The Tax Efficiency Strategy for Tax-Exempts to Address UBTI

by Jay C. Judas, JD, M.Sc., Managing Director

Historically, tax-exempts such as universities, charities and hospitals have seen their ability to invest their endowments burdened by existing tax laws.  Despite their tax-exempt status, these organizations can find their tax liability to be heavier for certain asset classes than that of for-profit corporations or individuals.  This inequality is mainly derived from the U.S. Treasury assessing UBIT or a tax on Unrelated Business Taxable Income of roughly 30% to 35%.  There is also discussion by the current U.S. Congress to assess a 1.4% tax on universities’ endowment income.

Tax-Exempt investors are hit with UBIT on any money earned from investment activities unrelated to the entity’s tax-exempt purpose as described in IRC §513(c).  For instance, a university’s endowment would face UBIT on a real estate investment since such an investment is not related to the university’s educational purpose.

A traditional work-around utilized by tax-exempts is to invest through a blocker corporation.  This strategy allows a tax-exempt to make real estate investments via hedge funds or private equity and have dividends, rental income, interest income and capital gains not treated as UBTI.  Most private equity and hedge funds are established as limited partnerships.  The LLP nature permits the fund itself to avoid taxation on profits and passes taxation along to the individual investor as a partner in the LLP.

A tax-exempt would not invest directly into the LLP but would make the investment through a C Corporation.  The profits passed along from the private equity or hedge fund real estate investment would be treated as a dividend and exempt from UBTI.  It is an expensive, complicated and a time consuming structure and, therefore, efficient mostly at only large investment levels.  

A much easier way to accomplish blocking UBTI is for a tax-exempt to make the investment into a real estate fund inside of a private placement structure, specifically, a deferred private placement variable annuity, or “PPDVA”.  A PPDVA blocks all taxation as long as the structure is in-force by applying long-standing insurance laws. 

In any private placement insurance transaction, the underlying assets of the annuity belong to the insurance company; albeit, segregated from the general account of the insurer and not subject to the insurer’s creditors.  In exchange, the policyholder, or tax-exempt, receives a deferred private placement annuity whose value is linked to the value of the segregated real estate fund investment.

From a governance perspective, financial reporting is simplified for the tax-exempt since it does not hold the real estate investment and, instead, owns a deferred annuity.  Without a distribution from the deferred annuity, there is nothing for the tax-exempt to report and, until that time, all growth or profits from the investment within the deferred annuity are tax-deferred under IRC §512.  Annuity income is excluded from UBTI.

As with any private placement life insurance transaction, the underlying investments are subject to the diversification thresholds described in IRC §817(h) where there must be at least five distinct positions or investments not exceeding specified percentages of the total value.  In most real estate funds, this is not a concern but should be monitored in instances of a fund’s draw down in any position, so any diversification failure may be cured within the acceptable grace period.

The other general rule to maintain tax-efficient treatment is to follow the Investor Control Doctrine (Rev. Rul. 82-54) whereby the deferred annuity owner does not directly control the investment(s) linked to the annuity’s value.  A professionally-managed real estate fund will meet this threshold.

As with any annuity, an annuitant must be selected as a measuring life.  A joint-annuitant is preferred so that the death of a single annuitant does not lead to the pre-mature end of the structure.  At the death of one annuitant, a ‘new’ joint annuitant is added to insure continuity. 

The annuitant can be chosen from several individuals connected to the tax-exempt but is usually an individual with a fiduciary duty to the organization such as a trustee or a board director or equivalent.

Unlike retail annuities, a PPDVA is institutionally priced with asset-based compensation.  Such pricing, combined with the ease of set-up, makes the use of a PPDVA as a UBTI blocker advantageous over the C Corporation arrangement.

While university endowments are a likely audience of the application of the PPDVA, other tax-exempts such as foundations, hospitals and associations, to name a few, share the same impediments with UBTI when it comes to real estate investments.

Real estate may be a desirable investment for tax-exempts but other common investments made through PPDVA structures include Oil & Gas, Timber & Agriculture, Infrastructure and Master Limited Partnership.


Jay C. Judas serves as a Managing Director for Crown Global and a member of the company’s International Group Executive Leadership Team focused on expanding key client relationships throughout the Americas, Europe, the Asia-Pacific, the Middle East and the Caribbean.

Mr. Judas previously served as the Senior Vice President & Chief Distribution Officer for Old Mutual’s Bermuda subsidiary and as the Vice President & Country Head of Life Distribution for Sun Life Financial’s Bermuda branch. 

A graduate of Rutgers University School of Law, Mr. Judas also holds a Master of Science in Leadership from Northeastern University and is a fourth-generation graduate of the University of Northern Iowa where he earned a Bachelor of Arts in Communications, Radio/Television Broadcasting. He is a long-time member of the Association for Advanced Life Underwriting (AALU) and a Board Director of P.J. Scooter, LLC.