How many UBTI silos do you have? IRS issues Proposed Regulations on separate trades or businesses to apply anti-netting rules of Code Section 512(a)(6)
Prior to 2018, exempt organizations generally were allowed to combine their profits and losses from their various activities constituting unrelated trade or business activities (as compared to the exempt purpose activities of the exempt organization). The effect was to permit a net loss from one unrelated trade or business activity to shelter a net profit from a different unrelated trade or business activity by combining all of the profits and losses from all of the unrelated trade or business activities in calculating unrelated business taxable income. The net profit from unrelated trade or business activities was subject to the unrelated business income tax under Section 511 of the Internal Revenue Code of 1986, as amended, which uses the same tax rate applied to for-profit corporations.
As part of the Tax Cuts and Job Acts adopted in 2017, Congress added Code Section 512(a)(6), which effectively prohibited the netting of profits and losses from more than one unrelated trade or business. The effect was to prohibit a net loss from one unrelated trade or business activity from sheltering a net profit from a different unrelated trade or business activity in calculating unrelated business taxable income. Left undefined by Congress was what would constitute a separate unrelated trade or business. Code Section 512(a)(6) applies to exempt organizations for taxable years starting after Dec. 31, 2017, although it does not apply to pre‑2018 net operating losses carried forward to post-2018 taxable years.
The Internal Revenue Service (IRS) previously provided interim guidance to taxpayers on the application of Section 512(a)(6) in IRS Notice 2018-67 (Aug. 22, 2018). Among other things, Notice 2018-67 establishes that it is a reasonable approach for taxpayers to rely on six-digit North American Industry Classification System (NAICS) codes to identify what constitutes separate trades or businesses. The six-digit NAICS is a fairly granular description of business activities, which includes 1,057 different codes.
On April 24, 2020, the Treasury Department published Proposed Regulations to implement Code Section 512(a)(6). The Proposed Regulations and related IRS and Treasury Department commentary may be found here. Comments on the Proposed Regulations may be submitted through June 23, 2020.
Use of two-digit NAICS sector codes to determine a separate trade or business
A major change in the Proposed Regulations is the adoption of the two-digit NAICS sector codes as a reasonable method for exempt organizations to identify what constitutes a separate unrelated trade or business. This is a pro-taxpayer liberalization of the anti-netting rule. As noted above, there are 1,057 six-digit NAICS codes. In contrast, there are only 20 two-digit NAICS codes, each of which identifies a broad sector of the economy. The NAICS codes may be accessed here.
The Proposed Regulations provide that an exempt organization conducting multiple unrelated trade or business activities within a single two-digit NAICS sector code will aggregate the profits and losses from all such activities into a single unrelated trade or business. This will allow the netting of the profits and losses of multiple business activities within the same two-digit NAICS sector code. For example, the commentary to the Proposed Regulations specifies that a hospital system operating pharmacies (even if separate books and records are maintained for each pharmacy) would report all of those activities as a single entry using the NAICS two-digit sector code for Retail Trade (44). It is important to note that the principal two-digit NAICS sector code for the main exempt activities of the exempt organization cannot be used to override the “separateness” of the unrelated business (e.g., a tax-exempt university may not classify everything under NAICS Code 61).
The selection of the applicable two-digit NAICS sector codes is made on the first IRS Form 990-T, Exempt Organization Business Income Tax Return, filed by the exempt organization after the Final Regulations have been published. A consistency rule will require that no change be made to the selected two-digit NAICS sector code in future years unless the exempt organization can demonstrate an unintentional error had been made.
Allocation of operating expenses
The Proposed Regulations continue to allow exempt organizations to use “any reasonable method” for allocating related operating expenses between exempt activities and unrelated trades or businesses, and between two or more separate unrelated trades or businesses. One addition to the Proposed Regulations is the statement that an allocation of expenses on the unadjusted gross-to-gross method based solely on the respective gross revenues generated from exempt function activities and unrelated business taxable income activities is an unreasonable allocation method. This position by Treasury and the IRS is based on the idea that an exempt organization may charge more for goods or services delivered as part of the unrelated trade or business (e.g., meal charges to non-members at a higher price, although presumably the cost of preparing the meal is approximately the same), which would then push a disproportionate amount of expenses to the activity generating the unrelated business taxable income (UBTI), artificially reducing the amount of the organization’s unrelated business taxable income.
