The choice of entity is critical in any investment. This decision is more complicated when one of the investors is a qualified plan described in section 401(a). The choice of entity is critical not only for the traditional reasons, such as management, control, liability, ease of exit strategy, and taxes, but also because of the fiduciary capacity in which the investments are made.
In addition, the tax issues are magnified. It is not merely the marginal difference between ordinary income and capital gains tax rates, but between a fully taxable investment versus tax-exempt income. For pension funds, it is difficult to decide to invest in a taxable transaction. Some pension funds absolutely will not invest in a taxable transaction. It is a religious issue for them and they will not bend. It may be because:
- they believe they have the inalienable right (or obligation) not to pay taxes;
- they refuse to incur the additional expense and aggravation of filing returns;
- they do not want to raise their tax exposure on other aggressive investments; or
- they believe that, as a fiduciary, they should not bear the risk associated with a 15% yield to earn a 10% net return, when they could have invested in a non-taxable 10% investment.
Some tax-exempt entities (other than pension funds) will avoid taxable investments based upon the belief that they may risk their tax-exempt status by engaging in too many non-exempt activities.
Some pension fund investment officers, however, evaluate taxable investments by looking at the net after-tax returns. If the yield is acceptable in light of the risk and the additional expenses associated with the taxes, they will invest. The tax may be paid either by the pension fund or by a taxable entity it owns in whole or in part.
INTRODUCTION TO UBIT
Notwithstanding its general exemption from federal income tax, a tax-exempt organization described in sections 401(a) or 501(c) and exempt from tax under section 501(a), or a state college or university described in section 511(a)(2)(B), will generally be subject to the unrelated business income tax ("UBIT") in any taxable year to the extent that it has unrelated business taxable income ("UBTI"), less corresponding deductions, exceeding $1,000. Pursuant to section 512, such an organization may realize UBTI to the extent that it has income derived from either:
- an "unrelated trade or business", as defined in section 513, carried on either directly by the organization or by any partnership in which it is a partner; or
- "debt-financed" property, under section 514, owned by the organization or any partnership in which it is a partner.
If a partnership carries on a trade or business that would produce UBTI if carried on directly by an exempt organization, the exempt organization will realize UBTI equal to its share of such partnership's gross income from that trade or business (whether or not distributed), less its share of deductions directly connected with that gross income. Section 512(c). Net losses from one taxable activity of the exempt organization or of the partnership may be used to offset net income from other taxable activities; losses from an activity that would have been exempt from tax if profitable, however, normally may not be used to offset UBTI. See Treas. Reg. § 1.512(a)-1.
Any UBIT to which an exempt organization is subject will be imposed at the federal income tax rates applicable to trusts or corporations (depending on the character of the underlying entity). In addition, any tax preference items that constitute part of an exempt organization's UBTI may be subject to minimum tax.
In order to simplify this article, the following discussion will focus on investments by qualified plans. Other exempt entities may have additional concerns relating to their continued qualification for tax-exempt status which are beyond the focus of the mini-program.
Unrelated Trade or Business.
The first category of income subject to UBIT is income derived from an "unrelated trade or business." To constitute an "unrelated trade or business," an activity must be a trade or business regularly carried on by a tax-exempt organization (or by a partnership in which such an organization holds an interest) and not be "substantially related" to the organization's tax-exempt purposes. The determination of what constitutes a "trade or business" and what is "regularly carried on" are often controversial. This is generally not the case, however, for qualified plans because any trade or business is, by statutory definition, an unrelated trade or business for a qualified plan. Section 513(b). The income derived from an unrelated trade or business may still avoid taxation if it falls within one of several applicable exclusions and is not attributable to "debt-financed" property, as discussed below.
Some of the more common types of income qualifying for exclusion include:
- dividends, interest, payments with respect to securities loans, annuities, income from notional principal contracts, and other substantially related income from ordinary and routine investments approved by the Service;
- certain qualifying rents from real property, including rents from personal property leased in connection with real property (provided that the amount of rent attributable to the personal property does not exceed ten percent (10%) of the total rent received under the lease); and
- gains or losses from the sale, exchange or other disposition of property (except for inventory, property held primarily for sale to customers in the ordinary course of the trade or business, and certain recapture items which had previously been used to offset earlier UBTI).
