UBI stands for “unrelated business income,” a concept unknown to the natural world but one that has infected the Internal Revenue Code (§ 513) for a long time. (UBIT stands for unrelated business income tax.) Basically, § 513 means that nonprofit organizations (operating nonprofits, foundations, endowments, IRAs) can’t engage in business operations or they will have to pay taxes on any revenues they generate. If they engage in too much business activity, they can lose their exempt status. An obvious example would be many of the items sold in museum gift shops.

UBI annoys me because it’s one of those examples of public policy that began life on relatively solid ground, then moved onto semi-thick ice, then onto perilously thin ice, and finally plunged into that dim watery hell reserved for government ideas so completely barmy even the beancounters at the IRS aren’t sure how it happened.

I could write a law review article about this, but since this is a blog post I’ll just give you the 80,000 foot level view of how mushrooming legislative and regulatory senility works. Let’s start back in 1950, which if you do the math turns out to be almost exactly two-thirds of the way back to when the income tax was first foisted onto an unsuspecting American public (in 1913).(1)

That was the year that Congress, in its infinite wisdom, decided that nonprofits couldn’t compete with taxpaying businesses. Well, ok, that’s maybe not as much of a slam-dunk as it sounds,(2) but unreasonable minds can disagree. I’ve started a lot of businesses in my time, some for-profit and some not-for-profit, and many of them are, I’m happy to report, still going strong.(3) Some of the nonprofits compete head-to-head with for-profits, but most don’t.

At first, the penalty for a nonprofit engaged in a for-profit business was death: its tax-exemption was revoked. But since this was like getting hanged for jaywalking, courts refused to find that any nonprofit was engaged in business (as defined in the Code). Congress finally got the message and decided simply to tax nonprofit business revenues (unless they got too high – an undefined state – in which case the penalty was still death).

So far we’re on reasonably solid ground. But then Congress, in its considerably-less-than-infinite wisdom, decided that since nonprofits shouldn’t be in business, they shouldn’t need to borrow money (§ 514(b)). And if they did borrow money, any profits would be taxed as though they were UBI. Hello? I can think of roughly 112 million entities that aren’t in business but that need to borrow money: American families, who hold mortgage debt, auto loans, consumer loans, credit card debt, student loan debt, etc., etc. We were now out on the ice, although ice that was probably still safe for the IRS to skate on.

But the next step was to extend the concept of no-debt-no-how-no-way to the investment portfolios of nonprofits.(4) Since it was perfectly clear that nonprofits could invest their assets legally, what the hell was the point of extending the no-debt rule to investment activities? How could investment activity be “unrelated” to the mission of the nonprofit? Here what the beancounters were presumably worried about was that nonprofits might borrow money to buy an investment asset (aka, buying on margin). But so what? If an investor wants to leverage itself up, let ‘em go ahead and do it. If the investor’s right, its returns will be higher than otherwise, and if it’s wrong it will pay a very serious price. This is a self-correcting problem, and the IRS found itself on very, very thin ice.

So, naturally, what the Service did was to double-down. With the ice cracking all around it and finding that it was impossible to crawl back to thick ice, much less solid ground, the IRS took the plunge (pun intended) and extended the We-Hate-Debt! rule to the portfolios of independent third party investment managers with which nonprofits were invested.

Hold on here, am I dreaming? The nonprofits didn’t borrow the money and weren’t on the hook for the repayment. Probably they didn’t even know the manager was buying securities using leverage. Nonetheless, the Debt Nazis went after these nonprofits with a vengeance, taxing any income produced by third party managers using leverage both at the Federal level and also at the state level. (The nonprofits had to file tax returns in every jurisdiction where their capital was invested.)

Public tax policy was now so firmly ensconced in a fantasy world that investment managers and nonprofits simply rolled their eyes and ignored the rules. They set up offshore funds structured as “blocker” corporations through which the nonprofits invested, and these offshore corporations magically “scrubbed” the UBI out of the returns. The nonprofit was invested exactly as it would have been if it had invested in the onshore fund, but it wasn’t paying any UBIT. And the IRS, possibly mortified by where the UBI rules had ended up, blessed this tawdry ruse. All was well.

Or was it? Billions and billions of dollars had now moved offshore, typically to someplace like Bermuda, the Bahamas or the Caymans. In addition, a huge infrastructure followed this money: lawyers, accountants, banks, administrators, trust companies and so on. So along with the capital, hundreds of thousands of good jobs flowed out of the US, and all because the good folks at 10th and Pennsylvania couldn’t find it within themselves to say, “Ok, we’re on thin ice here, so let’s not do anything else stupid.”

Just another of those Things That Annoy Me.

 

(1) Technically, a temporary income tax was imposed in 1862 to finance the Civil War (in the North).

(2) The fundamental idea seems to be that since nonprofits don’t pay taxes, they have an unfair advantage over businesses that do. A NY State Senator I’ll call Senator Hollowhead, excoriating NYU Law School for owning Mueller’s Macaroni, fulminated, “Soon, every noodle in America will be owned by some damned nonprofit!” But a moment’s thought (this moment never happened to Senator Hollowhead) suggests the absurdity of this view. Consider that the sole proprietor of Moneybags, LLC, a fellow near and dear to my heart, is in a much higher tax bracket than most app developers. (This is because most app developers haven’t started shaving yet.) What a gigantic competitive advantage these young sprouts have! I insist that every app developer pay the same tax rate I pay! Fond as I am of this idea, I suspect that it has no chance of being adopted, possibly because it’s idiotic. As a couple of very smart people have noted, “An income-tax exemption is not an input subsidy; it does not reduce the charity’s cost of purchasing goods. Viewed this way, the zero rate for charity is no more ‘unfair’ to a 35-percent-taxed competitor than are the progressive income-tax rates on individuals who conduct business activities in a … limited liability company.” Hear, hear! See, The Unrelated Business Income Tax: All Bark and No Bite?, Evelyn Brody and Joseph J. Cordes, No. 3 in the Seminar Series, “Emerging Issues in Philanthropy,” a joint project by the Urban Institute Center on Nonprofits and Philanthropy and the Harvard University Hauser Center for Nonprofit Organizations, March 1, 2001.

(3) Just to mention some you might have heard of, on the nonprofit side there’s The Investment Fund for Foundations (co-founded with a lot of others), and on the for-profit side there’s Greycourt, Moneybags and The Stewardship of Wealth. (Oh, you don’t consider writing and promoting a book to be a business? Maybe you’re unfamiliar with IRS Schedule C. Maybe you imagine me romantically scribbling away in my garret high above the 14th Arrondissement, Babette sprawled fetchingly nearby, trying to tempt me from my labors. It wasn’t like that.)

(4) The IRS was making the mistake of assuming that anything a nonprofit did using debt – not just competing with for-profit businesses – should be taxed. UBI had now become a cancer on the already pockmarked face of public policy.

Next up: Things That Annoy Me, Part 4

Please note that this post is intended to provide interested persons with an insight on the capital markets and is not intended to promote any manager or firm, nor does it intend to advertise their performance. All opinions expressed are those of Gregory Curtis and do not necessarily represent the views of Greycourt & Co., Inc., the wealth management firm with which he is associated. The information in this report is not intended to address the needs of any particular investor.