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Proposed Regulations Provide Needed Guidance on the Unrelated Business Income Tax Siloing Rules

On April 23, 2020, proposed regulations were published providing guidance on how an exempt organization with unrelated business income would determine if it has more than one trade or business, and if so, how to calculate unrelated business taxable income (UBTI).

The proposed regulations, in general, would apply to tax years beginning on or after the date the final regulations are published. The preamble to the proposed regulations states that for tax years beginning before the date the final regulations are published, an exempt organization may rely on a reasonable, good-faith interpretation of IRC Sect. 511-514, considering all the facts and circumstances when identifying separated unrelated trade or businesses under IRC 512(a)(6)(A). Exempt organizations may also rely on the proposed regulations in their entirety or for these same years, on the methods of aggregating under IRS Notice 2018-67 (issued in August 2018).

This article highlights some of the key guidance in the proposed regulations.

Determining which Unrelated Trade or Business are Aggregated

Before the Tax Cut and Jobs Act of 2017 (TCJA), exempt organizations calculated their unrelated business taxable income by determining its aggregation gross income from all unrelated activities and reducing that amount by the aggregate unrelated businesses deductions. With the TCJA and beginning for tax years beginning after December 31, 2017, IRC Section 512(a)(6) requires the taxable income to be calculated on a per unrelated trade or business basis. This means that one unrelated trade or business net taxable loss cannot offset the taxable income of another unrelated trade or business. Therefore, determining which trades or businesses can be aggregated as one became important to understand.

North American Industry Classification System (NAICS) Codes The proposed regulations expand the number of unrelated trades or businesses that can be aggregated, originally considered in IRS Notice 2018-67, which is good news for exempt organizations. The NAICS is a 6-digit industry classification system for purposes of collecting and analyzing data in the United States. In IRS Notice 2018-67, the IRS indicated the 6-digit code could be used to classify each unrelated trade or business. The proposed regulations allow exempt organizations to use only the first two digits in classifying their unrelated trade or businesses which expands the number that can be aggregated. This will save exempt organizations time and expense when calculating UBTI and preparing the Form 990-T. In addition, this could lead to lower unrelated business income tax since businesses that are aggregated can offset losses with income.

Investment Activities – The proposed regulations explain that certain unrelated activities of an exempt organization fall into the investment category and not separate small unrelated activities. Therefore, an exempt organization is allowed to aggregate unrelated trade or businesses from certain investment activities. These investment activities include its qualifying partnership interests, its qualifying S corporation interests, and its debt-financed properties.

Qualifying partnership interests are direct interests that meet the de minimis test or control test. The de minimis test is met if an organization does not own more than 2% of the profits interest or capital interest in a partnership. The control test is met if an organization does not own more than 20% of the capital interest and does not control the partnership. Similarly, qualified S corporation interests are defined as stock ownership of 2% or less in the S corporation (de minimis test) or stock ownership of 20% or less in the S corporation and is not controlled by the exempt organization (control test).

Control for these purposes is determined on a facts and circumstances basis, but an exempt organization is automatically deemed to have control if any of the following are true:

  • The exempt organization alone can require the partnership to perform any act that significantly affects the operation of the partnership or S corporation.
  • If any of the exempt organization’s officers, directors, trustees, or employees have the right to participate in the management of the partnership or S corporation.
  • If any of the exempt organization’s officers, directors, trustees, or employees have the right to conduct the partnership or S corporation business at any time.
  • The exempt organization has the power alone to appoint or remove officers or employees, or the majority of the directors of the partnership or S corporation.

The regulations also note that if an exempt organization owns S corporation stock that does not meet the requirements of a qualifying S corporation interest, the income of the S corporation and any gain or loss on the disposition of the S corporation stock is treated as one unrelated trade or business.

Net Operating Loss (NOL) Utilization

With the changes enacted in TCJA, net operating losses of one unrelated activity cannot offset the income of another unrelated activity. This creates a distinction between NOLs generated before 2018 (pre-2018 NOLs) and NOLs generated after 2017 (post-2017 NOLs). The TCJA did not specifically state how each of these NOLs were to be used. The proposed regulations clarify that if an exempt organization has both pre-2018 NOLs and post-2017 NOLs, the pre-2018 NOLs will be deducted before the post-2017 NOLs. In other words, pre-2018 NOLs will be deducted first against total unrelated activities with income, and then post-2017 NOLs can be deducted against income from the activity that generated the post-2017 NOL.

Public Support Test

IRC 501(c)(3) publicly supported organizations must meet a support test to be considered a public charity. IRC 512(a)(6) brought in to question how the support tests were calculated possibly making it more difficult for certain organizations to meet the public support test. The proposed regulations explain and amend IRC Sect 170 and 509, making it clear that unrelated trades or businesses can be aggregated when determining whether the organization is publicly supported.

Other Provisions

The proposed regulations also address unrelated business income as it relates to individual retirement accounts, subpart F income, and GILTI. It also clarifies investment activity indirect interests, look through provisions, transition rules, and related party aggregation. See the proposed regulations published in IR 2020-78 for more information.

These new proposed regulations have provided much-needed guidance for exempt organizations with multiple unrelated trades or businesses. They also provide some relief as compared to IRS Notice 2018-67 originally issued in 2018 as preliminary guidance. If you have questions about your organization’s specific situation, please reach out to our experts to further discuss.

This material has been prepared for general, informational purposes only and is not intended to provide, and should not be relied on for, tax, legal, or accounting advice. Should you require any such advice, please contact us directly. The information contained herein does not create, and your review or use of the information does not constitute, an accountant-client relationship.