On April 23, 2020, the Treasury Department and Internal Revenue Service (“IRS”) issued proposed Regulations (REG-106864-18) which provided further guidance on calculating unrelated business taxable income (“UBTI”) for separate trades or businesses. These proposed Regulations expand upon the interim guidance previously issued within IRS Notice 2018-67.
The Tax Cuts and Jobs Act of 2017 added Internal Revenue Code (“IRC”) §512(a)(6), which requires tax-exempt organizations to compute UBTI separately for each unrelated trade or business (“UTB”) activity (referred to as a “silo” or “siloing”). This rule generally prevents tax-exempt organizations from using losses from one UTB to offset income from another UTB.
The proposed Regulations largely remain consistent with the guidance in IRS Notice 2018-67. However, certain modifications were made in response to comments received in order to reduce the burden imposed by the new silo rules. A summary of modifications made within the proposed Regulations are outlined below.
Likely the most helpful provision of the proposed Regulations is the adoption of two-digit NAICS codes in place of the more specific six-digit codes. This modification will allow tax-exempt organizations to use only the first two digits of the NAICS code to categorize each UTB, allowing for broader classification of activities. However, once an organization uses the two-digit code to classify a UTB, it generally cannot change the code unless there was an unintentional error in the initial classification.
The proposed Regulations provide that a tax-exempt organization may treat investment activities collectively as a separate UTBs. This allows all income, deductible expenses, and losses from the following investment activities to be aggregated in computing a single UBTI amount:
- Qualifying partnership interests (“QPIs”);
- Qualifying S Corporation interests; and
- Debt-financed properties.
Partnership interests have to meet either a de minimis test or a control test to be considered QPIs. The de minimis test is met if the organization holds directly no more than 2% of the profits interest or capital interest of the partnership. A control test is met if the organization holds no more than 20% of the capital interest and does not control the partnership, considering all facts and circumstances. Notice 2018-67 had previously required tax-exempt organizations to aggregate related interests in determining whether it met the de minimis test or the control test. The proposed Regulations loosen these requirements significantly, and no longer require aggregation for the de minimis test and no longer including interests of disqualified persons in the control test.
contact a member of Withum’s tax-exempt organization professionals.
A qualifying S corporation interest must meet the definition of a QPI, considering the percentage of stock owned rather than a profits interest. In addition, the proposed Regulations also provide that each S Corporation interest that is not a “qualifying S Corporation” interest is considered to be its own separate trade or business. However, tax-exempt organizations must aggregate the interests of its supporting organizations and §512(b)(13) controlled organizations when determining ownership.
Net Operating Losses (“NOLs”)
The proposed Regulations provide that tax-exempt organizations with pre-2018 and post-2017 NOLs should first deduct its pre-2018 NOLs from its aggregate UBTI so as to fully utilize its pre-2018 NOLs. Post-2017 NOLs should be deducted thereafter with respect to each UTB activity under §512(a)(6)(A).
Other notable provisions of the proposed Regulations include the following:
- Controlled organizations – All “specified payments” (including rent, interest, and royalties) from a controlled entity would be treated as gross income from a separate trade or business. If an organization receives specified payments from multiple controlled entities, the payments from each controlled entity are treated as separate trades or businesses;
- Controlled foreign corporations (“CFCs”) – All income from CFC insurance activities under §512(b)(17) is treated collectively as one trade or business, even if received from multiple CFCs;
- Adjusted gross-to-gross method – When allocating indirect expenses to UBI, this method had been deemed unreasonable; and
- Public support tests – The proposed Regulations provide a favorable rule allowing organizations to aggregate all net income and net losses from unrelated business activities for purposes of public support calculations.
The Treasury Department and IRS have indicated their intent to finalize these proposed Regulations before the end of the year, giving tax-exempt organizations little time to read and to react to the proposed Regulations. Any comments on the proposed Regulations and requests for a public hearing are due by June 23, 2020. Withum recommends a readiness assessment and review of your UTB activities in conjunction with these proposed Regulations for planning purposes.
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