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What your IRA can learn about paying tax from Cornell University

September 09, 2010

When a charity becomes "tax exempt," it might think that it never has to worry about the IRS. That can be an expensive mistake. The Henry E and Nancy Horton Bartels Trust for the Benefit of Cornell University has learned that lesson the hard way. It's a lesson that also applies to IRA investors, qualified plan fund managers, and charitable trust investment advisors.

"Tax exempt" entities are really exempt only on certain kinds of income -- things like interest, dividends, and capital gains. The tax law doesn't want taxable businesses to face tax-free comptetition, so it imposes an "unrelated business income tax" (UBIT) on charities with business income. One often-overlooked part of the UBIT is its tax on income from "debt-financed property." The classic application of the debt-financed property UBIT is for charities that invest in leveraged real estate. But the tax -- imposed at corporation income tax rates -- can apply in other settings. A Federal Judge explains how the debt-financed UPBIT of the Bartels trust arose:

This case arises from some of the Trust's investment activities during the 1999 and 2000 tax years. During those years, the Trust invested in stocks purchased "on margin." In other words, the Trust used money borrowed from its broker to complete the stock purchases. The Trust subsequently sold the stocks.

When the Trust filed its "Exempt Organization Business Income Tax Return" for the 1999 tax year, otherwise known as its Form 990T, the Trust reported the income from the sale of the margin-financed securities as capital gains, without reporting any associated income tax liability. After an IRS audit, the Trust paid $48,770 in taxes on the margin sales for the 1999 tax year. For the 2000 tax year, the Trust reported income from the sale of the margin-financed securities as capital gains and paid the associated UBIT of $39,479.

The Federal Circuit Court of Appeals ruled that the UBIT applied here. UBIT also applies to Individual Retirement Accounts and pension plans, as well as to charities. Some points for IRA investors to keep in mind:

- Margin accounts in an IRA can make your IRA subject to UBIT.
- Debt-financed real-estate in an IRA can trigger UBIT.
- Hedge funds using debt can trigger UBIT, making such funds a dicey bet for IRAs.
- IRAs that invest in operating businesses through an LLC or other partnership can expect to file a Form 990-T and pay tax on their K-1 income.

Cite: Henry E and Nancy Horton Bartels Trust for the Benefit of Cornell University et al, CA-FC NO. 2009-5122.