LawFlash

IRS Provides Guidance for TEOs With Multiple Trades or Businesses to Calculate UBTI

April 28, 2020

The Internal Revenue Service (IRS) and the US Department of the Treasury released proposed regulations on April 23 that provide guidance for calculating UBTI and make some important changes to the interim guidance the IRS provided in Notice 2018-67. Tax-exempt organizations are now required to identify separate trades or businesses using the first two digits of the North American Industry Classification System (NAICS), but may still treat certain activities in the nature of investments collectively as one separate trade or business.

In summary, the proposed regulations, released on April 23, 2020, provide as follows, each discussed in more detail below:

  1. Exempt organizations will identify each separate unrelated trade or business using the first two digits of the NAICS code (i.e., the sector designation) that most accurately describes a trade or business
  2. Deductions will be allocated on a reasonable basis between separate unrelated trades or businesses
  3. All payments from each controlled entity, as defined in Section 512(b)(13), will be treated as gross income from one trade or business and cannot be combined
  4. For tax years beginning after December 31, 2017, an organization with more than one unrelated trade or business determines its net operating losses separately with respect to each trade or business; an organization with net operating losses for tax years beginning prior to January 1, 2018 (pre-2018) and for tax years beginning after December 31, 2017 (post-2017) deducts its pre-2018 losses from its total UBTI first and then deducts post-2017 net operating losses from the respective trade or business from which the loss arose
  5. Qualifying partnership interests, qualifying S corporation interests, and debt-financed property are “activities in the nature of investments” and are generally treated collectively as one trade or business

Background

Under Section 511(a)(1) of the Internal Revenue Code (Code), tax-exempt organizations are generally subject to tax on income arising from their unrelated trade or business activities. An “unrelated trade or business” is any trade or business, regularly carried on, the conduct of which is not substantially related to the exercise or performance of the organization’s tax-exempt purposes.

Prior to the enactment of the “Tax Cuts and Jobs Act,” tax-exempt organizations were permitted to aggregate gross income and deductions from all unrelated business activities without consideration of whether some business activities constituted a separate trade or business. The act added Section 512(a)(6) to the Code, which now requires tax-exempt organizations with more than one unrelated trade or business to calculate UBTI separately for each. Congress did not, however, provide explicit criteria for determining whether an exempt organization has more than one unrelated trade or business or how to identify separate unrelated trades or businesses to calculate UBTI in accordance with Section 512(a)(6).

On August 21, 2018, the IRS issued Notice 2018-67 (Notice). The Notice provided that exempt organizations could generally rely on a “reasonable, good-faith interpretation” of Sections 511–514 when identifying separate trades or businesses and calculating UBTI for purposes of Section 512(a)(6) until regulations were proposed. The Notice also identified the use of NAICS six-digit codes as a “reasonable, good-faith interpretation” for identifying separate trades or businesses. NAICS is an industry classification system for purposes of collecting, analyzing, and publishing statistical data related to the United States business economy that results from a cooperative effort between Canada, Mexico, and the United States. NAICS uses a six-digit coding system, dividing the economy into 20 sectors. The first two digits of the code designate the sector (e.g., retail trade; real estate and rental and leasing; healthcare and social assistance; and accommodation and food services). The third digit designates the subsector; the fourth digit designates the industry group; and the fifth digit designates the NAICS industry. When applicable, the sixth digit is used to designate the national industry, to reflect differences between the countries.

In the Notice, the US Treasury Department and the IRS requested comments on the interim guidance, and specifically how the NAICS codes may aid in determining how to identify an exempt organization’s separate trades or businesses for purposes of Section 512(a)(6).

The Notice also provided special interim guidance for investments in partnerships and allowed for the treatment of all “Qualifying Partnership Interests” as defined in the Notice to be treated as a single trade or business for calculating UBTI. The Notice indicated that the Treasury Department and the IRS would propose regulations treating certain activities in the nature of an investment as one trade or business for purposes of Section 512(a)(6)(A) to permit exempt organizations to aggregate gross income and directly connected deductions from such “investment activities,” and requested comments on the scope of investment partnership interests or other activities in the nature of an investment that should be included in the category of “investment activities” for purposes of Section 512(a)(6).

Proposed Regulations

On April 23, 2020, the Treasury Department and the IRS released proposed regulations that establish the method for determining whether an exempt organization has more than one unrelated trade or business for purposes of Section 512(a)(6) and identifying separate unrelated trades or businesses for purposes of calculating UBTI.

