Taxing the Tax-Exempt

Liz Gunnison this morning picks up on a startling article by Bloomberg's Ryan Donmoyer, in which not only is it mooted that hedge-fund managers should pay income tax on their income – something which has been in the air for a while, and which is perfectly sensible – but also that tax-exempt foundations, such as the $30 billion Harvard endowment, should pay income tax as well, on at least part of their income.

The point at issue is something known to tax lawyers as "unrelated business income tax," which is essentially a tax on leverage. As I understand it, if a non-profit endowment takes a billion dollars of its own money and buys a stock which pays a high dividend, then that dividend income is tax-free. If the same endowment leverages its billion dollars by buying options on the stock rather than the underlying stock itself, the gain it makes on those options is also tax-free. But if the endowment borrows the billion dollars from a bank before buying the stock, then the income is taxable.

It doesn't make any sense, frankly, to single out "debt-financed investing" for taxation in these days of extreme financial sophistication and embedded leverage. Virtually any debt-financed investment can be structured, for a fee, as a derivative instrument instead, so endowments could get around this rule even if offshore "blocker" companies were outlawed.

And it's worth noting that the rule affects much more than just hedge-fund investments. Big university endowments are essentially hedge funds themselves, albeit with much lower fees: they leverage themselves quite happily either before or instead of investing in hedge funds. So even pulling out of hedge funds entirely wouldn't solve their problem.

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