Despite qualification under one of the foregoing exclusions, income may still constitute UBTI if it is derived from "debt-financed" property, i.e., property that is held to produce income and with respect to which "acquisition indebtedness" has been incurred. In general, "acquisition indebtedness" is the unpaid amount of any indebtedness directly or indirectly incurred to acquire or improve the property. This includes:
- indebtedness secured by an existing mortgage or similar lien to which an acquired property is subject; and
- indebtedness incurred after the acquisition which would not have been incurred but for the acquisition or improvement of the property, if the incurrence of such indebtedness was reasonably foreseeable at the time of the acquisition or improvement.
During the period that an acquisition indebtedness is outstanding, a pro rata share of the tax-exempt entity's income from the "debt-financed" property will generally be treated as UBTI based on the ratio of the average outstanding principal balance of such debt over the average basis of the property during the applicable taxable year. In the case of a sale of debt-financed property, the portion treated as debt-financed is based on the highest amount of the acquisition debt outstanding during the twelve months preceding the sale.
Notwithstanding the foregoing, a "qualified organization" (i.e., qualified plans, most colleges and universities, and educational endowments) may incur or assume "acquisition indebtedness" with respect to real property without generating UBTI, provided that certain conditions specified under Code Section 514(c)(9)(the "real property exception") are met. These conditions are discussed by another speaker.
INVESTMENT IN A TAXABLE CORPORATION
A for-profit corporation is the investment entity with which people are most familiar. For most qualified plans, it is generally the preferred vehicle for investing in an active business in which the income would constitute UBTI. What it loses in flexibility, it gains in familiarity and ease of use.
If a tax-exempt entity acquires stock in a taxable corporation, distributions by the corporation generally will be excluded from UBIT either as dividends, returns of capital or capital gains. Gain from the sale of the stock is generally not treated as UBTI. The foregoing assumes that the investment was not made with borrowed funds. However, the underlying corporation will be subject to federal income tax and state and local income and/or franchise taxes.
A qualified plan will often capitalize the corporation partly with stock and partly with debt. Two tax problems can arise if care is not exercised. First, section 512(b)(13) treats certain deductible payments, e.g., interest and rents, as UBTI if received from a controlled corporation. Thus, if a taxable corporation is used, more than 20 percent of the stock should be held by a party not related to the qualified plan.
Second, section 163(j) limits the ability of a related tax-exempt person to strip earnings from a taxable corporation. If the debt-to-equity ratio exceeds 1.5 to 1, and the corporation's interest deductions exceed one-half of the adjusted taxable income (a proxy for cash flow), the deduction for interest paid to the related persons will be disallowed for that year, but may be carried forward. For this purpose, the related person definition is the more encompassing rules of sections 267(b) and 707(b)(1), rather than the 80 percent control definition contained in section 368(c) and used under section 512(b)(13).
INVESTMENT IN PASS-THROUGH ENTITIES
Generally, a tax-exempt organization will invest through a pass-through entity. This minimizes the overall tax burden imposed on the investment. In some situations, however, the tax-exempt entity may layer its investment, owning a separate taxpayer which then invests in the flow-through entity. This structure may be used for non-tax reasons, such as protection from liability or participation in management, or simply to isolate the tax reporting responsibility and preserve the non-UBIT filing status of the investor.
All of the following types of pass-through entities are generally permissible investments for exempt organizations (except as otherwise specifically noted), to be judged under the criteria generally applicable to all investments by the exempt organization. The type of pass-through entity in which an exempt organization invests will significantly affect the UBTI tax consequences faced by the entity.
The limited partnership is one of the most common forms of pass-through investment vehicles used by pension funds and other exempt organizations. The limited partnership offers the maximum flexibility for management, control, and allocation of income and losses, while preserving limited liability for the investor. Under the limited partnership statutes effective in many states, the limited partners can play a fairly active role in the internal management decisions of the partnership, provided they do not act on behalf of the partnership with respect to non-partners.
