There are more than $25 trillion dollars in U.S. pension plan assets as of December 31, 2016.[1] To a company (for purposes of this article the entity seeking pension plan investment is referred to as the “Company”) seeking investment capital, pension plans may be important potential investors. This blog article identifies two important considerations when seeking pension plan investment: 1. Will the assets of the Company be considered “plan assets”? and 2. Will an investment in the Company result in an income tax liability for the investing plan?
PLAN ASSETS: The first hurdle is whether the Company’s assets will be considered “plan assets” and what are the implications if the Company’s assets are regarded as plan asset? The general rule is in general that a portion of the Company’s assets will be treated as plan assets in percentage that pension plan investment bears to all investment.[2] As having the Company’s assets treated as plan assets turns the Company’s management into plan fiduciaries, plan asset treatment is to be avoided. To avoid a portion of its assets being treated as plan assets of the investing plans, the Company must meet one of the exceptions listed in the plan asset regulation.[3]
UNRELATED BUSINESS INCOME. Another issue for pension plan investors, completely apart from the prohibited transactions discussed above, is the determination of whether an investment in a Company will generate unrelated business income (“UBI”)[23] for the pension plan or exempt organization investor. As noted above, an operating company is not subject to plan asset treatment, but an operating company may well generate unrelated business income.[24] Income from a business that an exempt organization or pension plan operates or invests in is treated as UBI. UBI less allowable deductions results in unrelated business taxable income, upon which the unrelated business income tax is imposed[25].
Income from dividends, interest, royalties, rents and capital gains are excluded from UBI[26]. Rents of personal property and rents based on the income or profits of any person are includible in UBI.[27] A portion of dividends, interest, royalties, rents and capital gains derived from debt-financed property will be included in UBI.[28]
The allocation of net profits to an investing pension plan by a limited liability company (“LLC”) or other partnership that itself conducts an operating business will be treated as UBI to the investing Plan.[29] A plan really has three choices when considering an investment, (a) avoid an investment in an active business through a pass-through entity like an LLC, (b) invest in an active business through a pass-through entity and pay the tax on the UBI, or (c) form a wholly-owned C corporation to hold the interest in the operating LLC (generally known as a blocker corporation). Where a sponsor is promoting an investing in an operating business through a pass-through entity, the sponsor itself may form the blocker corporation through which plans, exempt organizations and foreign taxpayers may invest.
As a general rule, the purchase of an interest in an investment that would otherwise be exempt from UBI, for instance because it generates royalties, dividend, interest or rents, by incurring debt or buying subject to debt will cause a portion of the income to be taxed as UBI.[30] The determination that an investment constitutes “debt financed property” that will cause a portion[31] of the income from the investment to be UBI can be made at the investing plan level and at the investment level. For example, if a plan borrows to buy a corporate bond, a portion of the interest from that bond will debt-financed property. In addition, if a plan invests in an LLC that borrowed to acquire an asset, the debt-financed character of a portion of the income will be passed through to investing plans.
Section 514 provides a limited exception from acquisition indebtedness treatment for mortgage debt secured by real property owned by a “qualified organization”. The term “qualified organization” includes (a) a charitable educational organization, (b) a pension trust, (c) a corporation formed to hold real estate for a pension plan or charitable educational organization, and (d) a church retirement income account.[32] If a partnership or LLC will acquire real estate subject to mortgage debt, as is typical, the sponsor may make the investment more attractive to potential pension plan investors by satisfying the requirements for partnerships to avoid debt financed income for investing plans in the LLC’s operating agreement or the limited partnership’s limited partnership agreement.[33]
Michael Shaff joined the firm in 2011 as Of Counsel. He is chairperson of the Tax Practice Group. Michael specializes in all aspects of federal income taxation. Mr. Shaff has served as a trial attorney with the office of the Chief Counsel of the Internal Revenue Service for three years. Mr. Shaff is certified by the Board of Legal Specialization of the State Bar of California as a specialist in tax law. Mr. Shaff is a past chair of the Tax Section of the Orange County Bar Association. He is co-author of the “Real Estate Investment Trusts Handbook” published annually by West Group. Michael received his A.B. at Columbia College in 1976, his J.D. from New York University School of Law in 1979 and his LL.M. in taxation from New York University School of Law in 1986. He is admitted to practice law in the States of California, New York and Massachusetts and is a member of the Orange County Bar Association.
For more information about our Tax & Estate Planning practice, contact Michael Shaff at
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[1] https://www.ici.org/research/stats/retirement/ret_16_q4
[2] 29 C.F.R. §2510-3.101(a)(2)(second sentence); the first sentence of subsection (a)(2) establishes the “general rule” that a pension plan’s assets consist of its investment but not the underlying assets of the entity. The second sentence relegates that rule to being an exception.
