Many arts and culture nonprofits with significant endowments are invested in a wide variety of assets. Some, most notably investments in hedge funds, result in the organization receiving a Schedule K-1 in the first few months of a calendar year.
This is an important tax form, particularly if the filing reports any unrelated business taxable income or foreign activities. For finance leaders in arts and culture organizations, understanding how to interpret and report the information on a Schedule K-1 form is vital. Even if your organization is tax-exempt, it may be required to pay Unrelated Business Income Tax on income disclosed on Schedule K-1.
If it’s your first time receiving one of these filings, you may be unsure of how to proceed. In this overview, we summarize the key considerations nonprofit organizations in the arts and culture space should be aware of. Read on as we share how to interpret a Schedule K-1 and detail the best practices that tax-exempt organizations should follow to ensure they remain compliant with all tax regulations.
Schedule K-1 is a tax filing that reports the income, deductions, credits, and adjustments of a flow-through to the entity’s partners or shareholders. It’s issued to partners in a partnership (Form 1065) or shareholders in an S Corporation (Form 1120-S) on an annual basis.
A Schedule K-1 is an annual statement that is the product of an entity’s tax return and summarizes the partner or shareholder’s share of the financial activities the entity engaged in throughout the year. The majority of information on a Schedule K-1 is not relevant to tax-exempt organizations: reporting different classifications or income, deductions, and credits which are considered ordinary to the trade or business of the filing organization. However, nonprofit organizations must determine whether there is any unrelated business taxable income on any Schedule K-1 they receive as this must be captured on their annual Form 990 and 990-T filing.
Investments in hedge funds are a common reason for a nonprofit organization to receive a Schedule K-1. Organizations that do not have a calendar year should take care to report Schedule K-1 income in the appropriate tax year. For example, a nonprofit organization with a June 30, 2022 year-end would generally report 2021 calendar year K-1s on its 2022 tax return, as that is the calendar year ending with or within its own fiscal year.
When scanning Schedule K-1, there are a couple items in particular that finance leaders at a tax-exempt organization should look for. First, they need to confirm the “type of entity” is listed as an “Exempt Org”. Secondly, they need to pay attention to Box 20, Code V. This box reports the unrelated business taxable income related to the tax-exempt organization’s partnership or shareholding in the reporting organization.
If this box contains a value of $0 or is left blank, all an arts and culture nonprofit has to do is file it away with their tax records and retain it according to their organization’s document retention policy. If the box is blank, there may be a statement in the footnotes that says something to the effect of “unrelated business taxable income was considered and nothing applies for this entity”.
However, if there is a value in Box 20, Code V, it must be included in the arts and culture nonprofit’s Form 990-T: the filing that computes the tax an organization owes on its unrelated business income. Form 990-T is organized in silos and any income or losses from Schedule K-1 should be reported in the investment silo. If an organization receives multiple Schedule K-1s, these can be used to offset one another, as well as other investment Unrelated Business Taxable Income. Organizations should consult with their tax advisor to determine how to allocate Schedule K-1 income.
Any unrelated business income reported on Form 990-T should also be included on Form 990, Part VIII, Column C. This discloses the unrelated business income of the tax-exempt organization and should match what is reported on Form 990-T.
The second major issue that arts and culture nonprofits must consider when they receive a Schedule K-1 is whether they have any international reporting obligations. This can occur in scenarios where the arts and culture nonprofit is invested in a US-based domestic partnership which has then invested in a foreign entity.
Organizations are only required to report their share of any international activities. If an arts and culture organization owned a 20% stake in a partnership that transferred $1 million in cash to a foreign entity, it would be required to report a $200,000 transfer. Any cash transfers above $100,000 must be reported. However for non-cash transfers, there are no thresholds.
Common foreign reporting filings include:
When the reporting entity issues the Schedule K-1, it should include footnotes or additional documentation that enable arts and culture nonprofits to understand their reporting requirements. If this information is not included, entities are required to provide it upon request. Organizations should note that information can be presented either in the aggregate or in terms of your organization’s representative share.
The penalties for failure to comply with foreign reporting requirements can be steep: upwards of $10,000 per missed filing. Organizations should clarify filing requirements before committing to an investment and should endeavor to understand the activities of the foreign entity both now and in the future.
Whenever an arts and culture organization invests in a new investment vehicle, it should make a proactive effort to determine what reporting requirements the investment might trigger. This allows organizations to anticipate compliance obligations and ensure that they are well-positioned for a smooth tax filing process.
At Smith + Howard, our nonprofit accounting team has significant experience assisting arts and cultural institutions in understanding their Schedule K-1 obligations. Our skilled professionals work with a diverse range of arts and culture organizations across the nation and bring proven expertise in a wide variety of accounting and tax issues.
To learn more about how Smith + Howard can support your arts and culture nonprofit, contact an advisor.
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