An exempt organization that is a limited partner in a partnership will be subject to tax on any income derived from the unrelated trade or business activities of the partnership. See Rev. Rul. 79-222, 1979-2 C.B. 236. The exempt organization would be individually responsible for the filing of the UBTI tax returns and the payment of the tax. This includes tax filing and paying obligations in the states in which the partnership is doing business. Any exemptions or exclusions available to a partner will also apply to the partner's income from the partnership.
If the limited partnership is a publicly traded partnership ("PTP"), a tax-exempt partner's allocable share of its income will constitute UBTI regardless of the character of the income. Section 512(c)(2). President Clinton has proposed repealing this provision, treating income from a PTP in the same manner as income from other partnerships. Repeal was also included in H.R. 11 and H.R. 4210 in 1992.
The general partnership is even more flexible than the limited partnership, but is used less frequently by exempt organizations because the partners are jointly and severally liable for the obligations of the partnership. Moreover, each partner has apparent authority, if not actual authority, to act on behalf and bind the partnership. Thus, fiduciaries are reluctant to use a general partnership, except in very limited circumstances where the associated risk can be minimized.
Limited Liability Companies ("LLCs")
LLCs are generally intended to offer investors the limited liability provided by corporations, with the flow-through entity treatment for federal income tax purposes provided by partnerships. LLCs are organized pursuant to articles of organization (like articles of incorporation) and are generally operated pursuant to an operating agreement. The operating agreement (or bylaws) is more like a partnership agreement than corporate bylaws because LLCs have the ability to distribute income and capital in a manner other than in accordance with contributed capital.
Although Wyoming and Florida enacted LLC statutes in 1977 and 1982, respectively, LLCs were not viable until 1988 when the Service issued Rev. Rul. 88-76, 1988-2 C.B. 360, which held that a Wyoming LLC would be classified as a partnership for federal tax purposes. Since then, the IRS has also issued both published rulings (Rev. Rul. 93-5 (Virginia) and Rev. Rul. 93-6 (Colorado)), and private letter rulings classifying LLCs in several other states as partnerships. Eighteen states (including Delaware) have adopted LLC statutes.
Concerns have been expressed that LLCs constitute do-it-yourself integration that will erode the corporate tax base, which has caused the House Ways and Means Subcommittee on Select Revenue Measures to announce hearings on LLCs later this year. Proponents of LLCs, including the Service, state that the usefulness of LLCs is largely limited to situations in which limited partnerships or S corporations might otherwise have been used, rather than C corporations.
Although the LLC may be a useful vehicle in certain situations, its general utility is still quite limited (although growing), primarily because of uncertainties about the limited liability of members in states that do not have LLC statutes. Questions also continue on the management of an LLC and continued tax qualification as a partnership of widely-held LLCs.
LLCs generally have no restrictions on the kind of permissible shareholders and can generally own any kind of asset that a partnership could own. If classified as a partnership, an LLC can hold debt-financed real estate without incurring UBTI as long as it complies with section 514(c)(9). To date, LLCs have been used primarily for venture capital, real estate, start-up enterprises, professional service businesses and family firms. As the law related to LLCs evolves, and more states either adopt LLC statutes or permit the registration of foreign LLCs with limited liability, their use should expand.
A qualified plan is not eligible to be a shareholder of an S corporation. Thus, the S corporation is not a viable investment vehicle for a qualified plan.
Section 501(c)(2) Title Holding Company ("501(c)(2) THC")
Section 501(c)(2) provides an exemption from federal income tax for any corporation organized exclusively for purposes of holding property if the corporation meets certain specified requirements. To qualify for tax-exempt status, the 501(c)(2) THC must:
- Be organized and continue to qualify as a corporation understate law;
- Be organized for the exclusive purpose of holding title to the property and collecting the income therefrom as determined by reference to the corporation's activities, the events surrounding its incorporation, and its articles of incorporation; and
- Turn over the entire amount of its income less expenses to another organization exempt from tax under section 501(a).
The income-receiving organization must additionally exercise some form of control of the 501(c)(2) THC. The Service has taken the position that a 501(c)(2) THC will only qualify as exempt if its distributions of income are to only one or more related tax-exempt entities; multiple unrelated shareholders are not permitted. See GCM 37,351 (December 20, 1977); cf. Rev. Rul. 68-490, 1968-2 C.B. 241; Rev. Rul. 68-371, 1968-2 C.B. 204.
