By Marc Berger, CPA, JD, LLM
The recently issued proposed regulations interpreting Internal Revenue Code (IRC) Section 512(a)(6) provide additional guidance and builds on Internal Revenue Service (IRS) Notice 2018-67.
On April 24, 2020, the U.S. Treasury Department and IRS published proposed regulations under IRC Section 512(a)(6) in the Federal Register, which was added to the tax law as part of the 2017 Tax Cuts and Jobs Act (TCJA). The provision requires tax-exempt organizations with more than one unrelated trade or business to calculate unrelated business taxable income (UBTI) separately with respect to each unrelated trade or business. The underlying purpose of the provision is to prevent a net loss from one activity from reducing the net income from a profitable activity. As a result of having to treat each unrelated activity separately, Section 512(a)(6) has become known as the “Silo” provision. The provision has been effective for tax years beginning on Jan. 1, 2018 and thereafter.
The IRS released Notice 2018-67 in August 2018 to provide organizations and their tax advisors some guidance on how to interpret Section 512(a)(6). The proposed regulations generally follow the guidance in the notice, although they make several modifications in response to comments received from the tax-exempt organization community.
The principal issue for organizations seeking to comply with Section 512(a)(6) is determining how many unrelated trade or business activities they have. Congress did not 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 for purposes of computing UBTI in accordance with Section 512(a)(6). The proposed regulations seek to clarify these issues by establishing a method for determining whether an organization has more than one unrelated trade or business and by identifying separate unrelated trades or businesses. Most business activities will use the North American Industry Classification System (NAICS) business codes, and separate guidance is provided for investment activities. In each of these instances the proposed regulations start with the approach utilized in Notice 2018-67 but make some additional changes to this guidance based on the comments received.
Business Activities Other Than Investment Activities
The proposed regulations would classify most unrelated business activities pursuant to 2-digit NAICS codes, which differ from the more specific 6-digit NAICS codes proposed in Notice 2018-67. The 6-digit codes are described as follows: the first two digits designate the sector, each of which represents a general category of economic sector, e.g., real estate and rental and leasing (53), health care and social assistance (62), accommodation and food services (72); 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. A zero as the sixth digit generally indicates that the NAICS industry and the U.S. industry are the same.
After considering the comments received from its issuing Notice 2018-67, the Treasury Department and the IRS continue to view an identification method based on NAICS codes as administrable for exempt organizations and the IRS. However, in updating the guidance recommended in the notice, the proposed regulations provide that an exempt organization generally will identify its separate unrelated trades or businesses using the first two digits of the NAICS codes, i.e., by economic sector. While there are more than 1,000 NAICS 6-digit codes, the NAICS divides the economy into only 20 economic sectors. Using the 2-digit codes is expected to result in broader, less subjective identification of trades or businesses that would naturally permit the aggregation of similar activities. In addition, it was noted that the 2-digit codes are less likely to change over time because the codes are revised through notice and comment rulemaking (and OMB has historically not revised the codes at the 2-digit level).
Administratively, the proposed regulations provide that an exempt organization will report each NAICS 2-digit code only once. For example, a hospital organization may operate several hospital facilities in a geographic area (or multiple geographic areas), all of which include pharmacies that sell goods to the general public. Pharmacies are described under the NAICS 2-digit code for retail trade (44). Although each pharmacy potentially could be considered a “separate” trade or business under Section 512(a)(6), particularly if separate books and records exist for each pharmacy, the hospital organization would report all the pharmacies using the 2-digit code for retail trade (44), along with any other retail trades or businesses described by this code, on Form 990-T as one unrelated trade or business.
Finally, the proposed regulations provide that once an exempt organization has identified a separate unrelated trade or business using a particular 2-digit code, the organization may not change the 2-digit code describing that trade or business unless the organization can show that the 2-digit code chosen was due to unintentional error and that another 2-digit code more accurately describes the trade or business. This limitation will apply to codes reported on the first Form 990-T filed after final regulations under Section 512(a)(6) are published in the Federal Register. It is anticipated that the instructions to Form 990-T will be revised to describe how an exempt organization provides notification of such an error. In addition, the Treasury Department and the IRS are requesting comments regarding whether there are other circumstances in which an exempt organization should be permitted to change the selected 2-digit codes.
