by affected partnerships starting with their respective tax years beginning January 1, 2021 or later for which additional disclosure (and perhaps complexity) might be anticipated for recipients of that new Schedule K-3.
If you’re just realizing that you have not sufficiently examined the footnotes and/or you may not have filed the proper foreign forms (either this year or in years past), there may be some relief before these penalties are imposed. The relief is generally reserved for those organizations who have not yet been notified by the IRS of the filing delinquency.
The IRS offers delinquent international information return submission procedures to allow organizations to come forward to the IRS and file the late information returns. We highly recommend seeking assistance from your accounting firm or legal counsel to submit forms under these procedures to ensure proper compliance.
Obviously, the pandemic has thrown virtually everything we know into chaos, and there certainly are tax compliance challenges that have come about in the last 1 ½ years. For instance:
- Collecting and organizing data – It’s been more difficult to collect and organize data due to the inability to work or gather information in person, and there is a continued emphasis on the security protocols in place to keep the information protected.
- Paper-filing tax returns and collecting signatures – The IRS granted permission to use electronic signatures for certain income and informational forms this year, but that might change in the future.
- IRS assistance and processing, including IRS or state audits – As noted earlier, processing times are slow and responses to letters are slow; it takes persistence to reach the IRS these days — and that’s not going to change anytime soon.
- Remote employees – With the widespread use of work-from-home employees, we have seen a rise in out-of-state employees. And because each state has its own reporting requirements with payroll, nexus, and sales and use tax, that can add a complicating layer to it all.
The information provided here is of a general nature and is not intended to address the specific circumstances of any individual or entity. In specific circumstances, the services of a professional should be sought. Tax information, if any, contained in this communication was not intended or written to be used by any person for the purpose of avoiding penalties, nor should such information be construed as an opinion upon which any person may rely. The intended recipients of this communication and any attachments are not subject to any limitation on the disclosure of the tax treatment or tax structure of any transaction or matter that is the subject of this communication and any attachments.
