How UBIT Blockers Avoid Debt-Financed Income

Recent publicity about former Governor Mitt Romney’s $23 million IRA and its investments in foreign tax havens has raised the profile of so-called UBIT blocker corporations. What is a UBIT blocker and how does it work to the advantage of retirement accounts and other exempt organizations?

 Income from Debt-Financed Property is UBTI

 If an exempt organization borrows funds to acquire an asset, income from the asset is treated as debt-financed income to the extent of the debt financing. Debt-financed income is included in the organization’s UBTI, unless an exception applies. For example, rents from real property are generally excluded from UBTI. If, however, an exempt organization leases mortgaged property as an investment, part of the rental income is treated as debt-financed income. Similarly, if an exempt organization invests in a partnership that uses borrowed funds to acquire an asset, the debt-financed income rules apply to the organization’s distributive share of the partnership’s income from the asset. Because most alternative asset investments, such as hedge funds, use debt financing, exempt organizations cannot invest directly in hedge funds and other non-traditional investments without incurring UBTI.

Note: Under a special exception, debt incurred by educational organizations and qualified pension and retirement plans to purchase or improve real property is not treated as acquisition indebtedness. Thus, the real property is not debt-financed property and income from the property is excluded from UBTI. The exception is limited to real property and does not apply to hedge fund investments.

 Blocking Debt-Financed Income

 The debt-financed income rules reduce an exempt organization’s ability to take advantage of leveraged investments without suffering adverse UBIT consequences. Seeking to get around this restriction, some exempt organizations have interposed a corporation between themselves and the investment partnership. The result of such an arrangement is that dividends paid from the corporation to the exempt organization are treated as excludible dividends rather than debt-financed income. The taint of the debt financing does not flow through from the partnership to the corporation to the exempt organization.

Increasing the Advantage by Using Foreign Corporations

 Where do tax havens come in? If the UBIT blocker is a U.S. corporation, the corporation will owe income tax on its distributive share of the partnership income. To minimize the income taxation at the corporate level, exempt organizations use a foreign corporation to invest in the partnership owning the mortgaged property. Income of foreign corporations is not taxed until the income is repatriated to the U.S. Some foreign jurisdictions do not impose corporate taxes on corporations owned by non-citizens. Other countries impose very limited corporate taxes. Either way, by using a foreign corporation, an exempt organization can eliminate or minimize the tax payable at the corporate level, reducing the overall cost of the UBIT avoidance strategy.

UBIT Blockers Are Not Illegal

 The strategy of using UBIT blocker corporations is not illegal or contrary to any tax laws. Large retirement funds and exempt organizations are seeking to diversify their investment portfolios into non-traditional investments and to increase their returns using leveraged investments. Under the tax laws, income of foreign corporations owned by U.S. citizens or corporations is not subject to U.S. income tax until the income is brought into the country. Giant multinational corporations routinely use these tax principles to avoid billions in U.S. income tax on income of their foreign subsidiaries. The avoidance is permanent if the corporations use the income in their foreign operations rather than repatriate it. In contrast to business corporations, tax-exempt organizations may repatriate dividends from a foreign corporation without adverse UBIT consequences because of the dividend exclusion.

 Despite their legal status, the use of UBIT blockers by exempt organizations has resulted in millions of dollars in lost taxes that would have been paid as unrelated business income tax if exempt organizations made direct investments or invested in partnerships without using the intervening corporation. Federal legislators are well aware of the lost revenues resulting from UBIT blockers. In the current political climate emphasizing deficit reduction, Congress may act to reduce or eliminate the use of UBIT blockers by exempt organizations. More than likely, any changes will come as part of an overhaul of the whole system for taxing foreign income and will occur after the election year.

 For other articles discussing the use of UBIT blockers by exempt organizations, see Weisman, Romney’s Returns Revive Scrutiny of Lawful Offshore Tax Shelters (Feb. 2012); David Wheeler Newman, Recent Rulings Illustrate Creative Strategies to Deal with UBTI (2011); Council on Foundations, Statement Regarding Unrelated Debt-Financed Income and “Blocker Corporations” (2007)

 For a more detailed discussion of the UBTI and debt-financed income rules in the context of UBIT blockers, see Joint Committee on Taxation, Present Law and Analysis Relating to Tax Treatment of Partnership Carried Interests and Related Issues, Part II (2007).

