Seeking greater investment yields and rates of return than currently offered by conventional Wall Street equities and bonds, many private foundations and other tax-exempt organizations with significant endowments are frequently choosing alternative investments for their typically higher performance. Some of these investments originate from outside the United States. Although the net investment results of foreign investments, or domestic investments with foreign operations, can appear promising, they may come with onerous and complex U.S. tax reporting responsibilities. An investor’s failure to be aware of and comply with these rules could lead to costly IRS fines.
Rules for foreign investment have tightened
Alternative investments — both domestic and foreign — generally are complex, limited in regulation and relatively illiquid; they include hedge funds, managed futures, real estate, commodities and derivatives contracts. To complicate things further, many investors use a pass-through type of entity, such as a limited partnership (LP) or an alternative investment LP, to hold the investment, which allows for income, loss, credits or other tax obligations to pass through to the investor. The current demand for alternative investments is prompting investment managers to seek opportunities offshore. It is common to use a foreign equivalent of a pass-through entity as the principal investment vehicle for these offshore opportunities.
With the two stated purposes of combating tax evasion through investments outside the country and assisting in tracking the flow of funds for suspected terrorist activities, Congress enacted legislation and Treasury regulations to deal with these issues. To avoid noncompliance with these new rules and significant penalties, private foundations must become savvier about specific tax regulations, including U.S. Foreign Investment Disclosure Rules (USFID) and the U.S. Foreign Account Tax Compliance Act (FATCA).
Penalties for noncompliance with these filing requirements far exceed those for not filing your organization’s Form 990-PF or Form 990-T.
Ignorance will be no excuse
As in all tax obligations, lack of knowing about the rules does not excuse noncompliance. Many private foundations are unaware of these new reporting responsibilities; the “tax buyer beware” sign was lost in the fine print of the investment prospectus. Investors must gain an education about USFID and FATCA rules. The following can serve as a primer.
These rules generally require the reporting of property transferred as an investment of $100,000 or more, in one year, to a foreign corporation, partnership or trust. Accordingly, if a tax-exempt organization makes an investment of $100,000 or more within a one-year period, either directly or through a domestic or foreign investment LP, the organization is required to report the asset transfer on IRS-designated forms. The penalty for not reporting this transaction is typically 10% of the investment’s fair market value at the time of the transfer, with a penalty limit of $100,000, unless there was evidence of intentional disregard for the rules. In that case, the penalty is possible criminal charges.
USFID rules also require an additional U.S. disclosure form if the investor owns 10% or more of a foreign corporation. This is a common occurrence for foreign captive insurance companies, as tax-exempt organizations often have a 10% or more ownership interest. Further, USFID rules require special reporting if a tax-exempt organization has operations in countries designated by the U.S. government as “boycotting countries.” In both instances, failure to file disclosure of these types of activities will lead to severe monetary penalties, as well as possible criminal charges.
These rules apply to foreign entities and institutions that hold the investments of U.S. investors, including tax-exempt organizations, such as an exempt organization’s ownership of a foreign bank or brokerage account. FATCA rules require that foreign financial institutions (FFIs) register with the IRS and agree to report specific information about their U.S. accounts, including those of certain foreign entities with substantial U.S. ownership. This concerns tax-exempt organizations with significant investments; an FFI’s noncompliance can subject payments made by the FFI to its U.S. investors to a 30% withholding tax — which is likely to have a negative effect on the expected investment results. Compliance with FATCA rules is in addition to compliance with USFID rules.
Take corrective, preventive steps
If you think there is an error in your organization’s reporting, look into the IRS voluntary compliance program, which can help your organization eliminate the prior-year penalty exposure to USFID rules. The program could be terminated by the IRS in the future, so if you have previously unreported transactions or investments, you would be wise to not delay.
Take these steps in assuring compliance with USFID and FATCA reporting:
Gain a solid understanding of your organization’s investments and corresponding strategy for your alternative investments, especially those held offshore.
Create a team of representatives from your organization’s investment function, finance/tax function, external investment advisers, and external tax advisers; together they should address current tax issues and cure existing (prior-year) issues, and establish guidelines to ensure compliance with USFID and FATCA rules going forward.
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