Because a 501(c)(2) THC is not permitted to engage in any business other than holding title to real property and collecting the income therefrom, it generally cannot have UBTI without losing its exemption from tax. See Treas. Reg. § 1.501(c)(2)-1(a). However, a 501(c)(2) THC will not lose its exemption, but will be subject to the tax on UBTI, as a result of any debt-financed income under section 514. Any rent based on income or profits, which thus is not exempt from UBTI under section 512(b)(3)(B)(ii), will also not cause loss of a 501(c)(2) THC's exemption. The 501(c)(2) THC will, however, be subject to tax on the UBTI. Finally, under Treas. Reg. § 1.501(c)(2)-1(a), certain other types of UBTI will not cause a loss of a 501(c)(2) THC's exemption. Any UBTI received by a 501(c)(2) THC would be taxed at regular corporate rates. Section 511(a).
There are three main advantages to investing in a THC:
- First, a THC may insulate the corpus of a pension fund from liabilities arising in connection with the ownership of an investment in property. You should note, however, that efforts may be made to pierce this corporate veil, especially under some of the more recent environmental statutes.
- Second, if UBIT is incurred in connection with an investment, the taxpayer is the THC. Consequently, the controlling pension fund or other exempt organization avoids the administrative difficulties associated with paying the tax itself and submitting tax returns relating thereto.
- Third, if the investment is real estate, use of a THC may prevent the state in which the real property is located from obtaining jurisdiction over the pension plan and its assets.
While pension plans generally can rely on the real property exception to the debt-financed property rules, a 501(c)(2) THC is not eligible for this exception. See section 514(c)(9)(C). Thus, a THC would not be the preferred entity for holding a leveraged real estate investment.
When a 501(c)(2) THC is organized to make a participating mortgage loan or other equity participation arrangement, a risk exists that the income from the investment will not be exempt from tax if the arrangement is recharacterized as a partnership interest and the "partnership" is engaged in an active unrelated trade or business. If that occurs, the corporation will not qualify as a 501(c)(2) THC and will be treated instead as a taxable corporation.
Section 501(c)(25) Title-Holding Corporations or Trusts ("501(c)(25) THC")
Under section 501(c)(25), a corporation or trust will be exempt from tax if it is established exclusively for the purpose of acquiring and holding title to real property and remitting the income from the property to one or more exempt organizations.
To qualify for exemption, the corporation or trust must meet the following requirements:
- It must have no more than 35 shareholders or beneficiaries and only one class of beneficial interest;
- It must be organized exclusively to hold title to real property;
- The income from the real property must be collected and remitted to one or more shareholders or beneficiaries that are tax-exempt under section 401(a), 501(c)(3), 414(d), or 501(c)(25);
- The shareholders or beneficiaries must be permitted by majority vote to terminate the employment of the investment advisor; and
- The shareholders or beneficiaries must be allowed to terminate their interest in the entity by either selling or exchanging their interest or by redeeming their interest.
Like a 501(c)(2) THC, a 501(c)(25) THC will lose its exemption if it has any UBTI, other than debt-financed income. Unlike a 501(c)(2) THC, a 501(c)(25) THC is a qualified organization for purposes of the real property exception to the debt-financed income rules under section 514(c)(9). For this purpose, however, the 501(c)(25) THC is a flow-through entity and shareholders who are not able to take advantage of the real property exception on directly-owned, leveraged property will have debt-financed income.
A 501(c)(25) THC may only hold real property directly. Any interests held indirectly, as a tenant in common, or in a partnership or trust would cause the entity to lose its exemption. Incidental personal property may be held, provided the rent attributable to the personal property does not exceed 15 percent of the total rent from the property. President Clinton has reproposed provisions contained in both H.R. 11 and H.R. 4210 last year that would subject a 501(c)(2) and 501(c)(25) THC to UBIT if it has UBTI that is incidentally derived from the holding of real property, rather than treating the corporation as a fully taxable corporation, provided that the gross UBTI does not exceed 10 percent of the corporation's gross income.