IRS Releases Revised Publication 598

The IRS has released revised Publication 598, Tax on Unrelated Business Income of Exempt Organizations, effective as of March 2012. The publication covers four main topics:

  • Organizations subject to the tax
  • Tax and filing requirements
  • Unrelated trade or business
  • Unrelated business taxable income

 The section entitled “Unrelated Trade or Business” goes over the basic principles from the Code and Regulations concerning the basic requirements for taxatiion under the UBIT.  More importantly, it focuses on the sometimes tricky issue of whether a business is related or unrelated to an organization’s exempt purposes by using examples. The discussion contains numerous common examples of specific businesses and explains why these activities are related or unrelated for purposes of the UBIT. The “Unrelated Trade or Business” section also briefly discusses businesses that are expressly excluded from treatment as unrelated trades or businesses, such as businesses conducted by volunteers, sale of donated items, and the distribution of low cost articles incident to the solicitation of charitable contributions.

 The longest and most detailed section of Publication 598 is entitled “Unrelated Business Taxable Income.” It first discusses the categories of income that are excluded from UBTI. This part covers numerous modifications and special rules, including the treatment of advertising in periodicals, the deductions allowed in computing UBTI, rules for social clubs, VEBAs, and SUBs, income from partnerships and S corporations, and income from controlled organizations. The section concludes with a detailed discussion of the debt-financed property rules with several helpful examples.

 The IRS also maintains a web page on Publication 598. In a Recent Developments section, the IRS will post any changes that occur after the publication date of one revised edition and before the publication date of the following revision. For example, the Publication 598 prior to the current version was revised as of March 2010, applicable beginning with the 2009 tax year. In April of 2011, the IRS alerted taxpayers to the changes for the 2010 tax year. If the next revision of Publication 598 does not come out until March of 2014, an alert on this web page will likely be issued containing the changes for 2012.

 The IRS website has Publication 598 for the following revision dates: 2012, 2010, 2009, 2007, 2005, 2000, 1998, and 1995. If you need to know a UBIT provision applicable for a prior tax year, checking Publication 598 for the appropriate time period may be a good place to start.


Scope of Notational Principal Contract Exclusion from UBTI Clarified in Proposed Regs

This post is a heads up for exempt organizations that invest in nontraditional investments such as interest rate swaps and other notational principal contracts (NPCs). Income from NPCs is excluded from UBTI by Treas. Reg. §1.512(b)-1(a), which includes income from NPCs with other passive investment income such as dividends, interest, and annuities.

Note: Section 512(b)(1) lists five categories of passive income that are excluded from UBTI: dividends, interest, payments with respect to securities loans, amounts received or accrued as consideration for entering into agreements to make loans, and annuities. Although income from NPCs is not specifically mentioned in §512(b)(1), Treas. Reg. §1.512(b)-1(a)(1) does expressly identify income from NPCs as excludable passive investment income.

 What Are Notational Principal Contracts?

 An NPC is a financial agreement calling for the exchange of payments between two parties, at least one of which periodically pays amounts calculated by applying a rate determined by reference to a specified index to a notional principal amount in exchange for specified consideration or a promise to pay similar amounts.

 What Amendments Are Proposed?

 The proposed amendment to Treas. Reg. 1.512(b)-1(a)(1) is a conforming amendment to proposed amendments to Treas. Reg. §§1.1256(b)-1(a) and 1.446-3(c). Section 1256 provides special income tax treatment for section 1256 contracts, such as regulated futures contracts, that are marked to market and traded on a qualified board or exchange. Gain or loss on section 1256 contracts is generally treated as 60% long-term and 40% short-term capital gain or loss. Current §1256(b)(2)(B), added by the Dodd-Frank Act of 2010, provides that various types of swaps and similar contracts are not treated as section1256 contracts. The excluded contracts are almost identical to those listed as notational principal contracts under present Treas. Reg. §1.446-3(c), which discusses the recognition of income from NPCs that is necessary clearly to reflect income under §446.

