On April 24, the US Internal Revenue Service (the "IRS") issued proposed regulations1 (the "Proposed Regulations"), which clarify how tax-exempt organizations ("exempt organizations") calculate unrelated business taxable income ("UBTI") from separate trades or businesses. The Proposed Regulations are of interest to all exempt organizations that are subject to tax on their UBTI, particularly exempt organizations engaging in investment activity through partnerships (such as private investment funds).
While exempt organizations are generally permitted to receive passive-type income free of tax (such as dividends, interest, royalties and rents from real property), most exempt organizations are subject to tax on their UBTI. Generally, UBTI is gross income from a trade or business regularly carried on by an exempt organization that is not substantially related to its exempt purpose, less deductions that are directly connected with that trade or business. Sources of UBTI include income received through partnerships (including any entity treated as a partnership for federal tax purposes) that conduct an operating business, certain fee income and income from debt-financed property.
Exempt organizations were historically permitted to calculate UBTI on an aggregate basis, meaning that income from one unrelated trade or business could generally be offset by losses from another unrelated trade or business. The Tax Cuts and Jobs Act2 significantly changed the calculation of UBTI, effective for tax years beginning after December 31, 2017, with the addition of section 512(a)(6),3 which requires exempt organizations with more than one unrelated trade or business to calculate and pay tax on UBTI separately for each unrelated trade or business. Consequently, income from one unrelated trade or business can no longer be offset by losses from another unrelated trade or business (except net operating losses carried forward from a taxable year that began prior to January 1, 2018).4
In August 2018, the IRS issued Notice 2018-67 (the "Notice") to provide clarity regarding how exempt organizations should identify separate trades or businesses under section 516(a)(6) pending issuance of further guidance. Significant elements of the Notice are described in the following paragraphs.
Reasonable Interpretation and NAICS Codes. The Notice provided that exempt organizations were permitted to use a reasonable, good faith interpretation of the UBTI rules in order to determine their separate trades or businesses. Categorizing separate trades or businesses using the six-digit codes of the North American Industry Classification System ("NAICS") was considered a reasonable, good-faith interpretation for this purpose.
Partnerships Investments. The Notice established two safe harbor tests for calculating UBTI generated through investments in partnerships. Investments in partnerships meeting either (1) a de minimis test or (2) a control test could be treated as a single trade or business, which permits an exempt organization to aggregate its UBTI from all such partnership investments. In other words, all unrelated trade or business income and losses recognized from investments in partnerships that meet one of the safe harbor tests could be aggregated as income or loss from a single unrelated trade or business.
The de minimis test was satisfied where the exempt organization holds no more than 2% of the profits interest and no more than 2% of the capital interest of the partnership. For purposes of meeting the de minimis test, an exempt organization was entitled to rely on the percentage interest shown on the Schedule K-1 issued to the exempt organization. The exempt organization's percentage interest was to be determined by taking the average of the exempt organization's percentage interest at the beginning and at the end of the partnership's taxable year as shown on the Schedule K-1. If the Schedule K-1 did not specify the exempt organization's profits interest, the exempt organization could not satisfy the de minimis test for that partnership.
The control test was satisfied where the exempt organization holds no more than 20% of the capital interest of the partnership and does not have "control or influence" over the partnership. An exempt organization could also rely on the average percentage interest as shown on its Schedule K-1 for purposes of meeting the control test.
For purposes of both the de minimis test and the control test, an exempt organization was required to combine the percentage interest it owned in a partnership with the interests in such partnership owned by a "disqualified person" (within the meaning of section 4958(f)), a "supporting organization" (within the meaning of section 509(a)(3)), or a "controlled entity" (within the meaning of section 512(b)(13)(D)).
Transition Rule. The Notice included a transition rule that permitted an exempt organization to treat each partnership interest acquired prior to August 21, 2018, as comprising a single trade or business. Thus, all of the unrelated trade or business income and losses from each such partnership interest could be aggregated even if such partnership (or a lower-tier partnership) was engaged in multiple trades or businesses. However, the unrelated trade or business income and losses from such a transition partnership could not be aggregated with the unrelated trade or business income from other partnerships, including other partnerships that qualified for the transition rule or that met the control test or the de minimis test.
