IRS Issues Proposed Regulations for Unrelated Business Income Tax Calculation

The Treasury Department has issued proposed regulations that provide guidance to tax-exempt organizations on how to classify separate unrelated trades or businesses for reporting on Form 990-T. The proposed regulations allow exempt organizations—in certain cases—to treat investment activities as one unrelated trade or business.

Background

Enacted in December 2017 as part of the Tax Cuts and Jobs Act, Internal Revenue Code (IRC) Section 512(a)(6) required that unrelated business taxable income (UBTI) be computed separately by exempt organizations having more than one unrelated business activity. Before then, exempt organizations could aggregate unrelated trades or businesses on Form 990-T, allowing losses from one activity to offset income from another activity. Beginning in 2018, exempt organizations had to report unrelated businesses separately on Form 990-T, Schedule M; however, the new law did not specify how to identify a separate unrelated trade or business when calculating UBTI.

In August 2018, the Treasury Department and IRS issued Notice 2018-67 (the Notice) to provide initial guidance on the new law. In the Notice, the Treasury Department and the IRS said that one reasonable method to classify separate unrelated trades or businesses was to use the six-digit business codes of the North American Industry Classification System (NAICS). NAICS is an industry classification system used to collect, analyze, and publish data related to the US business economy.

Identifying Separate Unrelated Trades or Businesses

Under the proposed regulations, which were issued April 23, 2020, exempt organizations will identify their separate unrelated trades or businesses using the first two digits of the NAICS codes.

The first two digits of the NAICS codes represent a general category of economic activity, such as real estate rental and leasing (53); health care and social assistance (62); and accommodation and food services (72). The two-digit codes, which can be found on the NAICS website, cover 20 business sectors—compared to more than 1,000 categories when using the six-digit NAICS codes.

The two-digit code chosen, according to the proposed regulations, must identify the unrelated trade or business, not the organization’s exempt activities. For example, a college or university can’t use the 61 code for educational services to identify its unrelated trades of businesses.

An organization reports each two-digit code only once. The proposed regulations cite, as an example, a hospital system that operates facilities in several locations, all of which have pharmacies that sell goods to the general public. All the pharmacies would be reported on the code for retail trade (44-45), even though the pharmacies operate separately and the hospital system likely keeps separate books for each pharmacy.

Once an unrelated business has been identified with a two-digit code, the code cannot be changed unless the organization can show that the original code was selected because of an unintentional error or that another code more accurately describes the business. This limitation applies to codes reported on the first Form 990-T filed after the final regulations are published in the Federal Register.

The proposed regulations do not provide for any de minimis exception to implementing Section 512(a)(6).

Expense Allocations

With Section 512(a)(6), an organization with more than one unrelated business activity must allocate indirect expenses not only between the exempt and taxable activities but now also among the separate taxable activities. The Treasury Department didn’t fully address the issue of expense allocation in the proposed regulations and plans to issue separate regulations on allocation. In the meantime, the proposed regulations incorporate the existing allocation standard, which says that an organization must allocate deductions on a reasonable basis between separate unrelated business activities.

In addition, though, the proposed regulations declare that the unadjusted gross-to-gross method is not a reasonable way to allocate expenses. The gross-to-gross method uses a ratio of gross income from an unrelated business activity over the total gross income from all unrelated and related activities to allocate indirect expenses.

According to the proposed regulations, the charitable contribution deduction taken on Form 990-T will be applied after total UBTI is calculated. Organizations won’t have to allocate a charitable contribution deduction to each separate unrelated trade or business.

Treatment of Investment Activity

After the enactment of Section 512(a)(6) and the issuance of Notice 2018-67, many people questioned how an exempt organization’s investment activities, particularly investments in partnerships, would be reported. Would each partnership be a separate activity? How would NAICS codes apply to investments?

Under the proposed regulations, an organization’s investment activities would be treated collectively as one unrelated trade or business. Investment activities are limited to:

  • Qualifying partnership interests (QPI)
  • Qualifying S corporation interests
  • Debt-financed properties (within the meaning of IRC Section 514)

Investment activities would not include specified payments from controlled entities and amounts derived from controlled foreign corporations included in UBTI under Section 512(b)(17).

Qualifying Partnership Interests

A QPI occurs when an exempt organization holds a direct interest in a partnership that meets either the de minimis test or the control test outlined in the proposed regulations. Under the de minimis test, an organization can hold no more than 2% of the profits interest or 2% of the capital interest in a partnership. Departing from guidance provided in the Notice, ownership by disqualified persons, controlled entities, and supporting organizations doesn’t need to be evaluated for the de minimis test.

Under the control test, a partnership is a QPI if the organization—along with ownership by all supporting organizations and controlled organizations—holds no more than 20% of the capital interest and doesn’t control the partnership. According to the proposed regulations, all facts and circumstances are considered in determining if an organization controls a partnership. The proposed regulations outline several instances in which an organization controls a partnership. Control occurs when:

  • The organization by itself can require or prevent the partnership from performing any act significantly affecting the partnership’s operations;
  • Any of the organization’s officers, directors, trustees, or employees have the right to participate in management of the partnership; or have the right to conduct partnership business; or,
  • The organization by itself has the power to appoint or remove any of the partnership’s officers or employees, or a majority of directors.

Once a partnership interest is designated as a QPI and grouped with other investment activities, it remains a QPI until it no longer meets the requirements of being a QPI. An organization can’t deem a partnership a QPI one year and then the following year use the two-digit NAICS code to describe the partnership’s unrelated trades or businesses.