The proposed regulations provide that NAICS 2-digit codes are used to identify separate unrelated trades or businesses except to the extent provided in other paragraphs of the proposed regulations. An exempt organization’s investment activities fall under this exception as their rules are provided in other paragraphs of the proposed regulations.
The proposed regulations provide that exempt organizations may aggregate certain investment activities and treat them as one unrelated trade or business for purposes of Section 512(a)(6). For most exempt organizations those activities are limited to: (i) qualifying partnership interests (QPIs); (ii) debt-financed properties; and (iii) qualifying S corporation interests.
For partnership interests, Notice 2018-67 states that the category of “investment activities” should include only partnership interests in which the exempt organization does not significantly participate in any partnership trade or business. As in the notice, the proposed regulations define QPIs as partnership interests that meet one of two tests:
- A de minimis test, which the exempt organization satisfies if it holds directly no more than 2% of the profits interest and no more than 2% of the capital interest of the partnership; or,
- A control test, which the exempt organization satisfies if it directly holds no more than 20% of the capital interest and does not control the partnership, taking into account all facts and circumstances.
In response to comments received on the notice, the percentage interests held by disqualified persons (e.g., directors) do not need to be taken into account under the proposed regulations in applying the percentage thresholds of the de minimis and control tests. In addition, interests held by controlled entities and supporting organizations no longer need to be taken into account for the de minimis test (but do need to be combined for the control test).
With respect to the control test, the notice looked to whether the exempt organization had “control or influence” over the partnership, while the proposed regulations only look to “control.” The proposed regulations provide that control is shown if the exempt organization “by itself” has the ability to require the partnership to perform, or may prevent the partnership from performing, any act that significantly affects the operation of the partnership, or if it has the power to appoint or remove any of the partnership’s officers or employees or a majority of its directors. Like the notice, the proposed regulations also provide that control is shown if any of the exempt organization’s officers, directors, trustees or employees have rights to participate in the management of the partnership or conduct the partnership’s business at any time.
The proposed regulations allow exempt organizations to rely on the information in the annual Schedule K-1s provided to it for purposes of the de minimis and control tests. In addition, once an organization designates a partnership interest as a QPI, it cannot use the NAICS codes to subsequently identify trades or businesses of the partnership unless and until the partnership no longer qualifies as a QPI (in which case it would be required to use the NAICS codes).
Additionally, the proposed regulations temporarily maintain the “transition rule” that was provided in the notice, under which a partnership interest acquired prior to Aug. 21, 2018 may be treated as comprising a single trade or business under Section 512(a)(6). However, the proposed regulations state that an organization’s ability to rely on the transition rule ends at the beginning of the first day of its first taxable year beginning after the final regulations under Section 512(a)(6) are published in the Federal Register.
The proposed regulations provide that income from debt-financed properties includible in unrelated business income (UBI) under Section 512(b)(4) should be included in an organization’s trade or business from ‘investment activities’ for purposes of Section 512(a)(6). This treatment supports the IRS belief that debt-financed properties are generally held for investment purposes. In addition, an S corporation interest that meets either the de mininis or control test for QPIs is considered a “qualified S corporation interest” and would also be included as part of an organization’s ‘investment activities’ unrelated trade or business. An S corporation interest that is not a qualified S corporation interest would be treated as an interest in a separate unrelated trade or business.
The proposed regulations provide that all “specified payments” (i.e., interest, rents, royalties and annuities) received from controlled entities and includible in UBI under Section 512(b)(13) would be treated as a separate trade or business. Moreover, if a controlling organization receives these payments from two different controlled entities, the payment from each controlled entity would be treated as a separate unrelated trade or business.
