In a letter, dated April 11, 2012, to IRS Commissioner Shulman, the ABA Section on Taxation requested additional guidance concerning the application of the debt-financed income rules when an exempt organization borrows funds to conduct charitable programs or pay administrative expenses either before or after purchasing investment property. The Section on Taxation proposed examples that illustrate how the debt-financed income rules apply in four contemporary fact settings.

 Acquisition Indebtedness Defined

 Under §514, acquisition indebtedness is:

•  Debt incurred to acquire or improve property;
• Debt incurred before the acquisition or improvement of property, if the debt would not have been incurred but for the acquisition or improvement; or
• Debt incurred after the acquisition or improvement of property if the debt would not have been incurred but for the acquisition or improvement and incurring the debt was reasonably foreseeable at the time of the acquisition or improvement.

 Thus, the scope of acquisition indebtedness is not limited to debt acquired simultaneously with an asset purchase, such as with a purchase money mortgage. Indebtedness incurred before or after the acquisition of an asset may be treated as acquisition indebtedness with respect to the asset if certain conditions are present. The applicable rules depend on whether the debt is incurred before or after the asset is acquired.

 When debt is incurred before the acquisition of investment property, a “but for” test is applied. The indebtedness is acquisition indebtedness if the debt would not have been incurred but for the purchase of the property. When debt is incurred subsequent to a property acquisition, there is a two-fold test. The first part of the test is the same “but for” test applied when debt is incurred before the acquisition. The second part of the test asks whether having to incur the debt was reasonably foreseeable at the time of the purchase. These rules prevent exempt organizations from circumventing the debt-financed income rules by artificially timing incurrence of debt either before or after the acquisition of property.

 Debt Incurred Before Property Acquisition

 Reg. §1.514(c)-1(a)(2), Example (1) illustrates acquisition indebtedness incurred prior to the acquisition of investment property. An exempt organization pledges investment assets to secure a loan. Subsequently, the organization uses the borrowed funds to purchase property with a nonexempt use. The organization would not have borrowed the money but for the acquisition of the property. Thus, the loan is acquisition indebtedness and the purchased property is debt-financed property.

 Compare the foregoing example with an example proposed by the Section on Taxation:

 A an exempt school holds $ Z in money market funds in addition to the amount of working capital necessary to continue current operations. The organization needs approximately $ Z to construct a new classroom building. The current interest rates are quite low, and a lender is willing to provide a construction loan that will ultimately be converted into long-term loans secured by the new classroom building. Rather than using the $ Z in its money market funds, the organization decides to take out a construction loan, secured by a general pledge of its assets, to finance the construction of its new building. After taking out the loan and beginning the project, the organization is presented with an attractive investment opportunity that it did not foresee at the time of the borrowing, and it decides to use funds from the money market account to make that investment.

 The Section of Taxation correctly distinguishes its example from Example (1) of Reg. §1.514(c)-1(a)(2). In the example from the regulations, the exempt organization secures a loan but does nothing with the loan proceeds until it purchases the new nonexempt property. We are given no reason why the organization would borrow funds other than to make the subsequent purchase. The organization would not have borrowed the funds but for the purchase of the new property. In contrast, the ABA example gives the exempt organization an independent reason for financing the new classroom facility. Given the current interest rates, it makes business sense to finance the building rather than use the money market funds for the construction. The organization would have borrowed the funds even if the subsequent investment opportunity had not surfaced. Thus, there is no “but for” connection between the loan and the investment.

 Debt Incurred After Property Acquisition

 Example (2) of Reg. §1.514(c)-1(a)(2) illustrates acquisition indebtedness incurred after the acquisition of investment property. An exempt scientific organization used its working capital to remodel an office building which the organization leases for a nonexempt use. Subsequently, the organization mortgages its laboratory to replace the funds it used to remodel the building. Because the mortgage is on exempt use property, the organization may feel like the debt is not acquisition indebtedness. Under the two-fold rule discussed above, however, the organization would not have mortgaged its lab but for the remodel of the office building. Moreover, because the organization used its working capital to remodel the building, it was reasonably foreseeable that it would have to incur debt in order to fund its charitable programs. Thus, the mortgage is acquisition indebtedness with respect to the office building.

