Interest income can be debt-financed.

A recent case may cause some consternation to exempt organizations that borrow more funds than they currently need.

In Southwest Texas Electric Cooperative, Inc., TC Memo 1994-363, an electric cooperative was subject to unrelated business income tax (UBIT) on interest earned on Treasury note investments. The co-op had been granted a loan from the Rural Electrification Administration at a relatively low interest rate. The amount of the loan exceeded the co-op's immediate construction needs. Because of the difficulty in obtaining loans, however, the co-op decided to draw down the entire amount approved, and use the excess temporarily to purchase Treasury notes.

Interest income is generally exempt from UBIT. If the interest is earned on property acquired with borrowed funds, it is taxable under the "debt-financed property" rules.

The co-op made several arguments as to why imposition of the tax was improper. Its primary argument was that the funds were borrowed to construct property to be used to further its exempt purposes. The court rejected this argument because the funds were actually invested and thereby fell within the definition of debtfinanced property. The notes themselves would never be directly used in the co-op's exempt activities; they would be sold when the funds were needed. The ultimate purpose of the borrowed funds does not matter when they are temporarily invested.

This case may pose problems for issuers of tax-exempt bonds if excess proceeds are temporarily invested or held in an interestpaying escrow account. It appears that organizations will be better served by leaving the funds with the lender until they are needed.

From Jim Possin, CPA, Madison, Wise.