Investment activities as a separate trade or business
Another key development in the Proposed Regulations is the adoption of a standard under which certain investment activities of an exempt organization may be treated as a single unrelated trade or business (thereby allowing netting of the profits and losses of all such investment activities).
These investment activities include: (i) Qualifying Partnership Interests (QPI); (ii) interest, dividends, rents, annuities, royalties and capital gains received from debt-financed property; and (iii) qualifying S corporation interests. Through these rules, the IRS and the Treasury Department are trying to differentiate situations under which the exempt organization is acting as a passive investor as opposed to an active participant (although in a minority ownership position) with respect to an underlying trade or business.
i. With respect to exempt organizations investing in an entity taxed as a partnership, the general rule remains that the character of the activity conducted by the partnership will determine under which two-digit NAISC sector code the activity will be reported for UBTI purposes. The Proposed Regulations adopt two exceptions to the general rules, which will allow the exempt organization to treat the partnership interest as part of the investment activity unrelated trade or business: the De Minimis Test and the Control Test.
De Minimis Test: Under the De Minimis Test, a partnership interest (other than an interest as a general partner, which can never be a QPI) representing no more than a 2 percent capital interest and no more than a 2 percent profits interest will qualify as a QPI.
The Proposed Regulations include a percentage pass-through rule under which the exempt organization’s indirect percentage ownership of a lower-tier partnership is measured for purposes of the De Minimis Test only. For example, if the exempt organization owns 40 percent of Partnership A, which in turn owns 4 percent of Partnership B, the exempt organization would be deemed to indirectly hold 1.6 percent of Partnership B, which would qualify as a QPI under the De Minimis Test.
Control Test: Under the Control Test, a partnership interest (other than an interest as a general partner, which can never be a QPI) with no more than a 20 percent capital interest and the absence of indicia of control over the partnership (a facts and circumstances test) will qualify as a QPI. Indicia of control include the ability of the exempt organization to appoint or remove officers, employees or a majority of directors of the partnership; the ability to cause or prevent the partnership from performing any act significantly affecting the partnership’s operations; the right of the exempt organization’s officers, directors or employees to serve in management of the partnership; or the right of the exempt organization to conduct the business of the partnership.
QPI status is elective, with the election being made on IRS Form 990-T. However, once made, the QPI election cannot be changed back to non-QPI status under which the two-digit NAISC sector code will control reporting. Because of this multi-year consistency rule, exempt organizations will want to model whether inclusion of a partnership interest that meets the De Minimis Test or the Control Test is desirable. Of course, a partnership interest that ceases to qualify under either the De Minimis Test or the Control Test will automatically convert to non-QPI status.
ii. Income in the nature of interest, dividends, rents, annuities, royalties and capital gains received from debt-financed property under Code Section 514 (and thereby treated as UBTI) will be included in the same investment activity as an unrelated trade or business as QPIs of the exempt organization.
iii. Ownership interests in S corporations held by an exempt organization are each treated as a separate trade or business per Code Section 512(e)(1)(B). The Proposed Regulations provide an exception for qualifying S corporation interests, which are interests in S corporations that meet either the De Minimis Test or the Control Test applicable to QPIs. Qualifying S corporation interests will also be included in the same investment activity as an unrelated trade or business as QPIs and income from debt-financed property of the exempt organization.
The Proposed Regulations contain rules that address specified payments received from taxable controlled entities under Code Section 512(b)(13) (treating such payments from each controlled entity as a separate trade or business) or insurance income from certain foreign corporations under Code Section 512(b)(17) (treating such payments from each entity as a separate trade or business not netted against investment income or other UBTI). The Proposed Regulations also contain special rules for social clubs organized under Code Section 501(c)(7), voluntary employees’ beneficiary associations, and supplemental unemployment benefits trusts, and describe the manner in which these anti-netting rules apply to individual retirement accounts. Finally, the Proposed Regulations also clarify the manner in which net operating losses are applied in conjunction with Code Section 512(a)(6).
Once adopted as Final Regulations, the Proposed Regulations will apply for taxable years beginning on or after April 24, 2020 (and for calendar year exempt organizations, this means 2018, 2019 and 2020). For taxable years beginning prior to April 24, 2020, exempt organizations will be able to rely on either the Proposed Regulations in their entirety (no “cherry-picking” portions of the Proposed Regulations) or Notice 2018-67.
The author gratefully acknowledges the editing assistance of his Greensfelder colleagues Jay Nathanson and Rachel Hirshberg.