The U.S. Internal Revenue Service (IRS) and the U.S. Treasury Department ("Treasury") issued proposed regulations (REG-106864-18) addressing the so-called "silo" rule under Section 512(a)(6) of the Internal Revenue Code, which now requires tax-exempt investors to calculate unrelated business taxable income (UBTI) separately with respect to each unrelated trade or business. The proposed regulations largely adopt IRS guidance provided under Notice 2018-67, discussed in our previous publication "IRS Issues Guidance Affecting Tax-Exempt Investments in Private Equity Funds."

Under Section 511(a)(1), an exempt organization is subject to tax on UBTI derived from any unrelated trade or business it regularly carries on, less certain deductions. Prior to the enactment of Section 512(a)(6) under the Tax Cuts and Jobs Act (TCJA, Dec 22, 2017), an exempt organization deriving gross income from two or more unrelated trades or businesses would calculate UBTI by determining its aggregate gross income from all such unrelated trades or businesses and reducing that amount by the aggregate deductions allowed with respect to such unrelated trades or businesses. Section 512(a)(6) now requires an exempt organization to utilize a "silo" approach pursuant to which it must calculate UBTI (including for purposes of determining any net operating loss deduction) separately with respect to each unrelated trade or business.

Notice 2018-67 allowed exempt organizations to identify a separate unrelated trade or business by reference to the six-digit code assigned to such business under the North American Industry Classification System (NAICS). In this manner, exempt organizations were permitted to aggregate items of gross income and deductions as derived from a single trade or business to the extent they were proximately connected with a particular NAICS six-digit code. After considering comments to Notice 2018-67 regarding the reporting burden associated with NAICS six-digit codes, IRS and Treasury are now providing under the proposed regulations that an exempt organization generally will identify its separate unrelated trade or businesses using only the first two digits of the NAICS codes. The first two digits of the NAICS codes designate the sector, each of which represents a general category of economic activity. There are only 20 two-digit NAICS codes in all, which should limit the number of separate unrelated trades or businesses that may apply to any particular exempt organization.

The proposed regulations also maintain relief for exempt organizations with respect to investments in private equity funds and other types of investment partnerships. Under Notice 2018-67, the IRS acknowledged the high administrative burden associated with requiring an exempt organization to calculate UBTI separately with respect to each unrelated trade or business regularly carried on by a partnership in which the exempt organization is a direct or indirect partner. In the context of a private equity fund investment, Notice 2018-67 observed that it may be difficult for exempt organizations to obtain sufficient information regarding the trade or business activities conducted by lower-tier partnerships in which an investment fund may invest and indicated that proposed regulations would treat certain activities in the nature of an investment as one trade or business for purposes of Section 512(a)(6)(A).

The proposed regulations follow the approach suggested in Notice 2018-67 by treating certain "investment activities" as one trade or business for purposes of Section 512(a)(6)(A). Thus, exempt organizations may aggregate all items of gross income and deduction related to such "investment activities," e.g., items of income or deduction flowing from Schedules K-1 received with respect to a "qualifying partnership interest" (QPI) in an investment fund. Under the proposed regulations, a partnership interest is a QPI if it meets the requirements of a "de minimis test" or a "control test" as discussed below. Each test carries over from Notice 2018-67, with a few modifications.

Under the de minimis test, an investment partnership interest will qualify as a QPI if the exempt organization's average interest in the profits and capital of the investment partnership for the applicable taxable period does not exceed 2 percent. The proposed regulations also set forth new guidance on tiered partnership structures that will permit exempt organizations to ignore certain directly-held non-controlling interests in upper-tier partnerships. The preamble to the proposed regulations provides an example where an exempt organization directly holds 50 percent of the capital interests of an upper-tier partnership "XYZ" that it does not control. Partnership "XYZ" holds 4 percent of the capital and profits interests of lower-tier partnership "A," and 10 percent of the capital and profits interests of lower-tier partnership "B." Under the proposed regulations, because the tax exempt organization has no control over partnership "XYZ," it will be permitted to look to its indirect interest in each lower-tier partnership interest for purposes of applying the de minimis test. As a result, the interest in lower-tier partnership "A" will be treated as a QPI because the exempt organization's indirect interest in such partnership does not exceed 2 percent. On the other hand, the interest in lower-tier partnership "B" will fail to qualify as a QPI because the organization's indirect interest in such partnership exceeds the de minimis threshold.

An investment in a partnership not meeting the de minimis test may qualify instead as a QPI under the control test if the exempt organization directly holds no more than 20 percent of the capital interest in the partnership and has no control or influence over the partnership or its investments (as determined based on a facts-and-circumstances analysis). The proposed regulations list four non-exclusive situations where the exempt organization will be deemed to maintain "control" for this purpose: (i) the exempt organization, by itself, may require the partnership to perform, or prevent the partnership from performing, any act that significantly impacts the partnership, (ii) any of the exempt organization's officers, directors, trustees or employees have a right to participate in the management of the partnership, (iii) any of the exempt organization's officers, directors, trustees or employees have a right to conduct the partnership's business at any time, or (iv) the exempt organization has the right to remove any of the partnership's officers or employees or a majority of its directors.

The proposed regulations adopt the QPI transition rule set forth in Notice 2018-67 by waiving the de minimis and control test for partnership investments subscribed for prior to August 21, 2018, provided that such relief limits aggregation to items of UBTI from a directly held interest in a private equity or other partnership investment with multiple underlying trades or businesses (and does not provide relief for aggregating with other directly held private equity investments or similar partnership interests).

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