Henry E. & Nancy Bartels Trust v. U.S.

• Decision Date: 24 March 1999
• Docket Number: Docket No. 98-6141
• Citation: 209 F.3d 147
• Parties: (2nd Cir. 2000) HENRY E. & NANCY HORTON BARTELS TRUST FOR THE BENEFIT OF THE UNIVERSITY OF NEW HAVEN, Kenneth G. Bartels, John P. Loehmann, Philip H. Bartels, Marilou McLaughlin & Lawrence J. Denardis, Trustees, Plaintiff-Appellant, v. UNITED STATES OF AMERICA, Defendant-Appellee. August Term 1998 Argued:
• Court: U.S. Court of Appeals — Second Circuit

Page 147

209 F.3d 147 (2nd Cir. 2000)

HENRY E. & NANCY HORTON BARTELS TRUST FOR THE BENEFIT OF THE UNIVERSITY OF NEW HAVEN, Kenneth G. Bartels, John P. Loehmann, Philip H. Bartels, Marilou McLaughlin & Lawrence J. Denardis, Trustees, Plaintiff-Appellant, v. UNITED STATES OF AMERICA, Defendant-Appellee.

Docket No. 98-6141

August Term 1998

UNITED STATES COURT OF APPEALS FOR THE SECOND CIRCUIT

Argued: March 24, 1999;

Decided: April 11, 2000

Appeal from a judgment of the United States District Court for the District of Connecticut (Eginton, J.), in a refund action by plaintiff-appellant taxpayer, a tax-exempt trust formed to provide support for a university, upon an order granting taxpayer's motion for reconsideration and, on reconsideration, affirming an order granting defendant-appellee's motion for summary judgment and denying taxpayer's cross-motion for summary judgment, holding taxpayer's income derived from securities purchased on margin is subject to the unrelated business income tax under 511-14 of the Internal Revenue Code.

Affirmed.

PHILIP H. BARTELS (HOLLAND KAUFMAN & BARTELS, LLC), Greenwich, CT, for Plaintiff-Appellant.

PAULA K. SPECK for Loretta C. Argrett, Assistant Attorney General, Tax Division, Department of Justice, Washington, DC, (Kenneth L. Greene and Stephen C. Robinson, United States Attorney for the District of Connecticut, of counsel, on the brief), for Defendant-Appellee.

Before: PARKER and POOLER, Circuit Judges, and WEXLER,^* District Judge.

WEXLER, District Judge:

Plaintiff-appellant The Henry E. & Nancy Horton Bartels Trust for the Benefit of the University of New Haven ("Taxpayer"), appeals from a judgment of the United States District Court for the District of Connecticut (Eginton, J.), upon an order granting Taxpayer's motion for reconsideration and, on reconsideration, affirming an order granting the government's motion for summary judgment and denying Taxpayer's cross-motion for summary judgment in Taxpayer's refund action. Because we agree with the district court that Taxpayer's securities purchased on margin constitute debt-financed property and that income derived therefrom is subject to the unrelated business income tax ("UBIT") under 511-14 of the Internal Revenue Code ("Code"), 26 U.S.C. 511-14, we affirm.

I. BACKGROUND

The relevant facts, which are undisputed, may be summarized as follows: Taxpayer was created by a Declaration of Trust, dated November 30, 1988. The Internal Revenue Service ("IRS") granted Taxpayer tax-exempt status under 501(c)(3) of the Code on April 24, 1989. Taxpayer was formed to provide support for the University of New Haven ("UNH") and qualified as a "supporting organization" under 509(a)(3) of the Code. The Declaration of Trust gave Taxpayer's trustees broad discretion in investing its funds.

During the 1991, 1992, and 1993 tax years, Taxpayer invested in securities purchased "on margin," i.e., using funds borrowed from Taxpayer's stockbroker, Gilder, Gagnon, Howe & Co. ("Gilder, Gagnon"). In January 1995, Taxpayer filed Form 990-T, Exempt Organization Business Income Tax Return, for tax years 1991, 1992, and 1993, showing unrelated business income tax due on income derived from its margin-financed securities of $417, $2,948, and $6,123, respectively. Taxpayer paid the tax in full, with interest and penalties, but on May 22, 1995, Taxpayer filed a claim for refund of those payments. On April 25, 1996, the IRS denied taxpayer's refund claim. Taxpayer then brought this refund action.

In the district court, the government filed a motion for summary judgment, and Taxpayer filed a cross-motion for summary judgment. On March 17, 1998, the district court entered an order granting the government's motion and denying Taxpayer's cross-motion. The district court ruled that Taxpayer's income derived from securities purchased on margin is unrelated business taxable income under 511 of the Code.

Taxpayer moved for reconsideration. The district court granted the motion for reconsideration and, on reconsideration, affirmed its earlier order. Judgment was entered, and Taxpayer filed this appeal.