Qualified retirement plans and individual retirement accounts may pool their assets in a group trust without affecting the exempt status of the separate trusts. See Rev. Rul. 81-100, 1981-1 C.B. 326. Rev. Rul. 81-100 sets forth the following requirements for qualification as a group trust:
- The group trust must be adopted by each participating plan;
- The group trust instrument must expressly provide that only qualified plans and individual retirement accounts may participate;
- The assignment by a participating plan of its interest must expressly be prohibited;
- The trust's assets must expressly be prohibited from being diverted other than for the exclusive benefit of plan participants or their beneficiaries; and
- The group trust must be a U.S. trust, operated solely within the United States.
Section 401(a)(24) amended Rev. Rul. 81-100 to permit governmental plans described in section 818(a)(6) to participate in group trusts.
The UBTI provisions apply to group trusts as if the group trust was an individual qualified plan. The group trust files its own UBTI tax return and pays the tax itself; any UBTI and UBIT liability do not flow through the participating plans.
The assets of a group trust are plan assets under ERISA.
Insurance Company Separate Accounts
A life insurance company separate account is a segregated asset account of the life insurance company. The assets are segregated from the general assets of the company and are intended to be available only to the contract holders of the account and not to general creditors of the insurance company. The return to the investor is limited to the performance of the assets underlying the account.
In general, a life insurance company computes its net income by deducting from income any increase in its reserves and including in income any decrease in its reserves. Under section 817, the amount of life insurance reserves for pension plan variable annuity contracts with no guaranteed minimum return is generally equal to the net surrender value of a contract. For this purpose, the net surrender value is deemed to be an amount equal to the balance in the policyholder's fund, i.e., the asset share allocable to the contract. The reserves are adjusted annually by any increase or decrease in the value of the underlying assets, regardless of whether the assets are in fact disposed of during the taxable year. The company's basis in the assets underlying all variable contracts will also be adjusted for appreciation and depreciation, to the extent that reserves are adjusted. Thus, for the insurance company, corporate level capital gains and losses are eliminated. The net effect of the foregoing is that an insurance company's income or loss from a separate account with no guaranteed minimum return is generally eliminated to the extent of appreciation or depreciation in the underlying assets, although any income or loss from guarantees of a minimum return or underwriting income or loss will be included in determining the insurance company's tax liability. Since the contract holders' contracts will be based solely on the performance of the underlying assets, however, the performance of the underlying assets generally will be free of tax at both the insurance company and investor level, regardless of the character or source of the income.
Although the Treasury has authority to impose diversification standards on the investment of assets in separate accounts, these rules do not apply to pension plan contracts because Congress did not want insurance companies to be at a competitive disadvantage in managing qualified pension plan assets. Congress did, however, authorize Treasury to issue regulations applying the principles of section 514(c)(9) to separate accounts, but (according to the Conference Committee report) only if such regulations are prospective in application. No such regulations have been issued to date. Moreover, the regulatory authority does not extend to the application of the UBTI rules other than those applicable to debt-financed investments; e.g., income from the conduct of an active trade or business would not be affected. Thus, the income received by a qualified plan from such a pension plan contract is currently exempt from federal income tax, including UBIT.
The foregoing rules for separate accounts apply only if the insurance company is treated as the owner of the assets for federal income tax purposes. In a series of rulings in the early 1980s involving wraparound annuities and bank accounts, the Service and one court have concluded that the policyholder, rather the insurance company, will be treated as the owner of the assets in a separate account underlying investment annuity contracts if the policyholder controls the investment. If the insurance company manages the investment and the investment is not available except by the purchase of the annuity contract, however, the Service has taken the position that the insurance company will be treated as the owner of the assets.
These rulings all involved separate accounts which predate the diversification requirements enacted in 1984 as section 817(h), and Treas. Regs. § 1.817.5 promulgated thereunder. Pension plan contracts, however, are not subject to the diversification rules. Section 817(h). Nonetheless, there is some uncertainty as to whether the wraparound rulings apply to pension plan contracts.
