GOP Tax Overhaul Could Hit State and Local Pension Plans With Federal Tax

WASHINGTON — State and local government pension plans would be confronted with new costs and complications under the Republican tax bill the U.S. House approved last week.   

Some, but not all, public pension investments would become subject to what’s known as the Unrelated Business Income Tax, or UBIT, if the current version of the House bill were to be enacted. The proposed change to how the tax is applied would make it so state and local government pension plans are treated in a way that is similar to private sector pensions, or nonprofit organizations.

Hank Kim, executive director of the National Conference on Public Employee Retirement Systems, said that if the House proposal were to go into effect, it would be the first time that state and local pension systems would have to pay federal tax on their investments.

“It's a huge burden,” Kim added by phone this week.

Retired police, firefighters and teachers are a few examples of people covered by the state and local government pension plans that could be affected by the House proposal. Legislation the U.S. Senate Finance Committee has passed does not include similar UBIT provisions.

A Ways and Means Committee summary of the House bill says that the UBIT proposals in the legislation would increase federal revenues by about $1.1 billion between 2018 and 2027. GOP lawmakers are trying to revamp the tax code in a way that would not add more than $1.5 trillion to federal deficits over a decade, while also providing tax cuts for corporations and individuals.

Implications for Pension Funds

Although the health of public pension systems varies widely across the U.S., there are many examples of states and localities that are struggling to adequately fund the retirement plans.

The House bill raises the possibility that some plans would face new costs in the form of federal tax payments, which could eat into investment returns.

It would also introduce a new layer of considerations as pension fund managers decide how to structure investments. Additionally, they would have to weigh whether investments subject to the UBIT would yield adequate cash distributions each year to cover tax liabilities.

Public plans would enter into uncharted administrative terrain as well, as they would have to begin filing federal tax returns, something they do not do currently.

“There’s probably a lot of spillover complexity and compliance cost and unintended consequences that you just don't see when you sort of first say: ‘well, why don't they pay tax like a corporate pension plan?’” Richard Zarin, a partner who specializes in tax matters with the law firm Morgan, Lewis & Bockius, LLP, said during an interview.

Unrelated Business Income Tax would not apply to more traditional forms of investment income that pension funds might generate, like corporate stock dividends, capital gains, interest, and rent earnings from real estate holdings that do not involve debt-financing.

Where the tax could come into play is if a pension system puts money into more complicated real estate ventures, infrastructure projects, or certain private equity funds that invest in startups, or other businesses that are limited liability companies. (There are ways tax-exempt investors can shield themselves from UBIT liability by using intermediaries called “blockers.”)

Douglas Schwartz, a partner who focuses on tax law at Nossaman, LLP, flagged what are known as prepackaged funds as a special concern. He said that while pension systems could structure other investments to avoid the UBIT, with prepackaged funds this would not be so.

“They’ll take out debt, or they’ll invest in startups, and the investor has very little control over that,” he said of the funds.

Schwartz also pointed out that with the House bill's UBIT provisions, which would go into effect in 2018, there is no “grandfathering.”

So, in other words, a fund might have put money into an investment five or ten years ago assuming that it would be exempt from federal taxation. But, if the House measure were to win final approval, this would not be the case in the years ahead.

Constitutional Concerns?

The National Conference on Public Employee Retirement Systems, National Association of State Retirement Administrators and the National Council on Teacher Retirement wrote joint letters to congressional leaders earlier this month, urging that the UBIT language affecting state and local public pension plans be left out of any final legislation to overhaul the tax code.

In the letters, the groups allude to constitutional concerns. “State agencies are Constitutionally exempt from taxation and application of UBIT to public pension plans erodes the immunity states and the federal government each enjoy from taxation by the other,” they wrote.

But Daniel Hemel, a law professor at University of Chicago Law School whose research covers tax law, noted in an email that “states do not enjoy absolute immunity from federal taxation.”

He highlighted a 1988 U.S. Supreme Court opinion, in the case South Carolina v. Baker, that says while “all federal activities are immune from direct state taxation … at least some state activities have always been subject to direct federal taxation.”

Hemel also referenced the opinion of former Chief Justice Harlan Fiske Stone, in a case from the 1940s, New York v. United States, which seems to say that a nondiscriminatory federal tax can be applied to state governments as long as it does not “interfere unduly with the State's performance of its sovereign functions of government.”

“By that standard, it's very hard for me to see how the application of UBIT to state and local government pension funds would violate any constitutional provision,” Hemel said. “The tax is nondiscriminatory—it applies to other generally tax-exempt entities as well.”

He added: “The argument that the House provision violates the Constitution strikes me as a creative one but not a winning one.”

Kim, with the National Conference on Public Employee Retirement Systems, acknowledged that as the GOP-led tax overhaul effort has unfolded on Capitol Hill, state and local government groups have so far been largely preoccupied with issues other than the UBIT.

For instance, lobbying against proposals that would rollback the deduction for certain state and local taxes and that would eliminate tax-exemptions for interest earned on certain bonds.

“As they become more aware of the policy implications of UBIT,” Kim said of the state and local groups, “I think it will quickly rise to the top of the priority list.”