Identifying Separate Trades or Businesses

The proposed regulations not only keep the NAICS method for identifying separate trades or businesses, but also now require organizations to use this method. In response to comments regarding the burden related to the specificity of NAICS six-digit codes, however, the proposed regulations provide that an exempt organization will identify each of its separate unrelated trades or businesses using only the first two digits of the NAICS code (i.e., the sector designation) that most accurately describe a trade or business. The organization must choose the NAICS code that most accurately describes the unrelated trade or business in which the exempt organization engages (directly or indirectly) and not the code that identifies the activities in which the organization engages that are substantially related to its exempt activities. For example, a state college or university could not choose NAICS Code 61 (educational services) to identify all of its unrelated trade or business activity.

An exempt organization will report each NAICS two-digit code only once on Form 990-T, and it will treat all unrelated business activities properly classified under that code as one unrelated trade or business. For example, a hospital that operates more than one pharmacy would report all the pharmacies using the NAICS two-digit code for retail trade (44), along with any other retail trades or businesses described by this NAICS two-digit code, on Form 990-T as one unrelated trade or business, even if it maintains separate books and records for each pharmacy.

Once an exempt organization has identified a separate unrelated trade or business using a particular NAICS two-digit code, the organization may not change the NAICS two-digit code describing that trade or business unless it can show that (1) the NAICS two-digit code chosen was due to an unintentional error, and (2) another NAICS two-digit code more accurately describes the trade or business. However, this requirement applies only to codes reported on the first Form 990-T the organization files after final regulations under Section 512(a)(6) are published.

The Treasury Department and the IRS have requested comments on whether another method, or additional methods, of identifying an exempt organization’s separate unrelated trades or businesses better achieves the intent of Congress in enacting Section 512(a)(6) while still being administrable for exempt organizations and the IRS.

Allocating Expense Deductions

The proposed regulations incorporate the existing allocation standard in Treas. Reg. §1.512(a)-1(c), which provides that an exempt organization must allocate deductions on a reasonable basis between separate unrelated trades or businesses. However, the preamble to the proposed regulations notes that the Treasury Department and the IRS are concerned that permitting allocation methods based solely on reasonableness is difficult for the IRS to administer and may not provide certainty for taxpayers. As such, the Treasury Department and the IRS are continuing to consider the allocation issue and intend to publish a separate notice of proposed rulemaking providing further guidance on this issue. The proposed regulations do make clear, however, that allocation of expenses, depreciation, and similar items using an unadjusted gross-to-gross method will not be considered reasonable.

Payments from Controlled Entities

The proposed regulations provide that payments received by a controlling organization from a controlled entity that are treated as UBTI under Section 512(b)(13) (i.e., “specified payments”) will be treated as gross income from a separate unrelated trade or business for purposes of Section 512(a)(6). If the controlling organization receives specified payments from two different controlled entities, the payments from each controlled entity are treated as from separate unrelated trades and business and are not aggregated together. However, the specified payments from one controlled entity will be considered as gross income from one trade or business regardless of whether the controlled entity itself engages in multiple unrelated trades or business or whether it makes different types of specified payments to the controlling organization.

Net Operating Losses

The proposed regulations provide that an exempt organization with more than one unrelated trade or business determines the net operating loss (NOL) deduction allowed by Sections 172(a) and 512(b)(6) separately with respect to each of its unrelated trades or businesses. If an exempt organization has more than one unrelated trade or business, Treas. Reg. §1.512(b)-1(e), which explains the application of Section 172 within the context of the unrelated business income tax, applies separately with respect to each unrelated trade or business.

Section 512(a)(6)(A) does not apply to NOLs arising in tax years beginning before January 1, 2018; rather, such pre-2018 NOLs are taken against the total UBTI calculated under Section 512(a)(6)(B). An exempt organization with both pre-2018 and post-2017 NOLs will deduct its pre-2018 NOLs from its total UBTI under Section 512(a)(6)(B) before deducting any post-2017 NOLs with regard to a separate unrelated trade or business from the UBTI from that unrelated trade or business.

Activities in the Nature of Investments

In the Notice, the Treasury Department and the IRS indicated that they intended to propose regulations treating certain activities in the nature of an investment as one trade or business for purposes of Section 512(a)(6)(A) to permit exempt organizations to aggregate gross income and directly connected deductions from such “investment activities.”

The proposed regulations provide an exclusive list of “activities in the nature of investments” (“investment activities”) that will be treated collectively as a separate unrelated trade or business for purposes of Section 512(a)(6). For most organizations, these include (i) qualifying partnership interests (QPIs); (ii) debt-financed properties under Section 514; and (iii) qualifying S corporation interests, each discussed below.