An organization may rely on the Schedule K-1 it receives from the partnership to determine its percentage interest, if the K-1 lists the organization’s profits interest, capital interest, or both, for the beginning and end of the year. If that information isn’t provided, the organization can’t rely on the K-1. An organization calculates its percentage interest by averaging the beginning of the year and the end of the year interests. If a partnership interest is held for less than a year, then the average of the beginning and end of the period of ownership is used.

Indirectly Held Partnership Interests

A tax-exempt organization could hold more than a 20% capital interest in a partnership and still not control the partnership, under the meaning of control in the proposed regulations. That directly owned partnership may hold interests in other partnerships, and if so, the tax-exempt organization may be able to group these indirect partnerships as QPI if the indirectly held partnerships meet the de minimis test. In using the example in the proposed regulations, an organization holds a 50% capital interest in a partnership it doesn’t control. That partnership holds a 4% capital and profits interest in partnership A and a 10% capital and profits interest in partnership B. Partnership A would be a QPI because the organization indirectly holds 2% of the capital and profits interest of Partnership A (4% x 50%). However, Partnership B would not be a QPI because the organization indirectly holds 5% of the capital and profits interest (10% x 50%).

Qualifying S Corporation Interests

An organization may be able to aggregate its holdings in an S corporation with its UBTI from other investment activities if its ownership interest meets the same de minimis test or control test as for a QPI. Otherwise, the holding is treated as a separate unrelated activity, but the organization is not required to look through the S Corporation to determine if there is more than one unrelated trade or business. Again, an organization may rely on the K-1 it receives from the S corporation if the form shows the organization’s percentage of stock ownership.

Transition Rule

If an organization acquired an interest in a partnership before August 21, 2018, that is not a QPI, the organization may treat the partnership as a separate unrelated trade or business, regardless of how many unrelated businesses the partnership directly or indirectly conducts. This transition rule remains in effect until the first day of the first taxable year after the publication of the final regulations in the Federal Register.

Debt-Financed Properties

All UBTI from an organization’s debt-financed properties is to be treated as a separate unrelated trade or business along with other investment activities, according to the proposed regulations.

Net Operating Losses (NOLs)

For tax years beginning after Dec. 31, 2017, Section 512(a)(6) requires organizations to determine any NOLs separately for each unrelated trade or business. These are called post-2017 NOLs in the proposed regulations. NOLs generated before 2018, referred to as pre-2018 NOLs, however, can be taken going forward against total UBTI.

The law didn’t specifically address which NOLs to use first when an organization has both pre-2018 NOLs and post-2017 NOLs, particularly when pre-2018 NOLs have a carry-forward limitation and post-2017 NOLs don’t. According to the proposed regulations, pre-2018 NOLs are deducted first from total UBTI before deducting any post-2017 NOLs against as a separate trade or business. Pre-2018 NOLs will be taken against total UBTI in a manner that results in maximum use of the pre-2018 NOLs.

To further complicate matters, the Tax Cuts and Jobs Act changed the NOL deduction limitation to 80% of taxable income for post-2017 NOLs and prohibited any carry-back of newly generated NOLs. With the passage of the Coronavirus Aid, Relief, and Economic Security Act (CARES Act) in March 2020, the 80% income limitation was repealed and the carryback of NOLs was permitted for taxable years beginning after December 31, 2017, and before January 1, 2021. The Treasury Department and IRS said it would further consider how these changes in the CARES Act affect the calculation of UBTI under Section 512(a)(6) and may issue further guidance.

Additional Provisions

Effect on Public Support Tests

The siloing of activities under Section 512(a)(6) has the potential to negatively affect the public support tests of public charities, since losses from one activity cannot be used to offset income in another activity. To avoid this, the proposed regulations allow organizations with more than one unrelated business activity to aggregate their net income and net loss from those activities for the public support test purposes only.

Subpart F Income and Global Intangible Low-Taxed Income

The proposed regulations state that an inclusion of subpart F income under Section 951(a)(1)(A) or an inclusion of global intangible low-taxed income (GILTI) under Section 951(a) should be treated as dividends for the purposes of Section 512(b)(1). Under Section 512(b)(1), dividends are excluded as UBTI.

Social Clubs

The proposed regulations clarified that social clubs described under Section 501(c)(7) will not be able to use the NAICS two-digit code for arts, entertainment, and recreation (71) to identify all its unrelated trades or businesses. While this code made be appropriate for rounds of golf played by nonmembers and greens fees, other NAICS codes are more appropriate to describe other non-member income such as merchandise sales (45) or food and beverage services (72).

IRAs Described in Section 408(e)

The proposed regulations added a new paragraph clarifying that the section 513(b) definition of unrelated trade or business applies to IRAs.

What’s Next

The Treasury Department and IRS are accepting written or electronic comments on the proposed regulations, and requests for a public hearing. Comments must be submitted by June 23, 2020. Electronic submissions can be made through the Federal eRulemaking Portal at (refer to IRS and REG-106864-18). Written comments may be sent to:

CC:PA:LPD:PR (REG-106864-18), Room 5203
Internal Revenue Service, P.O. Box 7604
Ben Franklin Station
Washington, D.C., 20044

The regulations wouldn’t go into effect until they are published in the Federal Register as final regulations. Until then, exempt organizations may rely on the proposed regulations. In addition, exempt organizations may also rely on a reasonable, good-faith interpretation of the law when identifying separate unrelated trades or businesses, or may rely on the methods provided in Notice 2018-67.

We’re Here To Help

For questions on the proposed regulations and how they might impact you or your organization, please contact your Moss Adams professional.