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).