Governmental Plans and UBIT

[Guest JRGlovan]

I represent a state investment board that invests in numerous private equity funds on behalf of the state's various retirement plans. Recently, one of the funds (which is a limited partnership) created an alternative investment vehicle (AIV). The AIV is a limited liability company that is taxed as a partnership. A direct investment in the AIV will produce income that will constitute unrelated business taxabale income (UBTI) for the tax-exempt limited partners. The limited partners may choose to invest directly in the AIV, or may choose to invest through a so-called "blocker structure" that is designed to eliminate or absorb any UBTI.

My question is basically this: does a governmental plan need to be concerned about the unrelated business income tax (UBIT)? The arguments I have seen that say UBIT does not apply to governmental plans include: (i) that governmental plans are exempt from UBIT pursuant to intergovernmental tax immunity doctrine; (ii) that governmental plans are exempt from UBIT pursuant to Internal Revenue Code Section 115 as an alternative basis for exemption to Internal Revenue Code Section 501(a); or (iii) pursuant to News Release IR 1869 (August 10, 1977).

In contrast, some argue that UBIT might apply to governmental plans because (i) Treasury Regulations sections 1.511-2(a)(1)(i) and -2(b) apparently make the UBIT applicable to governmental plans (essentially an execption to intergovernmental tax immunity because of a statutory basis to collect the tax), and (ii) Section 115 applies only to separate entites that do not qualify as integral parts of a state.

Does anyone have any insight on this topic?

[Everett Moreland]

See Carol Calhoun,. Cynthia Moore & Keith Brainard, Governmental Plans Answer Book Q7:121-Q7:141 (2d ed. 2007)

[Guest David Lacy]

The better question is: Does anyone know of any governmental plan that files Form 990-T and pays UBIT taxes? I don't. Is the IRS aware that this is the case? Clearly they are. They regularly audit state universities for UBIT, as those are specifically subject to UBIT. They have never audited a governmental plan for UBIT that I am aware, as they know governmental plans do not consider themselves subject to it, given past IRS pronouncements like News Release IR 1869 (August 10, 1977) and other authority.

[Carol V. Calhoun]

It looks like I've already been heard from here indirectly. Here's a brief synopsis:

1. If a retirement system is an integral part of government, it is exempt from all tax, including on UBIT.
2. If a retirement system is an instrumentality of government, its income is excluded from federal income tax under IRC 115 to the extent the income is derived from an essential governmental function and accrues to a State or political subdivision.

Whether a retirement system should be considered an integral part of government or an instrumentality is in itself a muddy area, with private letter rulings taking opposite positions on what seem to be nearly identical facts.

To add to the confusion, in General Counsel Memorandum 34476 (Apr. 9, 1971), the IRS concluded that “when a state agency or instrumentality elects to be exempt under section 501, we believe that it should be subject to the burdens as well as the benefits of subchapter F” (emphasis added). In General Counsel Memorandum 36876 (Sept. 30, 1976), the IRS again held “that when a state agency or instrumentality qualifies for and elects exemption under section 501, it is subject to the burdens as well as the benefits of subchapter F” (emphasis added). In both cases, the entity was found to be subject to UBIT. The questions, therefore, are a) whether these old GCMs remain the position of the IRS, and b) whether a a retirement system that has qualified status (which in theory makes it exempt under 501) would similarly lose its exemption from UBIT. One complicating factor, of course, is that in theory, qualified status under 401(a) is not "elected," but simply occurs if the plan meets the requirements of 401(a).

When we looked at this some time back, we could not find any public retirement systems that were actually paying UBIT. However, they were quite split as to whether they thought they were subject to it. Some took the position that they were completely exempt. Some avoided all investments that could produce UBTI, believing that they were subject to UBIT. Some were taking a middle ground, avoiding directly commercial activity as potentially "not derived from an exempt governmental function," but taking the position that other investments were exempted by 115 even if they produced what would be UBIT in the case of a nongovernmental tax-exempt.