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Loan and UBTI


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If a retirement plan makes a loan to an unrelated operating business, and the interest is a fixed rate plus a percentage of the business profits, would that trigger UBTI?  Does it make a difference if the business is a corporation, partnership or LLC?

Thanks.

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On 11/13/2019 at 5:32 PM, cathyw said:

If a retirement plan makes a loan to an unrelated operating business, and the interest is a fixed rate plus a percentage of the business profits, would that trigger UBTI?  Does it make a difference if the business is a corporation, partnership or LLC?

Thanks.

If a company bought stock in an unrelated operating business (like, say, Disney!) and receives a percentage of profits (called a dividend), would that trigger UBTI?  Hopefully the answer is obvious.

Just in case, the answer is NO, no UBTI in that situation.

The key is the definition of UBTI: The IRS defines the income generated from unrelated business activities as income from a trade or business regularly carried on, that is not substantially related to the purpose that is the basis of the organization's exemption from tax.

The retirement plan is NOT carrying on a trade or business (the business is doing that). The retirement plan is just investing its money, which is exactly what it is supposed to be doing.

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It depends... I agree with Larry about Disney; however, if the investment is in a LLC than depending on the LLC operating business, you may be subject to UBTI.  I would recommend reaching to an ERISA attorney to determine if the debt (b/c of the UDFI of UBTI) and proceeds from the LLC is subject to UBTI.

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Thanks Larry.  Your answer is obvious when we're talking about an established corporate entity and the investment is the purchase of stock.  Suppose the unrelated business is a start-up entity, and the plan makes an outright investment and now has a minority ownership interest.   If the business is a partnership, we know that being a limited partner can generate UBTI.  I was taking it a step further removed.  If there isn't an equity investment but a loan, and the interest on the loan is measured (in part) by the profits, is that similar to receiving partnership profits that can generate UBTI?

Cathy.

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cathyw, you are correct to be concerned. If both (a) the "borrower" is a pass-through, e.g. LLC or LP, and (b) the "loan" were recharacterized by IRS as in substance equity (e.g., preferred partnership interest), then sure, you would have UBTI. I don't think there's a lot on this. Lots of plans and IRA's make loans with "equity kickers." Wise to follow the "pigs get fed, hogs get slaughtered" principle. An analysis would take into account the market rate of interest, security for indebtedness, share of profits, etc.

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14 hours ago, Luke Bailey said:

cathyw, you are correct to be concerned. If both (a) the "borrower" is a pass-through, e.g. LLC or LP, and (b) the "loan" were recharacterized by IRS as in substance equity (e.g., preferred partnership interest), then sure, you would have UBTI. I don't think there's a lot on this. Lots of plans and IRA's make loans with "equity kickers." Wise to follow the "pigs get fed, hogs get slaughtered" principle. An analysis would take into account the market rate of interest, security for indebtedness, share of profits, etc.

I agree with Luke; the equity kicker itself is not what produces UBTI.

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cathyw, the basic proposition that, in the case of an equity interest (e.g., an LP interest) in a pass-through, the character of the income at the entity level, e.g. active business income, carries through to the qualified plan or IRA, even if the qualified plan or IRA owns only a small slice of the entity and has no management role in it, is based on an old Revenue Ruling, from the early 70's I think, that dealt with a plan or tax-exempt org's investment in, if memory serves me correctly, an equipment leasing partnership. If you don't have it you should be able to find it using Google or Checkpoint or whatever.

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