 To resolve some uncertainties regarding the treatment of swaps that are traded on regulated exchanges, Proposed Treas. Reg. §1.1256(b)-1(a) provides that notational principal contracts described in Treas. Reg. §1.446-3(c) are excluded from treatment as section 1245 contracts. In turn, Proposed Treas. Reg. §1.446-3(c) clarifies some questions about NPCs and allows additional types of contracts to be classified as NPCs. For example, the proposed regulation provides that one party to a NPC must make a minimum of two payments to the other contracting party. The proposed regulation also includes as NPCs credit default swaps and swaps based on non-financial indices, such as weather-related swaps. Under the current regulation, a specified index includes only financial indices.

 What Is the Current Status of the Proposed Regulations?

 A public hearing about the proposed regulations was conducted on January 19, 2012, with 13 in attendance and one speaker.

Tax Court: An Exempt Organization Subject to the UBIT is Still an Exempt Organization

To those not accustomed to dealing with subchapter F of the Code (pertaining to exempt organizations) it may seem contradictory that so-called exempt organizations are subject to the unrelated business income tax. And the UBIT is not the only tax that may apply to exempt organizations. Charitable organizations which are private foundations are taxed on their net investment income and are subject to a series of excise taxes designed to curb particular behaviors susceptible to abuse. Thus, exempt organizations, which are not subject to the regular income tax imposed under §§1 and 11, are distinguished from for-profit companies that must pay income taxes. For convenience, we refer to them as exempt organizations, even though we know that they may be liable for the UBIT or other specialized taxes.

 Section 501 expressly recognizes that concept of tax-exempt organizations being subject to taxation. Exemption from taxation is provided under §501(a) for organizations described in §501(c), §501(d), and §401(a). These organizations are charities and 28 other categories of organizations described in §501(c), religious and apostolic organizations described in §501(d), and qualified retirement plans described in §401(a).

 Section 501(b) states that an organization exempt from taxation under §501(a) is subject to tax as provided in parts II (taxes on private foundations), III (the UBIT), and VI (taxes on political organizations) of subchapter F. Notwithstanding parts II, III, and VI of subchapter F, however, such an organization is “considered an organization exempt from income taxes for purposes of any law referring to organizations exempt from income taxes.”

 The Tax Court recently considered this seemingly straightforward Code provision in Research Corporation v. Commissioner, 138 T.C. No. 7 (2012).  Continue reading

Social Welfare Organization Derived UBTI from Members-Only Beach Club and Parking Lots

In Ocean Pines Association, Inc. v. Commissioner, the Court of Appeals for the Fourth Circuit held that a tax-exempt social welfare organization conducted an unrelated business when it operated two parking lots and a beach club limited to members only. The case was not complex, and the outcome was predictable. The court’s opinion, however, illustrates a classic analysis of the distinction between related and unrelated businesses under the UBIT.  Continue reading

Partial Exclusion for Post-2005 Payments Received from a Controlled Subsidiary under a Pre-Aug. 18, 2006 Contract Expired in 2011

In Publication JCX-6-12, dated January 27, 2012, the Joint Committee on Taxation listed tax provisions that expired in 2011 and provisions slated to expire through 2022. Only one item mentioned in the publication applies to the UBIT. Section 512(b)(13)(E), regarding certain payments received from controlled subsidiaries, expired for payments made after December 31, 2011.  Continue reading

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. Continue reading

Operation of Community Center Raises Various UBIT Issues in IRS Ruling

In PLR 201147035, a charitable organization devoted to disaster relief and general charitable purposes amended its articles to permit ownership and operation of community activity centers throughout country. The proposed community centers would offer a broad range of programs designed to serve all community members and would be accessible to the public through memberships. The organization was controlled by a fraternal beneficiary society described in §501(c)(8).

 In the ruling, the organization proposed to acquire its first community center. The acquisition was financed primarily through the issuance of long-term bonds. The community center would offer the following activities:  Continue reading