Description of Possible Options to Increase Revenues

my, these tax-exempt organizations should not be immune from sharing some of the costs of government through a modest excise tax on investment income.

2. The proposed excise tax would not apply to noninvestment income of such organizations, such as dues paid to membership organizations for their exempt purposes, charitable contributions, or related business income (e.g., tuition paid to schools or patient fees paid to hospitals). Accordingly, the proposed excise tax would have a limited impact on the activities of exempt organizations.

3. The proposed excise tax could be "sunsetted" so that it would not apply once the budget deficit is reduced to a specified level. Arguments against the proposal

1. Investment income of most tax-exempt organizations has been exempt from income or other Federal taxation since the inception of the tax statute, except in limited situations (such as debt-financed income or the excise tax applicable only to certain private foundations). This exemption reflects a recognition that many exempt organizations perform functions that lessen the burdens of government that otherwise would have to be financed out of tax revenues, promote the general welfare of the public at large, or contribute to the economic well-being of the country through promotion of business and labor.

2. The imposition of the tax would reduce the funds available to and needed by charities, social welfare organizations, and other exempt organizations in carrying out their nonprofit activities. The tax thus would adversely affect the beneficiaries of these programs, including the poor, the elderly, students, hospital patients, the environment, etc.

3. Unrelated business income tax-equity kickers on loans to business ventures

Present Law

A tax-exempt organization must pay tax at regular income tax rates on its unrelated business taxable income ("UBTI”). If a taxexempt organization makes an equity investment as a partner in a partnership, the income it receives attributable to the business activities of the partnership is UBTI. However, certain passive investment income, such as interest or dividends, generally is excluded from the definition of UBTI.

Due to the UBTI exception for passive investment income, if a tax-exempt organization makes a loan to a partnership, the interest it receives on the loan generally is not UBTI. However, it is frequently difficult to distinguish a debt investment from an equity investment. Court cases and revenue rulings indicate that a loan made with a significant "equity kicker" can still be debt, and no portion of the amounts received are other than interest, even though the return on the equity_kicker depends upon the entrepreneurial success of the venture. Even a return based on net profits may be considered interest on debt that is not UBTI, although economically it may be virtually identical to a preferred equity interest in the partnership.

In other contexts in the Code, a return based on net profits is not considered sufficiently passive to qualify for certain tax benefits that are available only if the recipient does not engage in significant active, business-type operations. For example, such a return generally would not constitute qualified income of a real estate investment trust (REIT). If such nonqualified income exceeds specified limits, the REIT no longer is treated as a passive conduit, but is subject to entity level taxation. A return based on gross receipts generally would be qualified income of a REIT even though in effect such amounts might produce a return based on net profits in certain circumstances.

Possible Proposal

The income of a tax-exempt organization from a partnership investment involving an equity kicker could be treated as an equity investment that may produce unrelated business taxable income. This rule could be limited to cases where the return on the investment is based on net profits of the venture.

Arguments for the proposal

Pros and Cons

1. Tax-exempt entities should not be able to receive amounts based on an increase in the equity value of a venture without

paying the same unrelated business income tax they would pay on an investment designated as equity.

2. Tax-exempt entities should be subject to at least the same standards of passivity, with respect to the income that may be received free of tax, as apply in determining whether a real estate investment trust is taxed at the entity level.

Arguments against the proposal

1. Tax-exempt entities should be permitted to maximize the amounts that they may receive free of tax, to enhance the funds available for their tax-exempt purposes.

2. Tax-exempt entities should not be held to a stricter standard distinguishing debt from equity than other investors.