We now affirm the district court's judgment.

II. DISCUSSION

A. Standard of Review

We review the district court's grant of the government's motion for summary judgment and denial of Taxpayer's cross-motion for summary judgment de novo. Eisenberg v. Commissioner, 155 F.3d 50, 53 (2d Cir. 1998).

B. Unrelated Business Income Tax

An organization exempt from tax under 501 of the Code may be subject to the UBIT on income it derives from a trade or business unrelated to its exempt purpose. See 26 U.S.C. 501(b). Section 511(b) imposes the UBIT on tax-exempt trusts for "unrelated business taxable income," as defined in 512. Id. 511(b). Under 512(a), "unrelated business taxable income" is defined, in general, as the "gross income derived by any organization from any unrelated trade or business (as defined in section 513) regularly carried on by it, less the deductions . . . directly connected with the carrying on of such trade or business." Id. 512(a)(1). Section 513, in turn, defines "unrelated trade or business" to include any trade or business "the conduct of which is not substantially related (aside from the need of such organization for income or funds or the use it makes of the profits derived) to the exercise or performance by such organization of its charitable, educational, or other purpose or function constituting the basis for its exemption under section 501" - subject to certain exceptions not applicable here. Id. 513(a).

As a general rule, 512 excludes from tax passive investment income, such as interest, dividends, and royalties, received by exempt organizations. Nevertheless, such investment income is taxable if derived from "debt-financed property," as defined in 514. Thus, while 512(b) generally excludes certain items of income from "unrelated business taxable income,"¹ it nullifies these exclusions for income derived from "debt-financed property," providing: "Notwithstanding paragraph (1), (2), (3), or (5), in the case of debt-financed property (as defined in section 514) there shall be included, as an item of gross income derived from an unrelated trade or business, the amount ascertained under section 514(a)(1) . . . ." Id. 512(b)(4). Section 514(a)(1) requires that income earned from "debt-financed property" be treated as income derived from an unrelated trade or business (in the proportion that the basis of the property bears to the amount financed) for purposes of determining unrelated business taxable income. Id. 514(a)(1).² The taxability of income from debtfinanced property has no effect on the tax-exempt organization's taxexempt status, but the income the organization derives from debtfinanced property is subject to the UBIT as income from an unrelated trade or business. See id. 501(b).

"Debt-financed property" is defined as "any property which is held to produce income and with respect to which there is an acquisition indebtedness (as defined in subsection (c)) at any time during the taxable year." Id. 514(b)(1). Expressly excluded from debt-financed property is "any property substantially all the use of which is substantially related (aside from the need of the organization for income or funds) to the exercise or performance by such organization of its charitable, educational, or other purpose or function constituting the basis for its exemption under section 501." Id. 514(b)(1)(A)(i).

Section514(c)(1), in turn, defines "acquisition indebtedness" generally as "the indebtedness incurred by the organization in acquiring or improving [debt-financed property]." Id. 514(c)(1)(A). Expressly excluded from acquisition indebtedness is "indebtedness the incurrence of which is inherent in the performance or exercise of the purpose or function constituting the basis of the organization's exemption, such as the indebtedness incurred by a credit union described in section 501(c)(14) in accepting deposits from its members." Id. 514(c)(4).

C. Imposition of UBIT on Taxpayer's Income Derived from Securities Purchased on Margin

Taxpayer argues that the income it derived from securities purchased on margin is not subject to the UBIT because: (1) Taxpayer's securities investment activities, including margin trading, do not constitute conduct of a "trade or business" under the Code; (2)neither Taxpayer nor any third-party (i.e., UNH or Gilder, Gagnon) derived a direct or indirect "unfair competitive advantage" over taxable entities from Taxpayer's margin trading and the income derived therefrom; (3)Taxpayer's securities purchased on margin are not "debt-financed property" under 514(b)(1); and (4) the exceptions to "debt-financed property" and "acquisition indebtedness" under 514(b)(1)(A)(i) and 514(c)(4), respectively, apply to exclude Taxpayer's income derived from securities purchased on margin from the UBIT. We disagree with Taxpayer's arguments, each of which we address below, and hold, as did the district court, that Taxpayer's income derived from margin-financed securities is subject to the UBIT under 511-14 of the Code.

1. Unrelated Trade or Business

Taxpayer initially argues that its securities investment activities, particularly its margin trading, do not constitute a "trade or business" under the Code, and, therefore, the income it derived from margin-financed securities is not subject to the UBIT. In this respect, Taxpayer argues that in determining whether an exempt organization's income is subject to the UBIT as "unrelated business taxable income" the following three requirements must be met: "(1) [i]t is income from trade or business; (2) such trade or business is regularly carried on by the organization; and (3) the conduct of such trade or business is not substantially related (other than through the production of funds) to the organization's performance of its exempt functions." Treas.Reg. 1.5131(a); see United States v....