INSIGHT: The Effects of the New Tax Law UBTI Rules on Tax-Qualified Pension Investments Are Still Unclear, Even After Additional IRS Guidance

On Dec. 22, 2017, the Tax Cuts and Jobs Act of 2017 was enacted. This law added a number of new sections to the tax code, including a new Section 512(a)(6), which, effective for years after Dec. 31, 2017, requires tax-exempt organizations to report unrelated business tax income (UBTI) separately for each trade or business. This approach is a departure from the previous rule for such organizations, which permitted these entities to essentially lump all UBTI together and reduce their total UBTI by all allowable deductions (this permitted UBTI gains and losses to offset each other on an aggregate basis, with the effect of reducing such entities’ taxable UBTI).

The implementation of Section 512(a)(6) appears to have arisen from concerns by the Internal Revenue Service that exempt organizations were not complying with the UBTI rules. Specifically the IRS was concerned that such entities were inappropriately generating large net operating losses (NOLs) to offset the UBTI generated by such entities. The new law’s requirement that exempt entities silo, or track and calculate UBTI separately for each trade or business, appears to be an effort to address this concern. The new law also limits the application of carryover NOLs for tax years beginning after Dec. 31, 2017, to UBTI related to the same trade or business that generated such UBTI, although it permits NOLs from previous years to be applied to UBTI related to any trade or business.

These changes are significant for exempt organizations, including tax-qualified pension plans, whose sole job, one could argue, is to invest the assets they hold to generate sufficient funds to pay plan benefits to participants and their beneficiaries. These entities, which, according to a Bloomberg News article dated Jan. 24, 2018, manage an estimated $7 trillion in assets, frequently invest in alternative investments (such as private equity, hedge funds, managed futures, real estate, commodities, and derivative contracts) that can generate UBTI. Because there is no current definition of a “separate trade or business” (including under the new law), these entities are left without guidance on how to comply with these new requirements.

For example, take a situation where a tax-qualified pension fund invests in 20 private equity partnerships, each of which then invests in 15 private equity investments. Is investing in private equity, generally, a separate trade or business? Or is investing in each private equity partnership a separate trade or business? Or, must a plan look through each private equity partnership to each separate investment? If the latter is the case, can a plan aggregate investments across investments that involve similar trades or businesses? How should a plan handle investments in a fund of funds, a fund that invests in other funds, each of which in turn makes their own investments?

On Aug. 21, 2018, the IRS issued Notice 2018-67 (the Notice), which provided that exempt entities can use a “reasonable, good-faith interpretation” when identifying a different trade or business pending proposed regulations, provided additional guidance and requested additional comments on how to implement Section 512(a). However, further guidance is still sorely needed.

What is UBTI?

Prior to 1950, the income of exempt organizations was completely exempt from taxation—including UBTI. This changed in response to the perception that exempt organizations were being given an unfair competitive advantage, most notably characterized by C.F. Mueller Co. v. Commissioner. In that case, an exempt organization purchased the C.F. Mueller pasta company (using a loan), with the tax-free income associated with the investment paid to New York University Law School. The IRS challenged the tax-exempt status of the organization, but the U.S. Court of Appeals for the Third Circuit (on appeal) rejected the challenge. As a result, the predecessor to current Section 511 was passed, providing for the application of UBTI to exempt organizations, commencing with tax years after Dec. 31, 1950. In 1969, UBTI was expanded to apply to private tax-qualified pension plans as well.

Definition of UBTI

Section 512(a)(1) defines UBTI as the gross income derived by an exempt organization from any unrelated trade or business that is regularly carried on by the organization, less expenses and certain adjustments. Under Section 513 and accompanying regulations, a “trade or business” is broadly construed as “any activity carried on for the production of income that otherwise possesses the characteristics required to constitute a trade or business within the meaning of §162.” Whether a trade or business is unrelated is generally strictly construed. In the case of a tax-qualified retirement plan, Section 513(b) provides that any trade or business is considered “unrelated.”

Debt-financed investments

Section 512 (b) states that, generally, proceeds from investments such as stocks, bonds, and real estate do not constitute UBTI under the theory that such investments are not likely to result in competition for taxable businesses having similar businesses and that incomes associated with such investments have long been recognized as a proper source of revenue for exempt organizations. These investment proceeds can include interest income, dividends, annuities, mutual fund distributions, rent from real property, royalties, and investment gains. Most investments in a tax-qualified pension plan, absent unusual structures or investment choices, will qualify as investment income.

However, consistent with the C.F. Mueller case and notwithstanding this general rule, Section 514 provides that proceeds from investments financed with debt are subject to UBTI. Debt-financed property is any property held to produce income that has “acquisition indebtedness.” “Acquisition indebtedness” is debt incurred (or related to) acquiring or improving the debt financed property. Under Section 514(c)(9), there is an exception to the general UBTI rules that provides that debt-financed property for acquisition indebtedness incurred by a plan in acquiring or improving any real estate will not, under certain circumstances, constitute UBTI.

What is the result of generating UBTI?

The result of generating taxable income in the form of UBTI in excess of a de minimis amount (currently $1,000) is, unsurprisingly, the taxation of these amounts in the form of unrelated business income tax (UBIT). In calculating the amount of UBIT owed, an exempt organization can take a deduction against UBTI for expenses, depreciation, charitable contributions, and expenses directly connected to the unrelated trade or business. Historically, the final amount of income was taxable to the exempt organization at individual tax rates and reported in the aggregate to the IRS annually on Form 990-T. Taxes were required to be paid quarterly, with the Form 990-T, Exempt Organization Business Income Tax Return, due within three-and-a-half months following the end of the tax year.

