Interest expense for UBTI purposes.

• Author: Sunshine, Barry
• Position: Unrelated business taxable income

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...