GILTI. The Notice clarified that global intangible low-taxed income ("GILTI") is treated as a dividend for purposes of the UBTI rules and, accordingly, is generally excluded from UBTI.
Although the Notice provided some clarity in applying section 512(a)(6), it also created new questions, particularly around the application of the safe harbor tests for investments in partnerships. For example, the Notice indicated that an exempt organization could not meet the de minimis test unless the exempt organization received a Schedule K-1 that identified its specific profits interest, but the Notice left unstated whether the exempt organization's specific capital interest was also required to be identified on the Schedule K-1 and whether the exempt organization could meet the control test if its Schedule K-1 did not identify its specific capital interest. Similarly, it was unclear what constituted "influence or control" over a partnership for purposes of satisfying the control test. The Notice did not provide any safe harbor for exempt organizations with a greater-than-20% interest in a partnership.
The Proposed Regulations
The Proposed Regulations incorporate several aspects of the Notice but make several changes to the guidance outlined in the Notice as well as providing new guidance.
Use of NAICS Codes. Proposed Regulations allow exempt organizations to categorize unrelated trades or businesses based on just the first two digits of the NAICS codes. The first two digits of an NAICS code designate the sector of a trade or business, each of which represents a general category of economic activity. The Proposed Regulations note that limiting classification to the first two digits, instead of all six digits, results in fewer and broader categories, which allows exempt organizations to more easily combine similar unrelated trades or businesses. There are 20 separate business sectors identified by the first two digits of the NAICS code, as compared to over 1,000 different six-digit NAICS codes.
Partnership Investments. The Proposed Regulations retain the de minimis and control tests that apply to investments in partnerships, with some modifications.
The de minimis test continues to require that the exempt organization own no more than 2% of the profits interest and no more than 2% of the capital interest in the partnership. For purposes of calculating the exempt organization's percentage interest under the de minimis test, the Proposed Regulations state that an exempt organization is not required to combine its interest with interests held by related parties. In addition, although an exempt organization is able to rely on the percentage interests specified in its Schedule K-1, the lack of a specific profits interest on the Schedule K-1 no longer prevents the exempt organization from meeting the de minimis safe harbor. However, as a practical matter, it remains unclear how the exempt organization will be able to determine whether it has met the de minimis test if the Schedule K-1 does not specify its percentage interest in capital and profits. The Proposed Regulations also provide that an exempt organization can meet the de minimis test with respect to its indirect interest in a lower-tier partnership that it holds through a direct interest in an upper-tier partnership so long as the exempt organization does not control the upper-tier partnership (even if such upper-tier partnership does not meet the control test because the exempt organization holds more than a 20% interest in the upper-tier partnership). For example, if an exempt organization holds a 50% direct interest in an upper-tier partnership that it does not control and the upper-tier partnership holds a 4% interest in the profits and capital of a lower-tier partnership, the exempt organization can satisfy the de minimis test (50% x 4% = 2%) with respect to the lower-tier partnership, even though the exempt organization can meet neither the de minimis test nor the control test with respect to the upper-tier partnership. As a practical matter, an exempt organization may not have sufficient information to know whether its indirect interest in a lower-tier partnership meets the de minimis test. Similarly, an exempt organization may find it difficult to ascertain what portion of the UBTI reported by the upper-tier partnership is attributable to the lower-tier partnership. It does not appear that the control test can be met with respect to interests in lower-tier partnerships.
The Proposed Regulations make some changes to the control test. The requirement that the exempt organization hold no more than 20% of the capital interest in the partnership was retained from the Notice. The Proposed Regulations require an exempt organization to combine its capital interest with capital interests owned by a "supporting organization" (within the meaning of section 509(a)(3)) or a "controlled entity" (within the meaning of section 512(b)(13)(D)) but do not require an exempt organization to take into account a capital interest held by a "disqualified person" (within the meaning of section 4958(f)). The elimination of the requirement to take into account interests held by disqualified persons (which can include board members and officers, among others) will make it easier for an exempt organization to determine whether it has satisfied the control test. The IRS indicated that it continues to consider whether an exempt organization should be required to take into account the ownership of supporting organizations over which it has little or no control. Additionally, the Proposed Regulations eliminate the Notice's reference to the exempt organization having "influence" over the partnership, instead requiring only that the exempt organization does not "control" the partnership. The Proposed Regulations provide that all facts and circumstances, including the partnership agreement, are relevant for determining whether an exempt organization controls a partnership. However, any of the following factors will indicate that the exempt organization controls the partnership: (i) the exempt organization on its own may require the partnership to perform (or prevent the partnership from performing) any act that significantly affects the partnership's operations; (ii) any of the exempt organization's officers, directors, trustees or employees have rights to participate in the management of the partnership at any time; (iii) any of the exempt organization's officers, directors, trustees or employees have rights to conduct the partnership's business at any time; or (iv) the exempt organization on its own has the power to appoint or remove any of the partnership's officers or employees or a majority of directors. An exempt organization's participation on a typical limited partner advisory committee does not appear to fall within any of these factors, but other types of approval rights could be problematic.