[3] 29 C.F.R. §2510.3-101 will be referred to as the “plan asset regulation” in this article.
[4] 29 C.F. R. §2510-3.101(b)(1).
[5] 29 C.F.R. §2510-3.101(j)(example 1).
[6] As Regulation D is an exemption from registration pursuant to Section 5 of the Securities Act of 1933, securities offered pursuant to Rule 504 or 506 would not satisfy this part of the plan asset regulation.
[7] 29 C.F.R. §2510-3.101(b)(2).
[8] 29 C.F.R. §2510-3.101(b)(3) and (4).
[9] 29 C.F.R. §2510-3.101(c)(1): “An ‘operating company’ is an entity that is primarily engaged, directly or through a majority owned subsidiary or subsidiaries, in the production or sale of a product or service other than the investment of capital.”
[10] 29 C.F.R. §2510.3-101(d).
[11] 29 C.F.R. §2510.3-101(e).
[12] 29 C.F.R. §2510.3-101(d)(3).|
[13] 29 C.F.R. §2510.3-101(e).
[14] 29 C.F.R. §2510.3-101(j)(example 7).
[15] 29 C.F.R. §2510.3-101(j)(example 8).
[16] 29 C.F.R. §2510.3-101(f).
[17] 29 C.F.R. §2510.3-101(f)(1).
[18] 26 U.S.C. §4975(e)(3).
[19] 26 U.S.C. §4975(a)).
[20] 26 U.S.C. §4975(f)(2).
[21] 29 U.S.C. §1106
[22] Harris Trust Savings v. Salomon Smith Barney Inc., 530 U.S. 238 (2000). Salomon Smith Barney acted as broker for a pension plan’s fiduciary, executing trades that constituted self-dealing prohibited transactions. (Id.) The Supreme Court found that although not a fiduciary, Salomon Smith Barney was a party in interest and therefore could be sued for the plan’s actual damages, effectively making the defendant the insurer of every transaction that the fiduciaries engaged in.
[23] Internal Revenue Code (I.R.C.), 26 U.S.C. §511-514.
[24] I.R.C. §512(a).
[25] Id.
[26] I.R.C. §512(b).
[27] I.R.C. §512(b)(3).
[28] I.R.C. §511(a)(1).
[29] I.R.C. §512(c)(1).
[30] I.R.C. §514(a).
[31] In short, the ratio that average acquisition indebtedness bears to the average basis of the debt financed property will determine the portion of the income from the debt financed property that will be UBI. As the amount of debt and the adjusted basis of the debt-financed property change, the portion of the income treated as UBI will change. I.R.C. §514(a).
[32] I.R.C. §514(c)(9)(C). The exemption for these organizations may reflect Congress’s determination that pension plans and certain educational institutions often invest in leveraged real estate.
[33] I.R.C. §514(c)(9)(E).
Michael Shaff joined the firm in 2011 as Of Counsel. He is the chairperson of the Tax Practice Group. Michael specializes in all aspects of federal income taxation. He has served as a trial attorney with the office of the Chief Counsel of the Internal Revenue Service for three years. Mr. Shaff is certified by the Board of Legal Specialization of the State Bar of California as a specialist in tax law. Mr. Shaff is a past chairof the Tax Section of the Orange County Bar Association. He is co-author of the “Real Estate Investment Trusts Handbook” published annually by West Group.
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Exit strategy, the plan for monetizing or disposing of a business, may seem remote and speculative when organizing a new business. But it is important to know what exit strategies are available and how those strategies are likely to be taxed depending on the form of entity through which the start up does business.
For more information about Tax & Estate Planning Practice, please contact Michael Shaff at (818) 444-4522 or .
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[1] Cal. Corp. Code §16306(a).
[2] Internal Revenue Code (“IRC”) §1060(b).
[3] Cal. Corp. Code §15902.01(a).
[4] Cal. Corp. Code §15904.04(a).
[5] IRC §351.
[6] Rev. Proc. 93-27, 1993-2 C.B. 343.
[7] Some entities like pension plans and IRAs may have to pay tax on the net income allocated to them from an LLC or other partnership that is engaged in an active business. (IRC §512.) LLCs and other partnership entities present similar issues for foreign investors.
[8] IRC §751(a).
[9] Generally, suspended losses may be claimed as the partnership generates net income or when it is ultimately disposed of.
[10] IRC §368(a)(1).
[11] E.g., Biefeldt v. Commissioner (7th Cir. 1998) 231 F.3d 1035.
[12] IRC §351. Care must be taken to convert to corporate form before undertaking acquisition negotiations.
[13] Voluntary employee benefit associations, supplemental unemployment compensations plans, social clubs and other exempt organizations that have borrowed to purchase the shares. (IRC §512(a)(3).)
