- The IRS and U.S. Department of the Treasury have issued proposed regulations providing guidance on how a tax-exempt organization with unrelated business taxable income (UBTI) determines whether it has more than one unrelated trade or business, and, if so, how the exempt organization should calculate unrelated business taxable income under the "siloing" rules.
- The proposed regulations establish the use of only the first two digits of the North American Industry Classification System (NAICS) code, describing the sector of economic activity, as the sole method for identifying separate unrelated trades or businesses for this purpose, with exceptions for certain types of income.
- Investment activities would be classified as a single unrelated trade or business and therefore permit the aggregation of gross income and deductions for all such activities, but the proposed regulations provide an exclusive list of the investment activities that can be treated in such a manner: qualifying partnership interests (QPIs), debt-financed properties and qualifying S corporation interests.
The IRS and U.S. Department of the Treasury have issued proposed regulations providing guidance on how a tax-exempt organization with unrelated business taxable income (UBTI) determines whether it has more than one unrelated trade or business, and, if so, how the exempt organization should calculate unrelated business taxable income under the "siloing" rules.
Evaluating Unrelated Business Activities
An exempt organization may engage one or more unrelated trades or businesses. Previously, an exempt organization deriving gross income from the regular conduct of two or more unrelated trades or businesses would have calculated its UBTI by determining its aggregate gross income from all such unrelated trades or businesses and reducing that amount by the aggregate allowable deductions. However, with the enactment of IRC Section 512(a)(6) by Public Law 115-97, commonly known as the Tax Cuts and Jobs Act (TCJA) of 2017, this aggregation of income and deductions from all trades or businesses is no longer permitted. Instead, an exempt organization must calculate its UBTI from each unrelated trade or business separately, where the UBTI from each trade or business may not be less than zero, preventing the offset of income from one trade or business using loss from another trade or business. Notice 2018-67 permitted the use of a good faith, reasonable method of determining whether an exempt organization had more than one unrelated trade or business under these new "basketing" or "siloing" rules and stated that a good faith, reasonable method would include using the six-digit code used by the North American Industry Classification System (NAICS) to identify separate trades or businesses.
The proposed regulations, issued on April 23, 2020, would establish the use of only the first two digits of the NAICS code, describing the sector of economic activity, as the sole method for identifying separate unrelated trades or businesses for this purpose. Each code shall be reported once, irrespective of whether an exempt organization has facilities that operate in multiple geographic locations. While this broader classification may permit an affected exempt organization to more easily determine which code applies and thereby apply the rules, given that there are only 20 two-digit NAICS codes, there is a real possibility of the imposition of additional tax.
After reporting a separate trade or business using a particular two-digit NAICS code, the exempt organization may not change the code unless the organization can show that such code was selected due to unintentional error and another code more accurately describes the trade or business.
Calculating UBTI: Investments and Net Operating Losses
The proposed regulations classify investment activities as a single unrelated trade or business and therefore permit the aggregation of gross income and deductions for all such activities. However, at the same time, the proposed regulations provide an exclusive list of the investment activities that can be treated in this manner: 1) qualifying partnership interests (QPIs), 2) debt-financed properties and 3) qualifying S corporation interests.
- QPIs: Among other things, the proposed regulations retain the interim rule from Notice 2018-67, which permits an exempt organization to aggregate its UBTI from certain partnership interests with multiple trades or businesses, i.e., all income and deductions from all QPIs, subject to certain enumerated restrictions and modifications.
- Debt-financed properties: The proposed regulations allow an exempt organization to include all UBTI from its debt-financed property or properties (and not just its unrelated debt-financed income from QPIs) in the list of investment activities treated as a single unrelated trade or business. This is provided, however, that if the income is rent from certain property that would be a trade or business, such income must be identified using a NAICS code for real estate rental and leasing.
- S corporation interests: The proposed regulations permit an exempt organization to aggregate its UBTI from an S corporation interest with its UBTI from other investment activities if the exempt organization's stock ownership (by percentage ownership) in the S corporation meets either the requirements provided in the de minimis test or the control test for "qualifying partnership interests."
The proposed regulations do not permit payments from controlled entities to be aggregated with investment activities but do permit the aggregation of all payments from a particular controlled entity as a single unrelated trade or business.
In discussing net operating losses (NOLs), the proposed regulations indicate that an exempt organization may have two types of NOLs: pre-2018 (not connected to a specific unrelated trade or business) and post-2017 (connected to specific unrelated trade or business). In such a case, the exempt organization may order its deductions to fully utilize its pre-2018 NOLs in a given year by deducting its pre-2018 NOLs from its total UBTI before deducting any post-2017 NOLs.
The proposed regulations clarify that for purposes of the Section 170(b)(1)(A)(vi) and Section 509(a)(2) public support tests, net income from unrelated business activities is calculated without consideration of these new rules. Any inclusion of Subpart F income or global intangible low-taxed income (GILTI) will be treated as a dividend for UBTI purposes. Furthermore, the proposed regulations set forth additional rules applicable to social clubs, voluntary employees' beneficiary associations (VEBAs) and supplemental unemployment benefits trusts.
The proposed regulations expressly solicit further comments as to the following open questions and issues, among others:
- whether another method, or additional methods, of identifying an exempt organization's separate unrelated trades or businesses aside from the first two digits of the NAICS code better achieves the intent of Congress in enacting Section 512(a)(6) while still being administrable for exempt organizations and the IRS
- whether there are other circumstances, aside from unintentional error, in which an exempt organization should be permitted to change a reported NAICS two-digit code
- whether any other methods of allocating expenses among exempt and taxable activities and among separate unrelated trades or businesses should be considered unreasonable (the proposed regulations specifically provide that an allocation based on an unadjusted ratio of gross unrelated income to total gross income is unreasonable), and whether any methods or rules could be adopted instead of using a reasonableness standard
- regarding the specific factors that should be considered when determining whether an activity is an investment activity for purposes of Section 512(a)(6)
- whether, with respect to a partnership interest:
a. certain rights or actions permitted by state law that are normal or routine should be disregarded in determining whether the partnership interest is a qualifying partnership interest
b. any specific rights or powers would never indicate that an exempt organization controls the partnership
c. a higher percentage of ownership should be permitted in taxable years in which an exempt organization's percentage interest increases as a result of the actions of other partners
- regarding the administrability of permitting the aggregation of indirectly held partnership interests that meet the requirements of the de minimis test
- whether an ordering rule may be necessary to clarify how excess charitable contribution carryovers interact with NOL carryovers in more than one unrelated trade or business
- regarding the application of Section 512(a)(6) to the calculation of the public support tests
- whether any additional transitional relief is necessary
The IRS and Treasury Department also anticipate that they may issue further guidance on how the calculation of UBTI is affected by the changes to NOL limitations and carrybacks made by the recently enacted Coronavirus Aid, Relief, and Economic Security Act (CARES Act).
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.