Real Estate Investment Trusts ("REITs")
A REIT is a flow-through entity that is analogous to a regulated investment company or mutual fund for real estate. Any distributions made by a REIT out of its earnings and profits will be treated as a dividend under section 316 and thus will be excluded from UBTI. Rev. Rul. 66-106, 1966-1 C.B. 151. Moreover, the tax on UBTI is not imposed on a REIT's undistributed income because such amounts are taxable at corporate rates, regardless of the nature of their income. See Treas. Reg. § 1.857-1.
REITS are subject to a number of requirements relating to the distribution of virtually all of their taxable income, which is not identical to their cash flow, due largely to depreciation. In addition, a number of restrictions apply to the classes of assets that may be held by a REIT and the type of income and activities of the entity.
Finally, strict ownership rules apply to REITs. The REIT must have no fewer than 100 beneficial owners, and no more than 50 percent of the shares may be held by five or fewer persons (the "5 and 50 rule"). For purposes of the 5 and 50 rule, a domestic qualified plan is treated as a single person, whereas a foreign pension plan is treated as a pass-through entity. Generally, a public plan would also be treated as a pass-through entity, but questions arise if it also has qualified under section 401(a). H.R. 4210 and H.R. 11 would have amended the 5 and 50 rule to treat qualified plans as pass through entities, provided that if a REIT violated the old 5 and 50 rule solely because of this change, and either one plan holds more than 25 percent of the REIT shares or more than 50 percent of the shares are held by five or fewer shareholders, each of which owns more than 10 percent of the shares, the REIT would not be disqualified but any plan with more than a 10 percent interest would be subject to UBIT on the underlying income of the REIT if the income would have been UBTI if the REIT was a partnership.
REITs have become very attractive to pension funds in recent years. Publicly-traded REITs offer the liquidity that other arrangements to invest in real estate lack. This simplifies valuation issues and exit strategies.
Investment as a Creditor
When a property is likely to generate income or gains that would be treated as UBTI, a loan may be preferable to a direct equity investment because interest income on a debt investment is generally exempt from UBTI. Moreover, the assets of the debtor will not constitute a plan asset under ERISA if the loan is respected. A loan, however, may be contrary to the investment objectives of the qualified plan unless it provides for participation in the underlying property's income or appreciation.
Through one form or another, equity participation arrangements allow the "lending" exempt organization to participate in the borrowing venture's future income or property appreciation. In exchange, the lender typically agrees to make the loan at a lower fixed interest rate than it otherwise would accept. These arrangements may include:
- A participating mortgage loan. This is a traditional fixed interest rate mortgage combined with an equity kicker. The equity kicker may take the form of a net or gross percentage of receipts, cash flow, profits or appreciation. Both the fixed and contingent interest elements should have priority over equity claims by the borrower;
- A conversion or option right. Here the lending exempt organization is granted an option to convert the loan into an equity interest in the borrowing venture. In contrast to the typical participating mortgage loan, the lender may eventually become a full partner in the venture rather than just a participant in the venture's profits or revenues;
- A participating ground lease. In this situation, the lending entity buys the property on which the project is to be built and leases it to the borrowing entity in exchange for a fixed rental plus a contingent amount based on the project's revenues or its income. In addition, the lender usually makes a fixed-rate permanent or construction loan to finance the project; and
- An equity interest coupled with another of the methods. This last common method of equity participation financing is to combine the grant of an equity interest in the venture with one of the above-mentioned forms. For example, a full equity interest could be granted to a lender along with a fixed-rate mortgage.
Because of their hybrid nature and their similar results, each of these equity participation arrangements may be recharacterized by the Service or the courts as another of the structures, or wholly as equity, with different attendant tax consequences. To determine whether an investment, or a portion thereof, should be classified as debt, the courts look to the intent of the parties as objectively manifested by their acts. This area of the law is like pornography; the courts profess to know it when they see it. They announce long laundry lists of factors that are closely scrutinized and then announce a result based on weighing all of the factors, providing little real guidance as to how they arrived at their solution.
The courts' or the Service's recharacterization as equity of an instrument structured as debt may have adverse consequences to an exempt entity which thought it was a lender. If the "debtor" is actively engaged in a trade or business, the tax-exempt entity may have substantial UBTI and the corresponding tax liability.