Educational Organization Unitizes Endowment; Unitrust Invests in Endowment Units

Once again, the IRS has ruled that an educational organization that owns an endowment fund and that is also trustee of an unrelated unitrust may unitize its endowment fund, exchange the assets of the unitrust for endowment fund units, and pay a contractual amount to the unitrust with respect to the units the unitrust owns. All without any adverse UBIT consequences to the educational organization or the unitrust. The purpose of such an arrangement is to allow the unitrust to take advantage of the large and well-diversified endowment fund, which earns a higher return than the unitrust can achieve investing on its own.

 PLR 201208038 is the latest ruling concerning a university that manages an endowment fund and also serves as trustee for various unrelated unitrusts. This post points out a few key points raised in the ruling.

 1. Investment Fee Prohibited. Typically, if an exempt organization provides investment services for another party, even another exempt organization, the activity is subject to the UBIT if regularly carried on. Thus, if the university charged the unitrust for its investment of the endowment fund, the fee would be taxable.  For the scenario described in the ruling to work, the university must furnish its services without charge. Because the university does not charge the unitrust for the services, the activity is not considered a trade or business because there is no profit motive.

 The university, in its capacity as trustee of the unitrust, can charge a trustee fee for its investment and other services to the unitrust.

 2. Contractual payments on units held by the unitrust excluded from UBTI. The university endowment fund invests in a range of fairly traditional investments. However, some income earned by the fund may be debt-financed income or otherwise subject to the UBIT. When the university determines an annual payout amount for the endowment, the unitrust receives a pro rata share based on the number of units it holds. The unitrust has no rights in the endowment fund except for the rights to receive contractual payout amounts and to redeem its shares for fair market value. Neither the payments from the fund nor the holding or redemption of the endowment units result in UBTI to the unitrust.

 Under §512(b)(1), dividends, interest, annuities and other specific types of investment income are excluded from unrelated business taxable income. The investment that generates such income is considered a passive activity rather than an active trade or business.The contractual payments made to the unitrust by the endowment fund are not specifically mentioned in §512(b)(1). Under Treas. Reg. §1.512(b)-1(a)(1), however, the exclusion is extended to other income substantially similar to the specified categories from ordinary investments to the extent determined by the Commissioner. The IRS regards the contractual payments on the endowment units to be income substantially similar to the categories expressly mentioned in §512(b)(1).

 The exclusion of the contractual payments is critical to the unitrust. A unitrust is exempt from income taxes so long as it does not have UBTI. If a unitrust has any UBTI whatsoever, all its income is subject to tax. Fortunately, any UBTI in the hands of the endowment fund does not retain its character as UBTI when paid to the unitrust as a contractual payment.

 3. Endowment fund units are capital assets. Although the contractual payments to the unitrust are ordinary income, the units themselves are capital assets. Thus, any redemption of the units by the unitrust will generate long-term or short-term capital gain, depending on the holding period.

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