 In contrast, the Section of Taxation proposes the following scenario:

 A charitable organization traditionally makes grants of $ X each year and funds those grants from interest, dividends, and capital gains on its investments. Due to increased need among the charitable class the organization serves, it decides to increase its grantmaking. In a particular year, interest, dividends and capital gains are insufficient to enable the organization to increase its grants and pay its administrative expenses. The Trustees reasonably determine that it would not be advantageous to liquidate any of the organization’s various investments at this time. On that basis, the Trustees decide to fund the organization’s grants and administrative expenses by borrowing from a line of credit secured by the organization’s existing investments. When the investments were purchased, the organization did not anticipate that it would later need to increase its grants at a time when its income was insufficient to fund its programs and when it was also reasonable to hold its investments rather than to liquidate them. Accordingly, any income from the existing investments will not generate UBIT solely because of the funds borrowed under the line of credit.

 Once again, the example proposed by the Section of Taxation is distinguishable from the example in the regulations. In Example (2) of Regs. §1.514(c)-1(a)(2), the organization knew it would have to borrow funds for its charitable activities when it used working capital to renovate a nonexempt use building. In contrast, in the Section on Taxation example, the organization anticipated its charitable giving levels would remain consistent when it purchased the investments. Due to the recession, however, the needs of the beneficiaries it served increased, causing it to need more than anticipated in its exempt activities. It was the increased need, rather than the earlier purchase of the investments, that motivated the borrowing. Although the organization could have sold the investments rather than borrowing, it was advised not to sell the investments at a depressed value. Thus, neither part of the two-part test for later borrowing is satisfied. It was not the existing investments that motivated the organization to borrow funds for its charitable activities. Moreover, when the organization purchased the investments, it was not reasonably foreseeable that a need would later arise to step up its grantmaking.

 Conclusion

 The letter from the Section of Taxation to the Commissioner Shulman raises some practical factual settings that exempt organizations may be facing currently. The examples proposed in the letter are well thought out and consistent with the language of §514 and the examples in Reg. §1.514(c)-1(a)(2). If adopted by the IRS, the examples would be helpful to exempt organizations in the conduct of their exempt activities and investments.

 §512(a)(3)(E). Unrelated business taxable income for social clubs, VEBAs, and SUBs is calculated differently than for most other exempt organizations. The special rules are contained in §512(a)(3). All income of a social club, VEBA, or SUB is taxable except exempt function income. Exempt function income has two components.  First, member contributions to a social club, VEBA, or SUB are exempt function income. The second component of exempt function income includes is income set aside for charitable purposes. For VEBAs and SUBs, the second component also includes amounts set aside to provide for the payment of life, sick, accident, or other benefits; provided, however, that the amount set aside for payment of benefits is exempt function income only to the extent that the amount does not exceed the qualified asset account limit under §419A. The qualified asset account limit is the amount reasonably and actuarially necessary to fund claims incurred but unpaid at the close of the taxable year for member benefits, plus administrative costs with respect to such claims.

 Comment: The difference between the two components of exempt function income is noteworthy. The first component is income in the traditional sense in that it is received from members and employers to pay for benefits and administration. The second component pertains to other income, such as investment income, but the amount included as exempt function is determined not with reference to the amount received but rather is limited to amounts set aside for the specified purposes, subject to the §419A limit (not taking into account any permitted reserve to fund post-retirement medical benefits).

 Prior to the Deficit Reduction Act of 1984, exempt function income of a VEBA or SUB included all amounts set aside for charitable purposes and for the payment of benefits. The 1984 Act added §512(a)(3)(E), which is the §419A limitation, to prevent VEBAs and SUBs from accumulating excessive non-taxed investment income in a set aside account.

 Treas. Reg. §1.512(a)-5T, issued in 1986, explains the application of §512(a)(3)(E). According to the regulation, UBTI of a VEBA or SUB is generally the lesser of:

•  the income of the VEBA or SUB for the taxable year (excluding member contributions); or
• the excess of the total amount set aside as of the close of the taxable year (including member contributions) over the qualified asset account limit (calculated without regard to the otherwise permitted reserve for post-retirement medical benefits) for the taxable year.

