Final UBIT rules lock in the tax for retirement-plan investors in private funds

The IRS and Treasury have published their final rules on unrelated business income tax (UBIT) for retirement-plan stakes in private funds, applying to taxable years that begin on or after Dec. 2, 2020. Groom Law's Benefits Brief expects many benefit plan investors to be affected; the rules reach into nearly every debt-financed fund structure.

The cause can be mundane. A tax-qualified retirement plan, a voluntary employees' beneficiary association, or an IRA can owe UBIT merely by holding an interest in a limited partnership that borrows to make investments. Section 514 of the Code treats a proportionate share of the income from that debt-financed property as unrelated business income. The fractions rule in Section 514(c)(9) has long shielded most debt-financed real estate from UBIT for qualified plans, but not for IRAs or VEBAs. Debt itself is not essential: if the partnership invests directly in an active trade or business — a hotel, say — Section 512(c) pulls the plan's share into the UBIT base.

Published at 85 Fed. Reg. 77952, the final rules carry out the 2017 Tax Cuts and Jobs Act changes to Section 512(a)(6). The old calculation was forgiving: a plan investor could offset its share of fund expenses against income and net most gains and losses across trades or businesses in the aggregate. For taxable years beginning after Dec. 31, 2017, a benefit plan with two or more unrelated trades or businesses operates under a different set of assumptions.

When UBIT applies, the cost lands on the plan trust, not the participant. The trust pays UBIT at individual rates (as high as 37 percent in 2020) and reports it on Form 990-T. State taxes and filings may follow. The same rule applies to pension plans and welfare benefit plans.

The final regulations govern taxable years beginning on or after Dec. 2, 2020. For earlier tax years — back to Jan. 1, 2018 — an exempt organization can rely on the final rules or on a reasonable good-faith interpretation of Section 512(a)(6), including the methods in Notice 2018-67 or the April 2020 proposed UBIT regulations. That transition window lets a plan choose between the IRS's final answer and the position it already took on prior returns.

The stakes have grown along with allocations. The issue has become more common as plan money moved into private equity, hedge funds, and real estate partnerships, Groom says. Each new LP interest in a debt-financed fund is a potential tax item, and the burden of tracking the underlying borrowing sits with the plan's tax preparer and the fund's books.

A foreign blocker corporation remains an available workaround, though not a free one. Plans have often used such entities to shelter other income from UBIT, and Groom says the costs and benefits have to be reviewed case by case. A structure that made sense when gains and losses could be netted in the aggregate deserves another look now that the post-2017 rules are final.

Documentation is the practical hurdle. A plan that wants to apply the final rules to 2018-2020 returns needs its fund sponsors to hand over borrowing and income details in usable form. The fund managers who built their offering materials around the old aggregate calculation will feel the request first.