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Employee benefit plans are holding more alternative investments, or investments without a readily determinable fair value

Alternative Investments Employee Benefit Plan Investment Risk and Tax Considerations

Many plan sponsors are revisiting investment strategies historically employed when making investment decisions. As a result, employee benefit plans are holding more alternative investments, or investments without a readily determinable fair value such as common collective trusts (“CCTs”), pooled separate accounts (“PSAs”), hedge funds and limited partnerships. As long as the plan document allows for such investments, decisions to revise a plan’s investment policy to add alternative investments are appropriate. However, plan sponsors will benefit from considering the following in addition to the investment risk related to alternative investments. 

Investment selection and ongoing due diligence – The criteria for evaluating alternative investments requires expertise that may be historically unavailable to plan sponsors, therefore additional investment advisors may be necessary. Once an investment is made, ongoing due diligence serves to assure that the investment continues to meet the plan’s needs, and this ongoing task varies by investment type.

Supporting documentation – Such investments typically have specific underlying contracts that require signature by plan management. We recommend great prudence when signing such contracts, including careful review of contract terms affecting the plan and the plan sponsor company, and implementing a policy to maintain signed copies. Terms may also include commitments to invest additional amounts in the future.

Liquidity of the investment – Many such investments impose restrictions on the frequency of liquidations, as well as restrictions prohibiting liquidation of the investment for a certain period of time after the initial investment is made. These conditions create challenges, especially in the employee benefit plan area where the priority is to pay benefits when due.

Determination of fair value – Determining the fair value of certain alternative investments, including CCTs, PSAs and hedge funds, is less cumbersome than others as such investments report a net asset value that can be used as a practical expedient to determine fair value. The ability to obtain and transact at the net asset value is especially important for plans requiring an annual financial statement audit. Certain investments operate on a reporting delay, whereby the alternative investment is unable to provide year-end values in a timely fashion and thus plan custodians reporting data on the alternative investment may have values of one to three months prior to the plan’s year-end. This timing can be challenging, as plan reporting on Form 5500 is as of the plan year-end.

Tax considerations of alternative investments – Certain investments may obligate a plan to file tax returns with the Internal Revenue Service (Form 990-T) and possibly certain states in order to relieve possible exposure for unrelated business income tax (“UBIT”). Care should be taken to determine whether there are federal and/or state UBIT liabilities being generated. UBIT generally occurs when the alternative investments have underlying trade or business activities or debt-financed activities. This information is typically reported to the plan by receipt of an annual Schedule K-1, so analysis of these forms is necessary. Additionally, the plan may need to make quarterly estimated tax payments during the year in order to avoid certain penalties.

Plans with direct ownership in foreign investments – In addition, there may be a filing requirement for certain foreign tax forms (including, but not limited to, Form 926 which is filed by way of attachment to Form 990-T, even in cases where Form 990-T may not be applicable) with the Internal Revenue Service. Form 926 is generally required to report certain transfers of tangible or intangible property to a foreign corporation. There is exposure for onerous penalties for any noncompliance with the reporting requirements for current and prior years. Such penalties (for each investment each year) are 10% of the investment’s fair market value at the time of the transfer, limited to $100,000 unless the failure to comply was due to intentional disregard. These filings are often required for investments in many defined benefit plans as more and more plan sponsors are diversifying into foreign investments.

Offshore Voluntary Disclosure Programs – Since 2009, the IRS has offered various programs designed for taxpayers to voluntarily disclose previously unreported foreign income or assets. Two of these programs are the Offshore Voluntary Disclosure Program (“OVDP”) and the Streamlined Filing Compliance Procedure (“SFCP”). Both of these programs provide an opportunity for taxpayers to come forward and disclose unreported foreign income and file informational returns while paying a reduced penalty or no penalty at all. Another program is the Delinquent International Information Return Submission Procedures, which is generally used when there is no additional tax due and the nonfiling of returns were due to reasonable cause. There is no set application deadline for these programs and the IRS can change the terms, increase penalties or decide to end the programs entirely at any time. Thus, plans that can benefit from these programs need to act promptly.

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Marie Arrigo is a Tax Partner and Co-Leader of the Family Office Services Practice for the Personal Wealth Advisors Group which provides tax consulting and compliance services to family offices, individuals, trusts and estates, and closely held businesses.

Diane Wasser is the Partner-in-Charge of the firm’s Pension Services Group. She has more than 20 years of experience providing employee benefit plan audit and consulting services to publicly and privately owned entities across the United States.