Interest expense for UBTI purposes.

Increasing numbers of pension plan trustees are allocating pension plan investments into nontraditional investments. These investments include investment partnerships or "hedge funds" that acquire securities, some with the use of partnership borrowings.

Under Sec. 514, a tax-exempt organization is taxed on its unrelated business taxable income (UBTI), which includes debt-financed income. Recently issued Letter Ruling, (TAM) 9717004 provides guidance in calculating the amount of deductible interest from debt-financed income. The TAM concluded that the debt/basis percentage d for other deductions must also be applied to the interest deduction, thus requiring an exempt organization to lose a percentage of its interest expense that it may not otherwise be required to lose.

Example: A pension plan acquires a 10% interest in a hedge fund for $1,000,000. At year-end, the plan's proportionate shares are 300,000 of capital gains, $200,000 of interest income, $30,000 of portfolio deductions and $300,000 of interest expense. The partnership provides that its debt/basis percentage is 35%.

The taxpayer computed its UBTI as follows:

Interest income         $ 200,000
Capital gains             300,000
Portfolio deductions      (30,000)
                          470,000
Debt/basis percentage          35%
                          164,500
Less interest expense     300,000

UBTI                    $(135,500)

In the ruling, the IRS concluded that only $105,000 (35% of $300,000) of interest expense was deductible in computing UBTI; as a result, the taxpayer had UBTI of $59,500.

Sec. 514(a)(1) includes in UBTI all gross income generated from each debt-financed property multiplied by the property's average acquisition indebtedness over the property's adjusted basis (debt/basis percentage). Sec. 514(a)(2) allows a deduction for each debt-financed property based on the property's debt/basis percentage. Sec. 514 allows a deduction for items directly connected with the debt-financed property. The taxpayer's position in TAM 9717004 was that the interest expense was directly attributable to those securities acquired solely on margin; without the securities purchased on margin, there would no UBTI. Hence, all the interest expense was deductible because all the income generated by the borrowing created UBTI. In other words, the debt/basis percentage for each security-purchased "debt financed property" would be 1000%.

Sec. 514(a)(3) provides that UBTI includes the sum of the deductions allowed under Sec. 514(a)(2). Regs. Sec. 1.514(a)-1(b)(3) provides that in order for deductions to be deductible, they must be "directly connected" with debt-financed property, and must have a proximate and primary relationship to such property or the income therefrom. The regulations cite the example of a taxpayer's building that is debtfinanced and has no other UBTI. The building has rental income of $20,000, property taxes of $5,000, acquisition interest of $5,000 and a budding manager's salary of $15,000. The debt/basis percentage is 50%; the regulations conclude that only 50% of the deductions are deductible. The regulations also state that if an organization owns a building that is entirely debt-financed, it will be allowed a full deduction (because the debt/basis percentage is 100%.

Following the regulations, the Service computed the investment partnership's debt/basis percentage based on all securities acquired, while the taxpayer computed the debt/basis percentage for each security purchased on margin. Based on the TAM'S conclusion, when computing the debt/basis percentage, property will include all securities purchased, whether or not on margin.