Qualifying Partnership Interests

Similar to the Notice, the proposed regulations provide two tests under which a partnership interest may be treated as a QPI:

  • De minimis test. A partnership interest generally meets the de minimis test if the exempt organization holds directly no more than 2% of the profits interest and no more than 2% of the capital interest in the partnership
  •  Control test. A partnership interest generally meets the requirements of the control test if the exempt organization (i) directly holds no more than 20% of the capital interest in the partnership; and (ii) does not have control or influence over the partnership

The proposed regulations make two very important changes to the proposed de minimis test set forth in the Notice. First, organizations are not required to combine the interests of a disqualified person, supporting organization, or controlled entity in the same partnership when determining whether a partnership interest meets the de minimis test.

Second, in the case of multi-tiered partnerships, if an exempt organization holds a direct interest in a partnership that it does not control, but that directly-held partnership interest is not a QPI under the control test because the exempt organization holds more than 20% of the capital interest, the organization may treat an indirect partnership interest in the lower-tiered partnership as a QPI if that indirectly held partnership interest meets the requirements of the de minimis test. In other words, the proposed regulations permit an exempt organization to aggregate the UBTI from some indirectly-held QPIs with its directly-held QPIs. This look-through rule does not apply to indirectly-held QPIs that do not meet the requirements of the de minimis test but may meet the requirements of the control test.

For the control test, the proposed regulations require organizations to combine the interests of a supporting organization or controlled entity in the same partnership, but also do not require an organization to take into account the interest of a disqualified person when determining whether a partnership interest meets the 20% threshold. The proposed regulations maintain “that all the facts and circumstances are relevant for determining whether an exempt organization controls a partnership,” and also provide the following four circumstances in which an organization is deemed to control a partnership:

  • the organization, by itself, may require the partnership to perform, or prevent it from performing, any act that significantly affects the operations of the partnership;
  • any of the organization’s officers, directors, trustees, or employees have rights to participate in the management of the partnership at any time;
  • any of the organization’s officers, directors, trustees, or employees have rights to conduct the partnership’s business at any time; or
  • the organization, by itself, has the power to appoint or remove any of the partnership’s officers or employees or a majority of directors.

For purposes of both the de minimis and the control tests, the proposed regulations continue to permit reliance on Schedule K-1 (Form 1065) if the form lists the exempt organization’s percentage profits interest or its percentage capital interest, or both, at the beginning and end of the year.

Once an organization designates a partnership interest as a QPI, it cannot change that designation unless and until the partnership interest is no longer a QPI. Once the partnership interest is no longer a QPI, the organization must identify the trades or business of the partnership that are unrelated trades or businesses with respect to the organization using the NAICS 2-digit codes.

Debt-Financed Income

The proposed regulations provide that all debt-financed property or properties as defined in Section 514 will be treated collectively with QPIs and qualifying S corporation interests as a separate unrelated trade or business for purposes of Section 512(a)(6).

Qualifying S Corporation Interests

The proposed regulations provide that an interest in an S corporation will generally be treated as an interest in a separate trade or business for purposes of Section 512(a)(6). However, an organization may aggregate its UBTI from an interest in an S corporation with the organization’s UBTI from other investment activities if the organization’s ownership interest in the S corporation meets the criteria for a QPI.

The Treasury Department and the IRS have requested comments regarding the specific factors that should be considered when determining whether an activity is an investment activity for purposes of Section 512(a)(6).

Additional Guidance

In addition to the guidance discussed above, the proposed regulations also clarify that:

  • For purposes of the unrelated business income tax generally and the application of Section 512(a)(6) specifically, an individual retirement plan (IRA) described in Section 408(e) uses the definition of “unrelated trade or business” in Section 513(b) applicable to trusts.
  • Inclusions of subpart F income under Section 951(a)(1)(A) and global intangible low-taxed income (GILTI) under Section 951A(a) are treated in the same manner as dividends for purposes of Section 512(b)(1).
  • Section 512(a)(6) does not change how the public support test is calculated for determining whether an organizations qualifies as a public charity; the proposed regulations include revisions to Treas. Reg. §§1.170A-9(f) and 1.509(a)-3 to permit an organization to continue to aggregate its net income and net losses from all unrelated business activities for purposes of determining whether the organization is publicly supported.

The IRS has indicated that it will update the Form 990-T and related schedules, and the respective instructions, as appropriate. Comments on the proposed regulations and requests for a public hearing are due by June 23, 2020.

Contacts

If you have any questions or would like more information on the issues discussed in this LawFlash, please contact any of the following Morgan Lewis lawyers:

Washington, DC
Celia Roady
Matthew R. Elkin
Alexander L. Reid
Caroline W. Waldner
Shira M. Helstrom
Chelsea R. Rubin