 Case Law. The computation of UBTI for VEBAs was the subject of recent litigation. Three VEBAs argued that the §419A limit applies to amounts accumulated in a set aside account at year’s end and not to amounts expended on benefits during the year. The VEBAs claimed that they used investment income, rather than member contributions, to pay benefits during the taxable year. Under their arguments, investment income would not be taxable if it was used by a VEBA during the taxable year to provide benefits. The VEBA prevailed in Sherwin-Williams Co. Employee Health Plan Trust v. Commissioner, 330 F.3d 449 (6^th Cir. 2003), nonacq., AOD 2005-02. VEBAs in two other cases lost similar arguments. In CNG Transmission Mgmt. VEBA v. United States, 588 F.3d 1376 (Fed. Cir. 2009), a VEBA argued that its investment income was used first to provide member benefits, leaving member income which is expressly included in exempt function income. The Federal Circuit Court of Appeals in CNG Transmission distinguished in part and rejected in part Sherwin-Williams, holding the §419A limitation applies to all amounts set aside for member benefits, whether or not actually expended during a taxable year. In Northrop Corp. Employeee. Ins. Benefit Plans Master Trust v. United States, 99 Fed. Cl. 1 (Cl. Ct. 2011), the federal claims court followed the Federal Circuit in rejecting the VEBA’s attempt to avoid UBIT on its investment income.

 Particularly given that the Congressional intent for enacting §512(a)(3)(E) was to limit the ability of VEBAs and SUBs to collect untaxed investment income in set aside accounts, the CNG Transmission and Northrop cases properly construe §512(a)(3)(E). As the IRS pointed out in its nonacquiescence to Sherwin-Williams:

 We disagree with the Sixth Circuit’s conclusion that investment income can be set aside and used separately before the end of a taxable year to pay the reasonable costs of administering health care benefits and thereby avoid the limits imposed by 512(a)(3)(E) on exempt function income. As discussed above, the statutory provisions are not dependent upon a determination as to whether particular sources of income were used to pay the costs of administration in any particular year.

 Treas. Reg. §1.512(a)-5T. In Sherwin-Williams, the Sixth Circuit referred to Treas. Reg. §1.512(a)-5T as supporting its conclusion that the §419A limitation applies to the amount of investment income remaining at the close of the taxable year. The court quoted the statement in Treas. Reg. §1.512(a)-5T, A-3(a) that the limitation applies to amounts set aside to pay benefits “as of the close of the taxable year.”

 In contrast, in CNG Transmission and Northrop, the VEBAs argued that Treas. Reg. 1.512(a)-5T was invalid. The Tax Court in CNG Transmission held that §512(a)(3)(E) was ambiguous and that Treas. Reg. §1.512(a)-5T was a reasonable interpretation of the statute that supports the government’s position. On appeal, the Federal Circuit concluded that the statutory language in §512(a)(3)(E) was not ambiguous; but even if §513(a)(3)(E) were ambiguous, Treas. Reg. §1.512(a)-5T was a reasonable interpretation of the statute entitled to deference.  As to the validity of the regulation, the Federal Circuit in CNG Transmission declined to consider the issue because it was not timely raised by the VEBA at trial.

 The Northrop court declared itself bound by the conclusion of the Federal Circuit in CNG Transmission that §512(a)(3)(E) was clear and unambiguous. Thus, any arguments that the temporary regulation is invalid or arbitrary were immaterial to the analysis in Northrop. The claims court acknowledged the VEBA’s arguments against the validity of Treas. Reg. §1.512(a)-5T, but declined to “indulge in an analysis of the status of” the temporary regulation that would be pure “dicta.”

  Section 512(a)(3)(E)  does not contain a reference to ”the close of the taxable year.” According to §512(a)(3)(E)(i), a VEBA or SUB may treat a set aside to pay benefits to members as exempt function income only to the extent that the set aside does not result in an amount of assets set aside for such purpose in excess of the account limit determined under §419A for the taxable year. Given the language of §512(a)(3)(E)(i), it seems that the phrase “as of the close of the taxable year” in Treas. Reg. §1.512(a)-5T refers to the time frame for applying §512(a)(3)(E) rather than to the balance existing at the close of the taxable year.

 To clarify the point, the final regulation could either replace the reference to the close of the taxable year with the wording of §512(a)(3)(E) or state that the limitation applies to amounts “used or set aside” by a VEBA or SUB as of the close of the taxable year.

 In its 2011-2012 Priority Guidance Plan, the IRS includes regulations under §512 explaining how to compute the UBTI of a VEBA as a priority under Employee Plans – Executive Compensation, Health Care, and Other Benefits, and Employment Taxes. Given the support for the regulation in CNG Transmission and Northrop, it is unlikely that the final regulation will differ significantly from its temporary predecessor.