Investment activities that are common for most taxpayers may create complications for tax-exempt entities. The United States Court of Federal Claims recently determined that two charitable trusts were liable for income taxes on profits derived from securities they purchased on margin. The Henry E. and Nancy Horton Bartels Trust v. United States, 104 AFTR 2d 2009-5117 (Fed. Cl. 2009). The decision reinforces the need for exempt organizations to carefully consider the tax implications of their financial management.
The decision involved two charitable trusts designed to make investments for the benefit of universities. As part of their investment plans, the trusts borrowed funds from a broker, using a margin account, to purchase stocks.
When a tax-exempt organization invests using leverage, the debt may cause the investment to fall into a category of regulated activity. Income arising from an activity of a tax-exempt organization that is beyond the scope of its tax-exempt purpose is known as unrelated business taxable income, or "UBTI." An organization must pay tax on UBTI even if it is tax-exempt. The primary objective of the tax on UBTI is to eliminate a source of unfair competition by treating unrelated business activities of exempt organizations the same as activities of competing nonexempt businesses. If an organization's UBTI is so large that it overshadows the organization's exempt purpose activity, the organization can risk losing its tax-exempt status.
Unfortunately for the trusts in Bartels, UBTI also includes a portion of income arising from certain debt-financed property. In general, the amount of income that constitutes UBTI is proportional to the amount of debt used to acquire the property.
In Bartels, the Court held that the trusts' purchase of stocks on margin resulted in debt-financed property and income arising from the stocks was, therefore, UBTI. The trusts argued that the income was not UBTI because it was "substantially related" to their exempt purpose of earning income. The Court rejected the trusts' argument, holding that it is the property itself, and not the income generated by the property, that must be substantially related to the exempt purpose. The trusts also argued there was no UBTI because the debt was "inherent" to the pursuit of their charitable investment purpose. The Court also rejected this argument, holding that, because many alternative investment strategies remained available to the trusts, purchasing securities on margin was neither inherent nor essential to the trusts' income-generating purposes.
Of course, nonprofits may decide to engage in an activity that produces UBTI and pay tax on the income arising from the activity. In some cases, the benefits may outweigh the tax. However, the determination to earn UBTI should be active and on a case by case basis to avoid incurring unexpected tax liabilities.
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