[14] See, e.g., United States—Peoples Republic of China Income Tax Treaty (1984), Article 9, Section 2, reducing the withholding on dividends paid by a corporation from one country to a resident of the other from the general 30% withholding rate to 10%.
[15] Differences in, or even a complete absence of, voting rights are permitted. (IRC §§1361(b)(1)(D) and (c)(4).)
[16] IRC §1361(a).
The Bush tax cuts. The Bush tax cuts primarily enacted by the 2001 and 2003 Tax Acts under President George W. Bush were extended through 2012 as part of the Tax Act of 2010. The Bush tax cuts currently set to expire at the end of 2012 include:
The Bush tax cuts also gradually reduced the estate tax over 2002 to 2009, leading to its repeal in 2010. The 2010 Tax Act reinstated the estate tax for after 2010 and enacted a $5 million exemption (adjusted for inflation in 2012), a top estate tax rate of 35%, and a step-up in basis through 2012. The 2010 Tax Act also introduced the new “portability” feature allowing a deceased spouse's unused exemption to be shifted to the surviving spouse.
Post-2012 scheduled changes. If the above provisions are allowed to expire, for tax years beginning after Dec. 31, 2012:
Additionally, after 2012, the estate tax exemption is scheduled to fall to $1 million and the top rate will revert to 55%.
AMT. For 2012, absent another patch, the AMT exemption amounts are $45,000 for married individuals and $33,750 for unmarried individuals, and most nonrefundable credits won't be allowed against the AMT. A Congressional Research Service report estimates that, unless Congress acts, 30 million plus taxpayers, or roughly one-fifth of all taxpayers, could be hit by the AMT in 2012.
Payroll tax cut. The Federal Insurance Contributions Act (FICA) imposes two taxes on employers, employees, and self-employed workers—one for Old Age, Survivors and Disability Insurance (OASDI; commonly known as the Social Security tax), and the other for Hospital Insurance (HI; commonly known as the Medicare tax).
To help stimulate the economy by increasing workers' take-home pay, the 2010 Tax Relief Act reduced by two percentage points the employee OASDI tax rate under the FICA (from 6.2% to 4.2%) and the OASDI tax rate under the SECA tax for the self-employed (from 12.4% to 10.4%) on the first $106,800 of wages. The temporary reduction was originally scheduled to expire at the end of 2011.
Current law. The 2-point reduction was ultimately extended through 2012. For the first $110,100 of remuneration received during 2012, the 4.2% and 10.4% rates apply. Absent Congressional action, the OASDI rates will revert to normal levels after 2012.
Obamacare investment tax. A Medicare contribution tax will be imposed after 2012 on the net investment income—generally interest, dividends, annuities, royalties, rents, and capital gains—of individuals meeting an income threshold. The tax will be 3.8% of the lesser of (a) net investment income or (b) the excess of modified adjusted gross income over $250,000 for joint return filers and surviving spouses, $125,000 for separate return filers, and $200,000 for other taxpayers. This special tax on investment income will only apply to taxpayers with adjusted gross income in excess of $250,000, taxpayers who also face the reinstated 39.6% top federal income tax bracket.
California Changes. California voters approved Proposition 30 and Proposition 39. Proposition 30 increases personal income tax rates for high-income earners by creating three new tax brackets. These brackets are effective for taxable years beginning on or after January 1, 2012, and before January 1, 2019.
Taxpayers, except heads of households and married filing jointly taxpayers, are subject to personal income tax:
The above thresholds for married filing jointly taxpayers are double those for single taxpayers.
Proposition 39 requires the use of single-factor apportionment for most businesses for taxable years beginning on or after January 1, 2013. An apportioning trade or business must apportion business income to California by multiplying the business income by the sales factor, unless the taxpayer is primarily engaged in agriculture, mining or drilling or banking businesses. The property and payroll factors will now only apply to those industries. The new rule is intended to have the effect of taxing a higher percentage of the net income of out-of-state businesses.
A lot can still happen on the federal side. Congress may reach an agreement to extend some of the Bush tax cuts before the end of the year or even in the new year as part of an overall budget reconciliation. In addition, an AMT “patch” is somewhat more likely to occur.
Michael Shaff, Of Counsel with Stubbs Alderton & Markiles, LLP discusses the Bush tax cuts and the post-2012 scheduled changes. Michael specializes in all aspects of federal and state taxation, including mergers and acquisitions, executive compensation, corporate, limited liability company and partnership taxation, tax controversies and real estate investment trusts.
Should you have further questions or concerns about the post-2012 tax cuts or our Tax & Estate Planning Practice, please contact Michael Shaff at or (818) 444-4522.