Increasingly over the last few years and coincidentally with the bursting of the stock market bubble and the proliferation of hedge funds, it appears more sponsors of small and mid-size plans are investing in various alternative investments as a means of increasing portfolio diversification and boosting returns. Further, these investments are being used not only within trustee directed portfolios, but also in plans with participant directed accounts. While the retirement plan trusts of many of this country's largest corporations have historically used alternative investments that generate unrelated business income (UBI) and related taxes, with smaller and sometimes less sophisticated plan sponsors now using alternative investments, it is worth reviewing the rules.
Unrelated Business Activity
Internal Revenue Code (IRC) section 401(a) does not specifically limit the investments that may be made by the trustee of a trust that is qualified under section 401(a). Generally, the contributions to the trust may be used by the trustees to purchase any investments permitted by the trust agreement to the extent allowed by local law. However, to the extent the trust has any unrelated business taxable income (UBTI), it will be subject to tax under IRC section 511. IRC section 511 imposes a tax on the unrelated business taxable income of certain organizations, including retirement plan trusts described in IRC section 401(a). In the case of retirement plan trusts, unrelated business activities generally take the form of either a trade or business (as defined in IRC section 162) or debt financed income. It should be noted that the exceptions under IRC section 513 to the tax on unrelated business income do not apply to IRC section 401(a) trusts. The exceptions under IRC section 513 apply only to the operation of trades or businesses under certain specified circumstances of foundations and other types of exempt organizations.
Unrelated Trade or Business Activities
The IRS regularly looks for trade or business activities in the retirement plan trusts of smaller employers. They are concerned that the retirement plan trust may be engaged in the same business as the plan sponsor where the management of the trust operation is directly or indirectly the same as the plan sponsor and the business expertise of the plan sponsor's management is applied to the trust business activities. Alternatively, the retirement plan trust may engage in a business activity that complements the plan sponsor's business. For example, the employer may be engaged in manufacturing and the retirement plan trust performs all or some portion of the marketing function.
Examples of other areas that the IRS looks at are income received from unexercised stock options that are issued on stock held in the retirement plan trust's portfolio. This income is treated as unrelated trade or business income under IRC section 513. Partnership investments are also scrutinized. If the retirement plan trust is a member of a partnership, which is engaged in a trade or business, the trust has UBI with respect to its portion of the partnership's distributable income.
Unrelated Debt-Financed Income
The second area of interest to the IRS, when reviewing a retirement plan trust for unrelated business activities, is unrelated debt-financed income. Generally, under IRC section 514(a), the income received from all income-producing property on which acquisition indebtedness exists is taxable in proportion to the amount of unpaid indebtedness. There is a limited exception to this general rule for the acquisition and improvement of real property (IRC section 514(a)(9)). With respect to acquisition indebtedness, the IRS's view is that it occurs if it can be shown that the liabilities would not have been incurred but for the purchase of the income producing property. The most common situations that result in UBTI to a retirement plan's trust are:
1. The trust is a member of a partnership (hedge funds for example) that leverages its investments; then the retirement plan trust's portion of the interest, dividends, gains, etc. that were earned on all of the partnership's debt-financed property is taxable.
2. Common stock purchased on margin results in a portion of the dividends and gains received being taxable.
3. Bonds purchased on margin result in a portion of the interest received being taxable.
4. Real property that is debt financed results in a portion of rental or lease income being taxable except as provided for under IRC section 514(a)(9)(B).
IRS Form 990 - T
Retirement plan sponsors who determine that the plan's trust has unrelated business taxable income must file an IRS Form 990-T Exempt Organization Business Income Tax Return annually to report the income and pay the taxes. The Form 990-T is due by April 15 each year (Note: this is one month earlier than other tax exempt organizations). The trust may receive up to two three-month extensions. The first extension is automatic. The second extension must be granted by the IRS. Since IRC section 401(a) trusts are not corporations, they are subject to tax at the individual tax rates with respect to their unrelated business income.
While many large plan sponsors routinely file returns to report UBTI, many smaller plan sponsors may not be aware of either the rules regarding UBI or their related filing obligation and tax liability. It is therefore important that the plan sponsor's advisors make their clients aware of the rules and assist them with reviewing their plan trust's investments to determine if unrelated business activities exist within their trust.
Peter S. Alwardt is a Partner in Eisner LLP's Employee Benefits Group and President of Eisner Retirement Solutions LLC. Peter has 20 years of consulting experience, specializing in employee benefits, tax and ERISA issues. He has an extensive background in consulting on qualified and non-qualified plan design, operational compliance, equity based plans, employee communications, and representation before the IRS and DOL. He can be reached at (212) 891-6022 or via email at firstname.lastname@example.org.