3978 / When are the earnings of a qualified pension or profit sharing trust taxable to the trust or to participants? When does trust income constitute unrelated business income?

Normally, neither a participant nor a trust pays any tax on earnings on a trust because as long as the plan meets the requirements of IRC Section 401(a), the trust is tax-exempt under IRC Section 501(a). The tax exemption also applies to trusts of plans covering self-employed individuals.

Trust income may be subject to income tax when it constitutes unrelated business income.¹ For example, a plan has unrelated business income from a trade or business regularly carried on by the trust.² This could occur when an exempt trust is a limited partner that receives unrelated business income to the same extent as if it were a general partner.³ A specific deduction of up to $1,000 is allowed against unrelated business income.⁴ Thus, a trust generally will pay income taxes when its unrelated taxable income exceeds $1,000.

Income from any type of property will be taxable as unrelated business income if the property has been acquired with borrowed funds, that is, debt-financed property. Thus, income from plan assets subject to debt, such as life insurance with policyholder loans, may give rise to unrelated business taxable income.⁵

Where a pension fund, in an attempt to increase the rate of return on three certificates of deposit, borrowed funds from a savings and loan with the three old certificates as collateral and was issued a new certificate in an amount equal to the borrowed amount, the net interest earned on the new certificate was income from debt-financed property.⁶

An exempt trust or 501(c)(3) organization may be a shareholder in an S corporation ( Q 3818). Ordinarily, such an interest would be treated as an interest in an unrelated trade or business; thus, items of S corporation income allocable to a plan could result in unrelated business income.

An employee stock ownership plan ( Q 3817, Q 3825) maintained by an S corporation is not treated as receiving unrelated business income on items of income or loss of the S corporation in which it holds an interest.⁷

Employer securities purchased by an ESOP with borrowed funds do not give rise to unrelated business taxable income because the indebtedness that an ESOP incurs to purchase employer securities is inherent in the purpose of the trust’s tax exemption.⁸ Securities purchased on margin by a profit sharing trust and by a pension trust have been held to be debt-financed property.⁹

Where a trust is taxed because of its unrelated business income, the tax rate is the rate applicable to trusts.¹⁰

A trust’s earnings are not entirely tax-free, but are merely deferred until they are distributed or made available to participants or their beneficiaries.¹¹