Transition Rule. The Proposed Regulations largely adopt the transition rule introduced in the Notice but with minor changes. The Proposed Regulations indicate that a partnership can apply either the transition rule or the look-through de minimis test (for indirect interests in lower-tier partnerships), but not both, for partnership interests that satisfy both. The transition rule will apply to a partnership interest acquired prior to August 21, 2018, even if the exempt organization's percentage interest in such partnership changes on or after August 21, 2018 (for example, as a result of the exempt organization making an additional investment in that partnership). The Proposed Regulations further state that the transition rule will expire on the first day of the organization's taxable year beginning after the final regulations are published.
Net Operating Losses. An exempt organization's net operating losses ("NOLs") must be applied separately to the unrelated trades or businesses that generated such NOLs, except in the case of NOLs arising from a taxable year beginning prior to January 1, 2018, which can be applied generally to the exempt organization's total UBTI. The Proposed Regulations clarify that if an exempt organization has both pre-2018 NOLs and post-2017 NOLs, it must apply the pre-2018 NOLs to its total UBTI before applying the post-2017 NOLs to the applicable separate unrelated trades or businesses.
Other New Guidance. The Proposed Regulations clarify that UBTI that is generated as a result of holding (directly or indirectly) debt-financed property is considered investment income that can be aggregated with UBTI from other debt-financed property and with income from partnership interests (and S corporation interests) that meet the de minimis test or the control test. The Proposed Regulations also provide that UBTI recognized as insurance income from a controlled foreign corporation ("CFC") can be aggregated with insurance income from other CFCs (but cannot be aggregated with other UBTI). All UBTI resulting from payments made by a controlled entity described in section 512(b)(13) is treated as a single and separate trade or business that cannot be aggregated with UBTI from other sources (including from other controlled entities). The Proposed Regulations confirm that Subpart F income and GILTI income are treated as dividends for purposes of the UBTI rules and, thus, are generally not treated as UBTI. Finally, the Proposed Regulations provide special rules that apply to social clubs, voluntary employee benefit associations, and supplemental unemployment compensation benefits trusts.
Effective Date. The Proposed Regulations will apply to taxable years beginning on or after the date on which they are published as final regulations. Prior to that date, an exempt organization may rely on a reasonable, good-faith interpretation of section 512(a)(6), including by relying on the Proposed Regulations in their entirety or on the Notice.
The Proposed Regulations set forth rules regarding the application of section 512(a)(6), which largely follow the approach taken by the Notice with some changes and additional guidance to address comments made in response to the Notice. In several cases, these changes and new guidance will provide additional leeway for an exempt organization to treat income and losses as being derived from the same unrelated trade or business, thus expanding the opportunity to aggregate such income and losses when calculating UBTI. However, there are still many common situations (including the ownership of more than a 20% capital interest in an investment partnership) in which an exempt organization may be treated as engaging in more than one unrelated trade or business which will require UBTI to be calculated on a segregated basis. Certain issues relating to the application of section 512(a)(6) are still under consideration by the IRS. Exempt organizations may want to comment on these and other aspects of the Proposed Regulations before they are finalized.
1 REG 106864-18.
2 Pub. L. No. 115-97.
3 All section references herein are to the Internal Revenue Code of 1986, as amended (the "Code").
4 Section 512(a)(6) does not prevent an exempt organization from using losses incurred from an unrelated trade or business in one taxable year to offset income from the same unrelated trade or business in a subsequent taxable year.
Originally published 5 May, 2020
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