With today’s economic uncertainty, businesses, including nonprofit organizations, are increasingly considering the use of alternative investments. But these investments can have unexpected tax implications for nonprofits. Here’s what you need to know before your organization moves ahead.

The basics

The term “alternative investment” stands in contrast to more traditional investment vehicles for nonprofits, such as stocks, bonds and mutual funds. Alternative investments generally don’t have an easily ascertained fair market value. Examples include hedge funds, private equity, real estate, venture capital and cryptocurrency investments.

Alternative investments are appealing largely because their long-term performance can be greater than those of traditional securities. They may provide investors with access to high-growth companies in cutting-edge industries and often are less vulnerable to financial market swings. However, because alternative investments may be illiquid, investors typically can’t easily cash out or shift their allocations. This can be a substantial risk to a nonprofit without other sources of available operating capital. The complex nature of such assets also increases risk to the investor, which is why returns may be higher. For instance, cash paid into a venture capital fund could be lost if that new business investment isn’t successful.

Form and management

Alternative investment funds generally are formed as partnerships or limited liability companies (LLCs). Both are types of pass-through entities, meaning the income and the tax liability pass through to the investors, who are considered partners or members.

Alternative investments may provide investors with access to high-growth companies in cutting-edge industries and usually are less vulnerable to financial market swings.

Manager selection is crucial – you want someone with a proven track record and access to the best investments. Nonprofits must pay attention to management fees. In addition to a base management fee (generally about 1.5% to 2% of the fund’s capital or net asset value), managers generally charge performance-based fees known as carried interest. These fees can reach as high as 20% or more of an alternative investment’s profits.

Tax matters

Although investment income (for example, dividends, gains and interest) typically is excluded from taxable unrelated business income (UBI), investors in partnerships or LLCs are treated as if they’re conducting that entity’s business. As a result, their distributions of income may be treated as taxable UBI.

In addition, UBI includes unrelated debt-financed income from investment property in proportion to the debt acquired to purchase it. The IRS defines debt-financed property as any property held to produce income (including gain from its disposition) for which there’s an acquisition indebtedness. In other words, if you used financing to invest in a fund — or, if the fund financed the purchase of an income-producing asset — some of the associated income may be taxable. Pass-through entities report each partner’s or member’s share of income, dividends, losses, deductions and credits on IRS Schedule K-1. Nonprofits can use the schedule to determine if they’ve received UBI income that must be reported on their Form 990-T. State taxes may also apply.

UBI could be included on the form in the boxes for ordinary income, net rental real estate income or other income, as well as in the footnotes. But it may not appear anywhere on the form or footnotes, especially if the income is derived from debt-financed property.

Tread carefully

Your organization must consider its objectives, shortand long-term needs, and the trade-offs (including loss of your original investment) the organization is willing to accept before venturing into alternative investments. We can help you evaluate whether alternative investments may be right for you.