Exempt organizations were also potentially subject to state filings and taxes. Effective in 2015, tax-qualified retirement plans also had to report these amounts on Form 5500-SUP, effectively giving the IRS notice to look for a corresponding Form 990-T (as well as the payment of taxes for reported amounts).

How does UBTI come into play with tax-qualified pension plans?

Generally, tax-qualified retirement plans are exempt from federal and state income taxes under Section 401(a). The trusts holding their assets are similarly exempt from federal and state income taxes under Section 501(a). However, as described above, while many investments might not be expected to generate UBTI, UBTI that is generated from a private plan’s assets remains subject to UBIT; many state and local pension plans have taken the position that they are not subject to any federal taxation, including UBIT.

Dealing with and avoiding UBTI

Some tax-qualified pension plans have the internal or external tax resources to simply calculate, report and pay UBIT. Others do not. One method to “cleanse” UBTI for a tax-qualified pension plan is to make an otherwise UBTI generating investment through a taxable corporation (a “blocker”), so that the corporation pays tax on the UBTI generating the investment, but the amounts that are paid to the exempt organization constitute investment income that would not constitute UBTI. This method essentially moves the taxable event from the exempt entity to the taxable corporation.

Guidance under Notice 2018-67

As described above, prior to the new tax law, exempt organizations, including tax-qualified pension plans, generally aggregated any and all UBTI, netted out all related deductible amounts, and reported and paid UBIT on such amounts. The new tax law changed this approach by requiring exempt organizations to “silo” UBTI (and related deductible amounts) separately for each trade or business, a significant change to how such entities have previously accounted for and reported such amounts.

Separate trade or business

The Notice recognizes that there is no statutory or regulatory definition for what constitutes a separate trade or business. The Notice provides that an exempt organization may rely on a reasonable, good-faith interpretation considering all of the facts and circumstances when identifying separate trades or businesses and points to both the North American Industry Classification System and Section 513(c) as guides, while also requesting comments on how to identify separate trades or businesses.

Specifically, the Notice notes that under Section 513(c), “an activity does not lose its identity as a trade or business merely because it is carried on within a larger aggregate of similar activities or within a larger complex of other endeavors which may, nor may not, be related to the exempt purposes of an organization.” Further, the Notice seems to suggest a look-through approach to partnership activities by stating that “one interpretation of § 512(a)(6) might require an exempt organization to calculate UBTI separately with respect to each unrelated trade or business regularly carried on by the partnership in which the exempt organization is a direct or indirect partner,” providing that if a partner holds multiple partnerships, “the exempt organization may be engaged in multiple separate unrelated trades or businesses through its interest in the partnership.” In taking this approach, the IRS does note the administrative burden in obtaining sufficient information from multi-tiered partnerships. The Notice also notes that the IRS intends to propose further regulations on investment activities with respect to the new provision.

Transition rules

Given the lack of clarity on how exempt organizations should comply with Section 512(a)(6), the Notice provides exempt organizations with transition guidance pending publication of proposed regulations. Specifically, this transition guidance includes:

• De minimis test. An exempt organization may aggregate its UBTI from a single partnership (including those with multiple trades or businesses) so long as the organization holds no more than 2 percent of the profits interest or 2 percent of the capital interest in such partnership.

• Control test. An exempt organization may aggregate its UBTI from a single partnership (including those with multiple trades or businesses) so long as the organization holds no more than 20 percent of the capital interest and does not have control or influence over the partnership. An organization will be deemed to have “control or influence” over the partnership if it may require the partnership to perform any acts or prevent the partnership from performing any act that significantly affects the operations of the partnership or if it has the right to participate in the management of the partnership or conduct the partnership’s business at any time, including to remove any of the partnerships officers, directors, trustees, or employees. Plans which have advisory or other board rights with respect to a partnership investment may trigger this test and should look closely at their ownership holdings with respect to such investments.

• Transition rule. Notwithstanding the de minimis test and the control test, under a final transition rule, investments acquired prior to Aug. 21, 2018, may treat each partnership interest as compromising a single trade or business.

An exempt organization may rely on the Schedule K-1 received from a partnership in determining its ownership for purposes of the de minimis and control tests.

Conclusions

As described above, private and public tax-qualified pension plans hold a huge amount of assets, the majority of which are exempt from taxation. The IRS has long been concerned about exempt organizations (including tax-qualified pension plans) complying with the UBTI rules and properly reporting and paying UBIT on these amounts. Therefore, while some have said that increased compliance efforts on existing UBTI and UBIT rules would have been a more appropriate next step, it is not a surprise that the new tax law would focus on these amounts, especially as a potential revenue-generating item.

However, the obvious result of the tax law as currently structured (and guidance issued to date) is that the legal uncertainties and administrative burden in attempting to comply with these new rules may very well outweigh the potential benefits in pursuing investments that generate UBTI and, therefore, require accounting for and paying UBIT. If exempt organizations generally, and tax-qualified pension plans specifically, avoid these types of investments going forward, not only will there be less taxable revenue generated by them, but also there is a risk that the potentially significant returns associated with such investments may not be attractive to such funds, which could result in less assets available to plan participants and their beneficiaries. This result, one has to assume, was the opposite of what Congress intended when enacting the new tax law.

Meredith L. O’Leary serves as counsel at Eversheds Sutherland (US) LLP based in the firm’s Washington, D.C. office. She regularly counsels both public and private companies on a diverse spectrum of employment, compensation, and benefits law. Her practice focuses on corporate transactions, executive and equity-based compensation arrangements, and the design, qualification, administration and termination of tax-qualified retirement plans, non-qualified deferred compensation arrangements, health and welfare plans, and fringe benefit packages.