The Internal Revenue Service (“IRS”) issued proposed regulations on April 23, 2020 (the “Proposed Regulations”) that clarify the method for grouping activities in calculating unrelated business taxable income (“UBTI”) for separate taxable trades or businesses, primarily for purposes of limiting the ability of a tax-exempt organization to offset losses against income, both currently and as carrybacks and carryovers, where the trades or businesses are viewed as separate.
This article sets forth select highlights of the Proposed Regulations as applied to tax-exempt organizations that qualify as such under Internal Revenue Code (the “Code”) section 501(c)(3), including most qualified pension and profit-sharing plans, colleges and universities and church-sponsored organizations (i.e., organizations listed in The Official Catholic Directory) (“Exempt Organizations”).
The Tax Cuts and Jobs Act enacted in 2017 added Code section 512(a)(6) which requires Exempt Organizations to calculate UBTI, including for purposes of determining any net operating loss (“NOL”) deduction, separately for each trade or business and prevents the use of losses from one unrelated trade or business to offset income from an unrelated trade or business. Prior to the enactment of Code section 512(a)(6), Exempt Organizations generally calculated UBTI on an aggregate basis, combining the gross income and deductions for all unrelated trades or businesses. While Code section 512(a)(6) eliminated the aggregate approach to UBTI calculations, the statute did not provide a clear definition of unrelated trades or businesses or a methodology for determining whether an Exempt Organization has more than one unrelated trade or business.
In response to confusion regarding these and other aspects of Code section 512(a)(6), the IRS provided clarification in the form of Notice 2018-67 and requested public feedback on the interim guidance. The Proposed Regulations supplement the guidance provided in Notice 2018-67 and request further public comment regarding outstanding issues in connection with the operation of Code section 512(a)(6).
Many Exempt Organizations invest in private funds, including hedge funds, private equity funds and real estate funds (“Funds”), that are typically partnerships for U.S. federal income tax purposes. These investments introduce the question of how to apply Code section 512(a)(6) if a Fund, or an investment by a Fund, generates losses while another Fund or Fund investment, produces profits for UBTI purposes. Under a long-standing Code provision, UBTI generated from such investments will be attributed to the direct and indirect Exempt Organization investors.
The Proposed Regulations do not change the prohibition against mixing income and loss from non-UBTI activities with income or loss from UBTI activities.
Notice 2018-67 allowed Exempt Organizations to treat separate investment activities as a single unrelated trade or business. The Proposed Regulations continue to permit this aggregation of investment activities as a separate unrelated trade or business and provide additional guidance on the specific activities that constitute “investment activities” for purposes of Code section 512(a)(6). Under the Proposed Regulations, the investment activities permitted to be aggregated for UBTI purposes primarily are: (i) qualifying partnership interests (each, a “QPI”); and (ii) debt-financed properties.
In addition to specifying investment activities that can be treated as a separate unrelated trade or business, the Proposed Regulations clarify the definition of a QPI. A partnership interest is a QPI to the extent that either: (i) the Exempt Organization holds directly no more than 2% of the profits interest and no more than 2% of the capital interest of a partnership (the “de minimis test”), or (ii) the Exempt Organization holds directly no more than 20% of the capital interest and does not exercise control over the partnership (the “control test”).
De minimis test
The Proposed Regulations modify the de minimis test to provide that:
The Proposed Regulations clarify the control test by providing that:
It would be rare for an Exempt Organization to control a Fund. The Proposed Regulations suggest that neither an Exempt Organization's election to require a Fund to use blockers nor that the right to become a member of an advisory committee would not evidence control, absent other factors.
In a very liberal rule, the Proposed Regulations include all UBTI from an Exempt Organization’s debt-financed property or properties as part of investment activities regardless of whether derived from a QPI. Effectively, this rule will expand the income and gain against which current losses and NOLs from QPIs can be used.
Based on the typical structure of investments typically made by Exempt Organizations in Funds the UBTI generated by Funds should generally be allowed to be aggregated by Exempt Organizations under the Proposed Regulations, which effectively will continue to allow the netting of income, gain, and loss from Fund investments. However, inasmuch as each investment is different and it may be impossible to predict whether an investment will generate income or loss, it may be advisable to review investments and other activities once the Proposed Regulations are finalized or in the event of subsequent modification.
Clearly, offshore feeder funds that are treated as corporations so as to insulate an Exempt Organization from UBTI from the "main fund" in which the feeder fund invests should not be subject to the Proposed Regulations because these feeder funds generally produce only income that is exempt from UBTI to its Exempt Organization investors.
On the other hand, if an Exempt Organization (e.g., a hospital) owns an interest in a partnership ancillary venture, such as a radiology or dialysis venture, together with a taxable partner, in light of the Exempt Organization's goal to avoid UBTI which generally requires the exercise of certain controls by the Exempt Organization, it is very unlikely that the Exempt Organization's interest in the venture would be treated as an investment under the control tests. On the other hand, given that most of these ventures have been intentionally structured to avoid UBTI, the Proposed Regulations are probably irrelevant for these purposes.
In addition to the investment activities provisions described above, the Proposed Regulations also address certain other matters as follows.
NAICS Code Safe Harbor
The Proposed Regulations simplify the process of determining whether an Exempt Organization has more than one unrelated trade or business through the use of two-digit North American Industry Classification System (“NAICS”) codes. Notice 2018-67 proposed the use of six-digit NAICS codes as a reasonable, good-faith interpretation when determining whether an Exempt Organization has more than one unrelated trade or business. Commenters generally opposed that approach, arguing (among other things) that the use of six-digit NAICS codes was overly burdensome, especially for small Exempt Organizations that lack significant resources for tracking the codes. Exempt Organizations can now identify each of its separate unrelated trades or businesses using one of the twenty two-digit NAICS codes that most accurately describes that trade or business.
Importantly, the NAICS code used to describe an unrelated trade or business in which the Exempt Organization engages must relate to the activities of the unrelated trade or business and not to the activities of the Exempt Organization that relate to its exempt purpose or function. The Proposed Regulations further provide that an Exempt Organization may use each two-digit NAICS code only once (i.e., if a hospital organization operates more than one pharmacy, all pharmacies would be reported under NAICS code 44 for retail trade). Finally, once an Exempt Organization selects a particular NAICS code to describe a separate unrelated trade or business, it may not change that NAICS code absent showing that the initial selection was the result of an unintentional error and that another NAICS code is more appropriate.
NOLs under Code Section 512(a)(6)
In response to comments regarding the timing of the use of NOLs generated before January 1, 2018 (which are not tied to a specific unrelated trade or business), and those generated after December 31, 2017 (which are tied to a specific unrelated trade or business), the Proposed Regulations specify the timing and use of such NOLs. An Exempt Organization must now offset its pre-2018 NOLS against total UBTI before it can use its post-2017 NOLs with regard to a separate unrelated trades or business against the UBTI from that unrelated trade or business.
Effect of proposed regulations
Until final regulations are issued, an Exempt Organization may completely rely on the Proposed Regulations or, alternatively, on Notice 2018-67.
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