The proposed regulations also provide that amounts received from controlled foreign corporations which are includible in UBI under Section 512(b)(17) would be treated as income from a separate unrelated trade or business. Finally, the proposed regulations clarify that inclusions of Subpart F income and global intangible low-taxed income (GILTI) are treated in the same manner as dividends for UBI purposes.
Net Operating Loss Deductions (NOLs)
As enacted, Section 512(a)(6) requires organizations with more than one unrelated trade or business to determine any NOL deduction separately for each trade or business. By limiting the reportable unrelated business taxable income from a separate trade or business to zero, the statute supports the underlying purpose of the provision to prevent a loss incurred from one trade or business to offset income generated from another trade or business. To preserve NOLs from tax years prior to the effective date of the TCJA, Congress created a special transition rule for NOLs arising in a taxable year beginning before Jan. 1, 2018 (pre-2018 NOLs). Section 13702(b)(2) of the TCJA provides that Section 512(a)(6)(A) does not apply to pre-2018 NOLs, i.e., that they may be used without regard to the Section 512(a)(6) limitation. For organizations with pre-2018 NOLs, and NOLs arising from years beginning after Dec. 31, 2017 (post-2017 NOLs), a question arose regarding the order in which such losses should be taken. Notice 2018-67 did not affirmatively answer that question, however the proposed regulations do.
The proposed regulations provide that an exempt organization with both pre-2018 NOLs and post-2017 NOLs will deduct its pre-2018 NOLs from its total UBTI before deducting any post-2017 NOLs with regard to a separate unrelated trade or business’s UBTI. Moreover, the proposed regulations state that pre-2018 NOLs are deducted from total UBTI in the manner that results in maximum utilization of the pre-2018 NOLs in a taxable year. This result is organization-friendly in that it allows for the maximum use of these NOLs before their expiration (pre-2018 NOLs expire after 20 years; post-2017 NOLs do not expire).
Charitable Contributions Deduction
For tax-exempt organizations that are corporations, Section 512(b)(10) limits the organization’s charitable contributions deduction to 10% of UBTI. The proposed regulations clarify that Section 512(b)(10)’s reference to ‘UBTI’ refers to UBTI after the application of 512(a)(6). This result is also organization-friendly in that activities with net losses will not lower UBTI for purposes of determining the 10% deduction limit since those loss activities will be limited to zero for purposes of Section 512(a)(6).
Allocation of Expenses
Regarding the issue of allocating expenses between separate unrelated trades or businesses, Notice 2018-67 stated that the Treasury and IRS were considering modifying the “reasonable allocation method” described in Treas. Reg. Sec. 1.512(a)-1(c) and providing specific standards for allocating expenses under Section 512(a)(6). The preamble to the proposed regulations state that Treasury and IRS are still considering the issue and intend to publish separate proposed regulations providing further guidance on this issue. Until these proposed regulations are issued organizations are instructed to allocate deductions in accordance with any reasonable allocation method. Per the IRS, utilizing gross revenues as a method of allocation is not reasonable as it overstates the deduction(s) in determining UBTI.
Proposed Applicability Dates and Approaches
The proposed regulations apply to taxable years beginning on or after the date they are published in the Federal Register as final regulations. For taxable years beginning before that effective date, exempt organizations may (1) rely on the proposed regulations in their entirety; (2) rely on the methods of aggregating or identifying separate trades or businesses provided in Notice 2018-67; or, (3) rely on a reasonable, good-faith interpretation of Sections 511 through 514, considering all of the facts and circumstances, when identifying separate unrelated trades or businesses under Section 512(a)(6).
While some important questions remain unanswered (e.g., allocation of expenses among various UBI silos), the proposed regulations should provide organizations some comfort in the potential aggregation of activities, which may help the determination of how many unrelated trades or businesses they have. However, this may not ease the inevitable result of increasing their unrelated business income tax liability exposure from a provision that tilts the proverbial “level playing field” towards their taxable entity competitors.