On April 23, Treasury and the IRS issued proposed regulations under section 512(a)(6) which provide more generous and comprehensive rules for the calculation of unrelated business income tax for separate unrelated trades or businesses than the interim guidance that was released in 2018. Exempt organizations and employee plans that have unrelated business income should be aware of the changes in the proposed regulations and should consider providing additional comments as requested by Treasury and the IRS.
The Tax Cuts and Jobs Act added Internal Revenue Code Section 512(a)(6) which requires tax exempt organizations to calculate unrelated business taxable income (UBTI) separately for each trade or business activity. This new rule prevents organizations from using losses from one unrelated trade or business to offset income from a different unrelated trade or business. However, the statute did not include rules for determining whether an organization has more than one unrelated trade or business or for identifying different unrelated trades or businesses. In August 2018, Treasury and the IRS released interim guidance in Notice 2018-67 (the Notice). The proposed regulations issued today build on that guidance and address many commenters’ concerns that the provisions in the interim guidance were too burdensome for organizations.
Separate Unrelated Trades or Businesses
NAICS Codes: Two Digits versus Six Digits
The proposed regulations provide that the primary mechanism for identifying separate trade or business activities is the use of NAICS codes. NAICS is an industry classification system that uses up to six-digit codes for classifying economic activities. Prior guidance from the IRS in Notice 2018-67 provided a safe harbor for organizations to use the six-digit codes to identify separate unrelated trades or businesses. The proposed regulations make a significant change from the interim guidance by allowing separate trades or businesses to be identified solely by two-digit NAICS codes. However, the regulations make it clear that an organization must use the code that identifies the unrelated trade or business and not the code that describes the organization's general activities.
Use of two-digit NAICS codes results in the aggregation of significantly broader categories of trades or businesses. For example, the change to two-digit codes reduces the total number of potential separate unrelated trades or businesses from over a thousand to twenty. This is a welcome change for many organizations and helps to reduce the administrative burden of the legislation.
The proposed regulations generally follow and expand the approach of the Notice by allowing organizations to aggregate certain investment activities and treat them as a single unrelated trade or business. The proposed regulations provide more comprehensive guidance on which activities constitute investment activities and include a specific list of activities that may generally be aggregated together as a single "investment" trade or business. Notably, this list includes all debt-financed income, qualifying partnership interests, and qualifying S corporation interests, but does not include controlled entities under section 512(b)(13) and controlled foreign corporations under section 512(b)(17). As a result, unrelated business income from each controlled for-profit entity, as described in section 512(b)(13), is treated as a single separate unrelated trade or business, and not included as investment activity. In addition, insurance income for all controlled foreign corporations, as described in section 512(b)(17), is treated as a separate unrelated trade or business.
Qualifying partnership interests are those that meet either a de minimis test or a control test. The de minimis test is met when the organization holds directly no more than 2% of the profits interest and no more than 2% of the capital interest of a partnership. In addition, if the organization does not control a directly-held partnership it may include indirectly-held partnership interests that meet the de minimis test. The control test is met if the organization holds no more than 20% of the capital interest and does not control the partnership. The proposed regulations provide that control is based on facts and circumstances, but also provides four elements that will be considered evidence of control. Under Notice 2018-67, for both the de minimis test and the control test, an organization was required to aggregate related interests in determining whether it met the 2% or 20% thresholds. The proposed regulations loosen this aggregation requirement significantly. Aggregation is no longer required for the de minimis test, and interests of disqualified persons are no longer included for the control test.
The proposed regulations include a transition rule for partnership interests that are not qualifying partnership interests that was originally provided in Notice 2018-67. However, this transition rule will end on the first day of the organization’s taxable year beginning after final regulations are published.
Different rules for identifying separate trades or businesses also apply to organizations with unrelated business income described in section 512(a)(3), which applies to social clubs, voluntary employee benefit associations, and supplemental unemployment compensation benefits trusts.
Net Operating Losses
Under section 512(a)(6) an organization cannot offset income from one unrelated trade or business with losses from a separate unrelated trade or business; however, it can use net operating losses (NOLs) with respect to each of its unrelated trades or businesses in calculating UBTI from those trades or businesses. Organizations may have two types of NOLs, those generated before 2018 that are not tied to a specific unrelated trade or business and those generated after 2017 that are connected to a specific unrelated trade or business. The proposed regulations clarify that an organization uses its pre-2018 NOLs against total UBTI before utilizing its post-2017 NOLs against UBTI for separate trades or businesses. In addition, the general NOL rules under section 172 were tightened as part of TCJA, but then were relaxed by the recently-enacted CARES Act. The proposed regulations do not address the various changes to the use of NOLs provided in section 172 and recognize that additional guidance will be needed.
The proposed regulations provide that additional guidance will be provided on the allocation of expenses among unrelated trade or businesses and between exempt and non-exempt activities. However, the proposed regulations explicitly provide that using an "unadjusted gross-to-gross" method for allocation is not a reasonable method of allocation. "Unadjusted gross-to-gross" allocation occurs when an organization charges different rates for exempt use and non-exempt use and allocates expenses based on the ratio of income received without adjusting for the difference in rates.
Subpart F and Global Intangible Low-Taxed Income (GILTI)
Under the proposed regulations, inclusions of subpart F income (under section 951) and GILTI (under section 951A) are treated in the same manner as a dividend under the unrelated business income rules, and therefore is generally not included in UBTI.
The proposed regulations also include guidance on the calculation of the public support test for organizations that may have higher unrelated business income due to the limitation on the use of losses. This increase in unrelated business income can impact the calculation of total support under section 509(a)(1) and (a)(2). 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.
Treasury and the IRS continue to request comments on these provisions. Comments are due 60 days after the proposed regulations are published in the Federal Register. There has been a concerted effort by Treasury and the IRS to finalize regulations relating to the TCJA as quickly as possible, so organizations should provide comments within this period. It is clear from the changes made between the Notice and these proposed regulations that comments can be effective in providing information and alternative approaches to Treasury and the IRS, and may result in changes that benefit exempt organizations.