Debt Financed Investments

See the IRS rules

Article on debt finance strategies for qualified plans

First, check to make sure that your plan document allows or does not prohibit margin accounts or other debt financed investments. Second, under IRC 514(b)(1), the stocks purchased on margin become “debt-financed property”. The term “debt-financed property,” means any property held to produce income, and with respect to which there is an acquisition indebtedness at any time during the taxable year. The ramifications of being considered debt-financed property is income attributable to the margin account is unrelated business taxable income (UBTI).

 

In Elliot Knitwear Profit Sharing, Etc. v. Commissioner of Internal Revenue , 614 F.2d 347 (3rd Cir, 1980) an employee profit-sharing plan that was exempt from tax under IRC 501(a) because it qualified under IRC 401(a) purchased securities on margin. The court held that the securities purchased on margin constituted debt-financed property and that the profits derived from their sale are taxable as unrelated business income since the purchase of securities on margin is not inherent to the purpose of a tax-exempt profit-sharing plan and that such purchases are not substantially related to the purpose of such an organization so as to be excepted from the definition of debt-financed property. The same logic applies to other debt financed investments.

 

Treasury. Regulation § 1.513-1 (b) provides additional guidance on this subject. A qualified trust is generally exempt from taxation on income that is derived from investment activity. However, if the trust conducts an active trade or business, the income derived from that activity is taxed as UBTI.

 

Buying stock on margin using funds loaned by a party in interest (for example, a broker-dealer) has been officially permitted by the DOL since at least March 1986. In Advisory Opinion 86-12A , the DOL, commenting on PTE 75-1, stated the following:

 

“The preamble to Part V of PTE 75-1 states that a normal part of the execution of securities transactions by broker-dealers on behalf of their customers, including employee benefit plans, is the extension of credit to the customers in order to permit settlement within the usual five-day period. The preamble further states that extensions of credit by broker-dealers also are customary in connection with certain kinds of security transactions, such as short sales and the writing of option contracts.

 

“The condition contained in paragraph (b)(1) of Part V of PTE 75-1 specifies that, in order to qualify for the exemption, an extension of credit must be in connection with the purchase or sale of securities. It is the Department’s opinion that the extension of credit by a broker-dealer to a plan purchasing securities on margin will satisfy the requirement imposed by paragraph (b)(1) of Part V of PTE 75-1. Accordingly, the exemption provided by Part V of PTE 75-1 encompasses the purchase of securities on margin if all the other conditions of the exemption are met.”