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It seems that more and more tax-exempts are employing non-traditional investments, such as venture capital funds and hedge funds, in an attempt to diversify their investment portfolios and increase their returns. From a tax perspective, these investments can prove to be potentially problematic if they are not structured properly.
Unrelated debt-financed income
Section 511 (a)( 1 ) imposes a tax, at general corporate rates, on otherwise tax-exempt entities engaging in an unrelated trade or business that results in unrelated business taxable income (UBTI). It is no secret that Congress enacted the UBIT regime to avoid unfair competition. Nor is it a secret that the goal of exempt entities is to avoid incurring this tax.
"Unrelated business taxable income" is gross income derived from any unrelated trade or business regularly carried on by an exempt entity, less any allowable deductions with respect to that unrelated trade or business, and subject to certain modifications.1 An "unrelated trade or business" generally includes any trade or business not substantially related to the tax-exempt entity's exempt purpose.2
Fortunately, dividend and interest income is generally excluded from the definition of UBTI.3 Hence, as a general proposition, tax-exempt entities are not subject to UBIT on their investment earnings. This is consistent with the purpose of the unrelated business income tax regime-i.e., there is little chance that a taxexempt entity would have an unfair competitive advantage over its for-profit counterparts merely because it is allowed to accumulate investment earnings tax-free.
Nevertheless, section 512(b)(4) provides that debtfinanced investment income, which would otherwise be excludable, is taxable. "Debtfinanced income" is generated by "debt-financed property." That, in turn, is property held to produce income that has been subject to "acquisition indebtedness" during the tax year.4 Very broadly, acquisition indebtedness is unpaid debt (1) incurred to buy or improve the property, (2) incurred before-hand solely for the acquisition or improvement, or (3) foreseeably incurred afterward solely for the acquisition or improvement.5
Nor is the exempt organizations debt the only debt that matters. The UBIT rules also apply to an exempt organization in its capacity as a partner in a partnership. Under section 512(b) (4), if the partnership regularly carries on a trade or business not related to the exempt partner's exempt purpose, the exempt partner's computation...